It Was the Worst of Times, Except . . .

It happens in most closely-held businesses: so long as the business is profitable and cash keeps flowing into the hands of the owners, everyone is happy. When the spigot slows, or is just plain turned off, however, the investor-owners (as distinguished from the management-owners) will have questions that they want answered, and quickly. When responses are not forthcoming, or are viewed as evasive, a lawsuit may not be far behind. iStock_000000181896XSmall11

In any litigation, there are few real winners. A lawsuit arises in the first place because someone was wronged, or believes to have been wronged, and there has certainly been an economic loss. Enter the attorneys, the accountants, perhaps, the “experts,” and rapidly-mounting costs.  Years may pass, and who knows what becomes of the business in the interim.

Sounds awful, right? But what if someone told you that, under the right circumstances, the costs may be cut by at least forty percent? You may say, “Tauric defecation.” (Any readers from Bronx Science out there?) “No,” I would reply, “it’s called tax savings.”

The Facts of a Recent PLR

Taxpayer was a shareholder in several closely-held corporations that owned and operated Business for many years. Taxpayer personally or jointly managed the finances of all the closely-held corporations that operated Business.

Taxpayer, E and F formed a closely-held corporation (“Corp.”), an S corporation, to operate Business in a new location. The shareholders agreed that Taxpayer was to manage Corp. and receive a management fee. The distribution of the remaining net profits was allocated among the shareholders based on their ownership percentages. For several years, E consistently received monthly distribution checks from Taxpayer. However, at some point the checks became less regular. After not receiving checks for several months, E made several inquiries of Taxpayer. There were several meetings and many letters and e-mails in which E asked Taxpayer for Corp.’s financial records. E eventually received some of the records, but they did not explain why Corp. was losing money. E filed a lawsuit against Taxpayer asserting causes of action that included fraud, breach of fiduciary duty, and breach of contract.

The jury found Taxpayer liable for breach of fiduciary duty and fraud. It also awarded E punitive damages. The court awarded costs to E. The final judgment against Taxpayer consisted of compensatory and punitive damages, prejudgment interest, costs, and post-judgment interest.

Taxpayer paid E the amounts ordered by the judgment of the trial court. In addition, Taxpayer paid legal fees to his accounting consultants and expert at trial, as well as to the attorneys he retained to defend him in the lawsuit at the trial court.

The Law

Section 162 of the Code provides a deduction for all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business. The regulations promulgated under Sec. 162 provide that deductible expenses include the ordinary and necessary expenditures directly connected with or pertaining to the taxpayer’s trade or business. The regulations under Section 263 of the Code provide that a taxpayer must capitalize an amount paid to another party to acquire any intangible from that party in a purchase or similar transaction. To qualify as a deduction  allowable under Sec. 162, an expenditure must satisfy a five part test: it must

(1) be paid or incurred during the taxable year,

(2) be for carrying on a trade or business,

(3) be an expense,

(4) be necessary, and

(5) be ordinary.

Thus, personal expenditures incurred outside of a taxpayer’s trade or business are not deductible under Sec. 162. In addition, capital expenditures under Sec. 263 are not deductible.

Once In A Lifetime

Even though a particular taxpayer may incur an expense only once in the lifetime of its business, the expense may qualify as ordinary and necessary if it is appropriate and helpful in carrying on that business, is commonly and frequently incurred in the type of business conducted by the taxpayer, and is not a capital expenditure. “Ordinary” in this context does not mean that the payments must be habitual or normal in the sense that the same taxpayer will have to make them often. A lawsuit affecting the “safety” of a business may happen only once in a lifetime. Nonetheless, the expense is an ordinary one because we know from experience that payments for such a purpose, whether the amount is large or small, are the common and accepted means of defense against attack. The term “necessary,” under Sec. 162, imposes the requirement that the expense be appropriate and helpful for the taxpayer’s business. However, if litigation arises from a capital transaction (e.g., the sale of property) then the costs and legal fees associated with the litigation are characterized as acquisition costs and must be capitalized under Sec. 263.

The Origin of the Claim

A payment will be deductible under Sec. 162 as a trade or business expense only if it is not a personal expenditure or a capital expenditure. The controlling test to distinguish business expenses from personal or capital expenditures is the “origin of the claim.” Under this test, the origin and character of the claim with respect to which an expense was incurred – rather than its potential consequences upon the fortunes of the taxpayer – is the controlling test of whether the expense was “business” or “personal” and, hence, whether it is deductible or not. Similarly, the origin and character of the claim with respect to which a settlement is made, rather than its potential consequences on the business operation of the taxpayer, is the controlling test of whether a settlement payment constitutes a deductible expense or  a nondeductible capital outlay. It should be noted that the “origin-of-the-claim” test does not contemplate a mechanical search for the first in the chain of events that led to the litigation but, rather, requires an examination of all the facts. The inquiry is directed to ascertaining the “kind of transaction” out of which the litigation arose. One must consider the issues involved, the nature and objectives of the litigation, the defenses asserted, the purpose for which the claimed deductions were expended, and all the facts pertaining to the controversy. Generally, amounts paid in settlement of lawsuits are currently deductible if the acts that gave rise to the litigation were performed in the ordinary conduct of a taxpayer’s business.

Similarly, amounts paid for legal expenses in connection with litigation are allowed as business expenses where such litigation is directly connected to, or proximately results from, the conduct of a taxpayer’s business.

The IRS Rules

The IRS determined that Taxpayer’s payments to satisfy the judgment awarded against him were ordinary and necessary expenditures. Under the origin of the claim test, E’s claims against Taxpayer had their origin in the conduct of Taxpayer’s trade or business – the management of Corp. Taxpayer’s activities that gave rise to the lawsuit did not result in the acquisition of a capital asset, did not perfect or defend title to an existing asset, and did not create a separate and distinct asset. Taxpayer did not receive a long-term benefit from the payments. An examination of all the facts indicated that the litigation payments were business expenses, and not personal or capital expenditures. Thus, the IRS concluded that the expenditures that Taxpayer paid, that resulted from the lawsuit by E against Taxpayer as the managing shareholder of Corp., were deductible under Sec. 162, provided that Taxpayer was not reimbursed for any of the payments by insurance or similar compensation.

Be Aware

In some cases, the deductibility of litigation-related expenses may not be relevant, as where the taxpayer’s costs are reimbursed by insurance.

In many other cases, however, the taxpayer and his or her attorneys ought to be aware of the opportunity for tax savings.

Although there is little that can be done about the facts when litigation has begun, a taxpayer should determine the kind of transaction out of which the litigation arose. He or she must consider the background of the litigation, its nature and its objectives. In turn, the defenses asserted may be framed in order to support the treatment of the litigation and settlement expenditures, as ordinary and necessary expenditures incurred in the conduct of the taxpayer‘s trade or business.

The goal in defending any litigation is damage-control, which includes the reduction of the economic cost of conducting and settling the litigation. The ability to reduce such cost through tax deductions can go a long way in making the economics of a deal easier to swallow.

It sounds pretty impressive, doesn’t it? What’s more impressive is that, this time, Congress did not wait until the very end of the year – or the beginning of the next year for that matter – to pass some important and long-awaited legislation. (the “Act”).

Most businesses and their advisers would have preferred to know months ago that many of the provisions summarized below were certain to be extended with retroactive effect. In that case, they would have had some time to do some tax planning.  But, as they say, “it’s better late than never,” “there’s always next year,” and “don’t look a gift horse in the mouth.” You get the drift.

What follows are some highlights of the Act that may be of interest to the closely-held business.

Permanent Extensions

Basis adjustment to S corporation stock.

The Act permanently extended the rule providing that a shareholder’s basis in the stock of an S corporation is reduced by the shareholder’s pro rata share of the adjusted basis of property contributed by the S corporation for charitable purposes.

Research credit.

The research and development (R&D) tax credit was permanently extended. Additionally, beginning in 2016, eligible small businesses ($50 million or less in gross receipts) may claim the credit against alternative minimum tax (AMT) liability, and the credit can be utilized by certain small businesses against the employer’s payroll tax (i.e., FICA) liability.

15-year straight-line cost recovery for qualified improvements.

The Act permanently extended the 15-year recovery period for qualified leasehold improvements, qualified restaurant property, and qualified retail improvement property.

Section 179 property.

The small business expensing limitation and phase-out amounts in effect from 2010 to 2014 ($500,000 and $2 million, respectively) were extended permanently.

The special rules that allow expensing for computer software and qualified real property (qualified leasehold improvement property, qualified restaurant property, and qualified retail improvement property) also were permanently extended.

The expensing limitation was modified by indexing both the $500,000 and $2 million limits for inflation beginning in 2016.

Exclusion of 100% of gain on certain small business stock.

The Act extended permanently the exclusion for 100% of the gain on certain small business stock for non-corporate taxpayers to stock acquired and held for more than five years. It also permanently extended the rule that eliminates such gain as an AMT preference item.

Extension of reduction in S-corp. recognition period for built-in gains tax.

The Act permanently extended the rule reducing to five years (rather than ten years) the period for which an S corporation must hold its assets following conversion from a C corporation to avoid the corporate-level tax on built-in gains.

Extensions through 2019

New markets tax credit.

The Act authorized the allocation of $3.5 billion of new markets tax credits for each year from 2015 through 2019.

 Bonus depreciation.

The Act extended bonus depreciation for property acquired and placed in service during 2015 through 2019 (with an additional year for certain property with a longer production period).

The bonus depreciation percentage is 50 percent for property placed in service during 2015, 2016 and 2017 and phases down, with 40 percent in 2018, and 30 percent in 2019.

The Act allows taxpayers to elect to accelerate the use of AMT credits in lieu of bonus depreciation under special rules for property placed in service during 2015. The provision modified the AMT rules beginning in 2016 by increasing the amount of unused AMT credits that may be claimed in lieu of bonus depreciation.

Extensions through 2016

Empowerment zone tax incentives.

The Act extended through 2016 the tax benefits for certain businesses and employers operating in empowerment zones.

Empowerment zones are economically distressed areas, and the tax benefits available include tax-exempt bonds, employment credits, increased expensing, and gain exclusion from the sale of certain small-business stock.

The Act modified the incentive beginning in 2016 by allowing employees to meet the enterprise zone facility bond employment requirement if they are residents of the empowerment zone, an enterprise community, or a qualified low-income community within an applicable nominating jurisdiction.

Additional Provisions

 Return filing dates: employee wages and nonemployee compensation.

The Act requires forms W-2, W-3, and returns or statements to report non-employee compensation (e.g., Form 1099-MISC), to be filed on or before January 31 of the year following the calendar year to which such returns relate.

The provision is effective for returns and statements relating to calendar years after the date of enactment (December 18, 2015).

Increase withholding on dispositions of United States real property interests

The Act increased the rate of withholding on dispositions by foreigners of United States real property interests from 10% to 15%.

The provision is effective for dispositions occurring 60 days after the date of enactment.

Alternative tax for certain small insurance companies

The Act increased the maximum amount of annual premiums that certain small property and casualty insurance companies (including “captives”) can receive and still elect to be exempt from tax on their underwriting income, and instead be taxed only on taxable investment income.

The Act increased the maximum amount from $1.2 million to $2.2 million for calendar years beginning after 2015, and indexed it to inflation thereafter. To ensure that this special rule is not abused, the Act also requires that no more than 20 percent of net written premiums (or if greater, direct written premiums) for a tax year is attributable to any one policyholder.

Alternatively, a company would be eligible for the exception if each owner of the insured business or assets has no greater an interest in the insurer than he or she has in the business or assets, and each owner holds no smaller an interest in the business than his or her interest in the insurer.

The provision is effective for tax years beginning after 2016.

Transfer of certain losses from tax indifferent parties

The Act modified the related-party loss rules, which generally disallow a deduction for a loss on the sale or exchange of property to certain related parties or controlled partnerships, to prevent losses from being shifted from a tax-indifferent party (e.g., a foreign person not subject to U.S. tax) to another party in whose hands any gain or loss with respect to the property would be subject to U.S. tax.

The provision generally is effective for sales and exchanges of property acquired after 2015.

What’s Next?

Are you kidding? We’re heading into an election year. Perhaps that’s why the so-called “extenders” described above were finally passed.

Estate tax repeal? Discouraging corporate tax havens? Overhauling the Code? All bets are off until 2017.

Happy New Year. Until then, we hope that you will continue to follow our weekly postings.

There is nothing like an old proverb to remind you of the obvious. Unfortunately, too many taxpayers need to be reminded all too often. It’s one thing when the reminder comes from the taxpayer’s own advisers – at that point, the taxpayer may still have an opportunity to “correct” his or her actions. It is a very different thing, however, when the reminder comes from the IRS or from a court.

Imagine being the taxpayer to whom the Tax Court directed the following statement:

There is no doubt [a taxpayer] is entitled to benefit from his hard work. However, there is also no doubt that it was [the taxpayer’s] choice to structure the payments in a certain manner. He now must face the tax consequences of his choice, whether contemplated or not.

Corp. was a closely-held C corporation, the issued and outstanding shares of which were owned 85% by Dad (together with Corp., the “Taxpayers”) and 5% each by Mom (together with Dad, the “Shareholders”) and their two daughters, all of whom sat on Corp.’s board of directors and served as corporate officers.

Dad was employed full time as the president and CEO of Corp. In that capacity he had final decision-making and supervisory power over all business matters, including compensation and tax return preparation and approval. As it often happens in small-to-medium size businesses, Dad had to be a jack of all trades and ended up performing the work of three to four individuals.

“It Was A Very Good Year”

Corp. never declared a dividend. The Taxpayers explained that, historically, they kept any excess cash in the business in order to fund its expansion, instead of paying it out as compensation or dividends.

During the tax years at issue, Corp’s business was more profitable than usual. As a result, Dad received not only his base salary, but Corp. also paid him a significant bonus. In fact, his total reported compensation for those years was more than three times his reported salary in prior years. These were also the first years that Corp. had paid bonuses.

 Also during these tax years, Corp. paid for materials and labor in connection with the construction of several structures on land owned by the Shareholders, including a new personal residence for the Shareholders and a barn (the “Barn”). amex corp

The Barn housed Dad’s office, which he used for both business and personal purposes. In addition, the Shareholders used a part of the building to store their personal vehicles and some Corp. vehicles. There was no lease or other written agreement for the use of the Barn between the Shareholders and Corp.

In addition, during the same tax years, Corp. paid and reported on its books as cost of goods sold personal credit card charges on the Shareholders’ behalf. Corp. never recorded these amounts as compensation for Dad and Mom on its books.

Finally, Corp. paid for the purchase of a sports car (“Car”) to which Dad took title in his individual capacity, explaining that this was because Corp.’s business insurance would not permit it to insure the Car. Corp. claimed depreciation deductions for the Car. The Taxpayers, however, did not produce any records or other evidence associated with the alleged business use of the Car. Corp. did not report the amount paid for the car as compensation to Dad.

IRS vs. Taxpayer

According to the IRS, the construction costs of the Shareholders’ house and the Barn, the personal credit card bills, and the purchase of the Car were personal expenses paid by Corp. The IRS argued that these amounts should be treated as a constructive dividend to the Shareholders and, thus, nondeductible to Corp. The IRS also argued that Corp. could not deduct depreciation for the car because it was Dad’s personal property.

The Taxpayers disagreed and petitioned the Tax Court for relief.

The Taxpayers admitted that they “mistakenly” reported the house construction expenses as cost of goods sold, and they conceded that the Corp.’s credit card payments were for personal expenses of the Shareholders.

They argued, however, that the Barn and the Car were capital assets owned by Corp. The Taxpayers contended that the Barn was a storage facility that belonged to Corp., and that any expenses related to that facility should be treated as business-related. They claimed that they used the facility to store Corp.’s vehicles.

However, the IRS pointed out that the Shareholders also used it to store their personal vehicles. Dad had one of his offices in the Barn, and he admitted to using it for both business and personal purposes. The title to the land on which the Barn was constructed belonged to the Shareholders, and the Taxpayers did not introduce any documents containing an agreement between the Shareholders and Corp. as to the use of the land or the ownership of any structures on that land. The only testimony Taxpayers introduced on the subject of the Barn’s ownership was Dad’s, and he did not shed any light on the title to the property or other arrangements with Corp. that would allow the Court to conclude that the Barn was used for legitimate business purposes. Thus, the Taxpayers failed to meet their burden of proof, and the Court concluded that the expenses paid by Corp. to construct the Barn were personal expenses of the Shareholders.

Next, the Taxpayers argued that the Car was an asset that belonged to Corp. and that was used for business purposes, namely, as a means of transportation for Dad between various Corp.   worksites. The IRS argued that because the title to the vehicle was in Dad’s name alone and Taxpayers did not introduce any evidence of the business use of the vehicle such as travel logs detailing date, mileage, and business purpose for the use of the Car, it must be a personal expense of the Shareholders. As a result, the Taxpayers failed to meet the burden of proof to show that Corp. purchased the Car for business purposes.

The Court’s Analysis

Gross income includes all income from whatever source derived unless otherwise specifically excluded. The definition of gross income broadly includes any instance of undeniable accession to wealth, clearly realized, and over which the taxpayer has complete dominion and control.

The IRS argued that the income the Shareholders received in the form of a “distribution” of corporate property was a constructive dividend. The Taxpayers, in turn, argued that the payments should be treated as compensation to Dad for the prior years of service when he was underpaid. Under both theories, the Shareholders would have been required to include the amounts received as ordinary income for the tax years at issue.

It should be noted, however, that if the Taxpayers prevailed, Corp. may have been able to deduct the amounts paid as an ordinary and necessary business expense, provided the amounts represented reasonable compensation. The Shareholders, however, could potentially have benefited from the lower tax rate on qualified dividend income.  Moreover, dividend treatment would have avoided the imposition of employment taxes.

Compensation?

The Code allows a taxpayer to deduct payments for reasonable compensation for services when incurred as ordinary or necessary business expenses during the taxable year.  Whether amounts are paid as compensation turns on the factual determination of whether the payor intends at the time that the payment is made to compensate the recipient for the services performed. Only if payment is made with the intent to compensate is it deductible as compensation. The relevant time for determining the intent is when the purported compensation payment is made, not when the IRS later challenges the payment’s characterization. The taxpayer bears the burden of proof as to intent to compensate.

According to the Court, the record did not support the Taxpayer’s assertion that Corp. intended the payments for the construction of the house, the Barn, credit card bills, and the Car to be compensation. The only evidence the Taxpayers introduced to prove compensatory intent was Dad’s “self-serving testimony,” as Corp.’s CEO and majority shareholder, that he always intended the payments as compensation for his services in prior years. The Taxpayers did not introduce into evidence any board resolutions that addressed the payment of compensation to Dad. Absent such evidence, the Court could not conclude that Corp. “intended an action not reflected in its corporate documents.”

The Court stated that it did not question Dad’s business decision to keep the money in the business instead of paying himself a higher salary. Because of his efforts, Corp’s business grew substantially—as did his compensation. However, on the record, the Court was convinced that the payments in question were not intended as compensation for services at the time they were made. Dad tacitly approved running the personal expenses at issue through the corporate accounts and recording them as cost of goods sold. Corp. did not report these expenses as compensation either on its books or on its tax return for the years at issue. Nor did Corp.  pay payroll taxes on these amounts. The Shareholders did not report these amounts on their tax return at all, and did not inform their tax preparer that they considered these payments compensation.

It seemed clear, the Court stated, that the Taxpayers played “tax audit roulette” by trying to hide the expense payments and pay as little tax as possible.

Under the circumstances, the Court concluded that Corp. did not intend to compensate Dad for his services at the time it paid the expenses in question. Thus, these amounts were not compensation for prior services that could be deducted by Corp. In addition, Corp. was not entitled to a depreciation deduction for the car because it was Dad’s personal property and the Taxpayers did not introduce any evidence of the business use of the car.

Dividend?

The Court then considered whether the payment by Corp. of the Shareholders’ personal expenses was a constructive dividend. If a distributing corporation has sufficient earnings and profits, the Court stated, the distribution is a dividend, and a shareholder must include it in gross income. [IRC Sec. 301 and 316]. A constructive dividend is a payment or economic benefit conferred by a corporation on one of its shareholders. A constructive dividend may arise through a diversion or conversion of corporate earnings and profits, or through corporate payments to third parties at the direction of shareholders. Whether corporate expenditures constitute a constructive dividend is a question of fact. The amount of the constructive dividend is equal to the fair market value of the benefits received.

In the years at issue, Corp. had sufficient earnings and profits to declare a dividend to its shareholders. Because Dad, as Corp.’s CEO and majority shareholder, had the ultimate control over Corp.’s dealings, he was able to divert corporate funds to pay his personal expenses. Moreover, he approved the payment of those expenses out of the corporate funds. These facts fit squarely into the definition of a constructive dividend.

When Will They Ever Learn?

Every tax adviser has encountered a situation like the one described above. That is because almost every business owner, to some degree, diverts business profits to the payment of a personal, non-business expense. Businesses sometimes pay for personal credit card expenses, residential property taxes, club dues, personal cars, trips, etc. They provide no-show, paying jobs for family members. They over- or under-pay related businesses for services or property.

It is also a fact that many business owners believe that their gambits will never be discovered, especially during a period that has seen Congress basically eviscerate the IRS’s enforcement budget.

Yet, as many tax advisers see every day, taxpayers do get “caught,” whether as a result of traditional IRS audit activity, the analysis of information collected through data mining using new technologies, increased state tax enforcement activity, whistleblowers, or other means.

The guiding principle, as always, should be the following: how would you conduct business with an unrelated third party? Would you charge a reasonable fee and expect to be paid only a reasonable fee? What would you do to determine the reasonableness of a payment? Would you insist that the arrangement between you be properly authorized and memorialized?

Within these parameters, there are many legitimate business and personal goals that a business owner can accomplish without necessarily weakening his or her position vis-à-vis the IRS. One need only ask how.

 

A Plethora of Partnerships

According to a recently released IRS analysis of tax return data, the number of partnerships and partners in the U.S. continues to increase, as do the total receipts and the value of total assets for all partnerships. LLCs classified as partnerships account for the majority of this growth.   

These figures are a manifestation of the fact that the partnership represents the most flexible form of business entity: there are no restrictions on who may be a partner; the only limitation on the economic arrangement among the partners is that it have substantial economic effect; and partnerships do not pay federal income taxes on their income, but “pass through” any profits and losses to their partners, who must include those profits and losses on their own income tax returns.

 As partnerships have grown in number, size, and complexity, the IRS has found it increasingly difficult to audit them and to collect any resulting income tax deficiencies, especially in the cases of large partnerships and tiered partnerships.

In response to these difficulties, Congress recently enacted the Bipartisan Budget Act of 2015 (“BBA”), adding a number of new tax compliance provisions to the Code. A key feature of the BBA is that it imposes liability for any audit adjustments with respect to an earlier partnership tax year on the partnership, rather than on those persons who were partners during the audited tax year.

Partnership Audits

Prior to the BBA, three different regimes existed for auditing partnerships. For partnerships with ten or fewer partners, the IRS generally applied the audit procedures for individual taxpayers, auditing the partnership and each partner separately. For most large partnerships with more than ten partners, the IRS conducted a single administrative proceeding (under the so-called “TEFRA” rules, which were adopted in 1982) to resolve audit issues regarding partnership items that were more appropriately determined at the partnership level than at the  partner level.  Under the TEFRA rules, once  the audit was completed and the resulting adjustments were determined,  the IRS recalculated the tax  liability of each  partner in the  partnership for the  particular audit year. In the case of  partnerships  with 100 or more partners that  elected to be treated as Electing Large Partnerships (ELPs) for  reporting and audit  purposes, partnership adjustments generally flowed through to the partners for the  year in which the adjustment took effect, rather than the year  under audit.

The BBA’s Changes

Under  the BBA, the TEFRA and ELP rules are repealed,  and the  partnership audit rules are streamlined into a  single set  of rules  for auditing partnerships  and their partners  at the  partnership level.

Under  the streamlined  audit approach, the IRS  will examine the partnership’s  items of  income, gain, loss,  deduction, credit,  and the partners’ distributive  shares, for  a particular  year of  the partnership  (the “reviewed  year”). Any adjustments (including interest and penalties) will  be taken  into account by, and will be collected from,  the partnership – not the reviewed year partners – in the year that the audit or any judicial review  is completed (the  “adjustment year”), and the tax resulting from such adjustments will be computed at the highest marginal rate for individuals or corporations without regard to the character of the income or gain.

A “Taxable Partnership”

This marks an important change in the audit of closely-held partnerships. The IRS will collect the tax from the partnership, even if the persons who were partners in the reviewed year are no longer partners in the adjustment year. Stated differently, the current-year partners will bear the economic burden even though the adjustments relate to a prior year in which the composition of the partnership may have been different.

Partnerships will have  the option, however,  of demonstrating  that the adjustment  would be  lower if  it were based  on certain  partner-level information  from the  reviewed year  rather than  imputed amounts  determined solely on the  partnership’s information in  such  year. This information could  include amended  returns  of partners opting to file, the tax rates applicable to specific  types of partners (e.g., individuals, corporations),  and the  type of income  subject to the  adjustment (e.g., ordinary income,  dividends,  capital gains).

Important Exceptions

Under the BBA, a partnership with 100 or fewer partners is permitted to elect out of  the new rules, in which case the partnership and partners  will be audited  under the general  rules applicable  to individual  taxpayers.

In order to qualify for this “small partnership” election, each partner of the partnership must be an individual, a C corporation, an S corporation, or the estate of a deceased partner. Another partnership and a trust cannot be partners of an electing small partnership.

Among other things, it should be noted that the election is to be made on an annual basis, it must be made on a timely-filed partnership return, and the  partnership must notify the partners of the election.

A partnership that does not qualify for the small partnership election, or which does not elect to be treated as such, will be permitted (in accordance with rules to be issued by the IRS), as  an alternative to  taking  the adjustments into account  at the  partnership level,  to  pass the adjustments along to its partners by issuing adjusted  Form K-1s  to the reviewed-year partners, in which case those partners (and not the partnership) will take the adjustments into  account on their individual returns  in  the adjustment year  through  a simplified amended-return  process.

A partnership must elect this alternative not later than 45 days after the date of the notice of partnership adjustment (a “6226  election”). Where the election is made, the reviewed-year partners will be subject to an increased interest charge as to any tax deficiency.

Looking Ahead

Because the BBA marks a significant change in the audit of partnerships, and because it applies to both existing and new partnerships, its effective date is delayed: the new rules will first become effective for returns filed for partnership tax years beginning after 2017.

Until then, the IRS should have sufficient time to promulgate any regulations to implement the changes. It should also afford partnerships the time to adjust to the new audit regime, and especially to the new default rule that applies to every partnership unless the partnerships elects out.

Most partnerships the qualify will likely make the annual election to be treated as a small partnership. However, many small partnerships will not qualify for this election because they include trusts or other partnerships as partners.

In any case, partners and partnerships will have to ensure that their partnership agreements address the new rules. This may include whether to elect out of the new regime or to elect to pass-through the adjustments to the review-year partners.

Partnerships may also want to include indemnity provisions in their agreements, pursuant to which current partners and former partners of a partnership will agree to indemnify the partnership or each other for their pro rata share of any deficiencies resulting from an IRS audit of the partnership. This may be especially important to transferees of partnership interests, including potential new investors, who are also likely to insist upon increased levels of due diligence before acquiring such an interest.

I don’t know about you, but the years seem to be going by faster and faster. Before you know it, these rules will go into effect. Don’t wait. Start your preparations now.

 

In General

In earlier posts, we described how a closely-held business may use a nonqualified deferred compensation (“NQDC”) plan to retain the services of, and to incentivize, a key executive employee. We also discussed the various requirements that such a plan must satisfy in order to successfully defer the inclusion in the employee’s income of the compensation provided under the plan and the imposition of the associated tax liability.

Because a substantial amount of compensation may be deferred under a NQDC plan, the IRS has an interest in ensuring that the plan is structured and operated in a way that complies with the applicable rules and, thereby, warrants such deferral.

Toward that end, the IRS recently updated its Nonqualified Deferred Compensation Audit Techniques Guide (the “Guide”).  The Guide offers some insight into how the IRS will apply these rules. Thus, any employer that has a NQDC plan in place should become familiar with the Guide and plan accordingly.

What is a NQDC Plan?

A NQDC plan is an elective or non-elective plan or agreement between an employer and an employee to pay the employee compensation in the future. Retirement-201x300

Under a NQDC plan, employers generally only deduct expenses when income is recognized by the employee.

NQDC plans typically fall into four categories:

  1. Salary Reduction Arrangements defer the receipt of otherwise currently includible compensation by allowing the participant to defer receipt of a portion of his or her salary.
  2. Bonus Deferral Plans resemble salary reduction arrangements, except they enable participants to defer receipt of bonuses.
  3. Supplemental Executive Retirement Plans, or SERPs, are plans maintained for a select group of management or highly compensated employees.
  4. Excess Benefit Plans are plans that provide benefits solely to employees whose benefits under the employer’s qualified plan are statutorily limited.

Within these general categories are particular kinds of NQDC plans, including those that are based upon the value of the employer’s stock, such as stock options, stock appreciation rights, and phantom stock.

Unfunded Plans

Most NQDC plans are unfunded because of the tax advantages they afford participants.

An unfunded arrangement is one where the employee has only the employer’s “mere promise to pay” the deferred compensation in the future, and the promise is not secured in any way. The employer may simply keep track of the benefit in a bookkeeping account, or it may voluntarily choose to transfer amounts to a “rabbi trust” that remains a part of the employer’s general assets, subject to the claims of the employer’s creditors if the employer becomes insolvent, in order to help keep its promise to the employee.

If amounts are segregated or set aside from the employer’s creditors for the exclusive benefit of the employee – they are identified as a source to which a participant can look for the payment of his or her benefits (a “funded” arrangement) – the employee may have currently includible compensation.

NQDC plans must be in writing. While many plans are set forth in extensive detail, some are referenced by nothing more than a few provisions contained in an employment contract. In either event, the form (in terms of plan language) of a NQDC arrangement is just as important as the way the plan is carried out.

Audit Potential

According to the Guide, a NQDC plan examination should focus on when the deferred amounts are includible in the employee’s gross income and when those amounts are deductible by the employer. Two principle issues stemming from deferred compensation arrangements include the doctrines of constructive receipt and economic benefit. The Guide also states that the examiner should address if deferred amounts were properly taken into account for employment tax purposes, given that the timing rules for income tax and for FICA/FUTA taxes are different.

When are deferred amounts includible?  

According to the Guide, employees must include compensation in gross income for the taxable year in which it is actually or constructively received. Under the constructive receipt doctrine, income, although not actually in the taxpayer’s possession, is constructively received by an employee in the taxable year during which it is credited to the employee’s account, set apart for the employee, or otherwise made available so that the employee may draw upon it at any time. However, income is not constructively received if the taxpayer’s control of its receipt is subject to substantial limitations or restrictions.

Establishing constructive receipt requires a determination that the recipient had control of the receipt of the deferred amounts and that such control was not subject to substantial limitations or restrictions. According to the Guide, it is important to scrutinize all plan provisions relating to each type of distribution or access option. It also is imperative, the Guide states, to consider how the plan has been operating regardless of the existence of provisions relating to the types of distributions or other access options.  The Guide identifies certain devices, such as credit cards, debit cards, and check books, that may be used to grant employees unrestricted control of the receipt of the deferred amounts. Similarly, permitting employees to borrow against their deferred amounts may achieve the same result.

Under the economic benefit doctrine, if an individual receives any economic or financial benefit as compensation for services, the value of the benefit is currently includible in the individual’s gross income if the employee has a non-forfeitable interest in the benefit.

If property is transferred to employee as compensation for services, the employee will be taxed at the time of receipt of the property if the property is either transferable or not subject to a substantial risk of forfeiture. If the property is not transferable and subject to a substantial risk of forfeiture, no income tax is incurred until the property is not subject to a substantial risk of forfeiture or the property becomes transferable.

Property is subject to a substantial risk of forfeiture if the individual’s right to the property is conditional on the future performance of substantial services, or if rights in the transferred property are conditioned upon the occurrence of a condition related to a purpose of the transfer.

In general, property is considered transferable if a person can transfer his or her interest in the property to anyone other than the transferor (usually the employer) from whom the property was received.

General Audit Steps

The Guide explains that issues involving constructive receipt and economic benefit generally will present themselves in the administration of the plan, in actual plan documents, employment agreements, deferral election forms, or other communications (written or oral, formal or informal) between the employer and the employee.

The Guide directs examiners to ask the following questions and to request documentary substantiation where appropriate:

  • Does the employer maintain any qualified retirement plans?
  • Does the employer have any plans, agreements, or arrangements for employees that supplement or replace lost or restricted qualified retirement benefits?
  • Does the employer maintain any NQDC arrangements, or any trusts, or separate accounts for any employees? If yes, the examiner should obtain complete copies of each plan including all attachments, amendments, restatements, etc.
  • Do employees have individual employment agreements?
  • Do employees have any salary or bonus deferral agreements?
  • Does the employer have an insurance policy or an annuity plan designed to provide retirement or severance benefits for executives?
  • Are there any board of directors’ minutes or compensation committee resolutions involving executive compensation?
  • Is there any other written communication between the employer and the employees that sets forth “benefits,” “perks,” “savings,” “severance plans,” or “retirement arrangements”?

When reviewing the answers and documents received in response to these questions, examiners are instructed to look for indications that –

A. the employee has control over the receipt of the deferred amounts without being subject to substantial limitations or restrictions. If the employee has such control, the amounts are taxable under the constructive receipt doctrine. For example, the employee may borrow, transfer, or use the amounts as collateral, or there may be some other signs of ownership exercisable by the employee, which should result in current taxation for the employee; or

B. amounts have been set aside for the exclusive benefit of the employee. Amounts are set aside if they are not available to the employer’s general creditors if the employer becomes bankrupt or insolvent. Examiners are also asked to confirm that no preferences have been provided to employees over the employer’s other creditors in the event of the employer’s bankruptcy or insolvency. If amounts have been set aside for the exclusive benefit of the employee, or if the employee receives preferences over the employer’s general creditors, the employee has received a taxable economic benefit. Examiners are told to verify whether the arrangements result in the employee receiving something that is the equivalent of cash.

Audit Techniques

In addition to providing the “general audit steps” described above, the Guide advises examiners to interview the employer-company personnel that are most knowledgeable on executive compensation practices, such as the director of human resources or a plan administrator.

Examiners, the Guide says, should determine who is responsible for the day-to-day administration of the plans within the company. For example, who processes the deferral election forms and maintains the account balances?

Examiners are also instructed to review the deferral election forms and to determine if changes were requested and approved. They are told to review the notes to the company’s financial statements, as well as any materials that are disclosed to shareholders if they are asked to vote on a compensation plan.

Examiners are asked to determine whether the company paid a benefits consulting firm for the executive’s wealth management and, if so, to review a copy of the contract between the consulting firm and the corporation. They must determine who is administering the plan, what documents were created by the administrator, and who is maintaining the documents.

In addition, examiners are directed to review the ledger accounts/account statements for each plan participant, noting current year deferrals, distributions, and loans. They are told to compare the distributions to amounts reported on the employee’s Form W-2 for deferred compensation distributions, and to determine the reason for each distribution. They are instructed to check account statements for any unexplained reduction in account balances, and to review any distributions other than those for death, disability, or termination of employment.

IRC § 409A

Finally, the Guide reminds examiners that, under Section 409A, all amounts deferred under a NQDC plan for all taxable years are currently includible in gross income (to the extent not subject to a substantial risk of forfeiture and not previously included in gross income), unless certain requirements are satisfied.

The Guide states that all plans must be in compliance with the final Section 409A regulations, both in form and operation.

Forewarned is Forearmed

It may sound trite, but it is preached every week in this blog.

If a closely held-business knows what the IRS is looking for when it examines a NQDC plan, then it knows what provisions to include in the plan, what pitfalls to avoid, and what documentation to prepare and maintain. In this way, it can proceed with confidence that the plan it has implemented will withstand IRS examination and will deliver the anticipated benefits to its key employee.

Oops

During the course of my career, I have sometimes gone months, if not years, without encountering a particular tax issue. I am aware of the issue and I am familiar with the relevant authorities, but it was not a concern for the clients whom I was then representing. Then, all of a sudden, the issue appears with a frequency that is simply uncanny. I am sure that many of you have had the same experience.

One such issue is the ownership by a nonresident alien (“NRA”) of shares of stock in an S corporation. Specifically, if such an individual owns shares of stock in a domestic corporation, the corporation is not eligible to elect to be treated as an S corporation for tax purposes. Rather, it will be treated as a C corporation, the taxable income of which is taxed at the corporate level and, then again, at the shareholder level when the after-corporate-tax income is distributed to such shareholders.

The prohibition, under the S corporation rules, against stock ownership by an NRA is so basic that you may ask, how can a corporation have knowingly issued shares to an NRA, or how can a shareholder have knowingly transferred his or her S corporation shares to such an individual?

The answer is, “pretty easily,” much to the regret of the other shareholders.

The context in which I recently confronted the issue was the proposed sale of assets by an S corporation, which proposed sale was preceded by the testamentary transfer of a deceased shareholder’s shares of S corporation stock to a trust for the benefit of individuals that included one or more NRAs.

Estates

The estate of a deceased shareholder who was a U.S. citizen or resident may own S corporation shares, even where an NRA is a beneficiary of the estate, but only for a reasonable period of administration. If the administration of the estate is unduly or unreasonably prolonged, the estate may, instead, be treated as a trust for income tax purposes. In that case, the rules described immediately below must be considered.

 Section 645 Electing Trust

In the case of a qualified revocable trust for which a timely election is made to treat the trust as part of the decedent’s estate for income tax purposes,  the trust may continue to own the deceased grantor’s S corporation shares for the duration of the so-called “section 645 election period” (generally, the date on which both the related estate and the trust have distributed all of their assets, though the trust’s qualification may end sooner ), even where an NRA is a beneficiary of the trust. At the end of such period, if the trust continues to hold the stock, it may be treated as a testamentary trust for a two-year period (see immediately below).

Testamentary Trusts

A domestic trust to which S corporation stock is transferred pursuant to the terms of a decedent’s will may hold the S corporation stock, but only for the 2-year period beginning on the day the stock is transferred to the trust, even where an NRA is a beneficiary of the trust. After the termination of the two-year period, the trust must determine how it may otherwise qualify as an S corporation shareholder.

Former Grantor Trusts

A domestic grantor trust is a trust, all of which is treated, for tax purposes, as owned by an individual (typically the grantor) who is a citizen or resident of the United States.

Upon the death of the deemed owner of the grantor trust, if the trust was a grantor trust immediately before the death, and it continues in existence after the death, the trust may continue to hold S corporation stock, even where an NRA is a beneficiary of the trust, but only for the 2-year period beginning on the day of the deemed owner’s death. In general, a trust is considered to continue in existence if the trust continues to hold the stock pursuant to the terms of the decedent’s will or of the trust agreement.  After the termination of the two-year period, the trust must determine how it may otherwise qualify as an S corporation shareholder.

QSST

A QSST is a permitted S corporation shareholder. It is defined as a trust that, among other things,  distributes or is required to distribute  all of its income to a citizen or resident of the United States. Thus, a QSST cannot have an NRA as its income beneficiary.  Of course, the NRA cannot be the remainderman.

ESBT

An ESBT is a permitted S corporation shareholder if it satisfies various requirements, including the requirement that an NRA cannot be a “potential current beneficiary” of the trust.  Thus, an NRA cannot be a beneficiary who is entitled to, or in the discretion of the trustee may, receive, a distribution of principal or income of the trust.

What To Do? Consequences?

OK, an S corporation shareholder has died and his or her shares of stock in the corporation are set to pass to or for the benefit of an NRA under the terms of the decedent’s will or trust.

In the case of (i) an estate, (ii) a testamentary trust, (iii) a former grantor trust, or (iv) a Section 645 trust, the corporation will have some time to consider its options. There aren’t many. At the end of the day, if the corporation is to retain its status as an S corporation, the NRA’s interest will have to be eliminated.

Of course, the foregoing assumes that the corporation and the other shareholders are aware of the NRA’s beneficial interest. What if they become aware of this interest only after the offending transfer has occurred?

At that point, the S corporation will have lost its tax-favored status, becoming a C corporation, the income of which is subject to so-called “double taxation.”  If the corporation desires to re-elect S corporation status, it will generally have to wait five years before doing so. When the “new” S election is made, the corporation will begin a new built-in gain recognition period.

IRS Ruling?

Alternatively, depending on the facts and circumstances, the corporation may be able to request a determination from the IRS that the termination of its election was inadvertent. The request is made in the form of a ruling request and should set forth all relevant facts pertaining to the event or circumstance, including a detailed explanation of the event or circumstance causing the termination, when and how the event or circumstance was discovered, and the steps taken after discovery of the terminating event so as to “correct” the terminating event in order that the corporation may again qualify as a small business corporation.

The corporation has the burden of establishing that, under the relevant facts and circumstances, the termination was inadvertent. The fact that the terminating event was not reasonably within the control of the corporation and was not part of a plan to terminate the election, or the fact that the terminating event or circumstance took place without the knowledge of the corporation, notwithstanding its due diligence to safeguard itself against such an event or circumstance, tends to establish that the termination of the election was inadvertent.

The status of the corporation after the terminating event and before the determination of inadvertence is determined by the IRS. Inadvertent termination relief may be granted retroactively for all years for which the terminating event is effective, in which case the corporation is treated as if its election had not terminated. The IRS may require any adjustments that are appropriate. In general, the adjustments required should be consistent with the treatment of the corporation as an S corporation during the period specified by the IRS. In the case of stock held by an ineligible shareholder (for example, an NRA) that causes an inadvertent termination, the IRS may require the ineligible shareholder to be treated as a shareholder of the S corporation during the period the ineligible shareholder actually held stock in the corporation. Moreover, the IRS may require protective adjustments that prevent the loss of any revenue due to the holding of stock by an ineligible shareholder (for example, an NRA).

Although the IRS may ultimately issue a favorable ruling, including retroactive relief, to redress the inadvertent termination of an S corporation’s election, it would behoove the corporation and its eligible shareholders to avoid finding themselves in the position where such action is required. The best way to do that is to adopt a shareholders agreement that, among other things, prohibits the transfer of stock to an ineligible shareholder, requires shareholders (and their transferees) to make whatever elections are necessary to preserve the Corporation’s status as an S corporation, requires shareholders to cooperate in restoring the corporation’s “S” election, requires shareholders to make their estate plans known to the corporation, and imposes economic penalties upon any shareholder who violates the foregoing provisions, including the cost of any IRS ruling request that become necessary as a result of such violation.

It is not unusual for a closely-held business or for its owners to issue or transfer equity in the business to a third party in order to raise necessary funding for the business or to secure the services of someone with a certain expertise. In most cases, where the equity transfer is made by the existing owners of the business, such owners may realize a gain on which they will be subject to tax for income tax purposes.

Often overlooked in such transfers, however, is the potential for incurring other, non-income taxes, including, in the case of a business that owns an interest in real property, state and local real estate transfer taxes.

Even when the owner-transferors are aware of this potential, they may, nevertheless, become liable for the tax where their individual transfers are aggregated by the taxing authorities for purposes of determining its application. The owners of one LLC recently had a close call in such a situation.

 The Transfers

Brother A and Brother B each held a 46.5% interest in LLC-I. The other 7% interest was held by B’s son, C. In turn, LLC-I owned a 96% interest in LLC-II, which owned real property located in NYC (“Property”). Property was managed by B and had been in the family for some time. The remaining 4% interest in LLC-II was owned by an unrelated party. Both LLC-I and LLC-II were treated as partnerships for tax purposes.

Brother B planned to develop the Property, but LLC-I needed additional funding and construction expertise for this purpose. In August of 2005, LLC-I transferred a 30% interest in LLC-II to the Transferee. LLC-I used the proceeds to purchase the lot adjacent to Property. This was followed by LLC-I’s transfer, in October 2005, of an additional 18% interest in LLC-II to the Transferee. At that point the Property was beneficially owned 48% by LLC-I, 48% by the Transferee, and 4% by the unrelated party, and there were no plans for further transfers.

After the Transferee’s entry, Brother A became uncomfortable with the investment because he could not get answers to his questions about the status of the development and, although it was an income-generating property, he received no income. He was also concerned that, if additional funding were needed, there would be capital calls, which he could not meet, which would result in the dilution of his interest or his being “squeezed out of the deal completely and [he’d] rather get something than nothing.”

Brother A offered to sell his interest in LLC-I to Brother B and to the Transferee. Because Brother B did not have sufficient funds to purchase A’s interest, Brother A transferred his entire beneficial interest in the Property to the Transferee in March of 2006. Rather than Brother A’s selling his interest in LLC-I, however, the transfer of his interest in the Property was effectuated as a transfer by LLC-I of a 22.32% interest in LLC-II to the Transferee, following which LLC-I distributed the sales proceeds to Brother A. It appears that the transfer was done in this way because it had the same economic effect as a sale of Brother A’s interest in LLC-I, but it kept investors who were not related to A and B’s families in LLC-II, rather than admit them into LLC-I.

After these three transfers, the Property was beneficially owned 70.32% by the Transferee (the sum of the three transfers by LLC-I), 25.68% by LLC-I, and 4% by the unrelated third party. The Transferee had obtained its entire interest in eight months.

The Transfer Tax Dispute

LLC-I determined that NYC real property transfer tax (“RPTT”) was due on the third transfer, apparently concluding that it should be aggregated with the previous two transfers. It was also determined that Brother A would pay the tax because the sale of his interest in LLC-I had provided him with the necessary funds. A transfer tax return was filed for the transaction, reporting that a 70.32% interest had been transferred and identifying LLC-I as the grantor. New-Brand-Hot-Sale-Baby-Kid-Children-House-font-b-Building-b-font-Blocks-font-b

The amount paid for RPTT, interest, and penalty was withheld from Brother A’s proceeds and paid by LLC-I to the City. LLC-I thus acted as a withholding agent and Brother A, not LLC-I, paid the RPTT, interest, and penalty at issue. A claim for refund was filed with NYC, which was disallowed. A request for conciliation conference was then filed, but the Conciliation Bureau sustained the disallowance of the refund claim. A petition was then filed with the Administrative Law Judge (ALJ) Division of the New York City Tax Appeals Tribunal.

Aggregation?

The ALJ considered the following issue: Whether the third transfer (by Brother A) of an economic interest in real property (LLC-II) should be aggregated with the two earlier transfers (by A and Brother B) to determine whether a controlling interest was transferred.

The NYC Administrative Code imposes a tax on the transfer of a controlling interest in an entity that owns real estate in NYC. A controlling interest is defined as 50% or more the stock of a corporation or of the capital, profits or beneficial ownership of a partnership.

A “transfer” is defined to include transfers of interests in entities “whether made by one or several persons, or in one or several related transactions, which shares of stock or interest or interests constitute a controlling interest in such corporation, partnership, association, trust, or other entity.”

The applicable regulation provides that related transfers “are aggregated in determining whether a controlling economic interest has been transferred.” It also provides that “[r]elated transfers include transfers made pursuant to a plan to either transfer or acquire a controlling interest in real property.”

This section also contains a presumption: “Transfers made within a three year period are presumed to be related and are aggregated, unless the grantor(s) or grantee(s) can rebut this presumption by proving that the transfers are unrelated.”

Because the three transfers at issue took place within a three-year period, they were presumed to be related. The taxpayer had the burden to rebut this presumption.

Neither the statute nor the regulation define a “related transaction” or explain what showing must be made to rebut the presumption. However, the regulation contains several illustrations that provide some guidance. In one illustration, A, B, and C each own 1/3 of a corporation. A sells his 1/3 interest to D, and within 3 years, B sells his 1/3 interest to D. The illustration concludes: “The transfers made by A and B are presumed to be related because they were made within a three year period” and tax will apply. The illustration does not mention the rebuttable nature of the presumption, but it also does not state that transfers to the same transferee are necessarily related and not subject to the rebuttable presumption.  

In another illustration, A and B each own 50% of a corporation. A sells 20% to C and, within 2 years, B sells 30% to C. The illustration concludes, “Since these transfers occur within a three year period, they are presumed to be related, and thus, subject to the transfer tax.” Again, the rebuttable nature of the presumption is not referenced to, but here, too, the parties could show that the transactions are unrelated.

A final illustration provides an example of unrelated transactions. A, B, and C each own 1/3 of a corporation. In Year One, A transfers her 1/3 interest to satisfy a judgment. In Year Three, B transfers his 1/3 interest to his spouse pursuant to a separation agreement. The illustration concludes: “The transfers by A and B will not be aggregated because the transfers are not related. Thus no tax is due.” This illustration presents a scenario of two transferors making transfers to two unrelated transferees for independent reasons. It concludes that they are unrelated, apparently because the non-identity of the transferors and transferees, and the reasons for the transfers, establish the independence of the transactions and rebut the presumption that they be aggregated simply because they occurred within three years of each other. This illustration suggests that transfers that are unplanned and independent of each other are not related, and that facts demonstrating this can rebut the presumption.

The ALJ’s Decision

In the case at hand, the ALJ found that, at the time of Brother A’s transfer, the Transferee owned 48% of the entity, there was no plan to make any further transfers, and the third transfer was for reasons unrelated to the initial transfers. The first two transfers were made to gain the funding and expertise of the Transferee, and were limited to a 48% interest. The third transfer was prompted by Brother A’s desire to exit the investment. The third transfer was unplanned, unexpected, and occurred for reasons unrelated to the first two transfers. NYC argued that the three transfers were related because they were all transfers of interests in the same entity that resulted in the transfer of a controlling interest. (Interestingly, it does not appear that NYC claimed that the third transfer had been part of a plan, or even that it was reasonably contemplated at the outset, so as to justify a claim that it was related to the earlier transfers.)

There is nothing in the regulation, the ALJ stated, to indicate that transfers of interests in the same entity were by definition related and that the presumption may not be rebutted in such a case. Indeed, the last illustration, above, was directly contrary to such an interpretation. According to the ALJ, to interpret the regulation as NYC argued would eliminate both the requirement that transactions be related to be aggregated, and the ability to rebut the presumption. The ALJ rejected this approach. For these reasons, the ALJ concluded that the third transfer was not related to the earlier transfers and, thus, should not be aggregated with them in determining if a controlling interest was transferred. Accordingly, the transfers were not subject to the RPTT, and the claim for refund was allowed.

 

Takeaways?

In the case described above, the LLCs were clearly real estate companies. The RPTT, however, is not limited to transfers of companies the values of which are attributable primarily to the values of their real properties. On the contrary, the transfer of a controlling interest in an operating company that owns a relatively small interest in real property will be subject to the tax, and the amount of the tax will be based upon the gross value (not reduced by any indebtedness) of the underlying real property.

A taxable transfer can turn into an expensive proposition given NYC’s top 2.625% tax rate, plus the State rate of 0.40%, so it would behoove the owners of a business that owns an interest in real property to “control” or plan for such transfers as best they can. In some cases, this will not be possible, in which case the consideration payable for the transfer should be negotiated taking into account the projected tax liability.

In other cases, however, a shareholders agreement or a partnership agreement can help to reduce the risk of a taxable event by restricting the transferability of the equity in the business. Of course, there should also be bona fide business reasons for the restrictions – the owners should not impair their interests solely to avoid a transfer tax.

Why, Oh Why?

We’ve heard it before: “Why would you choose to operate as an S corporation?”

Underlying this question are a number of other business-related questions, among which are the following:

  • Why would you limit the types of investors from whom you could accept equity capital contributions? Non-U.S. individuals, partnerships and other corporations cannot own equity in the S corporation without causing it to lose its tax-favored status. In addition, only certain kinds of trusts can own shares in an S corporation; in many cases, the trust, or its beneficiary, must make a special election in order to qualify the trust as a shareholder.
  • Why would you limit the type of equity interests that you can issue to an investor? S corporations can only have one class of common stock issued and outstanding –all of its shares must have identical economic rights. Preferred shares of stock are not permitted; special allocations of income and loss are not permitted. Many potential investors, however, will require a special return on and/or of their investment to compensate them for the use of their capital or for the risk they are assuming.
  • Why would you limit the number of shareholders? An S corporation cannot have more than 100 shareholders. Although special counting rules have alleviated this limitation in the case of family-owned corporations, other S corporations, with growing businesses, may have to confront this ceiling.

These are valid concerns that, in the case of a newly-formed business enterprise, may cause the owners to operate, at least initially, through an LLC that is treated as a partnership for tax purposes, rather than through an S corporation.

Caught Between Scylla and Charybdis?

The fact remains, however, that there are many S corporations in existence. Although an S corporation may “convert” into a partnership, the conversion, regardless of the form by which it is effected, will be treated as a liquidation for tax purposes. Thus, its shareholders will be taxed as though the corporation’s assets (including goodwill) had been distributed to them, as part of a taxable sale and liquidation, in exchange for their shares. If the corporation is subject to the built-in gains tax, it will incur a corporate level tax. s

Alternatively, the S corporation can free itself of the above limitations by revoking its election to be taxed as an S corporation. Of course, this will cause the corporation to be taxed as a C corporation: its profits will be subject to a corporate level tax and, when these after-tax profits are distributed to its shareholders, the shareholders will also be subject to tax.

What’s An S Corp. to Do?

Thankfully, there are situations where the choices are not as bleak, as a recent IRS letter ruling illustrated.

X Corp. was an S corporation. Y Corp. and Z Corp. were also S corporations. X Corp. had close to 100 shareholders.

The shareholders of X Corp. planned to restructure its business by undertaking several steps, the result of which would be that X would become a general partnership under State law, and Y and Z together would own all of the interests in X (the “Restructuring”). The shareholders of X would become shareholders in either Y Corp. or Z Corp., and Y and Z would be governed by identical boards of directors pursuant to a voting agreement entered into by their shareholders.

Following the Restructuring, the parties anticipated that both Y Corp. and Z Corp. would issue additional shares to new shareholders over time, so that the total number of shareholders in Y and Z together may exceed 100. However, neither Y nor Z would separately have more than 100 shareholders.

The Ruling

The IRS reviewed one of its published rulings in which unrelated individuals entered into the joint operation of a single business. The individuals divided into three equal groups and each group formed a separate S corporation. The three corporations then organized a partnership for the joint operation of the business. The principal purpose for forming three separate corporations, instead of one corporation, was to avoid the shareholder limitation for qualification as an S corporation and thereby allow the corporations to elect to be treated as S corporations.

In an earlier published ruling, the IRS had concluded, based on the same facts, that the three corporations should be considered to be a single corporation for purposes of making the election, because the principal purpose for organizing the separate corporations was to make the election. Under this approach, the election made by this “single” corporation would not be valid because the shareholder limitation would be violated. In reconsidering the prior ruling, the IRS concluded that the election of the separate  corporations should be respected. The purpose of the “number of shareholders” requirement, it said, was to restrict S corporation status to corporations with a limited number of shareholders so as to obtain administrative simplicity in the administration of the corporation’s tax affairs. In this context, administrative simplicity was not affected by the corporation’s participation in a partnership with other S corporation partners; nor should a shareholder of one S corporation be considered a shareholder of another S corporation simply because the S corporations are partners in a partnership.

Thus, the fact that several S corporations were partners in a single partnership did not increase the administrative complexity at the S corporation level. As a result, the purpose of the “number of shareholders” requirement was not avoided by the partnership structure and, therefore, the S elections of the corporations should be respected.

Accordingly, the IRS concluded in the letter ruling that Y and Z would continue to meet the S corporation requirements subsequent to the Restructuring, so long as neither Y nor Z exceeded 100 shareholders each.

Other Applications?

The above ruling indicates that the 100 shareholder limit may not be insurmountable if the business of the S corporations is conducted through a partnership.

Would the same strategy apply with respect to the single class of stock requirement? What about the restriction as to who may be a shareholder? The answer in most cases should be “yes.”

For example, A Corp. and B form partnership PRS to conduct a bona fide business. A contributes business assets to PRS, and B contributes cash, in a tax-free exchange for partnership interests in PRS.  A is an S corporation. B is a nonresident alien. Because the S corporation rules prohibit B from being a shareholder in A Corp., A and B chose the partnership form, rather than admit B as a shareholder in A, as a means to retain the benefits of S corporation treatment for A Corp. and its shareholders. According to the IRS, the partnership tax rules are intended to permit taxpayers to conduct joint business activity through a flexible economic arrangement without incurring an entity-level tax. The decision to organize and conduct business through PRS is consistent with this intent.

It is important to note, however, that the form of the partnership transaction may not be respected if it does not reflect its substance – application of the substance over form doctrine arguably could, depending on the facts, result in B being treated as a shareholder of A Corp., thereby invalidating A’s S corporation election. Thus, the form in which the arrangement is cast must accurately reflect its substance as a separate partnership and a separate S corporation. At the very least, there should be a bona fide business purpose for forming the partnership.

Don’t miss Part I, here!

 

Taxable Gift Transfers

In general, where property is transferred for less than an adequate and full consideration in money or money’s worth, the amount by which the value of the property exceeded the value of the consideration is deemed a gift. A necessary corollary of this provision is that a transfer of property in exchange for an adequate and full consideration does not constitute a gift for gift tax purposes. gifttax

The Treasury Regulations confirm that:

“[t]he gift tax is not applicable to a transfer for a full and adequate consideration in money or money’s worth, or to ordinary business transactions.”  The application of the gift tax depends “on the objective facts of the transfer and the circumstances under which it is made, rather than on the subjective motives of the donor.”  Thus, donative intent on the part of the transferor is generally not an essential element in such application.

The regulations define a “transfer of property made in the ordinary course of business” as (i) a transaction which is bona fide, (ii) at arm’s length, and (iii) free from any donative intent. A transaction meeting this standard “will be considered as made for an adequate and full consideration in money or money’s worth.” That is so even if one party to the transaction later concludes that the consideration he received was inadequate. In other words, even in the case of a bad bargain, no one would think for a moment that any gift is involved.

Of course, a transfer of property within a family group will almost always receive close scrutiny. However, a transfer of property between family members may nonetheless be treated as one “in the ordinary course of business” if it meets the criteria set forth above.

On numerous occasions, the courts have held that an arm’s-length transfer of property, in settlement of a genuine dispute between family members, was made for “a full and adequate consideration” because it was a transaction in the “ordinary course of business.” For example, a taxpayer’s settlement of litigation with a family member may be regarded as economically advantageous where the taxpayer was not certain of the outcome of the litigation and, by accepting the settlement, the taxpayer also avoided additional legal expense. In that case, the taxpayer may be said to have acted as one would act in the settlement of differences with a stranger, and a payment of settlement of the litigation may be described as “an adequate and full consideration in money or money’s worth.”

A transfer of property will be regarded as occurring “in the ordinary course of business” and thus will be considered to have been made “for an adequate and full consideration in money or money’s worth” if it satisfies the three elements in the regulations described above. To meet this standard, the transfer must have been (1) bona fide, (2) transacted at arm’s length, and (3) free of donative intent.

In applying this regulation to settlements of family disputes, the courts have identified certain subsidiary factors that may also be relevant. They have considered, for example:

  • whether a genuine controversy existed between the parties;
  • whether the parties were represented by and acted upon the advice of counsel;
  • whether the parties engaged in adversarial negotiations;
  • whether the value of the property involved was substantial;
  • whether the settlement was motivated by the parties’ desire to avoid the uncertainty and expense of litigation; and
  • whether the settlement was finalized under judicial supervision and incorporated in a judicial decree.

1.  Bona Fide

The requirement that the transfer be “bona fide” considers whether the parties were settling a genuine dispute as opposed to engaging in a collusive attempt to make the transaction appear to be something it was not. Here, there was no indication that the dispute between Father and Number Two was a sham designed to disguise a gratuitous transfer to Number Two’s children.  (A word of warning to advisors who would fabricate a dispute: don’t.)

Number Two was not working in concert with Father or Number One in any sense of the word. To the contrary, he was genuinely estranged from them, and this estrangement worsened as time went on. On both the business and family fronts, they each had (or believed they had) legitimate grievances against one other.

According to the Court, Number Two’s agreement to release his claim to 33 1/3 shares of Holding Co stock represented a bona fide settlement of this dispute. Although he had a reasonable claim to all 100 shares registered in his name, Father had possession of these shares and refused to disgorge them, forcing Number Two to commence litigation. The Court went on to note that the “oral trust” theory on which Father relied was evidently a theory in which he passionately believed. Additionally, it had some link to historical fact: at Holding Co’s inception, Number Two was listed as a registered owner of 33.33% of Holding Co’s shares even though he had contributed a disproportionately smaller portion of its assets.

2. Arm’s Length

The requirement that the transfer be “arm’s length,” the Court said, is satisfied if the taxpayer acts “as one would act in the settlement of differences with a stranger.” Number Two was genuinely estranged from Father and Number One. The evidence established that they settled their differences as such.

Number Two hired a lawyer and commenced lawsuits against Father, Number One and Holding Co. The lawyers for all parties negotiated for many months as true adversaries in search of a compromise. They eventually reached a settlement that Number Two accepted on his lawyer’s advice; both evidently regarded this compromise “as ‘advantageous economically.’” “The presence of counsel at the conference table for the purpose of advising and representing the respective parties as to their rights and obligations, together with other relevant facts and circumstances, dispelled any theory that a payment made in connection with such settlement was intended for or could have been a gift,” the Court stated.

All the elements of arm’s-length bargaining existed here. There was a real controversy among the parties; each was represented by and acted upon the advice of counsel; they engaged in adversarial negotiations for a protracted period; the compromise they reached was motivated by their desire to avoid the uncertainty and embarrassment of public litigation; and their settlement was incorporated in a judicial decree that terminated the lawsuits. Because Number Two acted “as one would act in the settlement of differences with a stranger,” his transfer of shares in trust for his children was an arm’s-length transaction.

3.  Absence of Donative Intent

Although donative intent is not prerequisite to a “gift,” the absence of donative intent is essential for a transfer to be treated as made “in the ordinary course of business.” Generally, donative intent will be found lacking when a transfer is “not actuated by love and affection or other motives which normally prompt the making of a gift.”

Number Two transferred 33 1/3 Holding Co shares in trust for his children. A transfer of stock to one’s children, however, is not necessarily imbued with donative intent.

Number Two’s objective throughout the dispute was to obtain for himself ownership of (or full payment for) the 100 Holding Co shares originally registered in his name. He filed lawsuits because he refused to embrace the “oral trust” theory and wished to obtain possession, in his own name, of all 100 shares.

Both economic and family reasons may have motivated Number Two to insist on securing outright ownership of (or payment for) all 100 shares. Having abruptly quit the family business, he was likely concerned about his own financial security, and he may have been reluctant to transfer wealth to his children, one of whom he had recently placed in a mental hospital.

The evidence clearly established that Number Two transferred stock to his children, not because he wished to do it, but because Father demanded that he do it. The transfer of stock in trust for his children was prompted by Father’s desire to keep the family business within the family. Number Two was forced to accept this transfer in order to placate Father, settle the family dispute, and obtain a $5 million payment for the remaining 66 2/3 shares.

Thus, the Court concluded that Number Two acquiesced in the notion of an “oral trust” because he had no other alternative. There was no evidence that he was motivated by love and affection or other feelings that normally prompt the making of a gift. Because his transfer of stock to his children represented the settlement of a bona fide dispute, was made at arm’s length, and was “free from any donative intent,” it met the three criteria for a transaction “in the ordinary course of business.”

The Tax Court Disagrees with the IRS

The Court next turned to the IRS’s argument that, because Number Two’s children were not parties to the litigation or settlement of the dispute, they did not provide (and could not have provided) any consideration to Number Two for the transfer of the shares. Because no consideration flowed from the transferees, the IRS contended that Number Two ‘s transfer was necessarily a gift.

According to the Court, the IRS’s argument derived no support from the text of the governing regulations, which provide that “[t]he gift tax is not applicable to a transfer for a full and adequate consideration in money or money’s worth.” They further provide that a “transfer of property made in the ordinary course of business * * * will be considered as made for an adequate and full consideration in money or money’s worth.”

The IRS’s argument, the Court noted, focused on whether the transferees provided consideration. However, the regulation asks whether the transferor received consideration, that is, whether he made the transfer “for a full and adequate consideration” in money or money’s worth. The regulation makes no reference to the source of that consideration.

The Court determined that Number Two received “a full and adequate consideration” for his transfer—namely, the recognition by Father and Number One that he was the outright owner of 66 2/3 Holding Co shares and Holding Co’s agreement to pay him $5 million in exchange for those shares.

Thus, the Court concluded that Number Two’s transfer of 33 1/3 shares of Holding Co stock to the trusts for his children constituted a bona fide, arm’s-length transaction that was free from donative intent and was thus “made in the ordinary course of business.” Because “[t]he gift tax is not applicable to a transfer for a full and adequate consideration in money or money’s worth, or to ordinary business transactions,” the Court found no deficiency in Federal gift tax.

What Does This Mean for Planning Purposes?

The application of the “ordinary course of business” exception in the context of a family dispute, as described above, is almost, by definition, something for which a taxpayer cannot plan. After all, a dispute among family members, especially in a business setting, can arise under any number of circumstances, few of which are reasonably foreseeable.

That being said, there are some important lessons to be derived from the Court’s discussion of the regulation’s three factors that may be applicable in many other family business settings.

As always, the members of a family that owns a business must never forget that any transactions involving the business, or transfers of interests in the business, within a family group will receive close scrutiny by the IRS that may result in the characterization of such transactions or transfers, at least in part, as taxable gifts. These transactions may include the sale or leasing of property, the sale of stock, the issuance of stock to an employee, the payment of compensation, including incentive and deferred compensation.

Although a gift may not even be intended, it will behoove the family to recognize the factors on which the IRS will focus and to prepare accordingly. Thus, the parties to a transaction should be represented by separate counsel, and they should act in an arm’s length manner, as one would act when dealing with a stranger. In this way, they will avoid the surprise that the IRS tried to spring on the taxpayer in the decision discussed herein.

“One Day, Lad, All This Will Be Yours.”

Many a closely-held business was created before its founder became a parent or when the founder’s children were still very young. As the business grew, and as the founder’s children matured, the founder may have entertained the notion of eventually having her children take over the business. In some cases, after finishing school, one or more of the children may have decided to join the business, to the delight of the founder.

From that point on, however, the children and the founder become engaged in a very delicate dance, of which they may not be fully cognizant. One child may be more capable than another; the founder may favor one child over the other. Depending upon the personalities involved, this situation can get ugly, and will sometimes raise unexpected tax issues, as was illustrated in a recent decision of the Tax Court.

 The Business

Father started the Business and, years later, his younger son (Number Two) joined him, followed later by Father’s elder son (Number One). The Business grew to cover many locations, each operated out of a separate corporation. Father, Number One and Number Two eventually came to own various percentages of these various corporations, with Father’s aggregate share being the largest.

In order to consolidate their interests in a single entity, Holding Co was incorporated with Father and his two sons as the original directors and officers.

Upon the incorporation of Holding Co, Father, Number One and Number Two each contributed to it their stock in the pre-existing corporations, in exchange for which each of them received100 shares of voting common stock. This was in keeping with Father’s decision to divide the shares evenly. The stock certificates indicated that they were each registered owners of 100 unrestricted shares of Holding Co common stock.

As it turned out, “[t]he decisions taken at [Holding Co’s] organizational meeting contained the seeds of the problem that would blossom into the tax dispute now before us.” Although Father, Number One and Number Two were each registered owners of 33.33% of Holding Co stock, the values of their capital contributions to Holding Co were disproportionate to their shareholdings, with Father making a disproportionately larger contribution.

The Dispute

As Holding Co continued to prosper, Father gave Number One more public and “glamorous” jobs, while Number Two had principal responsibility for operational and back-office functions. At the same time, Father and Number Two had a falling out as a result of certain non-Business related matters.

Number Two began to feel marginalized within the family business. He became dissatisfied with his role at Holding Co, with certain business decisions that Father and Number One had made, and with what he regarded as a lack of respect for his views. He began to discuss, in general terms, the possibility that he might leave the Business. This possibility became more concrete when Number One, without first discussing the matter with Number Two, hired Outsider to take over part of Number Two’s responsibilities in Holding Co. When Number Two learned of this, he quit the Business.

Upon leaving, Number Two demanded, but did not receive, possession of the 100 shares of stock registered in his name. He took the position that he was legally entitled to, and had an unrestricted right to sell, the shares registered in his name. He threatened to sell the shares to an outsider if Holding Co did not redeem them at an appropriate price.

Vintage Stock Certificate

Number Two’s threat to sell his shares to an outsider irked Father and Number One because they wished to keep control of the Business within the family. Father refused to give Number Two his stock certificates, contending that Holding Co had a right of first refusal to repurchase the shares. Father and his attorneys also developed an argument that a portion of Number Two’s stock, though registered in his name, had actually been held since Holding Co’s inception in an “oral trust” for the benefit of Number Two’s children.

This argument was built on the fact that Father had contributed a disproportionately larger portion of Holding Co’s capital yet had received only 33.33% of its stock. In effect, he contended that he had gratuitously accorded Number Two more stock than he was entitled to, and that, to effectuate Father’s intent, the “extra” shares should be regarded as being held in trust for Number Two’s children.

The parties negotiated for six months in search of a resolution. They explored, without success, various options whereby Number Two would remain in the business as an employee or consultant. Number Two offered to sell his 100 shares back to Holding Co, and the parties explored various pricing scenarios under which this might occur. As the family patriarch, however, Father had most of the leverage, and he insisted that Number Two acknowledge the existence of an oral trust for the benefit of Number Two ‘s children. Father’s insistence on an oral trust was a “line in the sand.”

Upon reaching an impasse, Number Two filed lawsuits against Father, Number One and Holding Co. The actions alleged that Number Two owned 100 shares of voting common stock, that these shares were “unencumbered and unrestricted as to their transferability,” and that the 100 shares should be delivered immediately to Number Two. Father answered that he had possession of all the stock registered in Number Two’s name and that a portion of the shares so registered were “held in trust for the benefit of * * * [Number Two’s] children.”

The Settlement

This litigation became nasty, and its public nature was extremely distressing to the family. In the course of negotiations, it became apparent to Number Two’s attorney that Number Two had to separate completely from Holding Co and that Father would not be placated unless Number Two acknowledged the supposed “oral trust” and placed some of the disputed shares in trust for his children.

Number Two firmly believed he was entitled to all 100 shares of Holding Co stock that were originally registered in his name, and that he had never held any shares under an oral trust for his children. He believed that he was being forced to renounce his ownership interest in the 33 1/3 shares and to acknowledge the existence of an oral trust in order to placate Father and obtain payment for the remaining 66 2/3 shares. However, he accepted his attorney’s advice that it was in his best interest to compromise and settle the litigation.

The parties ultimately reached a settlement along these lines. The parties agreed that Holding Co would purchase from Number Two the 66 2/3 shares of stock that he was deemed to own. They further agreed that his “2/3 stock interest was to be valued at Five Million Dollars for purposes of a settlement agreement” (Settlement Agreement). Number Two transferred these shares to Holding Co in exchange for $5 million.

The Settlement Agreement required Number Two to execute irrevocable declarations of trust for the benefit of his children, with Number One named as the sole trustee of each trust. Number Two assigned 33 1/3 shares of Holding Co stock to these trusts.

Finally, the Settlement Agreement required the parties to execute mutual releases respecting claims concerning Number Two’s ownership interests in Holding Co, and Number Two resigned from all positions he had held in the Business.

The IRS Gets Involved . . .

Number Two did not file a Federal gift tax return for the year of the Settlement Agreement. He did not believe that the Holding Co shares he transferred to the trusts constituted a taxable gift.

Almost thirty – yes, thirty – years later, as a result of some unrelated litigation, Number Two’s transfer of the Holding Co stock came to the attention of the IRS and, after an examination (and shortly after Number Two’s death), the IRS issued a timely notice of deficiency to Number Two’s estate asserting a deficiency of almost $740,000 in Federal gift tax.  The estate filed a petition with the Tax Court.  Tomorrow’s post will review the Court’s decision.