Drums. Do you hear them? Along the western shore of the Hudson River.[i] It seems that the unrest which began in New England earlier this year is spreading into the Mid-Atlantic States.[ii]

The owner of a New York business that employs nonresidents who, as a result of the pandemic, are working remotely from their homes in another state,[iii] should be attuned to recent developments that may affect their obligation to withhold New York taxes from the compensation payable to their nonresident, telecommuting employees.

The Tax Heard Round the States[iv]

On April 21, 2020, the Massachusetts Department of Revenue published a Technical Information Release[v] in which the Department sought to explain the income tax sourcing and withholding rules applicable to those non-resident employees who began telecommuting following (1) the State’s declaration of a state of emergency in response to the COVID-19 pandemic,[vi] and (2) the State’s emergency order requiring all nonessential businesses to close their physical workplaces and facilities.[vii]

According to the release, all compensation received for services performed by a nonresident who, immediately prior to the state of emergency, was an employee engaged in performing such services in Massachusetts, and who began performing services from a location outside Massachusetts due to a “pandemic-related circumstance,” will continue to be treated as Massachusetts source income subject to the Commonwealth’s personal income tax, and to income tax withholding by their Massachusetts employer.

New Hampshire – which does not have a personal income tax[viii] – was not pleased. What ensued was a months-long war of words between the two neighbors, which last week culminated in a Constitutional challenge when New Hampshire brought an action against Massachusetts in the U.S. Supreme Court[ix] claiming, among other things, that Massachusetts was infringing upon New Hampshire’s sovereignty by seeking to impose a tax upon New Hampshire residents in respect of income they earned in New Hampshire – not in Massachusetts.[x]

General Rule – Except in New York[xi]

It has long been accepted that a State may tax a nonresident individual only with respect to income that is generated by, or earned from, sources within that State.[xii] For example, a State may tax a nonresident on their rental income from real property located in the State, or on their share of partnership income from a business operating in the State.[xiii]

The same source-based limitation applies to the case of a nonresident individual who is employed by a business that operates within the State; specifically, the State may tax the nonresident employee’s wages, paid by their resident employer, only to the extent such wages are attributable to services rendered – i.e., earned – by the nonresident employee within the State, which is usually determined by comparing the number of days worked by the nonresident within the State with their number of days worked without the State.[xiv]

In other words, those wages earned by a nonresident employee for work performed outside the State may not be taxed by the State, and the employer is not required to withhold such taxes on behalf of the State.

New York

In the case of a nonresident employee who performs services for their employer both within and without the State, New York law is similar to that of other states; it provides that the nonresident’s income derived from New York sources includes that proportion of their total compensation for services rendered as an employee which the total number of working days employed within New York bears to the total number of working days employed both within and without New York.

However, any allowance claimed for days worked outside New York must be based upon “the performance of services which of necessity, as distinguished from the convenience, obligate the employee to out-of-state duties” in the service of their employer.[xv]

Is the Hudson Wide Enough?[xvi]

Coincidentally with the filing of New Hampshire’s complaint against Massachusetts, New York’s Department of Taxation and Finance issued guidance regarding the income taxation of certain nonresidents. Specifically, according to a set of newly-issued FAQs,[xvii] if a nonresident’s assigned or primary office is in New York, their days telecommuting during the pandemic will be considered days worked in New York unless the nonresident’s New York employer has established a bona fide employer office at the nonresident’s “telecommuting location.”[xviii]

In general, unless the New York employer of a nonresident employee[xix] specifically acts to establish a bona fide employer office at the employee’s telecommuting location, the nonresident employee will continue to owe New York personal income tax on income earned while telecommuting.

Convenience of the Employer

The foregoing represents what may be described as an extension of New York’s “convenience of the employer” rule, under which a nonresident employee whose assigned or primary office is in New York State, but who spends a “normal work day” at their home office outside New York, will nevertheless be treated as having worked in New York on that day, unless the nonresident employee can demonstrate that their home office is a bona fide employer office.[xx]

A number of factors are considered in determining whether a nonresident’s New York employer has established a “bona fide employer office” at the employee’s telecommuting location outside New York; specifically, the state in which the employee resides.

These factors are divided into three categories: the primary factor, secondary factors, and other factors. In order for an office to be considered a bona fide employer office, the office must meet either: (a) the primary factor (not likely[xxi]), or (b)(i) at least 4 of the secondary factors[xxii] and (ii) 3 of the other factors.[xxiii]

In general, unless the employer specifically acted to establish a bona fide employer office at the nonresident employee’s telecommuting location, the nonresident employee will continue to owe New York income tax on income earned while telecommuting.

Should the Rule Apply?

The question, of course, is whether it is appropriate for New York to apply its “convenience” rule given the circumstances under which so many nonresident employees are telecommuting.

There was nothing voluntary about their decision to work from home. Indeed, on March 7, 2020, New York’s Governor Cuomo declared a state of emergency, which was followed on March 20 by a statewide order that all non-essential workers work from home.[xxiv]

According to many jaded observers, what we are witnessing does not reflect a “logical” extension of New York’s rule but, rather, an attempt by the State to make up for lost tax revenues caused by the stay-at-home order and the resulting economic shutdown.

Although New York may defend its taxation of nonresident employees, in part, by reminding them that they may be entitled to a credit against the tax owing to their state of domicile for the tax paid to New York – thereby avoiding double taxation of such wages – the fact remains that such a credit has the effect of removing tax dollars from the employee’s fiscally-challenged state of domicile, and moving them to New York.

We’re Not Gonna Take It [xxv]

Within days of the issuance of New York’s guidance and the filing of New Hampshire’s complaint against Massachusetts, the New Jersey Senate responded with a bill[xxvi] which begins as follows:

The Legislature finds and declares that:

a. Thousands of New Jersey residents, many of whom work from home, have New York income taxes taken from their paychecks because their employers are located in the State of New York.

b. New Jersey allows those residents to claim a tax credit against their New Jersey income tax liability for the taxes they paid to New York, so that their income is not taxed again.

c. It is grossly inequitable that the State of New York receives and retains income tax revenue from New Jersey residents who may only infrequently and sporadically travel to New York to conduct business.

d. The inequity extends to New Jersey residents who may be required to pay higher New York income tax rates.

e. Current inequities have been growing over time as technology improvements have allowed New York businesses to decrease office space available to New Jersey residents working in New York and effectively use New Jersey’s infrastructure and services as support for their employees.

f. Current inequities have further been exacerbated by COVID-19, which is hastening the trend of New Jersey residents no longer truly working in New York and New York businesses downsizing New York office space available to New Jersey residents.

Unlike feisty New Hampshire, the New Jersey bill, as originally introduced, merely directs the State Treasurer to prepare and submit a report[xxvii] concerning New York’s taxation of the income earned by New Jersey residents, to determine how much credit New Jersey gives for taxes paid to New York,[xxviii] and to make recommendations for how New Jersey may resolve the “inequitable tax treatment” of New Jersey residents who commute to work for employers in New York.

The bill was almost immediately amended[xxix] to also request that the State consider participating in the above-referenced litigation between New Hampshire and Massachusetts.

Stay tuned.

What’s Next?

The issue of telecommuting preceded the COVID-19 pandemic and the resulting shutdown of many segments of the economy.

The “stay-at-home” orders – like those issued by Massachusetts and by New York – and the effect of the pandemic on the coffers of these and many other states, have brought into sharper focus the question of when it is appropriate for a state to tax the wages earned by nonresident telecommuters, and to require the in-state (or resident) employers of such individuals to collect this tax.

These circumstances have also raised the possibility that the states in which the telecommuting employees are domiciled may try to tax the nonresident businesses that employ them, thereby recapturing the tax revenue lost to credits.

This option will certainly be attractive in the case of New Hampshire and New Jersey,[xxx] who are fiscally tied, in a sense, to their more economically robust neighbors.

Moreover, this approach may be legally supportable under the Supreme Court’s reasoning in South Dakota v. Wayfair, and its adoption of the economic nexus standard.[xxxi] In fact, a recent survey of state tax departments revealed that many states consider the presence of a telecommuting employee of an out-of-state business as sufficient economic nexus for purposes of taxing such business.[xxxii]

In light of the foregoing, what is a New York business to do if some of its nonresident employees are telecommuting? First, investigate the tax treatment afforded by the states in which the telecommuting employees reside; and, second, keep an eye on New Hampshire v. Massachusetts.

[i] Have you read Drums Along the Mohawk, by Walter Edmonds? The story is set on the frontier of Upstate New York during the American Revolution. As you know, that “trouble” began in Massachusetts, then spread southward.

[ii] Do you discern a pattern?

[iii] In the case of New York City and the “adjoining” counties, we’re probably looking at New Jersey and Connecticut. Heading north, though, brings Massachusetts and Vermont into play; westward, we’re considering Pennsylvania.

[iv] Get it? “Shot heard round the world?” Lexington and Concord, April 1775?

[v] TIR 20-5: Massachusetts Tax Implications of an Employee Working Remotely due to the COVID-19 Pandemic.

See also TIR 20-10, which revised and extended TIR 20-10. https://www.mass.gov/technical-information-release/tir-20-10-revised-guidance-on-the-massachusetts-tax-implications-of#v-pass-through-entities The TIR was issued following the promulgation of emergency regulation 830 CMR 62.5A.3: Massachusetts Source Income of Non-Residents Telecommuting due to the COVID-19 Pandemic.

[vi] https://www.mass.gov/news/declaration-of-a-state-of-emergency-to-respond-to-covid-19

[vii] https://www.mass.gov/news/governor-charlie-baker-orders-all-non-essential-businesses-to-cease-in-person-operation

[viii] Well, not quite. The State does impose a tax on certain investment income above a threshold amount.

[ix] Article III, Section 2 of the Constitution gives the Court original jurisdiction “to controversies between two or more states.”

[x] The complaint in New Hampshire v. Massachusetts, was filed on October 19, 2020. https://www.governor.nh.gov/sites/g/files/ehbemt336/files/documents/nh-v-ma-action.pdf

[xi] And very few others.

[xii] The same rules generally apply between nations.

[xiii] Generally speaking, the nonresident partner is deemed to be engaged in the business conducted by the partnership.

[xiv] Physical presence is key.

[xv] 20 NYCRR 132.18.

[xvi] I promise not to say anything derogatory about New Jersey in this week’s post.

Trivia: Did you know that, during much of the 18th Century, the two colonies were engaged in armed conflict with one another over the location of their common border? YCMUTS. (Or is it YCMTSU?)

[xvii] Update October 19, 2020. Frequently Asked Questions about Filing Requirements, Residency, and Telecommuting for New York State Personal Income Tax. https://www.tax.ny.gov/pit/file/nonresident-faqs.htm#telecommuting

[xviii] Who speaks like that? By the way, Merriam-Webster defines “telecommuting” as working “at home by the use of an electronic linkup with a central office.”

[xix] We assume for purposes of this post that the employee is, in fact, a nonresident of New York.

All too frequently, however, an employee who is domiciled elsewhere, but who works in New York, will stumble into New York resident status for tax purposes by leasing or purchasing an apartment in New York City, or by acquiring a second home in New York (which need not be within easy reach of the employee’s place of business, but which must be suitable for year-round use). If the State finds that the individual has “maintained” a “permanent place of abode” in the State for “substantially all” of the tax year, has a “residential interest” in such place of abode (which is proving to be an evidentiary challenge), and has been present in New York for more than 183 days during such year, the individual will be taxed as a so-called “statutory resident” of the State for that year. https://www.taxlawforchb.com/2019/09/statutory-residence-in-ny-the-permanent-place-of-abode-test-is-in-need-of-repair/

[xx] TSB-M-06(5)I (May 15, 2006). Any day spent at the home office that is not a normal work day would be considered a nonworking day. A normal work day means any day that the taxpayer performed the usual duties of his or her job. For this purpose, responding to occasional phone calls or emails, reading professional journals or being available if needed does not constitute performing the usual duties of his or her job.

[xxi] The employee’s duties require the use of special facilities that cannot be made available at the employer’s place of business, but those facilities are available at or near the employee’s home.

[xxii] The home office is a requirement or condition of employment; The employer has a bona fide business purpose for the employee’s home office location; The employee performs some of the core duties of his or her employment at the home office; The employee meets or deals with clients, patients or customers on a regular and continuous basis at the home office; The employer does not provide the employee with designated office space or other regular work accommodations at one of its regular places of business; Employer reimbursement of expenses for the home office.

[xxiii] The employer maintains a separate telephone line and listing for the home office; The employee’s home office address and phone number is listed on the business letterhead and/or business cards of the employer; The employee uses a specific area of the home exclusively to conduct the business of the employer that is separate from the living area. The home office will not meet this factor if the area is used for both business and personal purposes; The employer’s business is selling products at wholesale or retail and the employee keeps an inventory of the products or product samples in the home office for use in the employer’s business; Business records of the employer are stored at the employee’s home office; The home office location has a sign indicating a place of business of the employer; Advertising for the employer shows the employee’s home office as one of the employer’s places of business; The home office is covered by a business insurance policy or by a business rider to the employee’s homeowner insurance policy; The employee is entitled to and actually claims a deduction for home office expenses for federal income tax purposes; The employee is not an officer of the company.

[xxiv] https://www.governor.ny.gov/news/governor-cuomo-signs-new-york-state-pause-executive-order

[xxv] Twisted Sister and New Jersey?

[xxvi] S-3064. https://www.njleg.state.nj.us/2020/Bills/S3500/3064_I1.PDF. The bill quickly advanced through the Senate’s Budget and Appropriations Committee.

[xxvii] Within six months of the date of enactment, which remains to be seen.

[xxviii] New York State’s top personal income tax rate is 8.82%. New York City does not tax nonresidents. Until recently, New Jersey’s top rate on individuals – 10.75% – kicked in at gross income exceeding $5 million; that threshold has now been reduced to $1 million. https://taxfoundation.org/new-jersey-millionaires-tax-fy-2021/

[xxix] https://legiscan.com/NJ/text/S3064/2020

[xxx] I hope folks don’t take this the wrong way. I’m not denigrating these states. For example, both New Jersey and Connecticut recently announced that their budget gaps were not as bad as expected. Most observers have attributed this to the strength of Wall Street firms . . . located in New York. See Bloomberg’s Daily Tax Report, “Connecticut Deficit Shrinks as Covid Tax Hit Less Than Forecast” (October 21, 2020).

[xxxi] 138 S. Ct. 2080 (2018). Even without Wayfair, the physical presence of a resident-telecommuting employee performing a significant function for the out-of-state business-employer may suffice.

[xxxii] The report can be obtained here: https://pro.bloombergtax.com/reports/survey-of-state-tax-departments/?trackingcode=BTXS205632 .

It should be noted that some states have chosen not to treat a resident employee, who is telecommuting for an out-of-state employer because of COVID-19 restrictions, as a point of nexus on which to justify the taxation of such employer.

In the Beginning

From the dawn of recorded history, those who have the means have purchased or otherwise financed the work of those whom we call artists – talented individuals capable of producing what we call works of art, but who are often bereft of any means.

In doing so, a symbiotic relationship has developed by which the former became patrons of the arts, which redounded not only to the benefit of artists, generally, but to society as a whole.[i]

Business owners were among the first patrons,[ii] and although they continue to play this role, they also realize that works of art may represent a wise long-term investment – an asset class, if you will – in which to invest some of their profits or disposable cash, and to help diversify their portfolio.

Whether intentionally or not, the Code has assisted many of these business owners with their investments in art, including the disposition of their collections, whether for charitable or other purposes.

Recent events, not the least of which is the presidential campaign, have highlighted some of the benefits bestowed by the Code upon business owners and investors, generally, and have sparked a debate over whether the Code should be employed in this manner.

The Painting

Many have pointed to the “revelations” made in the recent New York Times[iii] report regarding Mr. Trump’s income tax returns as evidence of how the Code is chock-full of provisions[iv] that only benefit the “wealthy.” Included on the list of vile villains are the checkered charitable easement, the depraved depreciation deduction,[v] and the loathsome like-kind exchange.

The press and the general public reacted to the article’s contents with what may be described as moral indignation, and even outrage.

On the same day as the NYT report, the Daily Beast reported that Botticelli’s[vi] “Young Man Holding a Roundel” (the “Painting”)[vii] is to be offered for sale at an anonymous online auction early next year.[viii] According to this article, the “billionaire Manhattan art collector Sheldon Solow bought” the Painting in 1982 for $1.3 million.[ix]

The Foundation

One week later, Bloomberg reported[x] that 99% of this Painting was owned by a private operating foundation organized in 1991 by “New York City real estate tycoon,” Sheldon Solow – the Solow Art & Architecture Foundation (the “Foundation”).[xi]

Almost in passing, the article tells us that, over the course of years, Mr. Solow made gifts of fractional interests in the Painting to the Foundation, leaving him[xii] with only a 1% interest. These gifts would have generated income tax deductions,[xiii] the article states, which would have sheltered a portion of Mr. Solow’s otherwise taxable income.[xiv]

According to the latest federal tax return filed by the Foundation that is available for public inspection (the “Tax Return”),[xv] the Foundation was organized to maintain and display “artwork for exhibition to the public at the 9 West 57th Street, New York building.”[xvi]

The Foundation is registered at this address, and the building in question is known as the “Solow Building,” an iconic New York City office tower that Mr. Solow owns and manages.[xvii]

In addition to the Painting, the Foundation owns twelve more major works of art[xviii] with a reported fair market value (exclusive of the Painting) of approximately $260 million in the aggregate.[xix]

The Bloomberg article indicates that Mr. Solow “plans to sell [the Painting] for more than $80 million” – the Tax Return reports the fair market value as $84.15 million[xx] – and explains that such a “windfall” would normally “result in at least a $33 million capital gains tax bill”[xxi] if sold by an individual investor.

However, the article continues, “because Solow routed [the Painting] through his private foundation, he’ll owe a fraction of that amount – and has already saved millions on his personal income taxes over decades.”[xxii]

Needless to say, neither the press nor the general public took notice. They couldn’t care less.

Indeed, on the face of it, there seems to be no reason for them to care – at least for now – because the tax consequences arising from Mr. Solow’s gifting of fractional interests in the Painting to the Foundation, and from the Foundation’s anticipated sale of the Painting, are within the parameters of what the Code historically has allowed, and even encouraged.[xxiii]

The Tax Benefits

In order to appreciate the tax planning manifested by Mr. Solow’s use of the Foundation, as well as some of the issues this may present, it would help the reader to have some basic knowledge of: the deduction allowed by the Code for charitable contributions of art; and the contributor’s relationship to the recipient of such art where such recipient is a private foundation.

Charitable Deduction

In general, the Code allows a taxpayer to claim a deduction for a charitable contribution of property in determining their income tax liability for the year in which the contribution is made.[xxiv]

A charitable contribution is one that is made to a domestic corporation or trust that is organized and operated “exclusively” for “charitable” purposes,[xxv] no part of the net earnings of which inures to the benefit of any private individual, which is not overly engaged in lobbying activities, and which does not participate or intervene in political campaigns.[xxvi]

In the case of a contribution made in-kind,[xxvii] the amount of the deduction allowed is generally equal to the fair market value of the property contributed.[xxviii]

However, the Code may reduce the amount of the deduction depending upon the nature of the property contributed and the character of the recipient charitable organization.

Specifically, the contributor’s deduction will be limited to their adjusted basis in the property[xxix] – in the case of non-depreciable property, such as artwork, the original purchase price for the artwork – if:

  • The gain realized on a sale of the property by the contributor would have been short-term capital gain;[xxx] or
  • The contribution consists of tangible personal property, such as art, and the recipient organization’s use of the property is unrelated to the purpose or function that constitutes the basis for the organization’s tax-exempt status;[xxxi] or
  • The recipient organization is a non-operating private foundation.[xxxii]

Thus, a contribution of art to a tax-exempt private operating foundation[xxxiii] that operates a museum, for example, will “usually” entitle the contributor to a deduction equal to the fair market value of the art at the time of the contribution,[xxxiv] provided the contributor’s holding period for the art contributed exceeds one year. What’s more, the contributor will not be required to recognize the appreciation (or built-in gain) inherent in the property.

Fractional Interests

“Usually” entitle? Yes, there is one more, fairly significant, factor to consider: gifts of fractional interests.

In general, the Code does not allow a deduction for a charitable contribution of a partial interest in property, such as art.[xxxv] However, a gift of an undivided portion of the contributor’s entire interest in a work of art generally is not treated as a nondeductible gift of a partial interest in property.[xxxvi]

For this purpose, an undivided portion of a contributor’s entire interest in the artwork must consist of a fraction or percentage of each and every substantial interest or right owned by the contributor in the artwork, and must extend over the entire term of the contributor’s interest in the artwork.[xxxvii]

A gift is generally treated as a gift of an undivided portion of a contributor’s entire interest in the artwork if the recipient organization is given the right, as a tenant-in-common with the contributor, to possession, dominion and control of the artwork for a portion of each year appropriate to its interest in the artwork.[xxxviii]

It should be noted, however, that a charitable contribution deduction will generally not be allowed for a contribution of a future interest in tangible personal property, including artwork.[xxxix] A “future interest” is one in which the contributor purports to give the art to a charitable organization, but has an understanding or agreement with the organization which has the effect of reserving to the contributor a right to use, possession or enjoyment of the artwork.[xl]

For example, a contribution of an undivided 25% interest in a painting with respect to which the recipient organization is entitled to possession during three months of each year will be treated as made upon receipt by the organization of a formal deed of gift – however, the period of initial possession by the organization may not be deferred for more than one year.[xli]

In addition,[xlii] if a contributor makes an initial fractional contribution of an interest in a work of art, then fails to contribute all of their remaining interest in such artwork to the same organization before the earlier of (i) 10 years from the initial fractional contribution, or (ii) the contributor’s death, then the charitable income tax deductions for all previous contributions of interests in the item will be recaptured (with interest).[xliii] Likewise, if the recipient organization of a fractional interest in a work of art fails to take substantial physical possession of the item during the period described above, or fails to use the property for a related exempt use[xliv] during the period described above, then the contributor’s charitable income tax deductions for all previous contributions of interests in the artwork will be recaptured (with interest).[xlv]

In any case in which there is a recapture of a deduction as described above, the Code also imposes an additional tax in an amount equal to 10% of the amount recaptured.[xlvi]

What’s more, no income tax charitable deduction is allowed for a contribution of a fractional interest in an item of art unless, immediately before such contribution, all interests in the art are owned (1) by the contributor, or (2) by the contributor and the recipient organization.

Finally, the value of a contributor’s charitable deduction for the initial contribution of a fractional interest in a work of art will be determined based upon the fair market value of the artwork at the time of the contribution of the fractional interest and considering whether the use of the artwork will be related to the recipient’s exempt purposes; however, for purposes of determining the deductible amount of each additional contribution of an interest in the same work of art, the fair market value of the artwork will be the lesser of: (1) the value used for purposes of determining the charitable deduction for the initial fractional contribution; or (2) the fair market value of the artwork at the time of the subsequent contribution.[xlvii]

Operating Foundation

As indicated above, a contribution of art to a standard private foundation will not generate a fair market charitable deduction for the contributor; the same gift to an operating foundation, however, is treated differently.

A private operating foundation is a kind of private foundation, meaning that it is not treated as a public charity for most purposes under the Code – generally speaking, it does not derive a sufficient portion of its revenues from the general public.[xlviii]

Unlike most private foundations, however – the activities of which are by-and-large limited to making grants to publicly-supported charities which directly engage in charitable activities – an operating foundation makes a statutorily prescribed level of expenditures directly for the active conduct of the activities constituting the purpose or function for which it is organized and operated, and substantially more than half of its assets are devoted directly to such activities.[xlix]

In other words, an operating foundation acts more like a public charity than like a private foundation. For that reason, a contributor who makes an otherwise qualifying contribution of tangible personal property – such as art – to an operating foundation, will be entitled to claim a fair market value deduction therefor.[l]

In addition, an operating foundation is not subject to the excise tax imposed by the Code in the case of a grant-making foundation that does not satisfy the prescribed minimum expenditure requirements.[li]

That being said, an operating foundation remains subject to the other excise taxes applicable to private foundations, generally.[lii] These excise taxes seek to influence the foundation’s decision-makers by dissuading them from engaging in certain “improper” activities, and by encouraging them to engage in others.


In the case of an operating foundation that engages in museum-like activities, the excise tax on acts of self-dealing,[liii] and the risk of private inurement, both feature prominently, especially where the foundation (i) holds fractional interests in the artwork acquired from its founder, or (ii) displays the artwork on properties related to the contributor or to businesses controlled by the contributor.

Because of these concerns, it is not unusual for such operating foundations (“OF”) to request private letter rulings from the IRS to the effect that their arrangement with the contributor or a related entity does not constitute an act of self-dealing.  The following scenario is fairly representative.

OF is an operating foundation that was organized by DP. OF owns artwork, including sculpture. Most of the artwork was contributed to OF by its founder, though some if it was independently acquired. OF was organized to promote and develop the general public’s interest in art. Its operations are located in a complex of office buildings. OF’s sculptures are exhibited outdoors and are at all times accessible to the general public. Some of these works sit on property owned by disqualified persons (including DP).

Works of art that are not suitable for external viewing are displayed by OF in building lobbies, building courtyards or public entrances, open spaces, and rights of way. Some of these buildings are owned by disqualified persons and others are not. All of this artwork is accessible to the public for viewing during business hours. The artwork is not displayed in private offices, or in areas that are not generally accessible to the general public.

Works of art that are not on display at the office complex are either on loan to various museums or universities, or are stored with an unrelated storage company that is experienced and equipped to handle such objects.

Artworks may be viewed by the general public by taking a guided tour provided by OF. Members of the public can also view the works on their own by walking through public thoroughfares, from which they can view certain pieces of art.

There is no evidence that any of the artworks are identified with any disqualified person; rather, they are considered a cultural asset of the “community.”

The Code imposes an excise tax on each act of self-dealing between a “disqualified person” and a private foundation.[liv]

The term “disqualified person” means, with respect to a private foundation, a person who is, among other things, a substantial contributor to the foundation, a foundation manager, or a member of the family of such a person. It also includes a partnership or a corporation in which a substantial contributor or a foundation manager owns equity in excess of a statutorily-prescribed limit.[lv]

According to the Code, “self-dealing” includes any direct or indirect transfer to, or use by or for the benefit of, a disqualified person of the income or assets of a private foundation.

The fact that a disqualified person receives an incidental benefit from the use by a foundation of its assets will not, by itself, make such use an act of self-dealing.[lvi] Thus, for example, the public recognition a person may receive, arising from the charitable activities of a foundation to which such person is a substantial contributor, does not in itself result in an act of self-dealing since, generally, the benefit is incidental.

In the fact pattern described above, OF displays a number of artworks in building lobbies, building courtyards, building entrances, open spaces, and rights of way. None of the artwork is displayed in private offices or in areas not generally accessible to the general public. In addition, only some of the artworks are displayed on properties owned by disqualified persons.

Under these facts, OF has probably not engaged in an act of self-dealing, provided disqualified persons have neither retained control over public access to the artworks, nor retained direct use of such artworks.

The primary beneficiaries of OF’s collection are the general public who view such artworks, and any benefits to disqualified persons are probably incidental.[lvii]

Coming Full Circle, or Roundel[lviii]

The Solow Art & Architecture Foundation is only one of many operating foundations in New York City, and throughout the country, through which real estate developers and operators, who may also be avid art collectors, share their collections with the general public.

By contributing their art collections to operating foundations, and by complying with the Code’s and the IRS’s requirements for maintaining their tax-exempt status and for avoiding the imposition of foundation excise taxes, these individuals lose a significant degree of control over the art, and subject their “relationship” to the art to public scrutiny, not only by the IRS, but also by a state’s attorney general, the public,[lix] and by the local press.[lx]

Although they certainly receive a tax benefit in exchange for transferring their art to a foundation, in the form of a not insubstantial income tax deduction, they forfeit the right to derive any economic benefit from the sale or other disposition of such art.[lxi] Judging by the appreciation in the value of the Painting, this is no small sacrifice.

Moreover, in the case of artwork, the contributor’s costs in preserving and restoring the artwork do not end with the transfer of the property to an operating foundation. Who else is going to pay to insure the artwork and to store it properly? Who will compensate a curator to care for it?

As we have stated many times on this blog, Congress often uses the Code as a tool for influencing the behavior of taxpayers. At some point, Congress decided that society would benefit from making works of art available to the general public.[lxii] It has chosen to promote the transfer of art from private individuals to the public by granting an income tax deduction in exchange for such a transfer. There is a quid pro quo – think of it as a private-public partnership.

The fact that art organizations like the Foundation exist, indicates that the above policy, as embodied in the Code, is working. Yes, the “wealthy” contributor receives a benefit, but so does the public.[lxiii] If “we” decide that the public should have greater access to the art, then Congress should impose more conditions on the contribution, but it should not eliminate the deduction lest it dissuade future contributions.

[i] These patrons had varying motives for their largesse. Initially, patrons may have acted to appease or honor a deity, or to glorify a city-state. Later, some acquired art to adorn their homes for their own pleasure. Others utilized their patronage to impress a segment of society, and to thereby gain “legitimacy” in more “sophisticated” circles.

[ii] The Medici were bankers.

[iii] The “NYT”. https://www.nytimes.com/interactive/2020/09/27/us/donald-trump-taxes.html .

[iv] “Loopholes” they call them, though I don’t always understand why. I’ve always understood the term to mean an ambiguity in the law, or a gap in the law’s coverage, such that one may avoid the intended effect of the law without actually violating the law.

[v] When last I checked, the blue collar worker in the neighborhood in which I grew up, in the Bronx, who owned the attached two-family house in which they lived, was entitled to claim deductions for depreciation (and other expenses) attributable to the rental portion of the building, without which they could not afford to keep that house.

[vi] Whose patrons were none other than the Medici.

[vii] You would know it if you saw it. It doesn’t do anything for me. Must be my peasant roots.

[viii] https://www.thedailybeast.com/sothebys-and-christies-online-art-sales-see-a-wild-west-boom-with-auction-houses-shut-by-covid-19 .

[ix] It has been on loan to the Metropolitan Museum of Art in NYC over the last several years.

[x] https://www.bloomberg.com/news/articles/2020-10-07/botticelli-sale-to-save-solow-33-million-in-capital-gains-tax .

[xi] It received its so-called “determination letter” (i.e., recognition of its tax-exempt status under IRC Sec. 501(c)(3)) from the IRS in 1991. Mr. Solow is the president of the Foundation, his son is Vice President, and the CFO of his business, Solow Realty & Development Group, is the CFO of the Foundation.

To view the Foundation’s annual federal income tax return, on IRS Form 990-PF, Return of Private Foundation, visit https://www.guidestar.org/profile/13-3614971 .

[xii] Or perhaps a trust for family members?

[xiii] The “book value” reported on the balance sheet of a private foundation’s 990-PF, Part II, reflects the “cost,” or fair market value, of the property at the time it was acquired by the private foundation. In the case of a gift of artwork (which is not depreciable), the beginning and ending book values should be the same.

The Foundation’s book value for its 99% interest in the Painting is approximately $60 million.

[xiv] Indeed, the size of the interest gifted in a particular tax year may have been dictated by, and tailored to, Mr. Solow’s expected income tax liability for that year.

[xv] For the tax year ending November 30, 2018. IRC Sec. 6104 requires that an organization described in IRC Sec. 501(c)(3), and exempt from federal income tax under IRC Sec. 501(a), make its annual tax return, as well as its tax-exemption application (on IRS Form 1023) and IRS determination letter, available for public inspection.

[xvi] In fact, paintings may be seen through the glass wall on the building’s ground floor – if you know to stop and look.

[xvii] You may know it by its sloping façade and the large red sculpture of the number “9” in front of the building. https://www.google.com/maps/uv?pb=!1s0x89c258f0a616f09d%3A0xd8f0bdcadcfe72ad!3m1!7e115!4shttps%3A%2F%2Flh5.googleusercontent.com%2Fp%2FAF1QipMoDALcZH5oybqyMeVVJc2vuJMK3e-jKLHTji9k%3Dw373-h200-k-no!5ssolow%20building%20nyc%20-%20Google%20Search!15sCgIgAQ&imagekey=!1e10!2sAF1QipN4qmnPLjUaPQGSbxOLJhDbzgn-3avg3KB5c8gl&hl=en&sa=X&ved=2ahUKEwjZmqbTmb7sAhUngnIEHSRxDTAQoiowE3oECA4QAw

[xviii] Including works by Van Gogh, Matisse, Miro, Lichtenstein, and others.

[xix] According to the Tax Return, Miro’s Triptych alone is worth $60 million.

[xx] An average annual return of 11.6%.

[xxi] According to the Foundation’s tax return, the painting had a fair market value of in excess of $84 million at the end of November 2018. It was purchased for approximately $1.3 million. Thus, the gain from its sale would be $82.7 million. The federal tax rate on the sale of collectibles by an individual is 28%. Then there are NY State and NYC personal income taxes, at the rate of 8.82% and 3.876%, respectively. And don’t forget the 3.8% federal surtax on net investment income (which the article may have omitted). That brings you to a tax in excess of $36 million.

Prior to the 2017 Tax Cuts and Jobs Act (P.L. 115-97), investors in art had the opportunity to defer the recognition of gain from the sale of artwork – and possibly avoid the income tax altogether, thanks to the basis step-up at death under IRC Sec. 1014 – by engaging in a like-kind exchange under IRC Sec. 1031. The Act eliminated this option.

[xxii] Referring to the fractional gifts. https://www.bloomberg.com/news/articles/2020-10-07/botticelli-sale-to-save-solow-33-million-in-capital-gains-tax .

Of course, as a tax-exempt organization, the Foundation will not be subject to income tax on the gain it realizes from the sale of its 99% interest in the Painting. IRC Sec. 512(b)(5).

[xxiii] The same way that depreciation deductions and like kind exchanges are.

[xxiv] IRC Sec. 170(a). This deduction is treated as an itemized deduction. Thus, the amount of the deduction may be limited in the case of higher income taxpayers. IRC Sec. 68.

In addition, in the case of an in-kind contribution of capital gain property to a public charity or to an operating foundation, the amount of the deduction for the year in which the contribution is made cannot exceed 30% of the contributor’s adjusted gross income. IRC Sec. 170(b)(1)(C). Any excess may be carried forward up to five years.

[xxv] IRC Sec. 170(c) defines this rather expansively. https://www.law.cornell.edu/uscode/text/26/170. Basically, organizations described in IRC Sec. 501(c)(3).

[xxvi] IRC Sec. 170(c)(2).

[xxvii] Property other than money.

[xxviii] IRC Sec. 170(e).

[xxix] Unless the fair market value is lower.

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

[xxxi] IRC Sec. 170(e)(1)(B)(i). In addition, in certain cases, the recipient organization must not dispose of the property during the taxable year in which the contribution was made.

[xxxii] IRC Sec. 170(e)(1)(B)(ii).

[xxxiii] IRC Sec. 170(b)(1)(F) and Sec. 4942(j)(3).

[xxxiv] A qualified appraisal is required. IRC Sec. 170(f); Reg. Sec. 170A-13, Sec. 1.170A-16, and Sec. 1.170A-17. In addition, IRS Form 8283, Noncash Charitable Contributions, must be completed by the contributor, the qualified appraiser, and the recipient organization. See also Form 8282, Donee Information Return.

[xxxv] IRC Sec. 170(f)(3)(A).

[xxxvi] IRC Sec. 170(f)(3)(B).

[xxxvii] Reg. Sec. 1.170A-7.

[xxxviii] Reg. Sec. 1.170A-7.

[xxxix] IRC Sec. 170(a)(3).

[xl] Reg. Sec. 1.170A-5.

[xli] Reg. Sec. 1.170A-5.

[xlii] Effective for contributions made after August 17, 2006. P.L. 109-280, the “Pension Protection Act of 2006.”

Query whether all of Mr. Solow’s fractional gifts preceded the change in the law?

[xliii] The contributor cannot change their mind.

[xliv] If, for example, an art museum described in Section 501(c)(3) of the Code, that is the recipient of a fractional interest in a painting, includes the painting in an art exhibit sponsored by the museum, such use generally will be treated as satisfying the related-use requirement.

[xlv] IRC Sec. 170(o).

A contribution occurring before the date of enactment is not treated as an initial fractional contribution for purposes of this rule. Instead, the first fractional contribution by a taxpayer after the date of enactment would be considered the initial fractional contribution, regardless of whether the taxpayer had made a contribution of a fractional interest in the same item of tangible personal property prior to the date of enactment.

[xlvi] IRC Sec. 170(o)(3)(B).

[xlvii] In other words, the contributor cannot benefit from the appreciation in the artwork after the initial fractional interest therein is gifted to the charitable organization.

[xlviii] IRC Sec. 509(a).

[xlix] IRC Sec. 4942(j)(3).

[l] IRC Sec. 170(e)(1)(B)(ii).

[li] IRC Sec. 4942(a).

[lii] https://www.irs.gov/charities-non-profits/private-foundations/private-foundation-excise-taxes .

[liii] IRC Sec. 4941. https://www.law.cornell.edu/uscode/text/26/4941

[liv] IRC Sec. 4941(a).

[lv] IRC Sec. 4946.

[lvi] Reg. Sec. 53.4941(d)-2(f)(2).

[lvii] In contrast, in Rev. Rul. 74-600 the IRS considered a situation in which a private foundation placed three paintings in the residence of a disqualified person, where they were displayed with the disqualified person’s large private art collection. Semi-annual tours (and other “special” tours) were conducted, on which over 2,000 persons viewed the paintings. It was held that, even though the paintings were sometimes made available for viewing by the public, the placement in the residence of a disqualified person resulted in a direct use of the foundation’s assets by or for the benefit of the disqualified person, and was therefore proscribed self-dealing under the Code. The outcome was not dependent on the number of people who viewed the art, or the frequency of such viewing, since the disqualified person retained control over public access to the paintings.

[lviii] I couldn’t resist. Apologies.

[lix] Again, just visit Guidestar.org.

[lx] Turning back to Mr. Solow, in January 2019, the Solow Building Company officially began leasing its residential rental and condominium property at 685 Third Ave., in New York City.

According to one article describing the new building, “the triple height lobby space will greet residents, with . . . a three-paneled masterpiece design by Joan Miró, borrowed from Sheldon Solow’s personal art collection, to be located on the back wall of the lobby. Of course, this is the same Miro identified on the Foundation’s balance sheet for the tax year ending November 2018. ”https://newyorkyimby.com/2019/01/sales-launch-for-solows-685-first-avenue-in-midtown-east-manhattan.html; https://www.crainsnewyork.com/article/20180511/REAL_ESTATE/180519974/sheldon-solow-using-joan-mir-oacute-paintings-from-his-tax-exempt-foundation-to-sell-condos-on-first-avenue .

[lxi] For example, many a collector has pledged their works of art as collateral to secure loans from unrelated lenders.

[lxii] That is why museums are generally exempt from tax.

[lxiii] At least in theory.

Round Two

“Painful social lockdowns in Europe and some American states helped blunt the coronavirus. Now, amid a fitful reopening, the pandemic is once again surging.”

So begins an article on the front page of last weekend’s Wall Street Journal.[i] The article describes how governments – in response to the “economic strain” being experienced by many businesses, the social “isolation” that has proven to be an ordeal for large segments of the population, and the general public’s “fatigue” with anti-virus measures[ii] – have allowed the re-opening of various kinds of institutions and business establishments.

Unfortunately, and almost immediately following the liberalization of “stay-at-home” orders, and the relaxation of restrictions on the operation of many businesses, we have started to witness a significant increase[iii] in the number of coronavirus cases throughout the country; consequently, some state and local governments have moved to reinstate social-distancing measures in various “hotspots” within their jurisdictions.[iv]

These developments do not bode well for businesses and their employees, or for the economy, generally. Indeed, even before the recent outbreaks, there was ample evidence that the beginning of the “economic recovery” we observed this summer was running out of steam.

According to the Federal Reserve – which has already reduced interest rates to near-zero – this situation calls for major fiscal stimulus; generally speaking, this means increased public spending, tax cuts, and incentives for spending by business.[v] This can only come from Congress.

Fiscal Stimulus

Ah Congress. Do you recall how quickly the CARES Act[vi] was enacted? It passed the Senate on March 25, 2020,[vii] with an amendment, by a vote of 96 to 0; on March 27, 2020, the House agreed to the Senate amendment by voice vote, and the President signed the legislation that same day.

At $2.2 trillion, the CARES Act represented the largest economic stimulus package in U.S. history. Considering its breadth and how quickly it was drafted, negotiated, and enacted, it would have been a remarkable piece of legislation under almost any circumstances. What’s more, it worked pretty well.[viii] The Paycheck Protection Program (“PPP”) loans probably rescued thousands of businesses and preserved millions of jobs.[ix] The Federal Pandemic Unemployment Compensation Program enabled millions of Americans to sustain their families.

Fast forward . . . to May 2020. The House introduced a second economic stimulus package (the “HEROES Act”), worth $3.5 trillion,[x] which passed by a vote of 208 to 199, by-and-large along party lines.[xi]

In July, the Senate introduced the HEALS Act, with a price tag of approximately $1 trillion;[xii] it was never brought to the Senate floor for a vote.

Almost five months after the House’s passage of the HEROES Act, the two parties – principally, the Administration and the Democratic leadership of the House and Senate – are still “negotiating” the terms of a stimulus package.[xiii] During this process, the Democrats pared down the HEROES Act to $2.2 trillion, while a “skinny” version of the HEALS Act[xiv] was introduced in the Senate.

In displays of election year politics, the HEALs Act was brought to the Senate floor, but failed to garner the necessary 60 votes to stop debate (which was a forgone conclusion),[xv] while the revised HEROES Act passed the House (with no prospect of being considered by the Senate).[xvi]

Then, this past Thursday, the Administration indicated that it would be willing to move closer to the spending levels proposed by the House by proffering a $1.8 trillion alternative. Many Senate Republicans, however, were quick to criticize the Administration’s offer.[xvii]

Status of Legislative “Efforts”

With only three weeks to go before the general election,[xviii] the likelihood of Congress enacting another comprehensive economic stimulus package seems remote.

The question then is whether the immediate post-election political environment will be conducive to the passage of some badly needed economic relief by the lame duck Congress, or whether political partisanship will continue to blind our legislators, thereby deferring any action into the next Congress.[xix]

That is not to say that the two political parties cannot agree on anything. In fact, they actually agree on many items and, with respect to many others they are separated only by what may be characterized as a question of degree.

Then there are some genuine substantive disagreements on what to spend money on, the significance of which cannot be understated. These are the issues that stand in the way of a comprehensive deal[xx] that covers a broad range of relief measures, the issues on which the House leadership has shortsightedly based its reluctance to pass legislation on what it describes as a piecemeal basis.[xxi]

There is one item, however, that can easily stand on its own, and that is not readily paired with the other provisions being contemplated; an item on which the two parties have been in agreement since the enactment of the CARES Act, and the effective date of which would be retroactive to the enactment of that earlier legislation. What’s more, this one item would actually unite the two parties against the Treasury Department. Finally, this item provides an immediate infusion of liquidity into the hands of many businesses.

The item in question: Ensure that otherwise deductible business expenses that were paid using loans forgiven under the PPP may still be deducted for purposes of determining the income tax liability of the borrower-business and its owners.

The IRS’s Misguided Interpretation

As you may recall, current IRS guidance bars the deduction of business expenses paid using a forgiven PPP loan. Last week, the Congressional Research Service[xxii] issued a brief report that examined the deduction issue and its history.

The report reminds us that the CARES Act has no language regarding the deductibility of expenses paid with PPP loan proceeds. The Code, it states, permits taxpayers to deduct any ordinary or necessary trade or business expenses, which would include PPP-eligible expenses. However, the Code also provides that an expense cannot be deducted if it is allocable to a class of income which is exempt from taxation.[xxiii]

The CRS then describes IRS Notice 2020-32,[xxiv] issued on April 30, 2020, which disallows deductions for business expenses paid for with forgiven PPP loans. According to the IRS, no deduction is allowed to a taxpayer for any otherwise deductible expense that is allocable to a class of income that is excluded from the taxpayer’s gross income or that is exempt from income taxes. In this way, the Code seeks to deny the taxpayer a double tax benefit.

Thus, the Notice concludes, to the extent the CARES Act[xxv] operates to exclude from a taxpayer’s gross income the amount of a PPP loan made to the taxpayer that is forgiven under the terms of the Act, the Code disallows any otherwise allowable deduction for expenses paid by the taxpayer with the loan.[xxvi]

The CRS report indicates that some policymakers have expressed concerns with the IRS’s guidance, including the Democratic and Republican chairs, respectively, of the House Ways and Means and Senate Finance Committees. In a letter to the Secretary of the Treasury, these committee chairs explained that:[xxvii]

“[W]e are writing to express our concern with the position taken by Treasury and the IRS in Notice 2020-32, which is contrary to congressional intent. Notice 2020-32 provides that otherwise deductible business expenses are not deductible if the taxpayer is the recipient of a Paycheck Protection Program (PPP) loan that is subsequently forgiven. We believe the position taken in the Notice ignores the overarching intent of the PPP, as well as the specific intent of Congress to allow deductions in the case of PPP loan recipients. . . .

“Providing assistance to small businesses, only to disallow their business deductions as provided in Notice 2020-32, reverses the benefit that Congress specifically granted by exempting PPP loan forgiveness from income. This interpretation means that whatever income a small business is able to produce will be taxed on a gross basis to the extent of the loan forgiveness, leaving substantially less after-tax capital for the swift economic recovery we hope is on the horizon.”

The chairs went on to explain that the exclusion of PPP loan forgiveness from income was specifically included in the CARES Act to provide a tax benefit to small businesses that received the PPP loan. “Had we intended to provide neutral tax treatment for loan forgiveness,” the chairs continued, the Act’s forgiveness provision “would not have been necessary. In that case, loan forgiveness generally would have been added to the borrower’s taxable income, and the expenses covered by the PPP loan would be deductible, reducing taxable income by an offsetting amount and resulting in no additional net income. Notice 2020-32 effectively renders” the income exclusion provision meaningless, and “is contrary to the intent of  . . . the CARES Act.”[xxviii]

Nothing in the CARES Act denies the borrower-business the ability to claim a tax deduction for legitimate and eligible expenses paid with the loan proceeds. Thus, the payment of the salaries, rent, etc. for which the PPP loans were intended should be deductible, thereby reducing the borrower’s tax liability. These deductions, which were to be generated by using the PPP loan proceeds for their intended purpose – not to mention the resulting tax savings and liquidity – were taken for granted by most loan applicants and their advisers, and were clearly intended by Congress.[xxix]

In the absence of an about-face by the Treasury, several bipartisan-backed proposals have been introduced separately by the Republican-controlled Senate and by the Democrat-controlled House – the first within a week of the release of the IRS’s interpretation – to allow taxpayers to receive PPP loan forgiveness without affecting their ability to claim business expense deductions.[xxx]

Unfortunately, these proposals have been held hostage to the “piecemeal” vs “all-or-nothing” stimulus package debate referenced above.

Why Wait for Congress?

The IRS’s position – that no deductions should be allowed for expenses paid using the proceeds from a PPP loan that is ultimately forgiven – converts that loan forgiveness into a meaningless gesture, and is contrary to the intent of the CARES Act.

Given the uncertain economic future faced by so many businesses, and given the continuing deadlock in Congress over any stimulus legislation, the IRS should reconsider its interpretation of this CARES Act provision and immediately withdraw its above-referenced “guidance.”

This one act would provide those businesses that participated in the PPP with additional liquidity – just as though they had received an infusion of cash – in the form of immediate tax savings. It would also deliver a positive message in the midst of what has been a frustrating and over-politicized post-CARES Act “legislative process” that has yet to yield a tangible result.


[i] “New Virus Cases Surge Across U.S., Europe,” Ted Mann, WSJ, Sat./Sun. Oct. 10-11, 2020.

[ii] Physical distancing, wearing masks, etc.

[iii] https://thehill.com/policy/healthcare/520419-us-coronavirus-numbers-rise-raising-worries-about-winter

[iv] For example, last week N.Y.’s Governor Cuomo imposed limits on certain public gatherings in specified areas of the state. In some communities, this action was met with outright hostility, and even physical abuse of law enforcement.

[v] We’re talking Keynesian economics here.

[vi] P.L. 116-136, Coronavirus Aid, Relief, and Economic Security Act (the “CARES Act”). Enacted March 27, 2020.

[vii] Yes, that’s right, it did not actually originate in the House, notwithstanding that Article I, Section 7, Clause One of the Constitution requires that “all bills raising revenues shall originate in the House of Representatives.”

The CARES Act originated in the Senate. In order to comply with the Constitutional mandate, the Senate adapted an earlier, unrelated bill passed by the House (in 2019), replaced it with what would become the CARES Act – see the reference to the “amendment” above – and returned it to the House where it passed by voice vote.

This sleight of hand was probably not what the Founders intended, but they also did not provide for the popular election of Senators; until 1913 (and the 17th Amendment), that responsibility belonged to the state legislatures.

[viii] That’s not to say there weren’t gaps or misjudgments. These are inevitable, especially given the urgency of the circumstances, the size of the effort, the complexity of the issues, and the speed with which it necessarily had to be implemented. Add to that the presence of bad actors, whose activities rose to the level of treason, at least in my book.

[ix] There are wildly differing estimates.

[x] The Health and Economic Recovery Omnibus Emergency Solutions Act (the “HEROES Act”). Suffice to say it was not limited to economic stimulus.

[xi] It was never brought to the Senate floor for debate and a vote.

[xii] Health, Economic Assistance, Liability Protection and Schools Act (the “HEALS Act”).

[xiii] With each side accusing the other of acting in bad faith.

They suspended their animus long enough for the Senate and the House to agree – on June 30 and July 1, respectively – to extend the PPP loan program until August 8, 2020.

[xiv] Hardly in the spirit of compromise.

[xv] The Senate’s cloture rule.

[xvi] Thus, each party won the right to blame the other.

[xvii] https://thehill.com/homenews/senate/520489-senate-republicans-rip-new-white-house-coronavirus-proposal .

A couple of days later, on Rush Limbaugh’s radio show, the president stated that he wants a stimulus package that is larger than that proposed buy the Democrats.

[xviii] And with members of Congress eager to hit the campaign trail themselves.

[xix] The 117th Congress begins on January 3, 2021.

[xx] Some might describe it as an all-or-nothing proposition.

[xxi] See, e.g., https://www.reuters.com/article/us-health-coronavirus-usa-democrats/democrats-reject-piecemeal-approach-to-u-s-coronavirus-relief-idUSKCN24O2AP . What ever happened to the old English adage “you can’t always get what you want, but if you try sometimes, you just might find you get what you need”?

[xxii] Congressional Research Service (“CRS”) serves as nonpartisan shared staff to congressional committees and Members of Congress. It operates solely at the behest of and under the direction of Congress.

[xxiii] IRC Section 265(a)(1).

[xxiv] https://www.irs.gov/pub/irs-drop/n-20-32.pdf

[xxv] Section 1106(i) of the CARES Act.

[xxvi] IRC Sec. 265(a)(1).

[xxvii] https://www.finance.senate.gov/imo/media/doc/2020-05-05%20CEG,%20RW,%20RN%20to%20Treasury%20(PPP%20Business%20Deductions).pdf and the Treasury’s defense of its position at https://thehill.com/policy/finance/495996-mnuchin-defends-irs-guidance-on-ppp-loans

[xxviii] I borrow $100; I pay expenses of $100; I deduct the $100 of expenses; the loan is forgiven; I have $100 of CODI; tax neutral result; no benefit to borrower. Ice in winter, right?

Compare: I borrow $100; I pay expenses of $100; I deduct the $100 of expenses; the loan is forgiven; no CODI; unlike the result described immediately above, I have a benefit equal to the tax savings attributable to the $100 of deductions.

[xxix] https://www.taxlawforchb.com/2020/05/deductions-for-ppp-covered-expenses-almost-there-how-will-your-business-use-the-tax-savings/

[xxx] The Safeguarding Small Business Act (S. 3596), the Heroes Act (H.R. 6800), the Small Business Emergency Protection Act (H.R. 6821; S. 3612), and the Safeguarding Small Business Act (S. 3596).

An updated version of the Heroes Act (H.R. 925), which allows deductibility, passed the House on October 1:


(a) IN GENERAL.—For purposes of the Internal Revenue Code of 1986 and notwithstanding any other provision of law, any deduction and the basis of any property shall be determined without regard to whether any amount is excluded from gross income under section 202 of this Act or section 1106(i) of the CARES Act.  [this is the exclusion from gross income for any PPP loan]

(b) ***

(c) EFFECTIVE DATE.—Subsection (a) and the amendment made by subsection (b) shall apply to taxable years ending after the date of enactment of the CARES Act.


What a Week

There is no denying that last week’s political events were historic; one can only hope they were aberrational.

The week began with the Sunday New York Times publishing a story in which it claimed to have obtained copies of Mr. Trump’s tax returns for several years, but not including 2018 and 2019.[i] According to the article, these returns portray a taxpayer who has regularly generated impressive revenues, but who has also regularly racked up equally impressive losses, as a consequence of which he has paid little to no Federal income tax for many years.[ii]

On Monday, in the midst of ongoing, but unproductive, discussions with the Administration over new economic stimulus measures, the Democratic leadership in the House introduced a scaled-down version of The Heroes Act,[iii] which was first submitted for consideration in May, and invited the Republicans to reconsider their position against the bill.

On Tuesday, we witnessed the two septuagenarian candidates[iv] for the U.S. Presidency square off in the first of what was to be three scheduled debates.[v] We all know how well that went. Let’s just say that neither “gentleman” discussed tax policy.

After the announcements by several blue-chip companies, on Wednesday and Thursday, that they were cutting tens of thousands of jobs, the Labor Department on Friday reported that permanent job losses had increased for the second consecutive month, to 3.8 million.

On Thursday, after further discussions with the Administration failed to generate a bipartisan measure – with the Republicans arguing that, even as revised, The Heroes Act was still too expensive – House Democrats passed their economic stimulus package[vi] as their Republican colleagues accused them of political gamesmanship.[vii]

Then came the announcement Friday that Mr. Trump had tested positive for COVID-19 – only one month before the general election – and that he would be hospitalized for several days, which will necessarily limit his campaign activities. The seriousness of his situation[viii] – when viewed against the backdrop of troubling economic news plus a resurgence of the virus in parts of the country[ix] – has led some political observers to wonder whether these circumstances will create a sense of urgency that may bring the two parties together long enough to pass a stimulus bill that both recognize is long overdue.[x]

In the meantime, as Mr. Biden continues his campaign, Mr. Pence and the Republican Party[xi] are probably doing what they can with the palpable absence[xii] of their candidate.

What’s Next?

Our country has seen its share of political upsets; take the 2016 presidential election, for example, in which Mr. Trump defeated Ms. Clinton, notwithstanding the latter’s political bona fides, and despite her having “won” the popular vote.

According to the latest NYT/Siena College Poll, Mr. Biden maintains a lead in the largest so-called “battleground states:” Pennsylvania and Florida.[xiii] Indeed, most national polls show Mr. Biden ahead in most battleground states.[xiv] Of course, many voters learned in 2016 that leading in the polls does not guarantee victory for a candidate.[xv]

In light of Mr. Trump’s condition, however, and with the election only 29 days away, what is the likelihood, realistically, of Mr. Trump’s erasing Mr. Biden’s lead and overtaking him?

The White House, however, is not the only prize in this election. In fact, a Democratic administration, even with the backing of a friendly House, will not be able to dictate, let alone implement, a change in tax policy. In order for Mr. Biden to have any chance of fundamentally changing how businesses and their owners are taxed, the Democrats will also have to reclaim the Senate.[xvi]

It just so happens that the Democrats actually have a decent chance of taking control of the Senate,[xvii] while also retaining their majority in the House.[xviii]

Under these circumstances, what should the owner of a closely held business be considering in terms of year-end tax planning, and at what point should such planning be put into effect? We’ll address these in reverse order.

When to Act?

Ideally, the planning should have begun months ago; in fact, many business owners have already determined how they will respond in the event of a Democratic victory. The implementation of these measures, however, should await the results of the election.[xix]

Trump Wins or the Senate Remains Republican

If Mr. Trump somehow remains in the White House, a Democratic sweep of Congress will represent a somewhat hollow victory unless the Party wins enough seats to override a presidential veto, which requires a two-thirds vote in each chamber.[xx]

Because no one is predicting a veto-proof Democratic majority in this November’s elections, the changes in the tax law enacted at the end of 2017[xxi] should be relatively safe through the end of 2022. However, the Congressional elections in November 2022 may very well yield such a majority, at which point the Democrats may be able to enact significant changes to the Code.

If the Republicans somehow maintain a majority in the Senate (say, 51 to 49), Mr. Biden will not be able to enact any tax increases through legislation[xxii] during his first two years in office, unless there are defections from the Republican side. Of course, even if they fail to secure the Senate this year, the November 2022 Senate races may give the Democrats a majority in both chambers of Congress.[xxiii]

Of course, many of the TCJA provisions that the Democrats are targeting are already set to expire at the end of 2025, which would be the final year of Mr. Trump’s second term.[xxiv] That being said, in the case of a Trump or Republican-Senate victory, a business owner will not have to take any action before the end of 2020 in order to take advantage of the existing tax laws, though they would have to keep their eyes on the 2022 races, and they certainly would not want to forget the end-of-2025 expiration date.

Biden Wins and Democrats Take the Senate

Call it a sweep, a trifecta, or whatever else you please, with the presidency and both houses of Congress under their control, the Democrats will be free to enact changes to the Code[xxv] during their first year in power with retroactive effect to January 1, 2021.

The Federal courts, including the U.S. Supreme Court, have held that the retroactive application of an income tax statute to the entire calendar year in which the statute was enacted does not per se violate the Due Process clause of the Fifth Amendment.[xxvi]

Start Planning for a Sweep Now (?)

The business owner will have only 58 days after the general election, and until the year-end, to implement any tax plans they may have decided upon after discussions with their advisers. Of course, that assumes the business owner has, in fact, had those discussions.

As indicated earlier, the election is 29 days away; that’s 4 weeks from tomorrow. For those business owners who have not yet considered whether or how they should plan for changes in the income, gift, estate and employment tax rules, along the lines described by Mr. Biden during the campaign, now is the time.

What to Consider

Let’s begin with a summary of Mr. Biden’s proposed changes to the Code:

  • Increase the maximum federal tax rate on ordinary income from 37% to 39.6%.
  • In the case of individuals with gross income for the taxable year in excess of $1 million, increase the federal tax rate for long-term capital gains (including with respect to carried interests) and for qualified dividends[xxvii] from 20% to the ordinary income rate of 39.6%.[xxviii]
  • Phase out the 20% qualified business income deduction[xxix] for taxpayers making at least $400,000 per year.
  • Limit the benefit of itemized deductions for higher income taxpayers.[xxx]
  • Impose the 12.4% Social Security tax – which is borne equally by the employer and the employee – on all wages in excess of $400,000.[xxxi]
  • Limit the use of like kind exchanges of real property[xxxii] to investors with annual incomes of not more than $400,000.
  • Eliminate the step-up in basis for assets acquired from a decedent.[xxxiii]
  • Reduce the so-called “basic exclusion amount” under the federal estate and gift tax, as well as the exemption amount under the generation-skipping transfer tax (“GSTT”), from $10 million to $5 million.[xxxiv]
  • Increase the federal income tax rate on C corporations from 21% to 28%.
  • Increase the effective rate on Global Intangible Low Tax Income (“GILTI”; basically, unrepatriated overseas income) from 10.5% to 21%.[xxxv]
  • Eliminate the ability to carry back net operating losses (“NOLs”) generated in 2018, 2019 and 2020, and eliminate the suspension of the “80%-of-taxable-income” limit for utilizing NOLs in 2018 through 2020.[xxxvi]

Anything Else?

What else might we reasonably expect from Mr. Biden? A good place to look is the 2017 Green Book[xxxvii] prepared by the Obama administration, from which the Democrats seem to have already borrowed “liberally.”

Among the revenue raisers included in the Green Book that take aim at the wealthy – and which may eventually find their way into Mr. Biden’s tax agenda – are the following:

  • Treat the gift or testamentary transfer of appreciated property as a taxable sale of the property in which the donor or decedent would realize a capital gain; the tax imposed on the gain deemed realized at death would be deductible on the decedent’s estate tax return;[xxxviii]
  • Impose a new annual minimum tax, equal to 30% of AGI for the year, on married taxpayers with AGI of at least $2 million, with the tax being phased in beginning with taxpayers having AGI of at least $1 million;[xxxix]
  • Require that a GRAT[xl] have a minimum term of ten years and a maximum term of the life expectancy of the annuitant plus ten years; require that the remainder interest in the GRAT at the time the interest is created have a minimum value equal to the greater of 25% of the value of the assets contributed to the GRAT or $500,000; prohibit the grantor from engaging in a tax-free exchange of any asset held in the trust;[xli]
  • If the deemed owner of a grantor trust engages in a sale or exchange transaction with that trust that is disregarded for income tax purposes by reason of the grantor trust rules, the portion of the trust attributable to the property received by the trust in that transaction (including the appreciation thereon) would be subject to estate tax as part of the grantor’s gross estate, would be subject to gift tax at any time during the grantor’s life that their treatment as the deemed owner of the trust is terminated, and would be treated as a gift by the deemed owner to the extent any distribution is made to another person;[xlii]
  • On the 90th anniversary of the creation of a trust, increase the trust’s inclusion ratio to one (1), thereby rendering no part of the trust exempt from GST tax.[xliii]

Of course, the progressive wing of the Democratic Party may have other ideas, but we won’t know what these are until the 117th Congress begins its work in January 2021.[xliv]

Regulatory Authority

In addition to the foregoing, business owners need to recognize that legislation amending the Code is not the only way by which taxes may be increased – the IRS’s regulatory interpretation of various statutory provisions may have the same effect.

Moreover, whereas the Trump administration has sought to limit the IRS’s regulatory activity, a Biden administration would likely give the agency greater latitude, more encouragement and, maybe, sufficient funding.[xlv]

What to Do?

So, what should the owners of a closely held business be considering – and planning to do – over the next 87 days?[xlvi]

Planning to Sell Your Business in 2021?

Ask a business owner and their advisers whether they’d prefer to sell their business at the end of the current taxable year, or at the beginning of the next? All other things being equal, the owner would select the following year to close the sale in order to defer payment of the resulting tax liability.

However, with the prospect of an almost 100% increase in 2021 for the tax rate applicable to capital gains, the owner and their advisers may, instead, prefer to close the sale and receive payment[xlvii] at the end of the current year.

If, for some reason, some portion of the purchase price has to be paid in the succeeding year (2021), it may behoove the seller to consider electing out of installment reporting[xlviii] in order to secure the current, lower rate, provided the payment is not deferred very long,[xlix] and certainly not beyond the tax due date for the year of the sale (2020).

In addition, the seller may insist that the cash payable at closing be allocated to its capital gain assets so as to maximize the recognition of the gain attributable to such assets.[l] The gain associated with its “hot assets” (to borrow a partnership tax term) will be recognized in the year of sale regardless.[li]

Yes, these measures seem counterintuitive in that they accelerate the recognition of gain, but it may be sensible from an economic perspective in light of the proposed increase in the applicable tax rate – the taxpayer has to run the numbers.[lii]

Finally, given the proposal to phase out the deduction based on qualified business income, this may be the last year in which the seller of a more substantial business will be able to claim that deduction in respect of any gain realized on the sale of inventory, receivables or assets that are subject to depreciation recapture.

What about Real Property?

A business that has already decided to sell a real property, but that plans to defer recognition of the gain from the sale by acquiring replacement property as part of a deferred like kind exchange,[liii] may want to consider completing the sale this year – the first leg of the exchange – and closing out the exchange next year.

It is unlikely that any change in 2021 regarding the law applicable to Section 1031 exchanges would capture a sale that occurred in the taxable year (2020) preceding the year in which the change is enacted.

Dividend Distribution?

A closely held corporation with profits generated in one year will often make a distribution of such profits in the following year. There are times, however, when rather than making such a distribution, the corporation reinvests its profits in furtherance of the business. When the accumulated earnings and profits are later distributed to the shareholders, they may be taxable as dividends.

How may a corporation, with accumulated earnings and profits, but without sufficient liquidity, make a distribution to its shareholders before the year-end so as to ensure they enjoy the current, lower capital gains rate?

For one thing, the corporation may borrow the necessary funds. Alternatively, it may issue its own obligation to its shareholders. The amount of the distribution will be the fair market value of the obligation, which will depend, in part, upon the interest rate and security of the obligation; thus, the amount distributed may not be the same as the face amount of the obligation.

Paying Year-End Bonuses?

Many closely held businesses pay end-of-the-year bonuses to their key executives and top-performing employees. These amounts are often paid at the beginning of the succeeding year.

In light of Mr. Biden’s proposal to apply the Social Security tax[liv] to all wages in excess of $400,000, the employer-business may want to consider paying the 2020 bonus this year rather than the next.

Before making this decision, however, the cost attributable to the payment of the additional tax in the following year (2021) should be compared to any tax savings that may be realized by the business by virtue of paying the higher tax. For example, a C corporation employer facing the possibility of an increased corporate income tax rate in 2021 (as described above) should determine when it would realize the most benefit from the payment.

Estate Planning Anyone?

If a business owner is already planning to make gifts of equity in the business to, or for the benefit of, their family members,[lv] but has not yet decided when to pull the proverbial trigger, well, now may be the time.

The prospect of the accelerated[lvi] reduction by at least 50% of the Federal unified gift and estate tax basic exclusion amount, and of the GSTT exemption amount, should be incentive enough for any such business owner, who faces a taxable estate, to act before the end of the year.[lvii]

What’s more, this may be their final shot at leveraging their remaining exemption amount – while also taking advantage of the current low interest rate environment[lviii] – by transferring an equity interest in their business through a zeroed-out GRAT, a sale to a grantor trust, or a bargain sale to a family member who may be active in the business.

On top of that, the value of the business has probably already been depressed, given the state of the economy. With the reduced entity value as the starting point, the gift or estate tax value of a non-controlling, non-transferrable interest in the business may reasonably be reduced still further by considering the factors at which the previously withdrawn IRS regulations were targeted.[lix]

PPP Loan Forgiveness

Wait, you may say, the PPP? That’s not on Mr. Biden’s list of proposed tax changes.

That’s correct, but it is significant that when the Democrat-controlled House introduced the original version of the Heroes Act back in May, the bill included a provision which would allow a taxpayer to whom a PPP loan was made to claim a deduction for any business expenses[lx] paid using the PPP loan proceeds, notwithstanding that the loan may be forgiven.[lxi] The Republican-controlled Senate had introduced a similar provision as part of a much smaller bill.

The scaled-down version of the Heroes Act that passed the House last week contained that same provision,[lxii] notwithstanding the turbulence and inter-party friction of the intervening period.[lxiii]

This bodes well, I think, for its ultimate passage sometime this year.[lxiv] The resulting tax savings should provide businesses that participated in the PPP (and whose loans are discharged without tax consequences) with some much needed liquidity as they continue to fight through the political, social and economic uncertainty in which we now find ourselves.

That’s all for now folks.

[i] https://www.nytimes.com/interactive/2020/09/27/us/donald-trump-taxes.html .

[ii] Among other things, the article also pointed out that Mr. Trump appeared to have claimed deductions for items that the article described as personal expenses.

In response, Mr. Biden, predictably, released his own returns to demonstrate how much more he has paid in taxes that his opponent.

[iii] It is substantively the same legislation, but the programs it seeks to create would cover a shorter period of time. https://appropriations.house.gov/news/press-releases/house-democrats-release-updated-version-of-the-heroes-act .

[iv] Mr. Trump, who turned 74 in June, and Mr. Biden, who will be 78 in November.

[v] The remaining presidential “debates” are currently scheduled for October 15 and October 22. The single vice presidential debate is still scheduled for October 7.

[vi] https://appropriations.house.gov/news/press-releases/house-passes-updated-heroes-act .

[vii] Surprisingly, a number of centrist Democrats were also not pleased with this tactic.

Meanwhile, in the north wing of the Capitol, Senator McConnell announced that he was dedicating this upcoming week to seating Federal judges.

One day later, after a third Senator (Ron Johnson) tested positive for COVID-19, McConnell announced that the Senate would not be meeting this week. Notwithstanding the change of plans, “The Senate’s floor schedule will not interrupt the thorough, fair and historically supported confirmation process previously laid out,” McConnell, said in a statement, adding that the Judiciary Committee had “successfully” met with senators appearing both in person and virtually since May.

In other words, Judge Barrett will have her turn at bat beginning October 12. https://www.nytimes.com/live/2020/10/03/us/trump-vs-biden .

[viii] The 74-year old President of the United States is in the hospital with an illness that has already killed over 200,000 Americans.

[ix] Not to mention the continuing relaxation of social distancing measures by governors in other parts of the country.

[x] https://thehill.com/homenews/house/519431-trumps-illness-sparks-new-urgency-for-covid-deal .

[xi] The RNC Chair also tested positive for COVID-19. https://www.thedailybeast.com/republican-national-committee-chairwoman-ronna-mcdaniel-tested-positive-for-coronavirus-on-wednesday .

[xii] Other than some videos and a drive around the hospital.

[xiii] https://www.nytimes.com/live/2020/presidential-polls-trump-biden .

[xiv] Texas is an exception. https://www.bbc.com/news/election-us-2020-53657174 .

[xv] Welcome to the Electoral College. See Article II, Section 1 of the Constitution, and the Twelfth Amendment.

But see the Supreme Court’s July 2020 unanimous decision in Chiafalo v. Washington and in Colorado Department of State v. Baca, where the Court basically held that a state may require an elector to support the winner of the popular vote in the state. Justice Kagan wrote for the Court. Justice Thomas wrote a concurring opinion based on the Tenth Amendment. https://www.brookings.edu/blog/fixgov/2020/07/14/supreme-courts-faithless-electors-decision-validates-case-for-the-national-popular-vote-interstate-compact/ .

[xvi] https://www.taxlawforchb.com/2020/08/bidens-tax-proposals-for-capital-gain-like-kind-exchanges-basis-step-up-the-estate-tax-tough-times-ahead/ ; https://www.taxlawforchb.com/2020/08/responding-to-the-democratic-partys-tax-plans/.

[xvii] https://fivethirtyeight.com/features/democrats-are-slight-favorites-to-take-back-the-senate/ . Assuming they take the White House, the Democrats will need a net gain of three seats in the Senate to win control of that chamber.

[xviii] Even if they control both houses of Congress, the Democrats will have to deal with the Senate’s cloture (or anti-filibuster) rule, which requires 60 votes to end debate on a matter – including a tax matter – and putting it to a vote, at which point only a majority will be required for passage. (There is no such rule in the House.) See Article I, Section 5, Clause 2 of the Constitution, which authorizes each chamber of Congress “to determine the rules of its proceedings.”

That being said, query whether the Democrats will be able to invoke the 1974 Congressional Budget Act’s “reconciliation” rule to circumvent the cloture rule, limit debate, and put a tax matter to a vote requiring only a majority? https://www.brookings.edu/policy2020/votervital/what-is-the-senate-filibuster-and-what-would-it-take-to-eliminate-it/. The Act allows reconciliation to be used for legislation that addresses revenues and spending, as well as the federal debt limit.

[xix] Here I go beating the dead horse again, but I can’t shake the memory of late 2012. For those of you who do not recall what happened, Federal tax increases were scheduled to go into effect on January 1, 2013 as a result of the expiration of the so-called Bush tax cuts. The only way this could be avoided was if President Obama and a lame-duck Congress could reach an alternative agreement. One of the taxpayer-friendly provisions scheduled to expire was the then-increased Federal estate and gift tax exemption amount of $5.12 million. Believing that the President and Congress would not reach a deal, many taxpayers made gifts at the end of 2012 in amounts sufficient to exhaust their exemption. Of course, a deal was reached on January 2, 2013 with retroactive effect (the “American Taxpayer Relief Act of 2012”), and the larger exemption amount was preserved. On January 3, clients started calling about reversing or rescinding their 2012 gifts. Many did not understand the meaning of “irrevocable.”

[xx] Article I, Section 7 of the Constitution.

[xxi] The Tax Cuts and Jobs Act; P.L. 115-97.

[xxii] Business owners need to recognize, however, that the passage of legislation by both chambers of Congress is not the only way by which taxes may be increased.

For example, after several failed attempts by the Clinton and Obama administrations at legislating restrictions on the use of valuation discounts for purposes of determining a taxpayer’s gift tax or estate tax liability arising from their lifetime or testamentary transfer of an interest in a closely held business to a member of the taxpayer’s family, the IRS proposed regulations that sought to limit the use of such discounts. See https://www.taxlawforchb.com/2016/09/the-irs-takes-the-offensive-on-valuation-discounts-part-one/ .

Although the proposed regulations were withdrawn in 2017 (after having been described as “unworkable” by the current administration), they may just as easily be reintroduced by the IRS at the direction of a Biden administration.

[xxiii] The 34 Class 3 Senators will be up for re-election in November 2022. See Article I, Section 3, Clause 2 of the Constitution.

[xxiv] The following are among the TCJA provisions set to expire at the end of 2025: These provisions include the reduced individual income tax rates, the increased exemption amount and phase-out threshold of the individual AMT, the increase in standard deduction of individuals, the suspension of miscellaneous itemized deduction, the suspension of limitation on itemized deductions, the suspension of deduction for personal exemptions, the limitation on deduction for qualified residence interest, suspension of deduction for home equity interest, the limitation on deduction for State, local, etc., taxes, the increase in percentage limitation on cash contributions to public charities, the limitation on excess business losses of non-corporate taxpayers, the qualified business income deduction, and the increase in estate and gift tax exemption.

Among those set to expire at the end of 2026: the additional first-year depreciation with respect to qualified property, and the election to invest capital gains in an opportunity zone.

https://www.jct.gov/publications/2020/jcx-1-20/ .

[xxv] Again, I am assuming that they will be able to circumvent the Senate’s cloture rule.

[xxvi] See, e.g., U.S. v. Darusmont, 449 U.S. 292 (1981). The Court stated that the retroactive imposition of a tax amendment may be so harsh and oppressive as to deny due process. In the case before it, the taxpayer had argued that they did not have notice of the change. The Court responded that the taxpayer could not claim surprise, since the proposed increase in the tax rate at issue had been under public discussion for almost a year before its enactment. Moreover, it stated, the amendments to the tax did not create a “new tax.”

[xxvii] IRC Sec. 1(h).

[xxviii] Remember to also consider the application of the 3.8% surtax on net investment income under IRC Sec. 1411.

[xxix] IRC Sec. 199A.

[xxx] IRC Sec. 63.

[xxxi] Don’t forget to add the 2.9% Medicare tax. IRC Sec. 3101, Sec. 3111, and Sec. 3121.

[xxxii] IRC Sec. 1031.

[xxxiii] IRC Sec. 1014.

[xxxiv] IRC Sec. 2010.

It’s also possible that the estate tax and gift tax exemptions may be reduced to their 2009 levels of $3.5 million and $1 million, respectively, coupled with a tax rate of 45%. President Obama’s 2017 Green Book took this position, and the progressive wing of the party may press the moderates for such an aggressive reduction in the exemption.

[xxxv] IRC Sec. 951A and Sec. 250.

[xxxvi] This reverses a provision of the CARES Act, P.L. 116-136, which temporarily suspended changes made by the TCJA.

[xxxvii] The 2017 Fiscal Year Revenue Proposals.

[xxxviii] Addresses the basis step-up at death. Mr. Biden has tossed this one around a bit.

[xxxix] Remember the “Buffet Tax?”

[xl] Grantor retained annuity trust, under IRC Sec. 2702.

[xli] Good-bye zeroed-out GRATs.

[xlii] No more sales to IDGTs.

[xliii] Wither the dynasty trust?

[xliv] Query whether the “progressives” will demand the application of more “punitive” measures in exchange for their cooperation.

[xlv] It’s not unreasonable to expect the IRS to try to burnish its image after reports over the last few years that it audits very few wealthy taxpayers. See, e.g., https://www.businessinsider.com/wealthy-who-dont-pay-taxes-rarely-pursued-by-irs-2020-6 .

[xlvi] The sum of 29 days to the election, plus 58 days to the year’s end.

No jokes about expatriating – not even to New Jersey.

[xlvii] Whether in cash, in kind, or in the form of the buyer’s taking subject to or assuming the seller’s debt.

[xlviii] IRC Sec. 453(d).

[xlix] To reduce the credit risk. Extreme example, close December 30 (just in case) for cash plus note, the note is satisfied January 2 – reduces credit risk.

[l] Section 1231 assets and capital assets defined in Section 1221.

[li] See, e.g., IRC Sec. 453(b) and Sec. 453(i).

[lii] https://www.taxlawforchb.com/2020/08/responding-to-the-democratic-partys-tax-plans/ .

[liii] Reg. Sec. 1.1031(k)-1.

[liv] 6.2% payable by the employer, and 6.2% payable by the employee (and collected by the employer).

[lv] Always an important factor – are the assets “disposable” from the donor’s perspective?

[lvi] Before 2026.

[lvii] If a taxpayer utilizes the higher exemption amount now, the IRS has indicated that it will not “claw back” the gift in the event the exemption amount is subsequently reduced.

[lviii] https://www.taxlawforchb.com/2020/09/intra-family-loan-the-gift-alternative-in-turbulent-times/

[lix] See above.

[lx] IRC Sec. 162.

[lxi] In Notice 2020-32, the IRS indicated that no such deduction would be allowed under these circumstances.

[lxii] Section 203 of the Heroes Act.

[lxiii] The deduction was not held back as a bargaining chip.

[lxiv] Yes, I believe the Lame Duck Congress will come through with a stimulus package.

Woe to Us?

We live in strange times.

The coronavirus pandemic hit the United States hard, the scientific community fears a second round later this year, and there have been wildly differing estimates over when an effective vaccine may be available.

Millions of Americans remain unemployed and are struggling to stay afloat, approximately one hundred thousand small businesses have already been lost and others are sure to follow, cities are eerily quiet as millions of office workers have adapted to conducting business remotely,[i] long-standing issues of economic inequality and discrimination have found new voices, generating sometimes violent protests across the country, and many who can relocate to more rural (even foreign) areas to ride out the “storm” have done so.[ii]

Notwithstanding the foregoing circumstances, Congress is unable to produce an economic stimulus measure or any social welfare package because of competing political “ideologies,” partisan politics, and election-year posturing.[iii]

We seem to be at odds with most of the world, the nation’s chief executive has intimated that he may not accept the results of the upcoming general election, Congress and former Pentagon officials are openly concerned about the role the military may be called upon to play in the aftermath of the election.[iv]

Oh, I almost forgot, we face the prospect of significant increases in the federal gift and estate taxes in the near future.

Life Goes On

In light of the general uncertainty surrounding us, many relatively well-off taxpayers who might otherwise have considered making gifts of property to their issue,[v] whether outright or in trust, in order to take advantage of the current basic exclusion amount,[vi] may no longer feel comfortable with giving up control of such property[vii] or of the income it generates, at least not without receiving something in exchange in order to provide themselves some financial cushion.

Fortunately, today’s historically low interest rate environment[viii] favors certain planning techniques that may allow a taxpayer to at least “freeze” the value of their gross estate by shifting appreciation to their issue, while at the same time providing the taxpayer with a degree of economic security.

These estate planning strategies seek to take advantage of the low rates that are now prevalent by requiring the taxpayer-donor to act as a lender while their issue-beneficiary (or a trust for their benefit) acts as a borrower.

In concept, the taxpayer will transfer money to their beneficiary in the form of a loan – evidenced by a note that includes terms for its repayment to the taxpayer – the proceeds of which the beneficiary will use to acquire property that may currently be undervalued but which is reasonably expected to appreciate (and/or generate income) over time. Alternatively, the taxpayer may sell such property to a grantor trust[ix] for the benefit of their issue in exchange for a term note.

There are other variations on this approach; in each case, their success from a tax planning perspective depends upon the appreciation in value of the property that is acquired by the beneficiary (or trust) using the loan proceeds, or that is sold by the taxpayer to the grantor trust, at a rate that exceeds the AFR, or other statutorily prescribed rate derived from the AFR,[x] at which interest is paid to the taxpayer.

Intra-family Loan

The most straightforward of these interest-sensitive techniques – but not necessarily the simplest – is a loan of money from the taxpayer to one of their issue, or to a trust for the benefit of such issue.

Assuming the taxpayer charges interest at a rate that is at least equal to the AFR, the transfer of money (by itself) will not be treated as a gift for purposes of the federal gift tax.[xi]

However, in order for this strategy to be successful, the property in which the child or trust invests the loan proceeds has to generate an economic return in excess of the AFR.[xii] In that case, the value “shifted” to the borrower-issue will exceed the amount to be repaid to the lender-taxpayer.[xiii] Stated differently, the “spread” between the AFR and the actual return on the property may be viewed a tax-free gift to the taxpayer’s issue.[xiv]

As mentioned above, the repayment of the loan – i.e., the return of the money transferred by the taxpayer, plus interest – may be a key consideration in the taxpayer’s decision to make a loan rather than a gift to the child.

Of course, in order for the repayment of the taxpayer’s “loan” to be treated as such – i.e., as a nontaxable return of capital to the taxpayer, along with the taxable interest that was charged by the taxpayer in exchange for the use of the taxpayer’s money –   the initial transfer from the taxpayer to their issue has to be respected as a bona fide loan.

One taxpayer recently learned that it is no simple matter to structure an intra-family loan that will be respected as such by the IRS and the courts.[xv]

Loans or Advances of One’s Inheritance?

Mom had five children. She and the children were among the beneficiaries of a trust established by her deceased former spouse (the “Trust”).

Mom was determined to divide her assets among her children equally. Her practice was to maintain a written record of any amounts she advanced to each of them, and the “occasional repayments” for each child. On the basis of her original intent, and on the advice of her tax counsel, she treated the advances as loans.[xvi]

Every year, Mom forgave the “debt” account of each child[xvii] to the extent of the-then applicable federal gift tax exemption amount.[xviii] According to the Tax Court (see below), Mom’s practice “would have been noncontroversial” – provided the original transfers from Mom were, in fact, bona fide loans – but for the substantial amount Mom advanced to Son.

Son took over Dad’s business. After enjoying some early success, Son began to experience serious financial difficulties; eventually, the business fell behind on its bills. At that point, Son entered into an agreement with the Trust to use its property as security for bank loans to Son’s business.[xix] Within a year, Son failed to meet his obligations under the loan, and the Trust was ultimately held liable for the loan owed to the bank.

Mom was aware of Son’s business issues. Over the course of 22 years, Mom made annual transfers of varying amounts to or for Son’s benefit, which she treated as loans;[xx] in the aggregate, these exceeded $1 million.

Son did not repay any part of these advances to Mom, although he was gainfully employed throughout those years.

Mom’s Estate Plan

During these years, Mom established the Revocable Trust, under the original terms of which she specifically excluded Son from any distribution of her estate upon her death.

Mom subsequently amended the Revocable Trust such that it no longer explicitly excluded Son from any distribution, but provided a formula to account for the “loans” made to Son during Mom’s lifetime.

Among the other estate planning documents prepared for Mom at that time was a document captioned “Acknowledgment and Agreement Regarding Loans” (the “Acknowledgment”). The Acknowledgment was dated and signed by Son. The Acknowledgment recited that Son had “received, directly or indirectly, loans from [Mom],” and that he had “neither the assets, nor the earning capacity, to repay all, or any part, of the amount previously loaned, directly or indirectly, to” him by Mom.[xxi]

Furthermore, Son “acknowledge[d] and agree[d]” that, “irrespective of the uncollectability or unenforceability of the said loans, or any portions thereof, the entire amount” thereof, “plus an imputed amount of interest thereon, computed at the Applicable Federal Rate for short-term indebtedness [[xxii]] determined as of the end of each calendar year, shall be taken into account” by the Revocable Trust for purposes of dividing the trust’s assets among Mom’s children (including Son) upon her death.

In essence, the value of the Revocable Trust’s assets – after allowance for expenses, including estate tax – would be divided equally among Mom’s children; however, each child’s “preliminary” share would be reduced by an amount equal to that child’s outstanding loans, if any, plus the interest deemed to have accrued thereon; the amount of such reduction would be redistributed pro rata (equally) among the other children.

IRS Audit and Tax Court

Following Mom’s death, the fiduciary of her estate filed an estate tax return on IRS Form 706.[xxiii] Among the assets included on the return were the debts owing from Son to Mom, which were valued at zero.

The IRS examined Mom’s estate tax return, and issued a notice of deficiency[xxiv] in which it asserted that the estate had undervalued Son’s debt; it also added the interest accrued on the debts to Mom’s gross estate.

In the alternative, the IRS argued that the advances Mom made to Son over the years should have been treated as gifts and, thus, should have been added to the “adjusted taxable gifts” included in computing Mom’s estate tax liability.[xxv]

Mom’s estate petitioned the U.S. Tax Court to review and reverse the IRS’s determination.

At some point in the judicial process, the IRS conceded its primary position in the notice of deficiency, that the estate tax return undervalued the debts from Son. Therefore, the issue before the Court was whether Mom’s advances to Son were loans or gifts.[xxvi]

The Court began by reviewing the “traditional factors” used to decide whether an advance was a loan or a gift. Those factors, the Court explained, are as follows: (1) there was a promissory note or other evidence of indebtedness, (2) interest was charged, (3) there was security or collateral, (4) there was a fixed maturity date, (5) a demand for repayment was made, (6) actual repayment was made, (7) the “debtor” had the ability to repay, (8) records maintained by the “creditor” and/or the “debtor” reflected the transaction as a loan, and (9) the manner in which the transaction was reported for Federal tax purposes was consistent with its status as a loan.

However, the Court added that these factors were not exclusive. Moreover, the Court explained, in the case of a family loan, “it is a longstanding principle that an actual expectation of repayment and an intent to enforce the debt are critical to sustaining the tax characterization of the transaction as a loan.”[xxvii]

In the present case, the Court continued, although Mom recorded the advances to Son as loans and kept track of interest, there were no loan agreements, there were no attempts to force repayment, and there was no collateral securing Son’s obligation to repay the loans.

The reasonable possibility of repayment, the Court commented, was an objective measure of a purported lender’s intent. In response to the estate’s assertion that, during her life, Mom considered these advances as loans, the Court stated that it could not reconcile the estate’s position with the deterioration of Son’s financial situation and the ultimate failure of Son’s business.

The Court observed that Mom may have expected Son’s business to do well, and may have been slow to lose that expectation. However, it was clear that Mom had realized Son was very unlikely to repay her loans when he executed the Acknowledgment and she contemporaneously amended the Revocable Trust to account for those loans in determining Son’s share of her estate at the time of her death.

At that point, according to the Court, the theretofore “loans” lost that characterization for tax purposes and became advances on Son’s inheritance from Mom.

Thus, the Court concluded the advances to Son were loans up to the time that Mom amended her Revocable Trust – in recognition of the fact that, given Son’s financial distress, the loans could not be repaid – following which the advances became gifts that should have been accounted for in determining Mom’s estate tax.


The Court was generous in finding that Mom’s advances were loans at any time they were outstanding, notwithstanding her initial confidence that Son would repay them.

Although the intent of the parties is a significant factor in determining whether they were creating a debt, there has to be a reasonable expectation of repayment, and that intent has to comport with the economic reality of creating a debtor-creditor relationship.

In this case, the arrangement between Mom and Son failed almost every traditional factor described by the Court, above; no note, no interest, no collateral, no payment, no demand for payment, no maturity date. On these facts, should Mom’s subjective belief in Son’s ability to pay have sufficed for purposes of treating the initial advances as loans? I would not have banked on that alone.

If a taxpayer is seriously contemplating a loan to their issue as an alternative to a gift, and if the parties believe that the investment to be made using the loan proceeds has a reasonable possibility of success (as discussed above), they should treat with one another as closely as possible as they would with an unrelated party.[xxviii]

For me, that means separate legal representation for the taxpayer and their issue, a written agreement to evidence the loan, a reasonable term of years that considers the taxpayer’s desire for the funds to be returned,[xxix] interest at the AFR payable at least annually,[xxx] no prepayment penalty,[xxxi] adequate security for the loan, reporting for tax purposes consistently with a debtor-creditor relationship, and consistent representations to others (for example, personal financial statements). In this way, the parties should be well-positioned to resist any claim by the IRS that the transfer of money was actually a taxable gift.

[i] With adverse consequences for the restaurants and other retail establishments that serviced them.

[ii] Reminiscent of emigres who, historically, flee their homes at the first sign of revolution?

[iii] Some may argue that this is to be expected in our two-party system. Others will say that this division is a good thing because the electorate will have a better idea of which party’s vision for the future of the country comports with their own. In response, I say, at what cost?

The most recent Gallup poll indicates that 75% of the public disapproves of the way Congress has handled its job. https://news.gallup.com/poll/1600/congress-public.aspx

[iv] See “Pentagon Leaders Worry Trump Will Drag Military Into Election,” by Jennifer Steinhauer and Helene Cooper, The New York Times (September 26, 2020).

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

[v] For our purposes, their children or grandchildren (the “beneficiary”). https://www.taxlawforchb.com/2020/03/think-before-you-gift-but-dont-take-too-long/

[vi] $11.58 million. IRC Sec. 2010 and Sec. 2505.

[vii] Or they may be interested in scaling back their plans for gifting.

[viii] At the most recent meeting of the Federal Open Market Committee, the Federal Reserve committed itself to keeping short-term interest rates near zero percent for the foreseeable future. https://www.thebalance.com/fomc-meetings-schedule-and-statement-summaries-3305975 .

The long-term Applicable Federal Rate (“AFR”) under IRC Sec. 1274 for September 2020 is only 1%; for October, it will be 1.12%. Rev. Rul. 2020-20. This is well-below a fair market rate that would be charged by a commercial lender.

[ix] Rev. Rul. 85-13. Most readers are probably familiar with a grantor’s sale to a grantor trust – a nonevent for purposes of the income tax. https://www.taxlawforchb.com/2015/08/sale-to-idgts-the-death-of-the-grantor/ A variation on this is the SCIN. https://www.taxlawforchb.com/2015/09/scin-ing-the-tax-adviser-part-i-of-ii/ .

Then there is the grantor retained annuity trust, or GRAT, which is a trust created under IRC Sec. 2702 and the regulations thereunder. In form, the GRAT involves the sale of property by the grantor to a grantor trust in exchange for the right to be paid an annuity from the trust every year, for a specified number of years. When this term of years ends, the property in the trust will either remain in trust for the benefit of the grantor’s issue, or it may pass outright to the issue as the beneficiaries of the remainder interest. The amount of the gift arising from the transfer to the trust is equal to the excess of (i) the value of the property transferred, over (ii) the present value of the grantor’s annuity interest.

[x] IRC Sec. 7520.

[xi] IRC Sec. 7872.

[xii] In other words, it has to exceed the amount of principal plus AFR-interest that is to be returned to the taxpayer.

[xiii] Stated differently, the lower the rate charged, the more effective the loan will be.

[xiv] An added benefit: the interest paid by the child to the taxpayer remains within the “family unit” rather than being paid to an unrelated commercial lender.

[xv] Est. of Bolles v. Comm’r, T.C. Memo 2020-71.

[xvi] The Court did not mention whether (i) the “debts” – the Court used quotations marks – were evidenced by promissory notes, (ii) Mom and the borrower-child had agreed to repayment terms (for example, a maturity date), (iii) interest was paid (or was imputed for tax purposes), (iv) the debt was secured in any way, or (v) Mom or the child represented to third parties that her transfers to the child were loans.

[xvii] A creditor’s forgiveness of an amount owing from a debtor generally results in the accretion of value in the hands of the debtor. For that reason, the debtor is treated as having realized income in the form of the debt cancelation. IRC Sec. 61(a)(11).

However, the Code also provides, for various policy reasons, that the cancelation of debt in certain circumstances should not be treated as a taxable event. For example, where the debtor is insolvent, the debt cancelation is not included in the debtor’s gross income to the extent of the debtor’s insolvency immediately before the cancelation; after all, to that extent, the debtor has not realized any accretion in value. IRC Sec. 108(a)(1)(B) and Sec. 108(a)(3).

Interestingly, Sec. 108 does not expressly refer to “gift” transfers of a debtor’s indebtedness. That said, under IRC Sec. 102(a)(1), an individual’s gross income does not include the value of any property acquired by gift.

[xviii] Currently at $15,000 per year. IRC Sec. 2503.

To illustrate how the annual gift exclusion works: during 2020, I can choose to make a gift of $15,000 to every person in the Manhattan phone book without incurring any gift tax liability and without consuming any part of my unified lifetime/testamentary exemption amount.

[xix] The agreement also reflected that Son’s business owed Trust back rent. It appears that Trust owned the real property out of which the business operated.

[xx] Mom directly transferred money to Son, deposited money into accounts to which Son had access, made payments on loans taken out by Son, and issued a letter to a lending institution allowing Son’s business to withdraw funds to pay interest on a loan.

[xxi] The Court’s opinion is silent as to whether Mom claimed a bad debt deduction under IRC Sec. 166 with respect to her advances to Son. Unlikely.

[xxii] Which may indicate that these were demand loans, without repayment terms or a maturity date. IRC Sec. 7872.

[xxiii] United States Estate (and Generation-Skipping Transfer) Tax Return.

[xxiv] IRC Sec. 6212.

[xxv] Under IRC Sec. 2001(b).

[xxvi] The estate argued that, under Tax Court Rule 142, the IRS had the burden of proof on the gift issue. Although the Court admitted that the estate’s position had some merit, the Court also stated it did not need to resolve the issue because the evidence in the case permitted a resolution on the record of trial.

[xxvii] The IRS and the courts have long recognized that transactions between members of a family and the family-controlled business – as is also the case for intra-family transactions, generally – are subject to rigid scrutiny, and are particularly susceptible to a finding that a transfer of funds by the business was intended as something other than a loan. https://www.taxlawforchb.com/2020/08/transfer-of-funds-between-related-entities-indebtedness-or-something-else/#_edn15

[xxviii] If the investment is something that the taxpayer, themselves, would not consider, then the taxpayer shouldn’t make the loan, at least under the assumption made herein that the taxpayer is not comfortable with giving up control of their property without receiving consideration in exchange therefor.

[xxix] To lock in the favorable AFR as the interest rate. The rate on a demand loan fluctuates month-to-month, though the blended rate (published twice a year) may be utilized. What’s more, what third party makes a demand loan, at least without valuable collateral?

[xxx] No third party would accrue the interest until the end of the term. In any case, we’re talking about very low rates here. If the borrower cannot handle current interest payments at this AFR, the taxpayer should probably forget about making the loan.

What’s more, we’re assuming herein that the taxpayer wants to be compensated for the use of their money.

[xxxi] Which effectively allows the borrower to turn the loan into a demand loan.

Stimulus Legislation Limbo

In has been 192 days since the President declared a national emergency concerning the COVID-19 outbreak.[i] Across the country, businesses and communities were immediately placed on lockdown[ii] in order to contain the virus. Unfortunately, this response plunged us into an economic crisis that continues to plague us.

Congress responded relatively quickly.[iii] Between March 3, 2020 and April 24, 2020, it enacted four major pieces of legislation aimed at stemming and, hopefully, reversing the damage inflicted on the economy.[iv]

These measures had a positive impact. There is no denying that the Paycheck Protection Program[v] has kept many businesses alive and has allowed others to retain their employees, while the Pandemic Unemployment Compensation Program[vi] kept many households afloat.[vii]

However, considering the size and severity of the challenges at which these measures were directed,[viii] and considering the temporary nature[ix] of the programs created by the legislation – the PPP stopped accepting applications after August 8, 2020, and the federal unemployment compensation payments stopped after July 31, 2020 – few can deny that more federal intervention is required; indeed, last month the Federal Reserve[x] warned that more economic stimulus measures are needed in light of what economists are describing as the longer-lasting impact of the pandemic.

That said, what has Congress – or, more accurately, the two major political parties – done during the 150-day period following the passage of the last relief measure? Mostly, nothing, though each party has proposed legislation that its leaders certainly knew would be unacceptable to the other – a $3.5 trillion relief plan introduced by the Democrats in May,[xi] and $1 trillion plan introduced by the Republicans in July.[xii] For example, after months of on-and-mostly-off discussions between the White house and the Democratic Party’s leadership, Sen. McConnell introduced a stimulus measure[xiii] on September 10 that failed to pass the Senate.[xiv] On September 15, the House’s bipartisan “Problem Solvers” caucus – don’t laugh – presented a $1.5 trillion middle-of-the-road stimulus package which received a cold reception from the leadership of both parties.[xv]


So, where are we now? The general elections are only 43 days from today. It appears that the chances of Congress’s passing any significant economic stimulus legislation before then, or during the immediately succeeding lame duck session, are remote. Thus, depending upon the outcome of the elections,[xvi] the earliest that new relief measures may be enacted is during January of 2021.[xvii]

Where does that leave the closely held business and its owners? The business may or may not have received a PPP loan;[xviii] it may be unsure whether the full amount of any such loan will be forgiven. It may have elected to defer (until the end of 2021 and 2022) the deposit and payment of its share[xix] of Social Security taxes on wages paid to employees through December 31, 2020.[xx] Like most other business owners, they are concerned about the future of their business, the state of the economy, the prospect of more federal relief, the likelihood of higher federal and state taxes, the possible resurgence of the coronavirus, etc.

Owners will do what they can to keep their businesses viable.[xxi] Although the great majority of owners will remain within the law, a not insignificant number may consider, and ultimately follow through with, a “strategy” that is often utilized by businesses in distress: failing to remit to the taxing authorities those taxes that the business has withheld or collected on their behalf – typically, the employee’s share of employment taxes on wages paid by the employer,[xxii] and state and local sales taxes.

Why would a business engage in such illegal behavior? The reasoning goes something like this: “Revenues were down. We just needed some time to recover – the tax money was going to help us sustain the business until it became profitable once again. At that point, we would have paid the taxes owing.”[xxiii] As you can imagine, it rarely works out that way, the business fails, and the owners are left holding the proverbial bag.

There are times, however, in which this decision is not adopted as a matter of “company policy” but, rather, is undertaken by only one well-positioned[xxiv] owner or officer of the business, unbeknownst to the others. As the co-owner of one New York business recently discovered, their inability to control the business may not be a defense against personal liability for such unremitted taxes.[xxv]

Whose Business Is It?

Taxpayer organized Corp, and had it certified as a minority business enterprise (“MBE”) in order to qualify for certain government-awarded projects.

At some point, Taxpayer asked Investor whether Corp could perform the “minority participation work” for Investor’s company (“IC”). Investor ultimately decided to invest in Corp, as a result of which Taxpayer became a 51% shareholder, with Investor owning the remaining 49% interest.

Investor became involved in the financial management of Corp. According to Taxpayer, Investor assumed responsibility for all “office” functions, including “payments and all the liabilities and distributions as far as checks and taxes,” while Taxpayer – who had no experience managing a business – remained responsible for projects in the field.[xxvi]

Corp’s checkbook was moved to Investor’s office. Taxpayer would travel to that office about once a week to sign checks prepared by IC’s controller at Investor’s behest, though Investor also maintained a facsimile stamp of Taxpayer’s signature, and would authorize its use without consulting Taxpayer. Taxpayer had no authority to issue checks without Investor’s permission.

The Agreement

Investor committed substantial sums of money to Corp, whereas Taxpayer invested little by comparison.

Taxpayer entered into an agreement with IC which recited that “[w]hereas [Corp] was indebted to [IC] . . . , and the parties desire to order their relationship in the event of certain contingencies,” the parties agreed that “upon the written demand of [Investor],” Taxpayer would resign his position as president of Corp, and would sell most of his shares of Corp common stock to Investor for a nominal amount.

According to Taxpayer, he entered this agreement because he needed the economic support of Investor and of IC.

Tax Problems

During the tax periods at issue, employment tax returns were filed on behalf of Corp, some of which were signed by Taxpayer and others by Investor; of these, some were accompanied by checks and others without payment.

Taxpayer first became aware that Corp was delinquent with regard to New York taxes during one of the earlier periods at issue. At that point, Taxpayer negotiated[xxvii] the terms of an installment agreement to pay off a New York tax debt of $75,000. As part of that negotiation, Taxpayer completed and executed a “responsible person” questionnaire, on which he indicated that he “participate[d] in making significant business decisions,” and that he was “responsible for maintaining and managing the business.” With regard to the question whether he had authority to perform specified functions, he checked the “yes” box for the following functions:

  • manage the business with knowledge and control over financial affairs;
  • pay or direct payment of bills or other business liabilities;
  • act, on behalf of the business, with the Tax Department;
  • hire and fire employees; and
  • negotiate loans, borrow money for the business, or guarantee business loans.

With regard to a question regarding Taxpayer’s “involvement in the financial affairs of the corporation,” Taxpayer responded “[a]ll financial affairs dealing with [Corp’s] day to day business.”[xxviii]

Taxpayer subsequently received a proposed assessment of trust fund recovery penalty[xxix] from the IRS, in excess of $10 million, which included the periods at issue with New York.

Taxpayer approached Investor and asked what he was going to do about the asserted tax liabilities. Investor responded that “this is my [i.e., Investor’s] responsibility. It is my money, I’ll take care of it.”[xxx]

Over time, Taxpayer continued to question Investor regarding Corp’s tax liabilities, and Investor would tell him, “don’t worry about it, I’m taking care of it, that’s my responsibility.” On such occasions, Investor would also remind Taxpayer that it was “his [Investor’s] company, his money.” According to Taxpayer, he had no ability to pay the tax debts without Investor’s approval, and the latter would not approve such repayments.[xxxi]

According to Taxpayer, Investor began to lose financial control of Corp as a result of Corp’s accumulating employment tax liabilities, plus a growing liability vis-à-vis Union. Investor attempted to negotiate a settlement with Union, as part of which counsel for Union asked that a “questionnaire” be completed on behalf of both Corp and IC. Investor forwarded the questionnaire to Taxpayer, who refused[xxxii] to complete it because, he said, he had no control of Corp’s finances and did not want to become personally liable under any settlement.

At that point, Investor exercised his right under the above-referenced agreement to purchase Corp stock from Taxpayer, and caused Taxpayer to resign his position as an officer of Corp.

ALJ Proceedings

New York’s Department of Taxation (the “Dept.”) issued notices of deficiency to Taxpayer, asserting withholding tax penalties for his “willful failure” to collect and pay over Corp’s withholding taxes when he was under a duty to do so (a “responsible person”).[xxxiii]

Taxpayer appealed the Dept.’s determination to the Division of Tax Appeals.

The Dept.’s Backup

The Dept. introduced bank signature cards for Corp’s account with Bank, including one that listed Investor, a replacement card that listed both Investor and Taxpayer which included a handwritten note that “[Taxpayer] may withdraw funds independently. Withdrawals by [Investor] must receive [Taxpayer’s] dual approval.”[xxxiv] A later card signed by Investor as “President,” removed Taxpayer’s authorization as a signer on the account.

In addition to the foregoing, Taxpayer represented Corp with regard to matters related to its MBE status, and even with regard to tax matters involving the Dept. For example, Taxpayer’s signature appeared on Corp’s application to register for a sales tax certificate of authority, which also identified Taxpayer as a “responsible person, with the title of president; it described Taxpayer’s primary duties as “[o]versees all business activities.”[xxxv]

According to the Dept.’s records, Taxpayer was identified as Corp’s contact person for corporation tax, sales tax, and withholding tax.[xxxvi]

The Dept.’s contact log also showed that Taxpayer spoke with the Dept.’s tax compliance unit a total of eight times regarding the taxes at issue, including conversations regarding the payment of the taxes.

Taxpayer’s Backup

Corp’s controller during the years at issue testified that all of the receipts for the two companies came to IC’s office, where they were transferred between Corp’s and IC’s bank accounts, as needed. According to the controller, it was Investor who determined which of Corp’s liabilities would be paid, including tax liabilities, and that if Taxpayer had directed her to pay those tax liabilities without the approval of Investor, she would not have done so. The controller testified that Taxpayer had no access to Corp’s checkbook.

An attorney who did legal work for IC and Corp testified that Investor was in complete financial control of Corp, kept Corp’s checkbook and the facsimile stamp of Taxpayer’s signature in his safe, and did not give Taxpayer access to either. The attorney also testified that Investor treated Taxpayer like an employee. Although Taxpayer enabled Investor to operate Corp as a minority enterprise, it was Investor’s business – “he put all the money into this business and it was his business. And he made that clear to everybody . . . including [Taxpayer]. It was not [Taxpayer’s] business to run.”

The ALJ’s Opinion

The Administrative Law Judge (“ALJ”) explained that the question of whether someone is a responsible person, under a duty to collect and pay over withholding taxes, ultimately turns on whether the individual “had or could have had sufficient authority and control over the affairs of the business to be considered a responsible officer or employee.”

The ALJ described the factors considered in determining one’s status as a responsible person for purposes of the withholding tax penalty, including the individual’s status as an officer, director, or owner of the business; authorization to write checks on its behalf; knowledge of and control over its financial affairs; authorization to hire and fire employees; whether the individual signed tax returns for the business; the individual’s economic interest in the business; and if the individual held himself out to third-parties as a responsible person.

The imposition of the penalty, however, required more than merely determining that an individual was a responsible person; it also had to be shown that such individual acted “willfully.” According to the ALJ, willfulness is shown through “conscious and voluntary acts done with the knowledge that the taxes would not be paid over, but rather used for other purposes.”

However, the ALJ also added that “a lack of knowledge that taxes were not being paid does not hinder a finding of willful failure to remit taxes, if the responsible person recklessly disregarded” their responsibility in seeing that taxes were paid.

After considering the various indicia of Taxpayer’s status as a responsible person for Corp, the ALJ concluded that Taxpayer qualified as a responsible person. In particular, the ALJ considered Taxpayer’s agreement to relinquish financial control of Corp to Investor while still exercising operational control. The ALJ also pointed to Taxpayer’s having continued to hold himself out as a responsible person for Corp even after becoming aware that withholding taxes were not being paid.

While acknowledging that a responsible person can make a reasonable delegation of responsibility, the ALJ found that Taxpayer’s delegation to Investor was unreasonable in the face of mounting evidence that Corp’s tax obligations were not being fulfilled. Because Taxpayer’s actions amounted to “more than accidental nonpayment,” the ALJ concluded that the willfulness requirement was met.

With that, the ALJ sustained the notice of deficiency,[xxxvii] and Taxpayer filed an appeal to the Tax Appeals Tribunal (“TAT”).[xxxviii]

Taxpayer’s Appeal 

Taxpayer argued that the ALJ incorrectly found that Taxpayer had sufficient control of Corp to be considered a responsible person. Taxpayer argued that he did not control Corp, and was thwarted in carrying out his duties. In particular, Taxpayer argued that access to a corporate checkbook was a significant factor in making a responsible person determination, and should be weighed in his favor. Taxpayer claimed that he had no actual authority, and could not pay the withholding taxes regardless of whether he wanted to. Thus, he argued, his actions could not be interpreted as willful.

The Dept. argued that the liability of a responsible person is personal in nature and cannot be avoided by pointing to another responsible person. The Dept. contended that finding an individual has control of a corporation does not depend on such individual’s actual assertion of such authority. According to the Dept., where “preclusion from carrying one’s corporate duties was foreseeable, and the product of” a taxpayer’s own actions, the taxpayer does not escape personal liability for the failure to collect and pay over taxes. The Dept., therefore, argued that Taxpayer’s disregard of his corporate responsibilities, by failing to ensure that tax payments were remitted to the state, met the requirement of willfulness.

According to the TAT, the question of whether someone qualifies as a person under a duty to collect and pay over withholding taxes is a factual one, and its resolution turns on a variety of factors, including those described in the ALJ’s opinion. Whether one held themselves out to third parties as a responsible person is also a factor to consider in making a responsible person determination.

The TAT considered whether Taxpayer presented facts showing that he lacked control and authority over the affairs of Corp. The TAT noted that Taxpayer was an officer of Corp and its majority shareholder, managed its field operations, had check signing authority, filed tax returns on behalf of the company, and had considerable economic interest in Corp. These facts, considered in conjunction with Taxpayer’s having held himself out to third parties, as well as to the Dept. itself in responding to its questionnaire, were uncontested and required the conclusion that Taxpayer qualified as a responsible person.

The TAT then observed that “willfulness” can be found where a responsible person recklessly disregards their corporate responsibilities, notwithstanding their lack of actual knowledge that taxes were not being paid. Corporate officers cannot absolve themselves, the TAT added, by disregarding their duty and leaving it to someone else to discharge. Similarly, declining to exercise one’s authority does not prevent one’s actions or inactions from being willful.

In the present case, the TAT continued, there was no question that Taxpayer left his duty to collect and pay over withholding tax to another person. According to the TAT, Taxpayer’s claims that he was “thwarted” in his attempts to comply with responsibilities for Corp’s tax obligations were difficult to reconcile with Taxpayer’s account of how different responsibilities for Corp were assigned since its formation. It seemed that the arrangement whereby Taxpayer claimed to have no control or authority to pay Corp’s tax obligations was one of his own making; it was a conscious and voluntary act that resulted in Corp’s failure to pay its tax. Even without knowledge that withholding tax would not be paid, this could be sufficient to sustain a finding of willfulness for purposes of the penalty. However, the TAT found that Taxpayer had actual knowledge that withholding tax was not being paid to the Dept. Thus, Taxpayer’s continued reliance on Investor to pay withholding tax constituted a reckless disregard of taxpayer’s duty to act.

Easier Said

Seems harsh, doesn’t it? It is clear that Taxpayer needed Investor’s financial support, and that Investor controlled Corp’s purse strings. However, the fact that Taxpayer “voluntarily” agreed to relinquish a measure of control over Corp was enough to doom him,[xxxix] notwithstanding that, as a practical matter, he could not compel payment of the delinquent withholding taxes.

The Dept.’s predisposition toward finding “willfulness” should dissuade any business owner from adopting the “company policy” described earlier.

That said, business owners also need to implement safeguards to ensure that no one of them, or any of the business’s key employees, is able to unilaterally divert any kind of withholding taxes toward the payment of business expenses. After all, the taxing authorities are not in the business of making loans to taxpayers.

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

[ii] Many are referring to this as the “Great Shutdown.” See, e.g., https://www.forbes.com/sites/iese/2020/05/14/the-great-shutdown-challenges-and-opportunities/#14206e8e6f12

[iii] And, I might add, effectively, under extreme circumstances. Yes, the legislation had its faults, there were parts that raised eyebrows, and pieces of it were difficult to implement, but when you consider the speed with which they acted to draft and pass these complex bills and get them to the President for enactment, they did a pretty good job. That’s why their subsequent performance and childish behavior are so disappointing.

[iv] The Coronavirus Preparedness and Response Supplemental Appropriations Act, P.L. 116-123; the Families First Coronavirus Response Act, P.L. 116-127; the Coronavirus Aid, Relief, and Economic Security Act, P.L. 116-136 (the CARES Act); and the Paycheck Protection Program and Health Care Enhancement Act, P.L. 116-139.

[v] “PPP.” It remains to be seen how the forgiveness stage of the forgivable loan program will be handled. We’ll know soon enough. And, yes, there were plenty of bad actors. Given the conditions and the circumstances in which they sought to take advantage of the rest of the public, the punishments meted out to them have been wholly unsatisfactory, at least insofar as having a cathartic effect upon the rest of us.

[vi] The $600/week payment. This program and the PPP were part of the CARES Act, passed in March.

[vii] An incidental benefit was realized by landlords and retailers – participating businesses were able to pay their rent, and households were able to shop for goods.

[viii] For example, over 20 million jobs lost in March and April 2020 alone; over 100,000 small businesses lost. https://www.washingtonpost.com/business/2020/05/12/small-business-used-define-americas-economy-pandemic-could-end-that-forever/. Many of these jobs have been recovered, but we remain millions behind from where we were before the pandemic.

[ix] Unlike my mother-in-law’s “sojourn” with us.

[x] https://www.businessinsider.com/stimulus-congress-needed-full-economic-recovery-recession-coronavirus-fed-president-2020-8

[xi] Which they have since slashed by about $1 trillion as a “show” of good faith.

[xii] I’m ignoring the questionable executive action taken by the President on August 8, 2020. https://www.nytimes.com/2020/08/08/us/politics/trump-stimulus-bill-coronavirus.html

[xiii] The “Delivering Immediate Relief to America’s Families, Schools and Small Businesses Act.”

[xiv] More accurately, the measure did not get beyond the Senate cloture rule which requires 60 votes to end debate on a proposal and then put it to a vote.

Of course, according to McConnell, the Democrats were to blame. And of course Schumer accused McConnell of using the vote as a campaign tactic.

[xv] Also last week, the Senate Republican leadership indicated it planned to send its members home to campaign – makes you question the wisdom of the 17th Amendment, doesn’t it – while Rep. Pelosi emphasized that she was ready to remain in Washington until a deal was negotiated.

As Stephen Sondheim wrote, “But where are the clowns? Send in the clowns. Don’t bother, they’re here.”

[xvi] If the Republicans somehow hold on to the White House or the Senate, deadlock may very well be the order of the day for many days to come.

[xvii] The 117th Congress starts on January 3, 2021, and the Presidential inauguration is on January 20, 2021.

[xviii] Approximately 5 million PPP loans were made, totaling well over $500 billion. https://www.sba.gov/article/2020/jul/13/sba-treasury-announce-release-paycheck-protection-program-loan-data

[xix] The employer’s share.

[xx] This deferral option was made available under the CARES Act.

The tax is equal to 6.2% of the first $137,700 of an employee’s wages for 2020. Mr. Biden has suggested eliminating the cap for wages in excess of $400,000.

Electing businesses will soon have to confront this deferred liability.

[xxi] With the Great Shutdown, commercial bankruptcies are up. https://www.taxlawforchb.com/2020/08/virus-to-economic-shutdown-to-bankruptcy-not-necessarily-but-be-prepared/

[xxii] The 6.2% Social Security tax and the 1.45% Medicare tax.

[xxiii] This has turned into a “refrain,” considering the number of such cases reviewed at both the federal and state levels.

[xxiv] “Well-meaning” is another story.

[xxv] In The Matter of the Petition of Christopher Black, Tax Appeals Tribunal, DTA No. 828015 (August 6, 2020).

[xxvi] Taxpayer managed projects, made sure jobs were billed correctly, and made sure jobs were completed on schedule.

[xxvii] Seemingly without the assistance of counsel.

[xxviii] Taxpayer later testified that he had answered the questions inaccurately because, he claimed, those questions as to his responsibilities with Corp were the same questions that MBE agencies used to audit his control over Corp’s operations, and he needed to be able to show that he maintained control over the corporation in order for Corp to retain its MBE status.

[xxix] For unpaid employment tax trust funds. IRC Sec. 6672.

[xxx] When later asked what he did to ensure that taxes were being paid, Taxpayer testified that “I couldn’t do anything about making sure that the taxes were being paid because it was his [Investor’s] money and his responsibility.”

[xxxi] When asked why he remained in his position with Corp as president even though he had no real control, Taxpayer replied: “Just trying to maintain my MBE certification” which, he believed, would provide opportunities for more contracts.

Ironically, the Port Authority later notified Taxpayer of its intent to decertify Corp as an MBE based on a report, the findings of which were described as follows:

“[Corp] is heavily dependent on another construction company, [IC], for financing, staffing, management and daily operations. [Investor], who also owns 44% of [Corp], owns [IC]. Although you referred to [Investor] as a ‘silent partner’, [Investor] exerts a substantial amount of control over the operations of [Corp].

“. . . [Corp] shares numerous management, office, and field employees, as well as equipment and warehouse space with [IC]. … You did not disclose this information in either the MBE/WBE Recertification Application or the [Background Qualification Questionnaires] submitted on behalf of [Corp] to work on WTC projects.”

A hearing officer upheld the proposed decertification of Corp as a MBE, citing, among other things, the existence of “several substantial non-documented interest free loans between [Corp] and parties related to [IC].”

[xxxii] On the advice of counsel. About time.

[xxxiii] Under NY Tax Law Sec. 685(g).

[xxxiv] The form also listed Investor as a responsible person of Corp, with his business title listed as vice president, and his primary duties described as “director of all business activities.

Taxpayer testified that the handwritten note was put on the replacement signature card in order to maintain Corp’s MBE certification at a time when he was trying to get Corp re-certified.

[xxxv] In connection with a sales tax audit of Corp, Taxpayer signed consent forms extending the statute of limitations for assessment. He also signed a statement of proposed audit change for sales and use tax. The record also contained a power of attorney, bearing Taxpayer’s signature, which appointed an attorney to represent Corp before the Dept. in withholding tax matters.

[xxxvi] A subsequent form also listed Investor.

[xxxvii] The IRS issued to Taxpayer a proposed assessment of trust fund recovery penalty, for unpaid employment tax trust funds, related to Corp under for some of the periods at issue with the Dept. Taxpayer argued that he should not be considered a ““responsible person” because he lacked financial control of Corp, which, instead, was controlled by Investor. Taxpayer submitted an affidavit in which Investor made the following statements:

“1. In addition to being a shareholder and director of [Corp], I held the corporate offices of secretary and treasurer, also. I have held these offices from the time I invested in [Corp] until the present. Neither [Taxpayer] (President/CEO for [Corp]) nor any other employee of [Corp] exercised control over the corporate disbursements (e.g., payments for vendors, creditors, union benefits and obligations, all payroll taxes, employer compensation and benefits, etc.).

  1. As Director/Secretary-Treasurer of [Corp], I had ultimate authority and absolute control over the financial disbursements of the company. I opened the bank account at [Bank] and added [Taxpayer] to the Master Signature Card and Agreement to Open Account(s) (the first signature card document for the [Bank] bank accounts (sic)….
  2. I controlled the payment of [Corp] bills and creditors at my office, which is separate and apart from [Corp’s] place of business. All correspondence, including bank statements came to my office. I handled all checking activity for [Corp] from my office. I kept the checks and check register at my office and only authorized personnel at my office had access to the checkbook. [Taxpayer] did not have access to the checkbook to make disbursements. I would direct my staff to write checks and [Taxpayer] would come to my office to sign the checks I authorized.
  3. … [Taxpayer], as President/CEO of [Corp], handled the operating activities of [Corp], but did not control any of the financial responsibilities and decisions of [Corp]. [Taxpayer] had signature authority on the bank account only to enable him to handle items related to running the operations of [Corp]; his authority did not include payment of [Corp] accrued liabilities, tax obligations, or anything beyond the company’s general operations.”

On the basis of the foregoing, the IRS Appeals Office determined that Taxpayer was not liable for trust fund recovery penalties.

Interestingly, both the ALJ and the TAT stated that the Dept. was not bound by determinations by the IRS. They rejected Taxpayer’s argument that such a determination was conclusive on the question of whether Taxpayer was a responsible person for purposes of the Tax Law.

Although the TAT agreed that NY Tax Law Sec. 685(g) and IRC Sec. 6672 were parallel statutes, and meanings given to terms used in the federal statute were relevant to construction of New York Tax Law (see NY Tax Law Sec. 607), such a principle did not require the Dept. to give deference to a factual determination of the IRS regarding the status of a responsible person. So much for conformity.

[xxxviii] Decisions rendered by the TAT are final and binding on the Department of Taxation and Finance, i.e., there is no appeal to the courts.

Taxpayers who are not satisfied with the decision of the TAT have the right to appeal the TAT’s decision by instituting a proceeding pursuant to Article 78 of the CPLR to the Appellate Division Third Department.

[xxxix] That, and his representation to the Dept. that he had authority, notwithstanding his inability to actually do anything.

What a Mess

A “perfect storm” may be defined as a critical state of affairs arising from the convergence of a number of negative factors, often after the unexpected introduction of some catalytic event.

The situation in which we find ourselves today may be described as a perfect storm from several different perspectives.

For many years, our nation has been fracturing along various socioeconomic lines. Until fairly recently, we have been able to repair some of the cracks in our social structure, and we have prevented certain identifiable fault lines from developing into fissures of any significance.[i]

The pandemic, however, has changed the environment in which these factors interact with one another, and it has influenced – in a very negative way – how their respective proponents perceive each other.

Although various and diverse “solutions” have been suggested by some hopefully-well-intentioned folks on the national stage, these proposals share a common element: the expenditure of significant funds by the federal government.

Throw Money at the Problem(s)

In order to finance the many programs being discussed, the federal government cannot simply print or borrow more money.[ii] At some point, presumably, it has to generate tax revenues.[iii]

Do voters want to pay more taxes? Probably not, regardless of the ostensible purpose for which they will be expended. So what is a group of elected officials to do without jeopardizing their livelihoods?

Collect as much tax as possible from as small a number of voters as practicable, and especially from those whom the public has identified as having benefitted the most from “the system.”[iv]

This approach to the problem is reflected in Mr. Biden’s tax proposals: increase the individual federal tax rate on ordinary income from 37% to 39.6% (43.4% when one adds the 3.8% surtax on net investment income[v] in the case of an individual investor in a business[vi] who does not materially participate in the business); increase the rate on “qualified” dividends from 20% (23.8%) to 39.6% (43.4%); increase the rate on long-term capital gains to 39.6% (43.4%); impose the 12.4% Social Security tax[vii] on all earned income in excess of $400,000;[viii] increase the corporate income tax rate from 21% to 28%; increase the tax on GILTI from 10.5% to 21%;[ix] reduce the estate, gift, and GST tax basic exclusion amounts from $10 million to $5 million;[x] eliminate the like kind exchange for real estate[xi]; etc.[xii]

The prospect of what many see as imminent, and significant, increases in federal taxes is causing members of the “targeted” population of taxpayers, especially those who reside in states or municipalities with high overall tax burdens (like New York, New Jersey and Connecticut[xiii]), to rethink their business plans, and even their way of life.

How Will Taxpayers React?

Beginning this summer, we have heard from the founding owners of many successful, closely held businesses – hardly members of the Gates, Buffet, Bezos, Hollywood, Professional Sports, or “family money” crowd[xiv] – who are concerned about the future. A sampling of their questions: Should I try to sell my business before the year-end?[xv] Does it make sense for me to utilize my gift tax exemption in 2020? How can I give up my New York residence?[xvi]

Each of these considerations involves a tax-related goal rather than a non-tax business-driven end. That’s ass-backwards, to use the vernacular, and that’s a sign of poor tax policy.

Of course, most business owners recognize – especially based on the history of recent legislation – that no tax law is “permanent.” In the meantime, they will cut costs,[xvii] try to be more efficient, try to generate more revenue, establish a line of credit, borrow money when necessary, and otherwise figure out how to sustain and strengthen their business.

There are some bad actors out there, however, who lack patience, who are less industrious, who are unwilling to make any sacrifices, and who are ready to buy into the proverbial “quick fix” for their tax problem.

Assuming the tax proposals put forth by the Democratic Party are eventually enacted into law, we are certain to encounter more unscrupulous promoters of such tax-saving schemes, along with their more-than-willing clients.

A recent decision of the U.S. Tax Court examined one such scheme.[xviii]

Tax “Strategy”

Taxpayer was employed as an officer of Limited Partnership (“LP”), and owned limited partnership units in LP. Taxpayer was also an officer of LP’s general partner.

During the year at issue, Taxpayer met with Adviser for the purpose of formulating a tax-planning strategy to eliminate the expected tax liability on the substantial income that Taxpayer was slated to receive later that year.

The recommended tax structure involved organizing multiple new entities owned or controlled by Taxpayer, and included an S corporation, a family limited partnership (“FLP”), and a family management trust. Under the structure, Taxpayer would contribute cash and marketable securities to the S corporation in exchange for its stock; Taxpayer would use the S corporation as a vehicle for day trading. The S corporation would then transfer those same assets to the FLP in exchange for a 98% interest as a limited partner. The trust would be the general partner of the FLP, holding the remaining 2% of the partnership interests.

Under the proposed tax strategy, Taxpayer would then liquidate and dissolve the S corporation, which would distribute the 98% limited partnership interest to Taxpayer, as its shareholder. Upon the liquidation of the S corporation, Taxpayer would own the 98% interest in the limited partnership, and the partnership would own the assets that Taxpayer had initially contributed to the S corporation.

Adviser indicated that the fair market value of the distributed limited partnership interests would reflect a reduced value, for tax purposes, because of the large discounts for lack of marketability and lack of control that would be applied in determining their value.[xix] The liquidation and dissolution of the S corporation would generate a tax loss for Taxpayer to report on their individual tax return.

Taxpayer decided to implement this strategy, organizing LLC (with Taxpayer as the sole member), S Corp, FLP, and Trust (with Taxpayer as trustee and their kids as beneficiaries). Initially, Taxpayer held the 2% general partnership interest in FLP, and S Corp held a 98% limited partnership interest, but Taxpayer then transferred the general partnership interest to Trust.

Following the formation of the entities, Taxpayer transferred their units in LP to LLC. Taxpayer also transferred cash and marketable securities from personal accounts to newly opened accounts of S Corp.

Shortly afterward, S Corp transferred most of those same, newly received assets to newly opened accounts of FLP, following which S Corp was left with very few assets other than its interest in FLP.

During the period of its existence – just over one month – S Corp executed a very small number of trades in securities.

Indeed, approximately two-and-one-half weeks after the incorporation of S Corp, Taxpayer again met with Advisor to begin taking steps to dissolve S Corp and distribute its assets. Taxpayer filed the required documents with the secretary of state to terminate S Corp, effective the last day of the calendar year.[xx] Taxpayer also signed a transfer and assignment of their interest in LLC to S Corp, retroactively effective Day One (two weeks prior). That same day, and acting in his capacity as president of S Corp, Taxpayer signed another transfer and assignment, this time of S Corp’s interest in LLC to FLP, retroactively effective Day Two. S Corp then transferred its remaining cash and marketable securities FLP. One week before the year-end,  S Corp transferred its only remaining asset, the 98% limited partnership interest in FLP, in equal parts to Taxpayer and their spouse, with each receiving a 49% limited partnership interest. In addition, Taxpayer transferred a limited partnership interest in FLP to each of three trusts established for the benefit of their three sons, effective the year-end.

Tax Returns

Taxpayer timely filed their federal individual income tax return for the year at issue. On that return Taxpayer reported, among other items, approximately $700,000 of wages, and over $1 million of nonpassive partnership income,[xxi] from LP.[xxii] Taxpayer also claimed a $2 million ordinary loss deduction on Schedule E from S Corp,[xxiii] resulting in a tax liability of zero.

S Corp filed its initial and final income tax return[xxiv] for the year at issue. On its return, S Corp reported an ordinary loss[xxv] (rather than a capital loss) in excess of $2 million, which was sufficient to offset Taxpayer’s total income from LP. The corporation reported the values of the 49% limited partnership interests in FLP distributed to each of Taxpayer and their spouse as ‘gross receipts.” To calculate the values of the distributed partnership interests, the total value of the cash, securities, and units of LP that Taxpayer had transferred to FLP through S Corp, was discounted by more than 40% for lack of control, lack of marketability, and other factors. S Corp reported as “cost of goods sold” its alleged total basis in FLP.[xxvi]

FLP also filed a federal tax return,[xxvii] on which it reported no gross receipts or sales, no deductions, and no business income or loss.

Examination and Tax Court

The IRS examined Taxpayer’s return and concluded that Taxpayer was not entitled to the claimed loss deduction on the grounds that the transactions generating the reported loss lacked economic substance; that S Corp was not a trade or business and that the transaction was not entered into for profit; that Taxpayer have failed to show that they incurred a loss on the liquidation of S Corp; and that Taxpayer understated the value of the distributed assets.

Taxpayer appealed the proposed adjustment with the IRS Appeals Office, but was unsuccessful. Taxpayer then petitioned the U.S. Tax Court.

The Court acknowledged that a taxpayer is generally free to structure their business transactions as they wish, even if motivated in part by a desire to reduce taxes. That being said, the Court then added that transactions “which do not vary control or change the flow of economic benefits” are to be “dismissed from consideration.”

The economic substance doctrine, the Court explained, allows courts to enforce the legislative purpose of the Code “by preventing taxpayers from reaping tax benefits from transactions lacking economic reality.” Thus, a court may disregard a transaction for tax purposes – even one that formally complies with the Code – if the transaction has no effect other than generating an income tax loss.

Whether a transaction has economic substance, the Court continued, is a factual determination for which the taxpayer bears the burden of proof.

According to the Court, a transaction “will be respected for tax purposes only if: (1) it has economic substance compelled by business or regulatory realities; (2) it is imbued with tax-independent considerations; and (3) it is not shaped totally by tax avoidance features.”[xxviii]

In other words, the transaction must exhibit an objective economic reality, a “subjectively genuine” business purpose, and some motivation other than tax avoidance.

Taxpayer contended that they organized S Corp as a vehicle through which to engage in day trading while still working at LP. They claimed that they transferred the cash and securities to S Corp in order to finance the day trading activities and that the transfers of assets to FLP through S Corp were for asset protection purposes.

The Court rejected Taxpayer’s argument, stating that “It is clear from the record, however, that [S Corp] existed only to generate a tax loss. Despite the time, effort, and cost of establishing the company, within 17 days of organization [Taxpayer] had begun taking steps to dissolve [S Corp] . . . before any actual significant trading had occurred.” In arriving at its conclusion, the Court considered the above-referenced factors.

Economic Substance[xxix]

The first prong of the economic substance inquiry requires that the transaction have economic substance compelled by business or regulatory realities. The Court explained,

A transaction lacks economic substance if it does not “vary control or change the flow of economic benefit[s]”.  Under the objective economic inquiry, the Court examines whether the transaction affected the taxpayer’s financial position in any way, such as whether the transaction “either caused real dollars to meaningfully change hands or created a realistic possibility that they would do so.”  A circular flow of funds among related entities does not indicate a substantive economic transaction for tax purposes.

The Court found that the transactions executed by Taxpayer to generate the claimed loss deduction failed to alter Taxpayer’s economic position in any way that affected objective economic reality. The asset transfers represented a circular flow of funds among related entities used to generate an artificial tax loss to offset Taxpayer’s income for the year at issue.[xxx]

Taxpayer, the Court determined, had constant control over the assets and entities at all relevant times; neither the contribution to S Corp nor its dissolution affected Taxpayer’s position or caused “real dollars to meaningfully change hands”. The form of Taxpayer’s ownership of the assets may have changed, but the substance did not. What’s more, there was no realistic possibility that the assets would change hands at any point.

Accordingly, the Court held that the transactions lacked objective economic reality and, therefore, failed to satisfy the first prong of the economic substance doctrine.[xxxi]

Subjective Business Purpose

The Court then considered whether Taxpayer had a “subjectively genuine business” purpose or some motivation other than tax avoidance.

After noting again that taxpayers are not prohibited from “seeking tax benefits in conjunction with seeking profits for their businesses,” the Court warned against a taxpayer’s entering into a transaction only for a tax-avoidance purpose.[xxxii]

In response to Taxpayer’s claim that S Corp was formed for the purpose of day trading, the Court pointed out that Taxpayer’s actions were not consistent with a profit motive.[xxxiii]

What’s more, after organizing S Corp, Taxpayer dissolved it almost immediately. Indeed, Taxpayer began taking steps to dissolve S Corp after completing a single day trade, and the majority of the day trades that S Corp transacted were executed after the process of dissolving the corporation had begun.

Before S Corp engaged in any trading, Taxpayer caused the company to transfer nearly all of its assets to FLP, a newly formed company that never engaged in any business activity and otherwise held no assets. The transfers to FLP, the Court observed, served no business purpose and offered no potential for profit. Moreover, Taxpayer could not identify a business motive or profit potential for using S Corp as a conduit for that transfer. Nor did Taxpayer identify any business purpose in transferring the LP units to FLP through S Corp. These transfers, the Court determined, served only to increase the claimed loss when S Corp dissolved shortly thereafter.

According to the Court, Taxpayer intended from the beginning to organize and dissolve S Corp within the same year in order to generate a tax loss in an effort to reduce their income tax liability arising from Taxpayer’s services for and investment in LP. Taxpayer did not have a genuine business purpose for establishing the entities, and their actions were taken solely for tax-motivated reasons. Taxpayer knew they would be receiving substantial income from LP and sought to generate a tax loss to offset it. Adviser offered Taxpayer a prepackaged tax strategy designed to create an artificial loss through a circular flow of assets, the application of substantial discounts, and the misreporting of the resulting loss as an ordinary loss, rather than a short-term capital loss.

Thus, the Court held that the transactions at issue did not have economic substance, and that Taxpayer was not entitled to the claimed loss deduction therefrom.

Let’s Be Careful Out There[xxxiv]

Most business owners work hard, rarely taking a break from their business – it is their calling, something that they enjoy and do well. Hopefully, their investment of time, effort and money leads to a successful conclusion.[xxxv]

In my experience, most successful business owners are not averse to paying taxes. They recognize that taxes are vital to maintaining our society and culture – a “necessary evil,” if you will.

That being said, too often they are portrayed as people who pay professionals to help them abuse “the system” and thereby “avoid” paying taxes, rather than as well-informed taxpayers who are merely doing what the Code allows, and even encourages, them to do.

This feeling of being put upon may result in some business owners becoming susceptible to unscrupulous promoters of schemes to “save” taxes. That’s the time to rely upon one’s instincts – that something cannot be as good as it seems – as well as upon one’s long-time advisers, who are almost certain to recognize a modern version of the snake oil salesman.

[i] https://pubs.geoscienceworld.org/segweb/economicgeology/article-abstract/58/7/1157/17270/Fractures-joints-faults-and-fissures?redirectedFrom=PDF

[ii] Some disagree. Have you heard of Modern Monetary Theory? https://www.newyorker.com/news/news-desk/the-economist-who-believes-the-government-should-just-print-more-money Does the government spend more than it collects in taxes? No problem. Does it have to borrow more? No problem. In that case, why collect taxes at all? To control inflation, they say.

As I have said many times before, I am no economist, but WTF?!

[iii] We’re already behind the eight ball with the trillions of dollars spent on countering the effects of COVID-19 and our response thereto.

[iv] The infamous bank robber, Willie Sutton, was once asked why he robbed banks. He is reputed to have replied, “Because that’s where the money is.” Duh?

[v] IRC Sec. 1411.

[vi] Basically, a Form 1040, Schedule E filer.

[vii] 6.2% on each of the employer and the employee.

[viii] Again, you have to ask, what about those folks who fall between the current cap of $137,700 and the proposed $400,000 threshold?

[ix] I will note that no one is suggesting that the inclusion of GILTI in gross income – a product of the 2017 tax legislation – is a bad thing.

[x] Reducing the exemption from today’s $11.58 million to $5.49 million.

[xi] It’s not far-fetched to imagine that the tax-deferred contribution of property to corporations or to partnerships may be eliminated in the not-too-distant future. The same goes for the tax-free corporate reorganization provisions. Each of these plays the same role in its respective sphere as does the like kind exchange for real estate. What about the elimination of installment reporting? It was actually repealed for accrual basis taxpayers back in 1999; it was only after intensive lobbying by the real estate industry and closely held businesses that it was reinstated the following year. Query how influential these groups would be today?

[xii] https://www.taxlawforchb.com/2020/08/bidens-tax-proposals-for-capital-gain-like-kind-exchanges-basis-step-up-the-estate-tax-tough-times-ahead/

[xiii] According to the Tax Foundation, the residents of these three States have the highest state-local tax burdens – paying somewhere between 12% and 13% of their total income to state and local taxes. https://taxfoundation.org/publications/state-local-tax-burden-rankings/

[xiv] The taxes we’re talking about are, to this “funny money” crowd, what a mosquito is to an elephant.

[xv] I might also add that, almost to a person, these folks expressed their desire to reward their key employees in the event of a sale, and to ensure continued employment for the rest of their workforce.

In fact, I can probably count on one hand the number of selling owners we have represented over the years who thought differently.

[xvi] https://www.taxlawforchb.com/2018/05/the-new-york-business-and-changing-domicile-let-it-go-let-it-go/

[xvii] That includes employees. That’s another upshot of the pandemic. Many businesses have realized they can make due with a smaller workforce.

[xviii] Daichman, v. Commissioner, T.C. Memo. 2020-126.

[xix] See, e.g., Rev. Rul. 59-60. The Court did not make any findings as to value.

[xx] In general, S corporations are required to use the calendar year for tax purposes.

[xxi] Reported to him by LP on a Schedule K-1.

[xxii] Form 1040, Schedule E, Part II.

[xxiii] Attributable to its liquidating distribution (and deemed sale per IRC Sec. 336) of the value-discounted FLP interests, and passed through to the shareholder under IRC Sec. 1366.

Query why there was no mention of the IRS’s standard position in estate/gift tax matters that interests in a partnership funded with marketable securities did not merit much in the way of valuation discounts.

Query also why there was no discussion of the Pope & Talbot decision, 162 F.3d 1236 (9th Cir. 1999), where a corporation made a non-liquidating distribution of limited partnership interests in a single partnership to its shareholders. The corporation had valued each partnership unit as a minority interest (a discounted value). The court disagreed. The units had to be valued (for purposes of IRC Sec. 311) as if sold in their entirety, as one; otherwise, the FMV of the underlying assets would not be accurately reflected.

Finally, query why no mention was made of IRC Sec. 336(d), which denies loss recognition to a liquidating corporation on certain distributions to related persons.

[xxiv] On Form 1120S, U.S. Income Tax Return for an S Corporation.

[xxv] Because it claimed to be a day-trader?

[xxvi] Taxpayer’s accountant prepared S Corp’s return with the assistance of Adviser, who directed the accountant to report the transactions as gross receipts and cost of goods sold, and who even provided the discounts and other information used to compute those amounts.

[xxvii] On Form 1065, U.S. Return of Partnership Income.

[xxviii] The Court recognized that there is “near-total overlap between the latter two factors.”

[xxix] The year at issue preceded the effective date of IRC Sec. 7701(o), which codified the doctrine.

[xxx] Just to recap: Taxpayer transferred substantial assets to S Corp, their wholly-owned corporation, which then transferred those assets to FLP. S Corp owned a 98% limited partnership interest in FLP, while Taxpayer, as trustee of the Trust, owned the remaining 2% as general partner. Within days of the transfers to FLP, S Corp dissolved, distributing its 98% interest in FLP to Taxpayer. Taxpayer claimed a loss deduction on their tax return by calculating the values of the distributed partnership interests based on substantial discounts.

[xxxi] Although failure to satisfy any one prong of the economic substance doctrine is sufficient for a finding that the transaction lacked economic substance, the Court nevertheless addressed the remaining two prongs.

[xxxii] In other words, a taxpayer who acts with mixed motives of profit and tax benefits may nonetheless satisfy the subjective test.

[xxxiii] Taxpayer had no past experience in day trading, yet conducted no prior research into the activity, did not consult any references, and did not otherwise seek advice before expending the time and resources to establish S Corp.

[xxxiv] Hill Street Blues fans will remember Sgt. Phil Esterhaus’s catch phrase.

[xxxv] Often the sale of the business.

NYC Real Estate on the Ropes

In March of this year, the Department of Homeland Security classified real estate as an “essential business.”[i] I imagine that the person in Washington who suggested that real estate be added to the list of enterprises that were deemed critical to the public’s security and well-being must have been thinking of New York City (“NYC”).

The real estate market is a major force in the life of the City, and any downturn in that industry is likely to have negative repercussions throughout NYC’s economy. This relationship has been borne out by the pandemic,[ii] which has had a significantly adverse impact upon the ownership and disposition of commercial real estate in the City, and upon the revenues of City government.[iii]

According to the Real Estate Board of New York, in the first half of 2020, total investment sales for commercial and multifamily rental properties experienced a 32 percent decline in the volume of transactions, and a 54 percent decline in total consideration, compared to the first half of 2019. The total tax revenue for the City and NY State generated from investment sales in the first half of 2020 was down 49 percent from the previous 6 months and 58 percent from the previous 12 months.[iv]

Perhaps more disconcerting, because of its potentially longer-term effects to the City’s real estate market, is the realization among many employers that their businesses may be operated remotely, without the heretofore significant cost of maintaining a physical presence in the City.[v]

At the same time, many of NYC’s more affluent denizens are preparing – some more publicly than others – to leave the City for jurisdictions with friendlier tax environments and more inviting climates.[vi]

Don’t Count NYC Out

Of course, this isn’t the first time many folks have counted the City out.

Many of us remember the extremely weak economy of the 1970s – often described as one in “freefall” – the oil embargo, the recession, and the City’s brush with bankruptcy.[vii] Over 600 hundred thousand jobs were lost – one-sixth of the City’s employment base – almost one million households were on welfare, graffiti was everywhere, arson was common, whole blocks were abandoned, crime was rampant, prostitutes crowded the streets around the then-under-construction Javits Center and, by the end of the decade, almost a million people had left the City.[viii]

The City bounced back.

More recently, many predicted that the September 11 attacks would lead to the demise of the City’s office market.

The City bounced back.

Bill de Blasio became Mayor in January of 2014.[ix] His term ends in December of 2021 – after years of watching all major crime indices increase.

The City will bounce back.

It would be wise to keep this history, and this potential, in mind as we consider the City’s future.

A recent article in Forbes, “The Case for Betting Long on New York City Real Estate,”[x] delivers a positive message both succinctly and pretty convincingly:

“The upshot is this: New York real estate has boosted the metropolitan economy for a decade with exceptional growth that can withstand even major adversity, like the current slowdown. The long-term trend is still upward.”[xi]

Be Smart – Don’t Forget Taxes[xii]

For those closely held investors who are already committed to holding NYC real properties, and for those who are thinking about making such a long-term commitment – perhaps to take advantage of the softer market – it is imperative that they understand the Federal, state and local income tax consequences arising from the acquisition, operation and disposition of their property.

It would be folly to ignore taxes – or, more appropriately, their economic impact on one’s investment – or to defer[xiii] planning for them, especially in the current environment: a softer real estate market with thinner margins, the near certainty of not insignificant income tax and other tax increases, the possible limitation on the use of the like kind exchange, and the possible elimination of the basis step-up at death.[xiv]

A recent decision by the NYC Tax Appeals Tribunal (the “Tribunal”)[xv] addressed what appear to have been the unanticipated NYC income tax consequences realized by a foreign corporation (from a state on the other side of the Hudson River[xvi]) on the indirect sale (the “Sale”) of its equity interest in a partnership that owned and operated real property in NYC.

The Joint Venture

Corp was a NY corporation that teamed up with Partner to form a joint venture (“JV”) to act as a construction contractor doing business primarily in the NY Metro area. Corp owned a 50 percent interest in JV.

At some point, JV ceased construction operations and, instead, acquired investment interests in three limited partnerships (the “LPs”) which engaged solely in the “holding, leasing, and managing” of their respective real properties located in NYC.

JV owned a limited partnership interest in each of the LPs.[xvii] None of the general partners of the LPs was related to either JV or Corp.

For all periods preceding JV’s sale of its interest in one of the limited partnerships (“LP-1”), Corp reported and paid NYC General Corporation Tax (“GCT”) on its share of the income, gain, and losses of the LPs.

Prior to the Sale, Corp “reorganized” itself as a New Jersey (“NJ”) corporation. Specifically, Taxpayer was newly incorporated under the laws of NJ in order to effectuate this reorganization; Taxpayer then elected to be treated as an S corporation for tax purposes; shortly thereafter, Corp was merged with and into Taxpayer in an “F” reorganization[xviii] – a “mere change in place of organization”[xix] – in which Taxpayer was the surviving corporation and successor to Corp.

As the successor to Corp, Taxpayer held the 50 percent ownership interest in JV.

The Sale, the Gain, the Exam

JV sold its limited partnership interest in LP-1 to an unrelated third party. It reported its gain from the Sale on its Federal,[xx] NY State, and City tax returns.

Taxpayer was allocated its 50 percent share of the gain realized on the Sale by JV (the “Capital Gain”), which it reported on its Federal corporate income tax return.[xxi] In turn, as an S corporation, Taxpayer must have issued Schedules K-1 to its shareholders, allocating the Capital Gain among them in proportion to their stock holdings.[xxii]

Taxpayer also reported the Capital Gain on its City GCT return,[xxiii] but excluded the gain from its entire net income (“ENI”) by deducting an amount equal to the Capital Gain from its Federal taxable income – the starting point for determining ENI – with a notation explaining that Taxpayer’s deduction was based upon its treatment of the gain as “Gain on the sale of partnership interest – not used in trade or business in NY.”

The NYC Department of Finance (the “Dept.”) examined Taxpayer’s GCT return for the year at issue, following which it issued a Notice of Determination[xxiv] to Taxpayer asserting a GCT deficiency for that year. The Notice explained that “Adjustment is made to include [the Capital Gain] from the sale of partnership interest” in Taxpayer’s ENI.[xxv]

Taxpayer disagreed with the Dept.’s conclusion, and filed a petition with the Tribunal to contest the asserted deficiency.

The Parties’ Positions

The issue before the Tribunal was whether, for GCT purposes, the Federal conformity provisions of the City’s Administrative Code (the “Admin. Code”) required the exclusion by a foreign taxpayer[xxvi] of the gain realized by such taxpayer from the sale of an interest in a limited partnership that did business in the City.

The parties agreed on the following basic facts:

  • During the year at issue, JV’s sole contacts with NYC were its investment interests in the LPs (including LP-1), which in turn owned interests in NYC real properties;
  • Neither JV nor Corp/Taxpayer directly or indirectly engaged in operating or managing any portion of business activities of the LPs, or engaged in a unitary business with any of the LPs;
  • JV did not independently conduct a trade or business in NYC, and had no property, payroll, or receipts in NYC; and
  • Corp/Taxpayer maintained its only office in NJ, and had no place of business in NYC.

Notwithstanding these agreed-upon facts, the Dept. argued that Taxpayer engaged in business within NYC by virtue of its ownership interest (through JV) in LP-1, which owned, leased, and managed property within NYC.[xxvii] The Dept. stated that because the GCT is imposed upon the privilege of doing business in NYC, and because Taxpayer was doing business in NYC – by virtue of (i) LP-1’s doing business in NYC, and (ii) JV’s derivatively doing business through its interest in LP-1, and (iii) Taxpayer’s interest in JV – the Capital Gain was properly included in Taxpayer’s ENI for GCT purposes.

Taxpayer argued that the proposed adjustment ran afoul of the Federal “conformity” doctrine.[xxviii] It submitted that as Federal income is the starting point for ENI,[xxix] Federal conformity required that NYC treat the Capital Gain as it would be treated under the Code; specifically, “In the case of a sale or exchange of an interest in a partnership, gain or loss shall be recognized to the transferor partner. Such gain or loss shall be considered as gain or loss from the sale or exchange of a capital asset…”[xxx]

Prior to the Tax Cuts and Jobs Act of 2017,[xxxi] Taxpayer continued, the “entity approach” to partnership taxation could apply to the disposition of a partnership interest.[xxxii] Under this approach, it noted, a partner is treated as though it owns a partnership interest, an intangible asset, as opposed to a proportionate, undivided share of the partnership’s underlying assets.[xxxiii] Taxpayer argued that the gain from the sale of the LP-1 partnership interest – an intangible not used in a trade or business – should be sourced to Taxpayer’s domicile outside NYC and, therefore, excluded from Taxpayer’s ENI.

The Dept. countered by stating that nothing in either NYC or NY State law barred the use of the “aggregate approach” toward the disposition of a partnership interest, meaning that a partner’s sale of a partnership interest could be treated as the sale by the partner of its separate, undivided interest in each asset owned by the partnership. In any case, it argued, the Federal conformity doctrine did not apply to the present case because, while the Code addresses the tax treatment of the disposition of a partnership interest, the GCT imposes a tax on the privilege of doing business in NYC.

The Tribunal’s Opinion

The Tribunal explained that the GCT is imposed on every corporation doing business, owning or leasing property, or engaging in various other activities in the City.[xxxiv] The tax, it stated, is computed as the sum of (1) the greatest amount of tax calculated under four alternative methods (including on the basis of the corporation’s ENI allocated to the City); plus (2) an amount of tax calculated on subsidiary capital.[xxxv]

The Tribunal also noted the Rules of the City provide that: “a corporation shall be deemed to be doing business in the City if it owns a limited partnership interest in a partnership that is doing business, employing capital, owning or leasing property, or maintaining an office in the City.”[xxxvi]

According to the Tribunal, interpreting “doing business” to include ownership in a limited partnership that does business in the City has been upheld by the NY courts on multiple occasions. “These decisions,” it stated, “bind this Tribunal and are determinative in this matter.”[xxxvii]

LP-1 conducted business within NYC because it leased, held, and managed real property in the City. Taxpayer, through JV, owned an interest in LP-1. Through its ownership in LP-1, Taxpayer was doing business in NYC.[xxxviii] Therefore, the Capital Gain, which flowed to Taxpayer from JV’s sale of its interest in LP-1, was properly included in Taxpayer’s ENI for the tax year at issue.

In reaching this conclusion, the Tribunal also rejected Taxpayer’s argument based upon Federal conformity. “This doctrine,” the Tribunal stated, “has its limits.” It explained that

“arguments in favor of applying the doctrine are particularly strong and persuasive where the State act and regulations were modeled upon the federal law and regulations and both statutes and regulations closely resemble each other. However, where state tax law diverges from federal law, there is no requirement that a court strain to read the federal and state provisions as identical.”

The Tribunal observed that Taxpayer did not establish any statutory authority or legislative history that would bind the City’s GCT calculations to the Federal tax treatment of the sale of a partnership interest. As a result, the differences between the two taxes “militated against the importing of federal treatment of the sale of partnership interests into the GCT’s ENI basis.”

Further, the Tribunal noted that “[T]he aggregate approach has been and continues to be applied for a variety of purposes under the GCT,” including the computation of ENI, and the character of items of income as coming from subsidiary or investment capital.[xxxix]

Therefore, Federal conformity did not require the exclusion of the Capital Gain from Taxpayer’s ENI for the tax year at issue.

Expensive Misunderstanding

The inclusion in Taxpayer’s ENI of its share of the Capital Gain subjected Taxpayer to NYC’s GCT at a rate of 8.85 percent. That’s an expensive tax, but it was one that should have been anticipated and accounted for in negotiating the terms of the sale.

Is it possible that Taxpayer’s shareholders confused the sourcing rule, applicable to nonresident individuals, which generally sources the gain from the sale of an intangible asset – for example, shares of stock of a corporation that does business in NYC – to the domicile of the nonresident? Is that why they “moved” Taxpayer (a pass-through entity) from NY to NJ?

But even that reasoning is unsatisfactory when one considers NY’s treatment of entities that own real property located in the State. For example, NY source income includes income attributable to the ownership of any interest in real property, including the gain from the sale or exchange of an interest in certain entities that own real property in NY.

Indeed, since 2009, items of gain derived from or connected with NY sources have included an interest in a partnership, LLC, S corporation, or non-publicly traded C corporation with one hundred or fewer shareholders, that owns real property located in NY, and has a fair market value that equals or exceeds 50 percent of all the assets of the entity on the date of the sale or exchange of the taxpayer’s interest in the entity.[xl] An interest in such an entity is treated as an interest in real property located in NY.

The bottom line: as we ride out what promises to be an undeniably rough time for the NYC real estate industry, it will behoove the long-term investor to familiarize themselves with, and to take advantage of, whatever tax benefits the law affords them – both during the operation and upon the disposition of their property – and to thoroughly consider, and plan for, the tax consequences of any transaction involving the property.  Of course, much may depend upon the outcome of the November elections.

The economic rewards of such “tax diligence” may be the difference between a successful and a not-so-successful investment.


[i] https://www.wsj.com/articles/real-estate-now-an-essential-business-new-york-state-says-11585869087 . https://chicagoagentmagazine.com/2020/03/31/during-coronavirus-shutdown-real-estate-is-deemed-an-essential-business/ In the Department’s report, “residential and commercial real estate services, including settlement services” are considered essential, as are “workers responsible for the leasing of residential properties to provide individuals and families with ready access to available housing.”

[ii] Look at what has happened to all of the restaurants and retail spaces – not to mention mass transit – that serviced the City’s “business districts” when office workers started to work remotely.

[iii] For example, in 2018, real estate related taxes (real property, commercial rent, hotel occupancy, mortgage recording, and transfer taxes) accounted for 52% of all New York City taxes collected. https://www.rebny.com/content/rebny/en/research/real_estate_policy_reports/2018-Economic-Impact-of-New-York-Citys-Real-Estate-Industry.html

[iv] Citywide, investment sales transactions declined 32%, consideration declined 54% and the average price declined 32% year-over-year.

Multifamily rental, elevator transactions declined 7%, consideration declined 56% and the average price declined 53% year-over-year.

Multifamily rental, non-elevator transactions declined 32%, consideration declined 42% and the average price declined 13% year-over-year.

Office transactions declined 27%, consideration declined 47% and the average price declined 27% year-over-year.

Industrial transactions declined 37%, consideration declined 60% and the average price declined 37% year-over-year.

Hotel transactions declined 70%, consideration declined 81% and the average price declined 37% year-over-year.

Retail transactions declined 27%, consideration declined 27% and the average price remained flat year-over-year.

Commercial condo transactions declined 68%, consideration declined 98% and the average price declined 93% year-over-year.


[v] Manhattan Faces a Reckoning if Working From Home Becomes the Norm, https://www.nytimes.com/2020/05/12/nyregion/coronavirus-work-from-home.html . “[A]s the pandemic eases its grip, companies are considering not just how to safely bring back employees, but whether all of them need to come back at all. They were forced by the crisis to figure out how to function productively with workers operating from home — and realized unexpectedly that it was not all bad. If that’s the case, they are now wondering whether it’s worth continuing to spend as much money on Manhattan’s exorbitant commercial rents. They are also mindful that public health considerations might make the packed workplaces of the recent past less viable.”

[vi] The prospect of a Democrat in the White House, along with what most believe will be the attendant federal tax increases, only exacerbates the matter. https://www.taxlawforchb.com/2020/08/bidens-tax-proposals-for-capital-gain-like-kind-exchanges-basis-step-up-the-estate-tax-tough-times-ahead/ ; https://www.taxlawforchb.com/2019/07/escape-from-new-york-it-will-cost-you/

[vii] “Economic and Demographic Change,” Samuel M/ Ehrenhalt, Monthly Labor Review, February 1993. https://www.millersamuel.com/change-is-constant-100-years-of-new-york-real-estate/

[viii] https://allthatsinteresting.com/1970s-new-york-photos

[ix] The views expressed are mine alone, and should not be attributed to Farrell Fritz.

[x] By Shimon Shkury. https://www.forbes.com/sites/shimonshkury/2020/07/30/why-were-betting-long-on-nyc-real-estate/#348720dc7ecb

[xi] In case you have forgotten, Amazon spent $1.15 billion to acquire the old Lord & Taylor Building in March of this year, as closures were being announced throughout the State.

[xii] By now, you’ve probably been wondering when, if ever, taxes would make it into the discussion.

[xiii] Like the pun?

[xiv] https://www.taxlawforchb.com/2020/08/bidens-tax-proposals-for-capital-gain-like-kind-exchanges-basis-step-up-the-estate-tax-tough-times-ahead/

[xv] Mars Holdings, Inc., NYC TAT ALJ Division, TAT (H) 16-14 (GC).

[xvi] I am often tempted to say something, anything, about our western neighbor. Check out this NYU publication: “Across The River, A World Away: Why We Trash New Jersey.” https://nyulocal.com/across-the-river-a-world-away-why-we-trash-new-jersey-d10dd1aa00b?gi=74f0e8c00b5c

[xvii] LP-1’s only significant source of income was from the holding, leasing, or managing of real property consisting of rental apartments within NYC.

JV held a 25 percent limited partnership interest in LP-2, which was formed to own and operate a rental housing project in the City.

Finally, JV owned a 0.01% limited partnership interest in LP-3.

[xviii] IRC Sec. 368(a)(1)(F).

[xix] Reg. Sec. 1.368-2(m). Basically a non-event for tax purposes. See https://www.taxlawforchb.com/2015/10/sometimes-an-f-is-a-good-result/

[xx] IRS Form 1065, U.S. Return of Partnership Income.

[xxi] IRS Form 1120S, U.S. Income Tax Return for an S Corporation.

[xxii] IRC Sec. 1366.

[xxiii] Form NYC-3L, General Corporation Tax Return. https://www.taxlawforchb.com/2020/07/an-s-corporation-in-new-york-city-eschew-obfuscation-or-not/

[xxiv] The counterpart to a Federal notice of deficiency.

[xxv] Administrative Code Section 11-602(8). This is equal to total net income from all sources; it is presumably the same as the entire taxable income (i) which the taxpayer is required to report to the IRS, or (ii) which the taxpayer would have been required to report to the IRS if it had not made an S corporation election.

[xxvi] Foreign = New Jersey.

[xxvii] Similarly, see IRC Sec. 875(1), which provides that “a nonresident alien individual or foreign corporation shall be considered as being engaged in a trade or business within the United States if the partnership of which such individual or corporation is a member is so engaged.”

Mind you, I am not suggesting that NJ is not part of the U.S., nor am I intimating that the Constitution be amended to provide for the removal of a state. Secession, on the other hand? The Constitution makes no mention of it, though it does address the partition of a state and the “junction” of existing states. Article IV, Section 3, Clause 1.

Remember the Harford Convention of 1814?

California and Texas have each seen active secessionist movements in recent years. (CA, most recently, in response to the election of Mr. Trump in 2016.)

In a 1993 referendum, more than 65% of Staten Island voted to secede from NYC, but was thwarted by Albany. The borough is making noise again this year.

Canadian law provides for legal secession.

[xxviii] In brief, the incorporation of Federal tax provisions into state tax law. For a general discussion of conformity, please see https://www.taxlawforchb.com/2020/06/conformity-the-lockdown-and-new-yorks-audit-of-like-kind-exchanges/#_edn1.

[xxix] Admin. Code § 11-602.8.

[xxx] IRC Sec. 741.

[xxxi] P.L. 115-97.

[xxxii] Grecian Magnesite, 149 T.C. No. 3 (July 2017), aff’d by 926 F3d 819 (DC Cir 2019). https://www.taxlawforchb.com/2017/07/foreigners-sale-of-partnership-interest-not-taxable/

The holding was effectively overturned by IRC Sec. 864(c)(8).

[xxxiii] Under the so-called “aggregate theory,” a partner’s sale of a partnership interest would be treated as the sale by the partner of its separate, undivided interest in each asset owned by the partnership.

The Code generally applies the “entity theory” to sales and liquidating distributions of partnership interests – it treats the sale of a partnership interest as the sale of “a capital asset” – i.e., one asset (a partnership interest) – rather than as the sale of an interest in the multiple underlying assets of the partnership.

That said, the Code carves out certain exceptions to this general rule that, when applicable, require that one look through the partnership to the underlying assets and deem the sale of the partnership interest as the sale of separate interests in each asset owned by the partnership; for example, where the partnership holds “hot assets,” or where it holds substantial interests in U.S. real property, in which case an aggregate approach is employed in determining the tax consequences of a sale.

[xxxiv] Admin. Code Sec. 11-603.1

[xxxv] Admin. Code Sec. 11-604.1.E

[xxxvi] 19 RCNY Sec. 11-06 [a]. This provision is subject to certain limitations which were not relevant here. See 19 RCNY § 11-06 [b] with respect to an interest in a publicly traded partnership or in a “portfolio partnership.”

[xxxvii] City Charter Sec. 170 [d]. “The tribunal shall follow as precedent the prior precedential decisions of the tribunal (but not of its small claims presiding officers), the New York State Tax Appeals Tribunal or of any federal or New York state court or the U.S. Supreme Court insofar as those decisions pertain to any substantive legal issues currently before the tribunal.”

[xxxviii] 19 RCNY Sec. 11-06 [a].

[xxxix] The Tribunal remarked that the same was true under the comparable NY State Corporate Franchise Tax. Both the State and City use the aggregate approach for purposes of determining whether a corporation is doing business in the jurisdiction.

[xl] NY Tax Law 631(b)(1)(A)(1). See also TSB-M-09(5)I. The portion of the total gain allocated to NY is determined by a fraction, the numerator of which is the FMV of the entity’s NY real property, and the denominator of which is the FMV of all of the entity’s assets.

A closely held business may come to our firm for any number of reasons. The owners may be selling the business, for example, or they may be thinking about spinning off a division. In some cases, the owners are considering the admission of a new investor, or the issuance of equity to a key employee; in others, they are contemplating whether to reorganize the business structure. Succession planning or estate planning are often motivating factors for which the owners seek our assistance. Then, of course, the business may have been notified by some taxing authority that its returns have been selected for audit.

Whatever the reason, one of the first documents we review is the most-recently filed federal income return for the business, and among the items within that return for which we search, in particular, are related party transactions, including loans to the owners.

Loan to Shareholder/Partner

How often do you encounter a situation, especially with a new client, in which the tax return balance sheet of a closely held business reports a loan to a shareholder or to a partner as an asset of the business?[i] If you’re like most tax advisers, you immediately check to see whether:

  • the amount of the loan reported on the return changed during the year,[ii]
  • the business reported any interest income,[iii]
  • any distributions were made to the owners,[iv] or
  • compensation was paid to those owners who were active in the business.[v]

Occasionally, the taxpayer will choose not to report a loan to an owner on the line designated for that purpose; instead, they include it in their response to that line of the balance sheet described as “Other assets,” which serves as a catchall.[vi]

In any case, once armed with this basic information, there are some obvious questions for the owners of the business, including, for example, “What are the terms of the loan,”[vii] “Is the loan evidenced by a promissory note?” and “Do you have board minutes describing the purpose for the loan, and approving its terms?”

By now, most of us have probably grown accustomed to hiding our disappointment at the all-too-frequent responses to the first two inquiries: “There aren’t any,”[viii] and “Nope,” respectively.[ix]

Sometimes, the adviser will be pleasantly surprised to be handed a loan agreement. Upon further inquiry, however, they learn that the terms of such agreement have not been enforced, or that the interest rate has been reduced without any change in the payment terms for the loan, and without any concession (i.e., consideration) from the borrower.[x]

It is unfortunate that, in most cases, the owners of a business do not appreciate the importance of transacting with their business on terms and in a manner that resemble, as closely as is reasonably possible, their interactions with unrelated persons.[xi]

Loan to “Related Entity”

If you’ve been around closely held business entities long enough, you know that loans to shareholders or partners are not always made directly by the entity to its owners; for example, they make take the form of a loan to a “related” or “somewhat related” business entity.

“But wait,” you may say, “there is no line on the business’s tax return balance sheet for such an entry.” Not expressly,[xii] but such intercompany loans are usually found in the line for “Other assets.” This line on the return directs the taxpayer to attach a statement in which the taxpayer must, presumably, identify the asset. However, because the return instructions do not provide any guidance on this point, many taxpayers will provide the barest description of the loan; for example, “loan to affiliate” without identifying the borrower or the nature of the relationship.[xiii]

Why would a taxpayer be reluctant to provide this information?

Does It Matter?

Ostensible loans to owners in the context of any closely held business can easily affect – in fact, may be intended to affect – the economic arrangement among the owners. In doing so, however, it may generate some unintended tax consequences. For example, if a so-called “loan” is not respected as such, what was treated as a non-taxable receipt of loan proceeds by the owner-borrower – and as a nondeductible payment by the entity-lender – may, instead, be treated as a taxable dividend or compensation. In the context of an S corporation, it is possible that the loan may be treated as a second class of equity if it is determined that the arrangement was undertaken with a principal purpose of circumventing the one class of stock requirement.[xiv]

The potential for skewing the economic arrangement among the owners is even greater where the “creditor” business is owned by members of a single family. The IRS and the courts have long recognized this truth, which explains why transactions between the family and their business – as is the case for strictly intra-family transactions, generally – are subject to rigid scrutiny, and are particularly susceptible to a finding that a transfer was intended as something other than a loan.[xv]

A recent decision by the Seventh Circuit considered a history of purported loans between a family-owned holding company (“Taxpayer”), taxable as a C corporation, and a number of business entities owned by a member of the family. The issue for consideration was whether Taxpayer was entitled to bad debt deductions in respect of such loans.[xvi]

The Family Company

Taxpayer was a family-controlled company founded by Dad. Over time, it added a number of subsidiaries. Taxpayer and its subsidiaries employed Son and his siblings in various capacities. The subsidiaries operated by Son did very well. Eventually, Son became a shareholder of Taxpayer.

Son started several businesses outside of Taxpayer (the “Son-Cos”), some of which complemented Taxpayer’s business, while others competed with Taxpayer and its subsidiaries.

Notwithstanding his independent ventures, Son continued to serve as president of two of Taxpayer’s subsidiaries for a number of years. Even after he stepped down as president, his sales and customer relations role with the subsidiaries remained unchanged; in fact, Son held various licenses that were useful to the subsidiaries for obtaining certain projects.[xvii]

Need A Loan? No Credit? Bad Credit? No Problem

Over a ten-year period, including the tax years at issue, Taxpayer advanced significant sums of money to Son-Cos, including, for example, guaranties of Son-Cos’ debts, lines of credit, and payments to Son-Cos’ creditors.

Taxpayer advanced funds to Son-Cos with the goal that Son would eventually be able to manage these companies independently, and in the belief that their various projects would throw off lucrative work for Taxpayer. In other instances, Taxpayer advanced funds because it sought to preserve its own relationships with certain investors in Son-Cos.

That said, Taxpayer continued to make advances to Son-Cos even after it became apparent that the companies were financially unstable – indeed, it made loans when the companies had more debt than equity on their financial statements, when they were unable to make payments on their bank loans, and when they could not pay their bills.

What’s more, Taxpayer advanced funds even though the advances created problems for Taxpayer in obtaining surety bonds, which were integral to its own business.[xviii] In addition, Taxpayer sometimes borrowed funds to make advances to Son-Cos.

At one point, Banks, which had provided loans both to Taxpayer and Son-Cos, sought to reduce their overall exposure to Son-Cos by shifting as much of the Son-Cos debt as possible to Taxpayer. Taxpayer agreed to assume a portion of Son-Cos’ indebtedness, to guarantee the Son-Cos debt, and to subordinate to Banks any and all debts owed to it by Son-Cos.

Indeed, Taxpayer continued to advance funds even after beginning to claim bad debt deductions with respect to its earlier advances to Son-Cos.

Documentation and Collection Efforts

Taxpayer recorded its many advances to Son-Cos as notes receivable in its books and records.

According to Taxpayer’s records, it ultimately advanced over $111 million to Son-Cos,[xix] but received payments of only $28.6 million. Taxpayer also recorded that it had accrued interest income in excess of $20.8 million, but received interest payments of only $10.3 million.

At some point, Taxpayer stopped accruing interest, and paying tax on it, altogether.

Taxpayer had in its possession numerous promissory notes which purported to reflect its advances to Son-Cos. However, not all the promissory notes were signed by Son. Individuals would sometimes sign notes “imitating” Son’s signature. Some notes were signed by other individuals, and still other notes had Son’s stamped signature. Some promissory notes were unsigned.

Most of the promissory notes had fixed schedules for repayment, and renewed promissory notes were renewed without Taxpayer’s receiving payments of principal or interest. Often, promissory notes were renewed when maturity dates arose and were consolidated routinely into new, larger amounts. Taxpayer did not increase interest rates on notes that were renewed.

Although Taxpayer’s directors regularly met with Son at its offices, Taxpayer never formally requested in writing that the outstanding advances be repaid.

Taxpayer did not pursue other avenues of collection. It failed to collect through liquidating Son’s shares of Taxpayer stock, and it failed to demand repayment when Son sold one of his companies. In fact, because Taxpayer had subordinated any rights to repayments to Banks, it was unable to enforce repayment.

Deductions Claimed

For the tax years at issue, Taxpayer claimed deductions on its federal corporate income tax returns[xx] for partially worthless bad debts that it asserted were owed to it by Son-Cos. Taxpayer ultimately wrote off millions of dollars’ worth of debt.

After an audit of Taxpayer’s returns, the IRS issued a notice of deficiency to Taxpayer, rejecting almost all of these write-offs.

Taxpayer petitioned the Tax Court to review the IRS’s determination, but the Tax Court upheld the deficiency. It determined that Taxpayer could not deduct the payments to Son-Cos as “bad debts” because Son-Cos and Taxpayer lacked a bona fide debtor-creditor relationship.[xxi]

The Tax Court on Bad Debt Deductions

As a general rule, the Code allows a deduction for “any debt which becomes worthless within the taxable year.”[xxii] That being said, the Code also distinguishes business bad debts from nonbusiness bad debts.[xxiii]

Business bad debts may be deducted against ordinary income, whether wholly or partially worthless during the year (to the extent of the amount that becomes worthless).[xxiv]

A nonbusiness bad debt may be deducted, but only when it becomes completely worthless in the year for which it is claimed, and then only as a short-term capital loss.[xxv]

In the case of a guarantor, the Code limits the deduction for bad debt losses to the amounts actually paid by the guarantor.

Taxpayer contended that it was entitled to business bad debt deductions for the tax years at issue for the advances made to, or for the benefit of, Son-Cos that became partially worthless during the years at issue.

The IRS contended that Taxpayer failed to establish that the claimed advances were bona fide debt. It further contended that Taxpayer’s motivation for advancing the funds was to provide capital injections or gifts to assist in forming new companies associated with Son, to provide disguised dividends for the use of Son’s licenses, or to provide compensation for work contracts that Son-Cos sent to Taxpayer, for services Son provided to Taxpayer, or for allegedly exchanging Son’s Taxpayer voting shares into nonvoting shares.

The Tax Court explained that there is no bad debt deduction without a bona fide debt.[xxvi] The IRS’s regulations define a bona fide debt, the Tax Court continued, as one “which arises from a debtor-creditor relationship based upon a valid and enforceable obligation to pay a fixed or determinable sum of money.”

Stated differently, the parties to the transaction must have had an actual, good-faith intent to establish a debtor-creditor relationship at the time the funds were advanced. An intent to establish a debtor-creditor relationship exists if the debtor intends to repay the loan and the creditor intends to enforce repayment.[xxvii]

According to the Tax Court, whether a purported debt is “in substance and fact a debt for tax purposes” is determined from the facts and circumstances of each case, with the taxpayer bearing the burden of proof.

Among the factors ordinarily considered by the courts in determining the parties’ intent, and whether a bona fide loan occurred, are the following, no single one of which is dispositive:

(1) the name given to the certificates evidencing the indebtedness,

(2) the presence or absence of a fixed maturity date,

(3) the source of payments,

(4) the right to enforce repayment,

(5) participation in management as a result of the advances,

(6) the status of the advances in relation to debts owed to regular corporate creditors,

(7) thin or adequate capitalization,

(8) the risk involved in making the advances,

(9) the identity of interest between creditor and shareholder,

(10) the use to which the advances were put,

(11) the ability to obtain loans from outside lending institutions,

(12) failure to repay advances on the due date,

(13) the intent of the parties, and

(14) the payment and accrual of interest.

After considering the circumstances of Taxpayer’s advances to or for the benefit of Son-Cos, and in the light of the factors set forth above, the Tax Court concluded that the advances did not represent bona fide debt. Taxpayer did not intend to create a bona fide debtor-creditor relationship, and the economic circumstances that existed during the time Taxpayer made its advances established that it did not reasonably expect repayment. Thus, Taxpayer was not entitled to bad debt deductions for the advances it made to Son-Cos during the tax years at issue.

Taxpayer then appealed the Tax Court’s ruling.

The Court of Appeals

Specifically, Taxpayer disputed the Tax Court’s determination that its cash payments to Son-Cos did not constitute loans that were deductible as “bad debts” when they went unpaid.

After reviewing the applicable Code and regulatory provisions, the Court framed the issue by stating that Taxpayer’s ability to claim the deduction turned on whether it had a debtor-creditor relationship with Son-Cos such that Son-Cos had an enforceable obligation to pay Taxpayer a fixed sum. To determine whether such a relationship existed, the Court looked to “a number of factors” as “indications of intent,” and reminded Taxpayer that it had the burden to establish the presence of such indicators. The Court acknowledged that courts generally view intrafamily transfers with “particular skepticism.”

Still, Taxpayer argued that the Tax Court’s “reliance on indicia of a debtor-creditor relationship prevented it from seeing the forest for the trees and that the only relevant factor is the intent of the parties.”[xxviii]

Taxpayer contended that it represented to third parties that the advances to Son-Cos were debts, and it possessed signed promissory notes, both of which indicated that it believed the advances to be debt for which it expected to be repaid.

The Court observed, however, that the way Taxpayer described the advances did not match the way that Taxpayer and Son-Cos treated those payments.[xxix] For example, the Court noted that, though many of the promissory notes had fixed maturity dates, Taxpayer routinely deferred payment or renewed the notes without any receipt of payment or other consideration.

Further, the Court pointed to evidence that Taxpayer did not expect to be repaid unless various other events occurred, such as Son-Cos securing additional investments and projects. This sort of relationship, the Court remarked, is that of an investor, not of a creditor: “[T]he creditor expects repayment regardless of the debtor corporation’s success or failure, while the investor expects to make a profit … if, as he no doubt devoutly wishes, the company is successful.”

Thus, although Taxpayer may have described the payments as debt, it did not treat them as part of an ordinary debtor-creditor relationship and, therefore, did not establish that the parties intended such a relationship.

Taxpayer had the burden of demonstrating that its payments to Son-Cos were bona fide debts that arose from a debtor-creditor relationship in which it expected Son-Cos to pay Taxpayer back in full. Because Taxpayer failed to carry its burden, the Court concluded that Taxpayer’s payments to Son-Cos were not “bad debts” qualifying for the deduction.

Economic Reality

The key to determining the character of a payment between related parties as a loan or as something else ultimately turns on the economic reality of the payment.

If an outside lender would not have extended credit on the same terms and under similar circumstances as did the related entity, an inference may arise that the advance is not a bona fide loan.

On the other hand, if the transfer and surrounding circumstances give rise to a reasonable expectation, and an enforceable obligation, of repayment, then the relationship between the parties will resemble that of a creditor and debtor.

In that case, the form of the transaction should be consistent with, and support, its substance: a genuine loan transaction. Thus, there should be a written promise of repayment, a repayment schedule, interest, and security for the loan.

The factors identified by the Courts, above, provide helpful guidance for structuring and documenting a loan between related persons, including a business entity and any of its owners. If these factors are considered, the parties to the loan transaction will have objectively determinable proof of their intent, as reflected in the form and economic reality of the transaction.

Of course, the parties will also have to act consistently with what the transaction purports to be – they will have to act as any unrelated party would under the circumstances.

[i] You’ll note that Sch. L to IRS Form 1065 refers to “[l]oans to partners (or to persons related to partners)” while Sch. L to Form 1120 does not include a reference to “persons related to shareholders.” The “related persons” are described in IRC 267(b) and 707(b).

[ii] The balance sheet asks for the amounts owing at the beginning and at the end of the year. A reduction may reflect a repayment, an increase may reflect an additional loan.

If the returns provided go back far enough, we’ll know when the loan originated, how long it has been outstanding, whether there have been any payments of principal, etc.

[iii] Actually received, or imputed under IRC Sec. 7872.

[iv] It irks me (and it will certainly irk the IRS) when I see C corporations making “loans” to shareholders that are proportionate to their stock holdings, while not making any dividend distributions.

[v] Especially in the case of an S corporation. The IRS and many courts have stated very clearly that an employee-shareholder cannot avoid employment taxes by choosing the receive “distributions” in respect of their stock rather than receiving wages in exchange for their services.

[vi] Sch. L, Line 14 of Form 1120; Sch. L, Line 13 of Form 1065; Sch. L, Line 14 of Form 1120S.

How do you think an IRS auditor is going to view this? I’m reminded of those individuals who file New York State income tax returns as non-residents and who intentionally fail to answer the question on the first page of the return regarding whether they maintain living quarters in New York.

[vii] Interest rate, collateral, payment schedule, acceleration events, events of default, remedies, etc.

[viii] In this case, the debt created is presumed to be a demand loan.

[ix] The laughter from the client following the third question is a different matter.

[x] I’ve grown tired of having this discussion in this age of low rates.

[xi] I’m not just talking tax, here. The limited liability protection afforded by the corporate and limited liability company forms of business entities are premised upon their “separateness” from their owners. There are juridical persons. Once the owners start to ignore that fact, the slippery slope will eventually allow third parties to ignore the business entity, and to pursue their business-related claims against the owners directly.

[xii] Which I’ve never understood. See, for example, IRS Form 5472, Information Return of a 25% Foreign-Owned U.S. Corporation, on which 25%-foreign-owned domestic corporations disclose certain transactions with the foreign shareholder or with certain foreign related persons.

[xiii] At that point, I ask for the returns of any related entities – there should be a corresponding debt reported.

That being said, the IRS has, over the years, added schedules to the basic business tax return forms that require the identification of certain related persons.

Thus, for example, Form 1120, U.S. Corporation Income Tax Return, Sch. K, Line 4 asks whether any corporation or partnership owns directly 20 percent or more, or owns directly or indirectly (applying the constructive ownership rules of IRC Sec. 267(c)), 50 percent or more, of the total voting power of the corporation’s stock. Line 5 of Sch. K asks whether the corporation owned such interests in other entities. If either of these questions is answered in the affirmative, the taxpayer corporation must file Sch. G, Information on Certain Persons Owning the Corporation’s Voting Stock, to identify these related persons who may be in a position to influence how it transacts business. (But see also IRS Form 851, Affiliations Schedule.)

Form 1065, U.S. Return of Partnership Income, Sch. B, Lines 2 and 3 ask similar questions with respect to a partnership. If answered in the affirmative, the partnership must also file Sch. B-1, Information on Partners Owning 50% or More of the Partnership, to provide information regarding these related persons.

Form 1120S, U.S. Income Tax Return for an S Corporation, Sch. B, Line 4 asks a similar question as to corporations or partnerships in which the S corporation is an owner. (Of course, these entities are not eligible to be shareholders of an S corporation.)

[xiv] Reg. Sec. 1.1361-1(l)(2)(i). Preferred stock comes to mind – it is often difficult to distinguish this class of equity from a debt instrument. But see the safe harbor for “straight debt” under the S corporation rules.

[xv] For example, a gift or a distribution.

Of course, any “presumption” against loan treatment may be rebutted by an affirmative showing that there existed, at the time of the “loan,” a real expectation of repayment and an intent to enforce the collection of indebtedness.

However, that does not eliminate entirely the potential for a gift.

According to the IRS, transfers reached by the gift tax “are not confined to those which, being without a valuable consideration, accord with the common law concept of gifts; they also include other transfers of property in exchange for consideration to the extent that the value of the property transferred by the donor exceeds the value in money or money’s worth of the consideration given therefor” – for example, a below-market loan. IRC Sec. 7872. However, if such a transfer is made in the ordinary course of business (a transaction which is bona fide, at arm’s length, and free from any donative intent), it will be considered as made for an adequate and full consideration in money or money’s worth. Reg. Sec. 25.2512-8.

[xvi] VHC Inc. v. Commissioner, No. 18-3717 (7th Cir. Aug. 6, 2020).

[xvii] Taxpayer’s board of directors determined that Son was a “key person” and that it would be in Taxpayer’s best interest to purchase keyman life insurance on his life.

[xviii] The millions of dollars of receivables Taxpayer had on its balance sheets attributable to the advances made to Son-Cos affected its ability to obtain surety bonds, which damaged Taxpayer’s ability to bid on projects that required bonding.

[xix] Did I mention that I’m up for adoption?

[xx] On IRS Form 1120.

[xxi] The Tax Court also rejected Taxpayer’s alternative arguments, including, for example, its contention that its payments to Son-Cos were ordinary and necessary business expenses.

[xxii] IRC Sec. 166. It is important to note that the creditor must be able to establish that the debt was not worthless for the year immediately preceding the year in which the deduction is claimed (i.e., the year in which the debt became worthless).

[xxiii] IRC Sec. 166(d); Reg. Sec. 1.166-5(b).

[xxiv] Reg. Sec. 1.166-3.

[xxv] IRC Sec. 166(d).

[xxvi] Reg. Sec. 1.166-1(c).

[xxvii] Reg. Sec. 1.166-1(c). A gift or a contribution to capital is not considered to create a debt for purposes of this rule.

[xxviii] As opposed to the more objective manifestations of such intent evidenced by the enumerated factors? Odd.

[xxix] Classic form vs substance.

The Convention

The Democratic Party’s “virtual” convention last week seems to have gone pretty well. All the stars of the Party’s firmament were on hand and spoke in “virtually” one voice in their assessment of the individual who currently occupies the White House and of his performance in carrying out the duties of the nation’s chief executive.

Speaking of performance, the Party’s Nominee for the Presidency delivered a relatively well-received speech.[i] After accepting the nomination – “with great honor and humility”[ii] – Mr. Biden set the theme for his campaign against Mr. Trump as one of “light vs darkness.”[iii]

Among the plots woven into this theme, taxes figured prominently. What follows are three excerpts from Mr. Biden’s speech:

“Working families will struggle to get by, and yet, the wealthiest one percent will get tens of billions of dollars in new tax breaks.”

“And we can pay for these investments by ending loopholes and the president’s $1.3-trillion tax giveaway to the wealthiest 1 percent and the biggest, most profitable corporations, some of which pay no tax at all.”

“Because we don’t need a tax code that rewards wealth more than it rewards work. I’m not looking to punish anyone. Far from it. But it’s long past time the wealthiest people and the biggest corporations in this country paid their fair share.”

If one were to search Mr. Biden’s speech for the root words “tax” and “wealth,” one would find that they appear together every time, usually in the same sentence.

In other words, he left little doubt of his intentions.

Recap of Biden’s Tax Plan

Last week’s post explored how these soundbites may be manifested as legislation to be enacted, Mr. Biden hopes, by a Congress controlled by the Democratic Party. Many of these proposals last appeared in President Obama’s Fiscal Year 2017 Budget[iv] – when he was a “lame duck” President facing a Republican Congress.[v]

In any case, the following outlines some of the key parts of Mr. Biden’s tax plan:[vi]

  • 6% tax rate for ordinary income[vii]
  • 6% tax rate for capital gain for individual taxpayers with more than $1 million of income[viii]
  • Eliminate the qualified business income deduction[ix] for individuals making over $400,000
  • Limit itemized deductions for those in higher tax brackets (above 28 percent)[x]
  • Impose the 12.4% Social Security tax[xi] on all wages over $400,000[xii]
  • Eliminate tax deferred like kind exchanges of real property[xiii] for investors with annual income in excess of $400,000[xiv]
  • Eliminate the basis step-up[xv] for a decedent’s assets,[xvi] or tax immediately the gain inherent in a decedent’s assets as if they had been sold at their date of death
  • Reduce the basic exclusion amount for purposes of the gift, estate, and generation skipping transfer taxes (the “transfer taxes”) from $10 million to $5 million,[xvii] and
  • Increase the flat corporate income tax rate from 21 percent to 28 percent.

Last week’s post also indicated that any tax legislation coming out of a federal government managed by the Democrats is not likely to adopt Mr. Biden’s proposals verbatim. The foregoing measures are intended to win an election.[xviii]

So, in the event of a Biden victory – not a sure thing – what can we expect?

Let’s start with his running mate, Senator Harris – after all, according to the popular aphorism, the vice president is only “a heartbeat away” from the presidency.[xix]

Senator Harris and Taxes

Senator Harris dropped out of the Democratic primary contest in late 2019, before the pandemic. Before then, however, she expressed a strong desire for repealing the 2017 Tax Cuts and Jobs Act, which would include, among other things:

  • reinstating the maximum 39.6 percent rate for ordinary income received by individuals,
  • re-imposing limits on itemized deductions,[xx]
  • returning the basic exclusion amount for transfer taxes to $5 million,
  • eliminating the $10,000 limit on itemized deductions for state and local taxes,[xxi]
  • eliminating the deduction based on qualified business income, and
  • reinstating a graduated corporate tax, with a maximum rate of 35 percent.

In addition, Senator Harris supported taxing capital gains realized by individuals at the same rate at which ordinary income is taxed (39.6 percent under her plan),[xxii] as well as imposing a financial transaction tax on trades of marketable securities. She also talked about imposing an additional 4 percent income-based premium on households making more than $100,000 (to help fund Medicare).[xxiii]

Therefore, it appears that the Senator’s stance on tax policy is not incompatible with Mr. Biden’s.

In fact – if I may take some poetic license[xxiv] – based on the restoration after 2025 of many provisions that were added to the Code in 2017 by the Republican Congress,[xxv] or that were temporarily suspended, the Democratic ticket is inadvertently “aligned” with the Republicans on many tax provisions, differing only as to the timing of their implementation or reinstatement.

Unfortunately for them – and perhaps for many closely held businesses and their owners – the Democratic Party is hardly a monolithic centrist block.

The “Progressives”

Last week, Senator Sanders had the following to say on the Daily Show: “We’re going to come together to defeat Trump, and the day after Biden is elected we’re going to have a serious debate about the future of this country.”

I wondered whether the “we” to which the Senator referred was the Democrats and the Republicans, or the progressive and centrist wings of the Democratic Party.

As he did in 2016, Senator Sanders emerged as a serious contender in 2020, challenging Mr. Biden for a long stretch of the Democratic primary race.[xxvi] Then there was Senator Warren.

And Senators Sanders and Warren weren’t the only ones challenging established centrist Democrats. Witness what happened to Democratic incumbents like Rep. Engel and Rep. Clay in the primaries.

And why was Rep. Ocasio-Cortez – the unofficial spokesperson for the progressive wing – chosen to step onto the national stage to second the nomination for Mr. Sanders for purposes of the formal roll call required by the rules of the convention?

The answer is clear: because the progressive wing of the Democratic Party has emerged as a factor to be considered in any legislative agenda. Indeed, according to some, “Progressives are expected to grow their numbers in the House . . . which they hope will give them more influence. ‘If we actually get to 15 to 20, which it looks like we will, that is a potent force. I mean, that can help set the agenda for our party,’ ” said Rep. Khanna of the Congressional Progressive Caucus.[xxvii]

What does that mean for taxes?

Of course, you’ve heard about the wealth taxes proposed during the Democratic primaries. There are many more ideas being floated within the Democratic camp; for example, Rep. Ocasio-Cortez wants to increase to 70 percent the rate on those individuals making at least $10 million; she has called for taxing capital gains at the same rate as ordinary income; and she wants to tax on an annual basis the appreciation in the value of investments (i.e., a “mark to market” system), rather than wait until the investments are sold.

Still others have argued that the best way to raise extra tax dollars from the so-called wealthy is by eliminating various deductions[xxviii] and exemptions.

The “Target” Taxpayers?

Which begs the question: Who are the “wealthy”? Are they the folks who make more than $400,000 per year, and thus are marked for “special” treatment by Mr. Biden based on an Obama Administration proposal from 2012? Who are the members of the “one percent” to whom he referred in his acceptance speech? For whom do Rep. Ocasio-Cortez and her coterie reserve their ire?[xxix]

Good questions. According to a recent article in USA Today, “it takes an annual income of $538,926 to be among the top 1 percent [nationally]. Among the approximately 1.4 million taxpayers who meet this threshold, the average annual income is about $1.7 million – about 20 times the average income of $82,535 among all taxpayers.”[xxx]

In New York, the article continues, the top 1 percent earn at least $702,000, and the average income of the top 1 percent is almost $2.9 million.[xxxi]

Still, the question remains unanswered.

Please indulge me as I try to impersonate an economist. (No, I did not stay at a Holiday Inn Express last night.)

The Target “Assets”

How much of this income is attributable to what an economist might describe as human capital, which rewards individuals based on their productivity or special skills? As long as the individual can perform, they will be compensated for their services. The higher salary, the year-end bonus, the nonqualified deferred compensation plan that vests upon the completion of a specified service or the achievement of a production goal, and similar measures of compensation, all represent a return on one’s human capital. It is not an asset that may be passed down to other generations.[xxxii] The value of this compensation is taxable as ordinary income.

“Wealth” on the other hand is something else. It represents the value of one’s property and, in particular, the ability of such property to generate income without effort on one’s part. It is often acquired by investing the after-tax proceeds from the compensation received in exchange for one’s human capital. By its very nature, it may be passed from one generation to the next – it is not dependent upon the expenditure of the next generation’s human capital.

Unlike compensation, the payment of which is required as a matter of law,[xxxiii] a distribution or other form of “return” with respect to one’s investment in an asset that represents equity in a business is not, strictly speaking, legally required; rather, it depends upon the success and well-being of the asset into which the taxpayer has invested their funds, and it depends upon the needs of the asset or business.[xxxiv] Such an investment entails a long-term risk, at least in the case of a closely held business, and one’s investment in such a business, once committed, is difficult to withdraw.[xxxv]

Speaking of the closely held business, it represents the intersection of the foregoing concepts.[xxxvi] It involves the taxpayer-owner’s “expenditure” of their human capital[xxxvii] and the investment of their after-tax funds,[xxxviii] thereby putting both at risk in the hope of realizing an asset that (i) will produce income, taxable at non-preferential ordinary rates,[xxxix] without the taxpayer’s continuing involvement, or (ii) may be liquidated through the sale of the asset.

On which form of “wealth” or income are Mr. Biden and the Democrats going to focus? Are they going to say to those of productive human capital, “you make a lot of money, you should pay more taxes in order to support the government and its programs.”[xl] Or will they focus on income-producing property instead? If the latter, will they distinguish between the closely held business, on the one hand, and marketable securities on the other?[xli]

Much remains to be seen, including how influential or demanding the progressives will be. Either way, the selection is fraught with political consequences.

The Closely Held Business Needs Protection

I can accept many of the income tax and employment tax provisions in Mr. Biden’s proposal.

Like Kind Exchange

I can even get behind some limitation on the use of like kind exchanges to defer gain recognition, but not based on the taxpayer’s overall income, and certainly not at $400,000.[xlii]

President Obama’s 2017 Green Book proposal for limiting the gain deferred to a specified amount – he proposed $1 million of gain per taxpayer per year – is much more palatable; for example, in the case of a partnership with three equal partners, $3 million of gain may be deferred in total.

That being said, and for the reasons mentioned earlier, a $3 million gain in the New York metro area is very different from the same gain in almost any other part of the country. Historically, Congress has been reluctant to match tax consequences to the cost of living in the geographic area in which they are realized, yet that is the only way the above limitation will make any sense.

That said, I do not understand Mr. Biden’s thinking on capital gains, on dividends and on the basis step-up[xliii] at death.

Capital Gain

Let’s assume an individual with $X of disposable cash. This individual may invest their money in the stock of a corporation that is readily tradeable on an established market, or they may choose to invest it among several such corporations so as to diversify their risk. Although they may not be guaranteed dividend distributions (periodic or otherwise), they are free to liquidate their investment at any time.  In addition, they will never be called upon to guarantee any indebtedness or other obligations of the business, nor will they ever be asked to make to make additional capital contributions.[xliv]

What if the same individual used their $X to organize a closely held business? They may pay themselves the equivalent of a relatively small salary (at least initially) for the services they render to the business and they forego the types of benefits often provided for key employees in established companies. If they are fortunate enough to have any after-tax profits, those will more likely than not be reinvested in the business by hiring employees and making capital expenditures necessary for the business. In the vast majority of cases, the business will be organized as a pass-through entity; thus, its profits will be taxed to the individual as ordinary income whether or not the individual receives a distribution from the business. What’s more, the operation of the business will occupy this individual’s every waking hour, seven days a week. In time, after a lot of effort (human capital) and a bit of luck – 90 percent of startups fail, 75 percent of venture-backed startups fail, under 50 percent of businesses make it to their fifth year, 33 percent of startups make it to the 10-year mark, and only 40 percent of startups actually turn a profit[xlv] – the business may be doing well enough to draw the attention of a larger competitor[xlvi] or of a private equity fund.

Why would our hypothetical individual go into business, with all the risk and additional effort that it entails, only to be taxed upon the successful sale of the business at the same rate at which their salary would have been taxed had they gone to work for someone else (with the attendant employment and retirement benefits), and had invested their $X in publicly traded securities? It’s a basic principle of economics, is in not, that the greater the risk to which an investor exposes themselves, the greater the return they would require in exchange. It’s to encourage such investment, and to offer the possibility of that return, that long-term capital gains are taxed at a lower rate than ordinary income.

Qualified Dividends

Dividends are taxable at the rate applicable to long-term capital gain. Why? Because like capital gain they represent a degree a risk for which the investor has no contractual recourse against the C corporation to which the investor has contributed capital in exchange for shares of stock.[xlvii]

Broadly speaking, however, who owns the equity interests in respect of which any dividend would be payable, and whose income tax liability is the subject of this discussion?

According to an Urban-Brookings Tax Policy Center study conducted just a few years ago,[xlviii] approximately 75 percent of outstanding C corporation stock is held by non-taxable accounts; for example, qualified retirement funds;[xlix] insurance companies;[l] nonprofits;[li] foreigners; and others. The dividends paid to these holders in respect of their stock are generally not subject to federal income tax, nor is the gain they realize on the sale of such stock.

Foreign investors held approximately 25 percent of U.S. C corporation stock. The “default” federal income tax rate for dividends on such stock is set at 30 percent[lii] – well below the rate on ordinary income for U.S. individuals. Treaties, however, typically reduce this rate to 15 percent (and sometimes lower). What’s more, a foreigner’s gain from the sale of domestic stock is exempted from U.S. income tax. Thus, for purposes of the Urban-Brookings study, they were treated as non-taxable account holders.

In light of the foregoing, is it proper to tax the dividends paid to U.S. individuals at a rate of 39.6 percent? Actually, one also needs to consider the 3.8 percent surtax for net investment income.[liii] That would bring the total tax rate applicable to an individual’s dividend from a C corporation, or to their long-term capital gain from the sale of C corporation stock, to 43.4 percent.

Basis Step-up

In the alternative, let’s assume that our hypothetical business owner dies prematurely. The cause of death? Work.[liv]

The fair market value of the business is included in the decedent’s gross estate for purposes of the federal estate tax.[lv] Let’s assume that the taxable estate exceeds the decedent’s exclusion amount[lvi] – estate tax will be owing. Let’s also assume that the business will be sold.[lvii]

It is commonly understood that the basis step-up is intended to prevent the decedent’s estate from being taxed twice on the same asset: once upon the transfer of the asset at death, and again on the sale of the asset; the basis step-up addresses the gain realized on the sale.

The first factor to consider is whether there is a risk of double taxation: specifically, should there be a basis step-up where the decedent’s taxable estate is less than the decedent’s exclusion amount such that no estate tax is owing? What if the asset passes to the decedent’s spouse or to a charity, such that the marital deduction or charitable contribution deduction[lviii] applies to eliminate any estate tax exposure? When a property is gifted to a beneficiary without incurring any gift tax, the latter takes the property with the same basis it had in the hands of the individual making the gift.[lix]

The second factor is whether there is a sale of the asset, whether by the estate or by the decedent’s beneficiaries: should the basis step-up be accounted for only upon a sale of the asset, while the beneficiaries use a carryover basis for cost recovery purposes?[lx]

Does Kiss Have the Answer?

Assume Congress decides upon a scaled back basis step-up and an increased, but still preferential, capital gain tax for the disposition of a closely held business, along the lines alluded to above. What else in Mr. Biden’s tax plan may satisfy the progressive wing of his party without offending his centrist base, while perhaps even garnering some support from across the aisle?

Do you remember Gene Simmons,[lxi] the bassist for the rock group Kiss, and the co-lyricist for many of their hits?[lxii] It was reported in a March 31, 2019 article on GOBankingRates.com, that he was not planning to leave his substantial fortune to his kids. “What I wanna do,” he said, “is what every bird does in its nest – it forces the kids to go out there and figure it out for themselves. In terms of an inheritance and stuff,” he continued, “they’re gonna be taken care of, but they will never be rich off my money . . . they should be forced to get up out of bed and go to work and make their own way.”

Gene Simmons is not the only wealthy individual who plans on spending their money. Many other celebrated entertainers and business folk likewise have been quoted in the press as having announced that the vast majority of their wealth will be transferred to various charities.[lxiii] They concede that their children will be given a degree of economic security not bestowed on others, but they also add that their children will have to work if they want to make their mark or build and accumulate wealth.

If the statements attributed by the articles to these people are true, then it appears that a significant number of wealthy individuals – many of whom ceased using their human capital long ago – are not interested in leaving all, or even most, of their wealth to the next generation.

That being said, and considering Mr. Biden’s support among many members of this well-heeled group, might the least politically disruptive approach to “making the rich pay their fair share” be one that borrows liberally[lxiv] from President Obama’s 2017 Green Book?

The Green Book would have:

  • made “permanent” the estate tax, generation-skipping transfer tax, and gift tax parameters that applied during 2009
    • thus, the top tax rate would be increased from 40 percent to 45 percent, and
    • the exclusion amount would be reduced from $10 million to $3.5 million per person (rather than the $5 million under Mr. Biden’s proposal) for purposes of the estate and GST taxes, and to $1 million for gift taxes[lxv]
  • revised the rules applicable to grantor retained annuity trusts (GRATs)[lxvi]
    • require a ten-year minimum term
    • require a maximum term tied to the life expectancy of the annuitant plus ten years
    • prohibit the grantor from engaging in a “tax-free exchange” of any asset held in the trust[lxvii] by requiring that the asset received by the trust be included in the grantor’s estate
      • another proposal, but not included in the Green Book, would have eliminated “zeroed out” GRATs by requiring that the funding of the GRAT result in some taxable gift
    • provide that, on the 90th anniversary of the creation of a trust,[lxviii] the GST tax exemption amount allocated to the trust would terminate, thereby rendering the trust subject to the GST tax
      • this was aimed at so-called “dynasty” trusts, the creation of, and the distributions from which, would have escaped gift, estate and GST taxes
    • eliminate the present interest requirement for gifts to qualify for the gift tax annual exclusion, but impose an annual limit of $50,000 (indexed for inflation) per donor on the donor’s transfers of property that will qualify for the gift tax annual exclusion[lxix]
      • this would likely result in some taxable gifts in the case of life insurance trusts that hold policies with large premiums.

Why Lou, Why?

Some readers may wonder why a tax adviser to closely held businesses and their owners would espouse any of Mr. Biden’s proposals, and even suggest the adoption of some of President Obama’s 2017 Green Book proposals.

Because some of them are reasonable – they make sense;[lxx] some address what I have long believed were unintended consequences.[lxxi] I would add, as a second reason, because there are folks in Congress who want to do a lot worse; they may be well-intentioned, but their policies will ultimately hurt us. Some reasonable compromise is called for. Moreover, let’s not forget that the $10 million basic exclusion is a recent development, of a temporary nature, and not a long-recognized constitutional right.

If I could bend your ear a bit longer, it may be a good idea to cap the estate tax deduction for charitable contributions[lxxii] made to private non-operating foundations, as opposed to public charities. The removal of a significant amount of wealth, and the income therefrom, beyond the reach of the estate tax and the income tax in exchange for an annual charitable distribution based on 5 percent of the fair market value of the foundation’s assets does not seem like a good deal from the perspective of the general public.

Finally, and neither party ever makes this suggestion, Congress should increase the IRS’s enforcement budget. There are a lot of genuinely bad actors out there who are getting away with “murder.” Secretary Mnuchin reported in 2017 that for every one dollar spent on enforcement, the IRS collects four dollars.[lxxiii] That’s a great return in any circumstances.

There’s a lot more we can discuss, but I’ve already gone too long.


Including by some Republican pundits who “complimented” Mr. Biden; for example, Karl Rove, speaking on Fox News immediately after the convention concluded, commented that Mr. Biden’s presentation was “a very good speech,” acknowledging that Biden’s centrist position could present a challenge for Republicans. Having said that, however, he later added, “There were moments where – granted, he didn’t misstate, he didn’t lose words, the flow was pretty good – but you looked at him, and you said, ‘that’s an old guy and he’s doing his best.’”

[ii] I recognize that we are still in the introductory portion of this week’s post, but I have to digress. It irks me when candidates for election to an office – any office – state, as Mr. Biden did: “So, it is with great honor and humility that I accept this nomination . . . ”

“Humility?” This is Mr. Biden’s third attempt. It may have been his fourth if President Obama had not talked him out of running in 2016.

Politics is a dirty business – whether conducted at the national level or within the offices of a local business – and anyone who rises to, and succeeds at, its highest levels has probably compromised themselves in some morally questionable way.

By now, you’ve figured out that I enjoy quoting from certain movies to convey or stress a message. Among these is Gladiator. You may recall this exchange between Marcus Aurelius and General Maximus after the Emperor has asked Maximus to succeed him, temporarily, upon his passing:

Marcus Aurelius: Won’t you accept this great honor that I have offered you?

Maximus: With all my heart, no.

Marcus Aurelius: Maximus, that is why it must be you.

[iii] The Los Angeles Times published the full text of the speech: https://www.latimes.com/politics/story/2020-08-21/joe-biden-acceptance-speech.

[iv] The “Green Book.”

[v] I’ll endeavor to identify the similarities in the endnotes as we go along.

[vi] https://www.taxlawforchb.com/2020/08/bidens-tax-proposals-for-capital-gain-like-kind-exchanges-basis-step-up-the-estate-tax-tough-times-ahead/

[vii] This is already scheduled to be reinstated in 2026. See the Tax Cuts and Jobs Act, P.L. 115-97; “TCJA”.

[viii] President Obama’s Green Book proposed raising the top tax rate on capital gains and qualified dividends from 20 percent to 24.2 percent. Perhaps this is where we will ultimately end up. For now, it’s the campaign season.

[ix] Already scheduled to disappear after 2025. TCJA.

[x] President Obama’s Green Book included this proposal. This limitation would reduce the value to 28 percent of the specified exclusions and deductions that would otherwise reduce taxable income in the higher income tax rate brackets.

[xi] The employer pays half of this, and collects the other half from the employee – each at 6.2 percent.

[xii] It currently stops at $137,700.

[xiii] IRC Sec. 1031.

President Obama’s last Green Book would have limited the amount of capital gain deferred under Sec. 1031 to $1 million (indexed for inflation) per taxpayer per taxable year. https://home.treasury.gov/policy-issues/tax-policy/revenue-proposals

[xiv] Anyone wondering “Why $400,000?” Why is Mr. Biden drawing the line there, and promising that folks making no more than that amount will not see an increase in taxes?

Let me take you back to 2012. (No, this doesn’t involve a crazy trip in a DeLorean.) We were approaching a “fiscal cliff;” specifically, the nation was facing over $500 billion in federal tax increases and budget cuts that were scheduled to go into effect on January 1, 2013 – the expiration of the so-called Bush tax cuts. The only way this could be avoided was if President Obama and a lame-duck Congress could reach an alternative agreement for reducing the deficit. (It’s laughable today, isn’t it?) The President’s plan at one point included higher taxes for folks making more than – you guessed it – $400,000.

In an article dated December 18, 2012, the U.S. News & World Report explained that although “$400,000 is unquestionably a high income . . . earnings are relative. A family earning $400,000 in Manhattan exists in a very different world than one earning $400,000 in” most any other part of the country. It went on to describe how the after tax cost of living in Manhattan was more than double the national average.   https://www.usnews.com/news/articles/2012/12/18/how-rich-is-400000-where-you-live-obama-willing-to-raise-taxes

By the way, $400,000 in 2012 is equal to over $451,000 today.

According to a July 29, 2020 article in Kiplinger, the cost of living in Manhattan was 145.7% above the national average. https://www.kiplinger.com/real-estate/601142/20-most-expensive-cities-in-the-us

[xv] IRC Sec. 1014.

[xvi] President Obama’s Green Book proposed the elimination of the step-up in basis at death, but with certain protections for the middle class, surviving spouses, and small businesses.

[xvii] IRC Sec. 2010, 2505 and 2631. This is already scheduled to occur after 2025. TCJA.

[xviii] Hence, Mr. Rove’s observation regarding Mr. Biden’s posture as a centrist.

[xix] Mr. Biden will turn 78 this November, after the election. Senator Harris will turn 56 years of age in October.

[xx] Also set to be reinstated in 2026. TCJA.

[xxi] Ironically, this would benefit higher income taxpayers. What’s more, this limitation is set to expire at the end of 2025. TCJA.

Other deduction limitations that will expire after 2025, and from which higher income taxpayers will benefit, are the limitation on qualified resident interest and the suspension of home equity interest.

According to the “List of Expiring Federal Tax Provisions 2016-2027” prepared by the Staff of the Joint Committee on Taxation, JCX-1-18 (Jan. 9, 2018), twenty-three provisions from the TCJA relating to individual income taxes will expire with 2025, as a result of which the amount of tax owing by most taxpayers will increase. Among these expiring provisions are the following: the reduced individual income tax rates, the increased AMT exemption and phase-out threshold, the increased standard deduction, the qualified business income deduction for pass-through business entities, and the increased estate and gift tax exemption. With the expiration of these provisions, and the restoration of others that have been suspended, the Code will look very much as it did at the end of the Obama Administration, with the exception of the reduced corporate tax rate and the taxation of overseas earnings on a current basis, which will continue (and which was long overdue).

[xxii] She did not indicate whether this increased rate would apply only to individuals with income in excess of a prescribed threshold, as Mr. Biden has. In any case, it should cover profits interests.

[xxiii] https://taxfoundation.org/kamala-harris-tax-proposals/

[xxiv] It’s my post after all.

[xxv] In accordance with the schedule set by the TCJA.

[xxvi] Query the effect of the pandemic.

[xxvii] “Biden Unites Democrats – for now,” by Jordain Carney and Mike Lillis, The Hill, August 22, 2020. According to the article, “Democrats are bracing for an all-out fight over their agenda” if Mr. Biden wins the White House in November.

[xxviii] The deduction for interest on acquisition indebtedness for a principal residence has been mentioned, as has the deduction for state and local taxes. Occasionally, there have even been whispers about the depreciation deduction in respect of real property.

[xxix] I can’t explain why, but when I think about this group I am reminded of Robespierre, the Committee of Public Safety, and The Reign of Terror. It’s a visceral reaction.

[xxx] “How much do you need to make to be in the top 1% in every state? Here’s the list,” by Samuel Stebbins and Evan Comen, USA Today, July 1, 2020. https://www.usatoday.com/story/money/2020/07/01/how-much-you-need-to-make-to-be-in-the-1-in-every-state/112002276/

[xxxi] Manhattan skews these figures.

[xxxii] This point is reinforced in the rules that govern the taxation of IRD (income in respect of a decedent), the most common example of which is compensation for services that has accrued to the service provider’s date of death but which remains unpaid. This “asset” is included in the decedent’s gross estate but it does not enjoy the benefit of a step-up in basis. Instead, the beneficiary to whom the IRD will be paid must pay tax at the ordinary income rates; however, in recognition of the fact that the value of the IRD has been included in the service provider’s gross estate, the beneficiary is allowed to deduct one-half of that portion of the estate tax paid by the estate that is attributable to the value of the IRD. IRC Sec. 691.

[xxxiii] The same holds true for interest paid to a creditor with respect to a loan. The creditor has recourse against the debtor’s property, and has a preference over the debtor to the latter’s property. That’s why compensation and interest are taxed as ordinary income. Similarly as to rent from real property, or a royalty in respect of a license. These are contractually enforceable payments.

[xxxiv] Does a real property require major capital improvements? Does a manufacturer have to purchase new equipment? Does the business need to invest in research in order to improve an existing product or process, or to develop a new one? Is the business expanding in order to take advantage of a new opportunity?

[xxxv] Certainly not without significant loss. Compare that to a marketable security, or to a publicly traded corporation that regularly offers to redeem its shares.

[xxxvi] Think of it as the overlapping parts of a Venn Diagram.

[xxxvii] Often for below market pay.

[xxxviii] We’re not just talking about equity. Remember, borrowed funds are repaid with after-tax dollars. Only the interest incurred for the use of such funds is generally deductible.

[xxxix] Think of the sole proprietorship, the partnership and the S corporation – all are pass-through entities the profits of which are taxed to their owners as ordinary income. These business entities are the vehicles of choice for the closely held business.

[xl] “From each according to his ability,” as Herr Marx wrote in his “Critique of the Gotha Program” (1875).

[xli] They should.

[xlii] Have any of these folks ever been in business?

[xliii] I am disregarding the proposal that calls for taxing the “gain” from the deemed sale of assets at death as it requires the introduction and implementation of an entirely new tax scheme – this is not the time. If we ever determine that such a system is right for us, it will take a couple years to figure it out, and it should be introduced during a relatively stable period. In any case, we cannot have both an income tax on the deemed sale of assets and an estate tax on the value of such assets.

[xliv] As an aside, they have no exposure as a “responsible person” for the sales tax and employment taxes of the business.

[xlv] https://review42.com/what-percentage-of-startups-fail/

[xlvi] A “strategic” buyer.

[xlvii] Preferred stock is the exception, in certain circumstances, but even there the holder is junior to every other creditor of the business. Compare interest, rents and royalties which are payable in exchange for the payor’s use of the payee’s property.

[xlviii] “The Dwindling Taxable Share of U.S. Corporate Stock,” Steven M. Rosenthal and Lydia S. Austin (2016).

[xlix] Defined contribution and defined benefit.

[l] Held in non-taxable segregated reserves to fund annuity contracts and whole life insurance.

[li] See IRC Sec. 512(b)(1).

[lii] IRC Sec. 871 and Sec. 881; fixed or determinable annual or periodical gains, profits, and income.

[liii] IRC Sec. 1411.

[liv] No joking here. I’m serious.

[lv] IRC Sec. 2031 and Sec. 2033.

[lvi] IRC Sec. 2010.

[lvii] All too often, owners fail to consider succession. In addition, their children often have no interest in continuing the business.

[lviii] IRC Sec. 2056 and Sec. 2055.

[lix] IRC Sec. 1015.

[lx] For example, beneficiaries who receive real property from a decedent, and continue to hold it for investment or for use in a business, may depreciate their stepped-up basis for such property.

[lxi] This Israeli-American was born Chaim Witz, changed his name to Gene Klein, became known professionally as Gene Simmons, and adopted the stage persona of “The Demon” as a member of Kiss.

[lxii] Including “Rock and Roll All Nite”.

[lxiii] It’s part of humanity’s relentless search for some form of immortality? Have you ever represented an institution that sought to change the name of a building after a subsequent donor offered a lot more money for the honor? I have.

You know what the ancient Greeks used to say about hubris, right? The gods have fixed limits on humanity; to disregard these limits, to challenge the natural order of the cosmos, to defy the gods, will elicit some form of punishment.

[lxiv] Like the pun?

[lxv] Thus limiting one’s ability to remove appreciation from one’s estate.

[lxvi] IRC Sec. 2702; Reg. Sec. 25.2702-3.

[lxvii] Under the grantor trust rules; specifically IRC Sec. 675(4). See Rev. Rul. 85-13.

[lxviii] Still very generous if you ask me.

[lxix] Thus eliminating the need for Crummey powers.

[lxx] Especially with respect to funding Social Security.

[lxxi] For example, the zeroed out GRAT.

[lxxii] IRC Sec. 2055.

[lxxiii] https://www.brookings.edu/opinions/steven-mnuchin-makes-a-welcome-case-for-boosting-irs-funding/