Related Party Expenses

It is not unusual for one close corporation to pay the expenses incurred by a related corporation or business. There are many circumstances in which such a payment may occur, but they share one overriding theme: the related corporations view themselves – or, more properly, their owners view them – as a single economic unit or business enterprise.

For example, one corporation (the “Obligor”) that has incurred a business expense or liability may not have the funds with which to satisfy the expense, while its parent or sister corporation (the “Payor”) has excess cash available. Rather than contributing or lending the funds to the Obligor, the Payor may simply choose – i.e., its owners may cause it – to pay the expense directly itself. Then, at the end of its tax year, the Payor will often claim the payment as a deductible business expense, thereby reducing its taxable income.

The IRS and the courts have a long history of examining such scenarios and of recharacterizing the “flow of funds” between the related corporations to reflect the tax consequences that would have resulted if the parties had dealt with one another on an arm’s-length basis.

The Chief Counsel’s Office of the IRS recently considered a case in which a corporation paid certain expenses related to services that were rendered for the benefit of a joint venture in which the corporation was a member.  Interestingly, however, this “field attorney advice” did not involve the corporation’s payment of an unrelated party’s fee for such services, nor did it involve the payment of wages to the joint venture’s employees. Rather, the advice addressed the corporation’s payments to its own employees in respect of services performed for the joint venture.

Constructive Capital Contribution

The Code allows a deduction for ordinary and necessary business expenses, including a reasonable allowance for salaries or other compensation for personal services actually rendered.

It is implicit in the Code that a taxpayer generally may not deduct the expenses of another taxpayer, even though those expenses would otherwise be ordinary and necessary trade or business expenses. A parent corporation may not, therefore, deduct compensation paid by it to the employees of its wholly owned subsidiary, even though the indirect benefit of their services inures to the parent corporation as the sole shareholder of the employer-subsidiary.

There is, however, a limited exception to this rule: A deduction may be allowable by a corporation if it paid the related corporation’s business expense for its own direct and proximate benefit, or if the expense was incurred by the corporation with the underlying motivating purpose of protecting and promoting its own business (as opposed to that of the related corporation).

In order for compensation payments to be for a taxpayer’s own direct and proximate benefit, the taxpayer must prove that the specific services performed by the employees involved were for its direct and proximate benefit. The indirect benefit that inures to a parent corporation when one of its subsidiaries successfully performs its functions does not satisfy the requirements for a business deduction by the parent.

For example, the IRS held in Rev. Rul. 84-68 that a parent corporation may not deduct as a business expense the cash bonuses that it pays to the employees of its wholly-owned subsidiary.  Instead, because the payments by the parent-shareholder were made to protect its investment in the subsidiary, they represented an additional cost (basis) for its subsidiary shares, and should be treated as an additional contribution to the subsidiary’s capital, accompanied by a constructive payment by the subsidiary of the cash bonuses to its employees, for which the subsidiary was entitled to a ordinary business deduction.

 The Joint Venture Expenses

In this case, the taxpayer-corporation paid for services performed on behalf of the joint venture of which it was just one member.

According to the IRS, “[a] contribution to capital need not be made pro rata with contributions from other shareholders. . . [and] a payment to a corporation can be a capital contribution even if some shareholders contribute less than others or nothing at all.” Moreover, a contribution to capital may occur even if it “is not recorded as a contribution to capital on the corporation’s balance sheet.”

The IRS analogized the situation to Rev. Rul. 84-68 stating that expenses paid by a taxpayer-shareholder for the operation of a subsidiary’s business that do not provide a proximate and direct benefit to the taxpayer are not deductible by the taxpayer.

The IRS acknowledged that this case differed from Rev. Rul. 84-68 in that the taxpayer paid its own employees, not the joint venture’s employees, and the joint venture was, of course, not wholly-owned by the taxpayer.

With respect to the former, the IRS noted that payments to the employees of the taxpayer-parent for services performed on behalf of a subsidiary – which did not provide a proximate and direct benefit to the taxpayer – would be treated the same way as payments to the subsidiary’s employees: as a capital contribution by the taxpayer to the subsidiary.

With respect to the latter, a less than 100 percent shareholder may make a capital contribution even though it is not made pro rata with contributions from other shareholders and some shareholders contribute nothing at all. Similarly, the fact that the joint venture did not record the payment of the expenses as a contribution to its capital did not stop the contribution to capital from being treated as having occurred for tax purposes.

Therefore, the IRS concluded that the payment of expenses for the services provided to the joint venture by the employees of one of its members should be treated as a contribution of additional capital to the joint venture by the taxpayer-member, accompanied by a constructive payment of the expenses by the joint venture from its own funds, for which the joint venture was entitled to a business deduction.

Takeaway

It is sometimes difficult for the owners of related close corporations to remember that the corporations are, in fact, separate taxpayers. Business exigencies or, more frequently, convenience may cause the owners to ignore corporate formalities, sometimes generating unexpected results like the ones described above.

In order to avoid the IRS’s recharacterization of payments made between related corporations or other businesses, or of payments made by one related corporation on behalf of another, it is important that the owners of such businesses consider the tax consequences thereof before making the payments. This will require that they properly identify the reason for and nature of the payment, and that they contemporaneously document the flow of funds that actually occurs, or is deemed to occur. As always, the related businesses should endeavor as much as possible to approach their intercompany transactions as if they were unrelated parties.

Hail the Partnership! Don’t Abuse It.

Of all forms of business enterprise, the partnership (or an LLC treated as a partnership for tax purposes) is most often cited by tax practitioners as the most attractive vehicle for operating a business. Indeed, partnerships permit taxpayers to conduct joint business (including investment) activities through a very flexible economic arrangement without incurring an entity-level tax.

Implicit in the Code’s partnership rules are the requirements that (i) the partnership must be bona fide and each partnership transaction must be entered into for a substantial business purpose, (ii) the form of each partnership transaction must be respected under substance over form principles, and (iii) the tax consequences to each partner of partnership operations and of transactions between the partner and the partnership must accurately reflect the partners’ economic agreement and clearly reflect the partners’ income.

However, the flexibility of this vehicle also enables its misuse for improper tax avoidance purposes. Where a partnership is formed or availed of in connection with a transaction, a principal purpose of which is to reduce substantially the present value of the partners’ aggregate federal tax liability in a manner that is inconsistent with the intent of the Code’s partnership rules, the IRS may ignore the partnership, or recast the transaction for federal tax purposes.

A recent decision illustrates the IRS’s authority.

Protection “Plus”

Company, which was owned by two shareholders, the Principals, was engaged in the environmental remediation business.

In order to protect themselves from certain personal liabilities that may arise from the operation of the business, the Principals restructured Company so that several other corporate entities stood between them and Company. restructuring

 

Step One

Specifically, the Principals each formed holding corporations (“Holding Corps”) as “S” corporations, and they each entered into an employment agreement with their respective Holding Corp, pursuant to which they agreed to render “construction management, indemnity, and financing services” exclusively for the Holding Corp.

Step Two

Each Holding Corp then adopted an employee stock ownership plan (“ESOP). Each ESOP then purchased all the shares of its respective employer- Holding Corp.

Step Three

The two Holding Corps (each now owned entirely by its respective ESOP) entered into a general partnership (“Partnership”), to which they agreed to provide (through their respective employees) “construction management, indemnity, and financing services.”

Step Four

The Principals also formed a third holding corporation, Corp, and transferred their shares in Company to Corp.

Step Five

Finally, the Partnership purchased all of the shares of Corp.

As a result, Company was owned by Corp, which was owned by the Partnership, which in turn was owned by the Principals’ two Holding Corps, which were owned by ESOPs. This elaborate corporate structure provided the Principals with multiple levels of protection from personal liability, and more . . . .

The “Joint Venture”

An opportunity arose to do environmental remediation work for a large redevelopment project (“Project”). To win the contract, however, Company would have to post a large bond. To ensure that Company could afford the bond, the Principals caused Company and the Partnership to form a joint venture (“Joint Venture”). Interestingly, Company and the Partnership executed the joint venture agreement one week after the Partnership was formed and just over a month before Company won a subcontract for the Project.

Under the terms of the joint venture agreement, Company would do the environmental remediation work, and the Partnership would supply financial guaranties. In exchange for these services, Company would receive thirty percent of the Joint Venture’s profits, and the Partnership would receive seventy percent.

The Tax Court

The Tax Court found that the Principals performed the same roles for Company after forming the Partnership as they did before.

The joint venture agreement provided that the Joint Venture would reimburse Company for costs incurred in the remediation work, plus five percent. The agreement obligated the Joint Venture to keep books and records and to file income tax returns. It contemplated that the general contractor on the Project would award the subcontract to Company, not to the Joint Venture, and make payments directly to Company.

The Joint Venture obtained an employer identification number and its own bank account. It also tracked its own financing and prepared its own progress reports.

As the joint venture agreement contemplated, Company received payment from the general contractor directly, not through the Joint Venture. However, Company then paid the Partnership an amount that represented only 50.4% of the profits, not the 70% contemplated by the joint venture agreement.

Moreover, and notwithstanding the terms of the agreement, the Joint Venture’s accountant opted not to file a tax return for the Joint Venture. Instead, the accountant believed that separately reporting Company’s and the Partnership’s income from the Project was sufficient.

The Tax Court found that the Joint Venture’s structure had significant federal income tax consequences. A joint venture is considered a “partnership” for tax purposes. Accordingly, the Joint Venture would pay no tax on its income, but pass that income on to its members, Company and the Partnership.

Company, a “C” corporation, would have to pay corporate income tax on its thirty-percent share of the venture’s profits. As a general partnership, the Partnership would pay no income tax on its seventy-percent share; instead, that income would pass through to its owners, the two Holding Corps.

The Holding Corps (which owned the Partnership) were S corporations, whose income would pass through to the their respective shareholders. Because all of the Holding Corps’ shares were owned by tax-exempt retirement savings plans (the ESOPs), the Partnership’s seventy percent share of the Joint Venture’s profits would only be subject to federal income tax if and when the ESOPs distributed benefits to their participants (including the Principals).

In short, only thirty percent of the Joint Venture’s income would be subject to tax on a current basis. (Hmm.)

On the basis of the foregoing, the Tax Court held that the Joint Venture was not a valid partnership for tax purposes and, therefore, that all of the Joint Venture’s profits were taxable income to Company.

The Ninth Circuit affirmed the Tax Court’s decision.

 The Court of Appeals

For tax purposes, a “partnership” is defined as “a syndicate, group, pool, joint venture, or other unincorporated organization” that carries on “any business, financial operation, or venture” and that is not “a corporation or a trust or estate.”

To determine whether a purported joint venture is a valid partnership, courts ascertain whether “the parties in good faith and acting with a business purpose intended to join together in the present conduct of the enterprise.”

Over the years, the courts have distilled eight factors to consider in measuring the parties’ intent:

(1) the agreement of the parties and their conduct in executing its terms;

(2) the contributions, if any, which each party has made to the venture;

(3) the parties’ control over income and capital and the right of each to make withdrawals;

(4) whether each party was a principal and co-proprietor, sharing a mutual proprietary interest in the net profits and having an obligation to share losses, or whether one party was the agent or employee of the other, receiving for his services contingent compensation in the form of a percentage of income;

(5) whether business was conducted in the joint names of the parties;

(6) whether the parties filed federal partnership returns or otherwise represented to persons with whom they dealt that they were joint venturers;

(7) whether separate books of account were maintained for the venture; and

(8) whether the parties exercised mutual control over and assumed mutual responsibilities for the enterprise.

The court noted that the parties disregarded the terms of the joint venture agreement both by arbitrarily reducing the Partnership’s share of profits and by failing to file a tax return. These deviations from the agreement suggested that the Company and the Partnership did not intend in good faith to act as partners, and did not exercise mutual control over the enterprise.

The court also found that the Partnership contributed nothing of value to the Joint Venture because the performance bond was issued based not on the Partnership’s financial guaranties, but on the collective net worth of Company, the Partnership, the Principals, and the Holding Corps as related entities. The marginal value of the Partnership’s guaranty suggested that the Partnership did not make a meaningful contribution to the Joint Venture, and that the partnership and Company did not act as bona fide partners.

The venture’s imposition of a profit cap on the Partnership demonstrated that the Partnership exercised no control over income and capital, further suggesting that the Partnership did not act as a bona fide partner.

The joint venture agreement’s provision guaranteeing reimbursement of Company’s costs showed that Company and the Partnership did not intend to share profits and losses as bona fide partners would.

On the basis of the foregoing, the Court concluded that the Joint Venture was not a valid partnership for tax purposes.

Don’t Let the Tax Tail Wag Uncontrollably

As we have seen in many prior posts, it is imperative that a business transaction or structure have a bona fide and substantial business purpose, and that analyses of its form and of its substance lead to the same result.

The golden rule is to first determine what is required from a business perspective, to determine what alternative structures or combinations thereof can attain the desired business result, and then to see which of these either is the most tax efficient or can be modified, without unduly impairing the business result, to achieve tax economies.

In earlier posts, we discussed how the division of a closely-held, corporate-owned business may be effected without incurring an income tax liability for either the corporation or its shareholders. The ability to effect such a division on a tax-efficient basis may be especially important in resolving a dispute between shareholders who may have already incurred significant legal costs in trying to divorce themselves from one another.

Forms of Division

There are two basic forms of corporate division. In the “split-off” form of division, the parent (“distributing”) corporation distributes all of its shares in a subsidiary (“controlled”) corporation to one of more of its shareholders in a complete redemption of their shares in the parent corporation, leaving the parent corporation in the hands of its remaining shareholders. In the “split-up” form of division, the parent corporation distributes all its shares in at least two subsidiary corporations to at least two different sets of shareholders in a complete liquidation of the parent corporation. (In contrast, a “spin-off,” changes the relationship of the parent and subsidiary corporations to that of brother-sister corporations, with at least one of the parent shareholders also owning all the shares of the former subsidiary corporation.)

As the saying goes, however, “all good things come hard,” and a tax-free split-off or split-up is no exception, especially in the case of so-called “cash rich” divisions that continue to be closely scrutinized by the IRS.

Basic Requirements for a Tax-Free Division

The Code generally provides that, if certain requirements are satisfied, a distributing corporation may distribute the stock of a controlled corporation to its shareholders without the distributing corporation or its shareholders recognizing income or gain on the distribution.

However, numerous requirements must be satisfied in order obtain this result. One such requirement is that the distributing corporation and the controlled corporation must each be engaged in the active conduct of a trade or business immediately after the distribution (“active trade or business requirement”; i.e., a trade or business that has been actively conducted throughout the 5-year period ending on the date of the distribution). Another requirement is that the transaction must be carried out for one or more corporate business (not shareholder) purposes (“business purpose requirement”). In addition, the transaction must not be used principally as a device for the distribution of the earnings and profits of either the distributing corporation or the controlled corporation (a “device”).

The IRS Smells A . . .

The IRS recently announced that it was studying issues relating to corporate divisions having one or more of the following characteristics:

 

  1. ownership by the distributing corporation or the controlled corporation of investment assets having substantial value in relation to (a) the value of all of such corporation’s assets, and (b) the value of the assets of the active trade(s) or business(es) on which the distributing corporation or the controlled corporation relies to satisfy the requirements; or
  2. a significant difference between the distributing corporation’s ratio of investment assets to assets other than investment assets and such ratio of the controlled corporation; or
  3. ownership by the distributing corporation or the controlled corporation of a small amount of business assets in relation to all of its assets.

According to the IRS, these types of transactions may present evidence of a device for the distribution of corporate earnings and profits, may lack an adequate business purpose, may lack a qualifying active business, or may violate other requirements for tax-free treatment.

Nature of the Assets

The IRS is concerned about transactions that result in (i) the distributing corporation or the controlled corporation owning a substantial amount of cash, portfolio stock or securities, or other investment assets, in relation to the value of all of its assets and its qualifying business assets, and (ii) one of the corporations having a significantly higher ratio of investment assets to non-investment assets than the other corporation.

The IRS is also concerned about transactions in which the distributing corporation or the controlled corporation owns a small amount of qualifying business assets compared to its other assets (non-qualifying business assets).

No Rulings

The IRS announced that, while the above situations are under study, it ordinarily will not issue private letter rulings as to their tax status.

Specifically, it will not issue a ruling as to the tax-free qualification of a distribution if, immediately after such distribution, the fair market value of the gross assets of the trade(s) or business(es) on which the distributing corporation or the controlled corporation relies to satisfy the active trade or business requirement is less than five percent (5%) of the total fair market value of the gross assets of such corporation.

Nor will the IRS issue a ruling relating to the qualification of a distribution if, immediately after such distribution, each of the following conditions exist:

  1. the fair market value of the investment assets of the distributing corporation or the controlled corporation is two-thirds or more of the total fair market value of its gross assets; and
  2. the fair market value of the gross assets of the trade(s) or business(es) on which the distributing corporation or the controlled corporation relies to satisfy the active trade or business requirement is less than 10 percent (10%) of the fair market value of its investment assets; and
  3. the ratio of the fair market value of the investment assets to the fair market value of the assets other than investment assets of the distributing corporation or the controlled corporation is three times (3x) or more of such ratio for the other corporation (i.e., the controlled corporation or the distributing corporation, respectively).

However, there may be unique circumstances, the IRS noted, to justify the issuance of a ruling. In determining the existence of such circumstances, the IRS will consider all facts and circumstances, including, for example, whether a substantial portion of the non-qualifying business assets would be qualifying business assets but for the five-year requirement.

Advice to Taxpayer?

Over forty years ago, the IRS issued a revenue ruling in which it stated that there was no requirement in the rules for a tax-free corporate division that a specific percentage of the corporation’s assets had to be devoted to the active conduct of a trade or business. It noted, however, that the percentage of the active business assets was a relevant factor for purposes of determining whether the distribution constituted a device.

Then, about ten years ago, the IRS eliminated a relatively short-lived requirement, for ruling purposes, that the value of the corporation’s active trade or business assets had to represent at least five percent (5%) of its total asset value.

It remains to be seen what the outcome of the IRS’s recently-announced study will be. Whether it will lead to proposed legislation or regulations, or some other form of guidance for the subject transactions, is a matter of speculation at this point.

What is clear is that the IRS remains concerned about “cash-rich” corporate divisions. This explains its emphasis on the value of the corporation’s active trade or business assets relative to its investment assets, as well as its focus on the active trade or business, business purpose, and device requirements for a tax-free corporate division.

In the case of most divisions of close corporations, the concerns described above are not likely to be present. The corporate parties will have engaged in an active trade or business, and their assets will not include investment portfolios that are overly large relative to their business assets.

There may be situations, however, in which the “percentage guidelines” set forth above may prove helpful in planning for a division, as where a close corporation may have sold one line of business and, rather than distributing the net proceeds therefrom to its shareholders, or reinvesting the proceeds in another active business, it has acquired cash-equivalent or other investment assets.

If it later becomes necessary, from a business perspective, to divide the corporation and its remaining line(s) of business among its shareholders, the taxpayer’s advisers will have to be mindful of the relative value of the corporation’s investment assets, and they may have to plan for them accordingly.

In the meantime, it will behoove tax advisers to keep abreast of the IRS’s pronouncements in this area.

“Tax-Free” Basics

In general, gain or loss must be recognized upon the exchange of property by a taxpayer if the new property differs materially, in kind or extent, from the old property.

The purpose of the so-called “reorganization” provisions of the Code is to except from this general rule certain specifically described corporate exchanges that are required by business exigencies and that effect only a readjustment of a taxpayer’s continuing interests in property under modified corporate forms.

“F” Reorgs

The Code describes several types of corporate transactions that constitute “tax-free” reorganizations. One of these, described in section 368(a)(1)(F) of the Code, is “a mere change in identity, form, or place of organization of one corporation, however effected” (a “Mere Change”) – or an “F” reorganization. Red pencil marking an F on paper close up. Image shot 2009. Exact date unknown.

Although the statutory description of an F reorganization is short, and some courts have described F reorganizations as “simple,” questions have arisen regarding the requirements of F reorganizations.

In particular, when a corporation changes its identity, form, or place of incorporation, what other changes (if any) may occur, either before, during, or after the Mere Change, without affecting the tax-free status of the Mere Change ? In other words, what other changes are compatible with the Mere Change?

These questions can become more pronounced if the transaction that is intended to qualify as an F reorganization is composed of a series of steps. Moreover, changes in identity, form, or place of organization are often undertaken to facilitate other changes that may be difficult to effect in the corporation’s current form or place of organization.

The IRS recently issued Final Regulations in which it addressed many of these questions.

 Mere Change

Like other types of corporate reorganizations, an F reorganization generally involves, in form, two corporations, one (a Transferor Corporation) that transfers (or is deemed to transfer) assets to the other (a Resulting Corporation). However, the statute describes an F reorganization as being undertaken with respect to “one corporation” and provides for treatment that differs from that accorded other types of reorganizations in which assets are transferred from one corporation to another (Asset Reorganizations).

An F reorganization is treated for most purposes of the Code as if the reorganized corporation were the same entity as the corporation in existence before the reorganization. Thus, the tax treatment accorded an F reorganization is more consistent with that of a single continuing corporation in that

(1) the taxable year of the Transferor Corporation does not close and includes the operations of the Resulting Corporation for the remainder (post-reorganization portion) of the taxable year, and

(2) the Resulting Corporation’s losses may be carried back to taxable years of the Transferor Corporation.

Because an F reorganization must involve “one corporation,” and continuation of the taxable year and loss carrybacks from the Resulting Corporation to the Transferor Corporation are allowed, the statute cannot accommodate transactions in which the Resulting Corporation has pre-existing activities or tax attributes.

Similarly, the requirement that there be “one corporation” means that the status of the Resulting Corporation as the successor to the Transferor Corporation must be unambiguous.

The Final Regulations

Based on the above principles, the Final Regulations provide that a transaction (a “Potential F Reorganization”) that involves an actual or deemed transfer of property by a Transferor Corporation to a Resulting Corporation is a Mere Change that qualifies as an F reorganization if six requirements are satisfied (with certain exceptions).

In the context of determining whether a Potential F Reorganization qualifies as a Mere Change, deemed asset transfers include, but are not limited to, the deemed asset transfer by the Transferor Corporation to the Resulting Corporation resulting from a so-called “liquidation- reincorporation” transaction; and the deemed transfer of the Transferor Corporation’s assets to the Resulting Corporation in a so-called “drop-and-check” transaction in which a newly formed Resulting Corporation acquires the stock of a Transferor Corporation from its shareholders and, as part of the plan, the Transferor Corporation liquidates into the Resulting Corporation.

Viewed together, the following six requirements ensure that an F reorganization involves only one continuing corporation and is neither an acquisitive transaction nor a divisive transaction.

Resulting Corporation Stock Issuances and Identity of Stock Ownership

A transaction that shifts the ownership of the equity interests in a corporation cannot qualify as a Mere Change. Thus, the Final Regulations provide that a transaction that involves the introduction of a new shareholder or new equity capital into the corporation does not qualify as an F reorganization.

In accordance with this principle, the first requirement in the Final Regulations is that immediately after the Potential F Reorganization, all the stock of the Resulting Corporation must have been distributed (or deemed distributed) in exchange for stock of the Transferor Corporation in the Potential F Reorganization.

The second requirement is that, subject to certain exceptions, the same person or persons own all the stock of the Transferor Corporation at the beginning of the Potential F Reorganization and all of the stock of the Resulting Corporation at the end of the Potential F Reorganization, in identical proportions.

Notwithstanding these requirements, the Final Regulations allow the Resulting Corporation to issue a de minimis amount of stock (not in respect of stock of the Transferor Corporation) to facilitate the organization or maintenance of the Resulting Corporation. This rule is designed to allow, for example, reincorporation in a jurisdiction that requires minimum capitalization, two or more shareholders, or ownership of shares by directors. It is also intended to allow a transfer of assets to certain pre-existing entities.

In addition, the Final Regulations allow changes of ownership that result from either (i) a holder of stock in the Transferor Corporation exchanging that stock for stock of equivalent value in the Resulting Corporation but having terms different from those of the stock in the Transferor Corporation or (ii) receiving a distribution of money or other property from either the Transferor Corporation or the Resulting Corporation, whether or not in redemption of stock of the Transferor Corporation or the Resulting Corporation.

In other words, the corporation involved in a Mere Change may also recapitalize, redeem its stock, or make distributions to its shareholders, without causing the Potential F Reorganization to fail to qualify as an F reorganization.

These exceptions reflect the determination of the IRS that allowing certain transactions to occur contemporaneously with an F reorganization is appropriate so long as one corporation could otherwise effect the transaction without undergoing an F reorganization.

Resulting Corporation’s Assets or Attributes and Liquidation of Transferor Corporation

In general, and consistent with the statutory mandate that an F reorganization involve only one corporation, the third requirement under the Final Regulations is that the Resulting Corporation not hold any property or have any tax attributes immediately before the Potential F Reorganization.

However, the Resulting Corporation may hold a de minimis amount of assets to facilitate its organization or to preserve its existence (and to have tax attributes related to these assets), and the Resulting Corporation may hold proceeds of borrowings undertaken in connection with the Potential F Reorganization.

Under the fourth requirement in the Final Regulations, the Transferor Corporation must completely liquidate in the Potential F Reorganization for federal income tax purposes. Nevertheless, the Transferor Corporation is not required to legally dissolve, and may retain a de minimis amount of assets for the sole purpose of preserving its legal existence.

One Acquiring Corporation, One Transferor Corporation

A Mere Change involves only one Transferor Corporation and one Resulting Corporation. Thus, the Final Regulations provide that only one Transferor Corporation can transfer property to the Resulting Corporation in the Potential F Reorganization.

Thus, the fifth requirement under the Final Regulations is that immediately after the Potential F Reorganization, no corporation other than the Resulting Corporation may hold property that was held by the Transferor Corporation immediately before the Potential F Reorganization if such other corporation would, as a result, succeed to and take into account the tax attributes of the Transferor Corporation.

A transaction that divides the property or tax attributes of a Transferor Corporation between or among acquiring corporations, or that leads to potential competing claims to such tax attributes, will not qualify as a Mere Change.

The sixth requirement under the Final Regulations is that immediately after the Potential F Reorganization, the Resulting Corporation may not hold property acquired from a corporation other than the Transferor Corporation if the Resulting Corporation would, as a result, succeed to and take into account the tax attributes of such other corporation. Thus, a transaction that involves simultaneous acquisitions of property and tax attributes from multiple transferor corporations will not qualify as a Mere Change.

Similarly, the Final Regulations provide that a Mere Change cannot accommodate transactions that occur at the same time as the Potential F Reorganization if those other transactions could result in a corporation other than the Resulting Corporation acquiring the tax attributes of the Transferor Corporation.

Series of Transactions

In some cases, business or legal considerations may require extra steps to complete a transaction that is intended to qualify as a Mere Change. The Final Regulations provide that a Potential F Reorganization consisting of a series of related transactions that together result in a Mere Change may qualify as an F reorganization, whether or not certain steps in the series, viewed in isolation, might, for example, be treated as a redemption of stock, a complete corporate liquidation, or as a contribution of property to a corporation . For example, the first step in an F reorganization of a corporation owned by individual shareholders could be a dissolution of the Transferor Corporation, so long as this step is followed by a transfer of all the assets of the Transferor Corporation to a Resulting Corporation.

Mere Change within Larger Transaction

An F reorganization may be a step, or a series of steps, before, within, or after other transactions that effect more than a Mere Change, even if the Resulting Corporation has only a transitory existence following the Mere Change. In some cases an F reorganization sets the stage for later transactions by alleviating nontax impediments to a transfer of assets. In other cases, prior transactions may tailor the assets and shareholders of the Transferor Corporation before the commencement of the F reorganization.

Although an F reorganization may facilitate another transaction that is part of the same plan, the IRS has concluded that step transaction principles generally should not re-characterize F reorganizations because F reorganizations involve only one corporation.

Thus, the Final Regulations provide that related events preceding or following the Potential F Reorganization that constitutes a Mere Change generally will not cause that Potential F Reorganization to fail to qualify as an F reorganization.

The Final Regulations also provide that the qualification of a Potential F Reorganization as an F reorganization would not alter the treatment of other related transactions. For example, if an F reorganization is part of a plan that includes a subsequent merger involving the Resulting Corporation, the qualification of a Potential F Reorganization as an F reorganization will not alter the tax consequences of the subsequent merger.

Transactions Qualifying under Other Reorganization Provisions

In some cases, an asset transfer that would constitute a step in an F reorganization is also a necessary step for characterizing a larger transaction as a non-recognition transaction that would not constitute an F reorganization.

In general, the Final Regulations provide that if a Transferor Corporation’s transfer of property qualifies as a step in both an F reorganization and another type of reorganization in which the Resulting Corporation is the acquiring corporation, the transaction qualifies for the benefits accorded to an F reorganization. (There is an exception for specifically described acquisitive asset reorganizations.)

Distributions

The Final Regulations provide that, if a shareholder receives money or other property (including in exchange for its shares) from the Transferor Corporation or the Resulting Corporation in a transaction that constitutes an F reorganization, the money or other property will be treated as having been distributed by the Transferor Corporation in a transaction separate from the F reorganization. In substance, such a distribution is functionally separate from the Mere Change, and should not be treated the same as an exchange of money or other property for stock of a target corporation in an acquisitive reorganization.

Employer Identification Numbers

It should be noted that the IRS is studying the very practical issue of how to assign (or reassign) employer identification numbers (“EIN”) to corporate taxpayers following an F reorganization. After all, although an F reorganization generally involves, in form, two corporations, the Transferor Corporation (with an existing EIN) and the Resulting Corporation (with a new EIN) are treated as the same taxpayer. In some cases, it will be important to the Transferor Corporation that the Resulting Corporation continue to use the Transferor Corporation’s EIN.

An “F” Can Be Good

Although you wouldn’t want to receive it as a grade in school, an “F,” as it relates to a reorganization, can prove to be a very useful tool in the restructuring of a close corporation. The key is to recognize the opportunities for its application, whether it be to effect a change in corporate form or in state of organization, or to defend against the characterization of a transaction as a taxable liquidation-reincorporation. You never know when you may need an “F.”

Make sure you check out Part I before reading below…

The Bigger Picture

In addition to the SCIN-specific issues, the complaint touches on a number of themes of which every estate-planning adviser – and every client – should be aware.

The Facts Matter

An adviser should assume that the IRS will scrutinize the estate plan closely, especially in the case of a large estate or a prominent client.

The adviser should prepare for such an exam contemporaneously with the implementation of the plan, not later. This may be especially important in the case of a client’s premature or unexpected death.

The Technique and Execution Matter

An adviser should recognize that certain techniques, including the use of SCINs, are likely to attract the attention of the IRS.

Whenever a “risky” technique is employed as part of an estate plan, it must be prudently and properly executed if it is to withstand IRS scrutiny.

As a general rule, transfers between family members will be subject to greater scrutiny, and could be challenged as not being bona fide and not being conducted at arm’s-length. Failing to have separate counsel for the parties to the transaction will only exacerbate the matter. The estate plan as a whole could be deemed to be a testamentary device deployed purely to avoid tax liability.

Educate the Client

The client must be presented with alternatives, each of which may accomplish his or her testamentary goals. It is not the adviser’s role to make the necessary “business” decisions.

Assess the Risks

For each alternative, the client must also be informed of the attendant risks, the likelihood of their being realized, and the economic consequences thereof. Without this information, how can the client be expected to make any decision?

According to the complaint, nowhere in DT’s presentation was there a comprehensive list of the relevant and material risks. Rather, it is alleged that DT assured the decedent that its estate plan hedged all risk, maximized the transfer of wealth, and minimized taxes.

One Tool May Not Suffice

In light of the strict scrutiny that a particular decedent’s estate is likely to receive (for example, because of the size of the estate), it may behoove the estate planner to use more conservative and more reliable estate planning techniques.

If more “aggressive” techniques are to be used, the planner should consider not making them the centerpiece of the estate plan. The planner should also consult with subject matter experts, including other legal counsel, doctors, actuaries and others, in connection with the formulation and implementation of such an estate plan.

Too Good to be True

A proposal that purports to eliminate all economic risk to the taxpayer’s estate is the sort of estate plan that the IRS routinely rejects as having no economic substance.

DT’s SCIN-GRAT “circular” transaction eliminated the risk incumbent in the SCIN transactions. Only if the transaction involves an appropriate degree of economic risk will it be found to be a bona fide transfer. Without such risk, the IRS is bound to scrutinize a transaction, like the SCIN, and challenge it as strictly a tax avoidance device.

Substance Over Form

In the case of the decedent’s estate, the IRS concluded that the transfers of stock

in exchange for the SCINs should be viewed as gifts because the SCINs lacked the indicia of genuine debt in that there was no requirement of repayment of principal, there was no reasonable expectation that the debt would be repaid, and DT’s use of the §7520 mortality tables to set the terms of the SCINs was unfounded.

The arrangement was nothing more than a device to transfer the stock to family members at a substantially lower value than the fair market value of the stock.

Although an estate may vigorously maintain that a decedent intended to enforce and collect on a note, it is difficult to support such an assertion without the kind of proof that is demonstrated by the actual receipt of payments.

Know the Law and Apply It

The client will reasonably assume that the adviser is – and the adviser must actually be – intimately familiar with the applicable statutes, regulations, administrative and judicial pronouncements.

In recommending any estate planning technique, the adviser must be able to anticipate the IRS’s reaction and arguments, and he or she must plan for them accordingly.

According to the complaint, the existing authority made clear that the absence of periodic payments of principal in connection with all of the SCINs and, in particular, no requirement of the payment of any risk premium until the end of their term, made them susceptible to being challenged as not being bona fide transactions. DT should have known, it continues, that the IRS generally challenges estate plans that provide purported “win/win” scenarios.

Conflicts?

It is not unusual for an estate planner, acting on behalf of a client’s estate, to defend its planning and the implementation thereof to the IRS. In doing so, however, the planner must walk a very fine line and must be completely transparent with respect to its client.

For example, the complaint alleges that DT’s provision of services to the decedent’s estate subsequent to his death was not only intended to defend its plan to the IRS, but also to conceal the defects in that plan from the executors of the client’s estate.

“How Do We Kosher This Pig?”

A former colleague would sometimes put this question to me when confronted with an IRS examination of a transaction or plan that we had not structured, but that we were retained to defend. Too often, there was little we could do to reverse what had already been done, and it was too late to do what should have been done earlier.

This question also highlighted the importance of planning thoroughly and in advance of engaging in any transaction. The best time to prepare for an audit is before the subject of the audit has even occurred.

What would you do?

The decedent was an extremely wealthy man, with a net worth in excess of $3 billion. You are the executor of his estate.

Prior to his death in 2009, he retained one of the top tax firms in the country to review his existing estate plan.

Under his existing plan, which included some taxable bequests, over $700 million would pass to his spouse and about $2.2 billion would pass to various charities, leaving an estate tax bill of about $88 million. The assets passing at his death would receive a step-up in basis for purposes of determining the gain realized on their subsequent sale, thereby reducing the future income tax liability of his beneficiaries. death-tax-photo

The decedent was very ill when he engaged the tax firm, but he wanted to explore the possibility of leaving more of his wealth to his children and grandchildren.

The decedent told the tax firm that he wanted to structure his estate in a tax efficient manner, but did not want to take any unnecessary risks in his estate planning. In particular, he did not want his estate to attract unnecessary IRS attention.

After presenting an overview of several wealth planning options that were potentially available to the decedent – including the use of GRATs, sales to intentionally defective grantor trusts, educational trusts, and testamentary charitable lead annuity trusts – the tax firm focused on the use of SCINs in combination with GRATs.

Within less than one month’s time, a SCIN-based estate plan was implemented: trusts were established and funded with “seed” money, for the benefit of the decedent’s children and grandchildren; and the decedent sold shares of stock in his corporation to the trusts in exchange for 5-year self-cancelling installment notes (“SCINs”), which included risk premiums for the cancellation feature, annually payable interest, and balloon principal payments. He then contributed the SCINs to 5-year GRATs. According to the tax firm, this structure ensured a “win if you live, win if you die” outcome.

Specifically, if the decedent died within 5 years, the SCINs would be cancelled, no further payments under the SCINs would be due, and the stock (which had been transferred to the trusts in exchange for the SCINs), would remain with the trusts.

If the decedent lived, upon the expiration of the 5-year term, virtually all of the principal and risk premium interest payments associated with the SCINs issued by the trusts (which had been transferred to the GRATs) would be transferred to the remainder beneficiaries of the GRATs – the trusts. Thus, the obligors and the obligees on these SCINs were to be one and the same: the trusts.

Seven weeks after the implementation of this plan, the decedent passed away, never having received any interest or principal payments in respect of the SCINs or the GRAT.

You filed estate tax and gift tax returns with the IRS and paid almost $168.5 million of federal estate tax and almost $83 million of federal gift tax.

The IRS examined these returns and challenged the estate plan. It determined that the estate owed almost $846 million of gift tax, and almost $1.887 billion of estate tax (including penalties), for a total deficiency of over $2.7 billion, plus interest.

You consulted with the estate’s professional advisers, and then filed a petition with the U.S. Tax Court in June of 2013.

In July of 2015, you and the government reached a stipulated decision in which you agreed to:

  • Deficiencies of gift tax of approximately $178 million;
  • Estate tax of approximately $153 million; and GST tax of approximately $46 million. This totaled $377 million, as opposed to the more than $2.7 billion originally sought by the IRS.

Are you relieved? Somewhat.

Are you satisfied? Not really, especially when you consider that the hundreds of millions of dollars paid to the IRS would not pass to the charities that were the intended residual beneficiaries of the decedent’s estate.

“Call My Lawyer!”

On September 24, 2015, the executors for the Estate of Davidson filed a complaint against Deloitte Tax LLP (“DT”) in NY Supreme Court, in Manhattan for recovery of approximately $500 million in additional estate and gift taxes, and related fees, penalties, and interest that the executors claim were assessed by and paid to the IRS as a result of DT’s alleged failure to: (i) disclose all material risks and information; (ii) provide reasonable and appropriate advice given the then-existing state of estate and tax planning knowledge; and (iii) design and implement a bona fide and defensible plan that could withstand the inevitable IRS scrutiny that would occur.

Over the course of 90-plus pages, the complaint provides what purports to be a detailed description of the decedent’s discussions with DT, the implementation of his estate plan, its shortcomings, the dispute with the IRS, and the resolution thereof at the Tax Court.

SCINs

The complaint touches on many of the factors that must be considered in structuring an estate-planning transaction that involves the use of a SCIN. For example, the complaint alleges that DT failed to:

  • Design and implement bona fide economic transactions, conducted at arms’ length, as opposed to purely tax driven transactions;
  • Properly structure the SCIN transactions with appropriate capitalization, interest rates, and repayment terms;
  • Use decedent’s actual anticipated life expectancy in creating the term for the SCINs, as opposed to the 5-year term from mortality tables under IRC §7520, which could not be relied on in light of decedent’s poor health;
  • Calculate the appropriate “risk premium” for the SCINs, instead of improperly relying upon the §7520 mortality tables;
  • Provide for the actual payment of at least a portion of the risk premium to the decedent during the term of the SCINs;
  • Provide appropriate amortization for the repayment of the SCINs, as opposed to, among other things, the use of a “balloon payment” due at the end of the SCINs’ 5-year term, which created the impression that there was no realistic expectation of repayment to the decedent;
  • Fund the trusts that were obligors under the SCINs with sufficient assets in order to be able to repay the holders of the SCINs upon maturity of the SCINs;
  • Create defensible and acceptable transactions, instead of creating circular, illusory arrangements by which certain obligors under the SCINs would in effect owe themselves in the event that the decedent survived their 5-year term; and
  • Separate out the various transactions in a manner that gave independent significance to each transaction, as opposed to effectuating all the various transactions within less than a month, and in some instances on the same day, making the plan subject to challenge under the “step-transaction doctrine.”

So what’s the punchline?  Check in for Part II tomorrow to find out!

Last week, we considered NY’s income tax treatment of the gain realized by a non-resident of NY on his or her sale of stock in a corporation that owns NY real property. Although the strength of the NY real property market cannot be ignored, there are a number of other NY-based businesses in which nonresidents have invested significant sums of money, especially technology start-ups.

In the case of such investors, it is not enough to consider where and how to invest their money – it is equally important that they consider how they will be able to withdraw their investment so as to minimize the resulting tax impact and, thereby, to maximize the economic return on the investment.

A recent decision by NY’s highest court illustrated the plight of one nonresident investor who learned this lesson too late.

 The Stock Sale and The 338(h)(10) Election

Taxpayer was one of several nonresident shareholders of Corp, which was organized as an S corporation for federal and New York State tax purposes. In 2007, Corp’s shareholders, including Taxpayer, sold their Corp. stock to Yahoo, Inc., realizing over $88 million in gain.

The shareholders and Yahoo decided to treat this transaction as a “deemed asset sale” for income tax purposes under IRC Sec. 338(h)(10). Consequently, the stock sale was ignored and, instead, Corp was treated as having first sold its assets to a Yahoo-owned subsidiary, and then as having made a liquidating distribution of the sale proceeds to its shareholders.

Under the S corporation rules, the gain realized on the deemed asset sale flowed through the corporation and was taxable to Corp’s shareholders. The basis in their shares of Corp stock, in turn, was increased to reflect the flow-through of this gain. On the deemed liquidation of Corp, the resulting gain, if any, to the Corp shareholders was determined by subtracting this adjusted stock basis from the amount deemed distributed by Corp.

Corp reported its gain from the deemed asset sale, and the amount that passed through to Taxpayer, as part of its federal tax return, but Corp excluded the amount deemed distributed to Taxpayer from its 2007 NY S corporation franchise tax return. For his part, taxpayer reported and paid federal taxes for the 2007 tax year on his share of the asset sale gain, as required by federal law, but did not report or pay any NY income taxes associated with the sale.

Based on the results of a subsequent audit, NY assessed a deficiency in state income taxes on Taxpayer’s gain from the Corp transaction, relying on a 2010 amendment to NY’s tax law that provides, in relevant part, that “any gain recognized on [a] deemed asset sale for federal income tax purposes will be treated as New York source income.”

Taxpayer paid the tax deficiency and, thereafter, demanded a tax refund, stating that the 2010 amendment was unconstitutional and claiming that his corporate-derived gain was obtained from the sale of Corp stock, which is considered intangible personal property and nontaxable as to a nonresident.

NY Taxation of Nonresidents, In General

In general, a nonresident of NY is subject to NY personal income tax on his or her NY source income that enters into his or her federal adjusted gross income.

NY source income is defined as the sum of income, gain, loss, and deduction derived from or connected with NY sources. For example, where a non-NY resident sells real property or tangible personal property located in NY, the gain from the sale is taxable in NY.

Under NY tax law, income derived by a nonresident from intangible personal property, including gain from the disposition of such property, constitutes income derived from a NY source only to the extent that the property is employed in a business, trade, profession, or occupation carried on in NY.

NY’s History With Sec. 338(h)(10)

In 2009, NY’s Tax Appeals Tribunal considered a nonresident’s sale of stock in a NY S corporation.  The Tribunal confirmed that, even though the selling shareholders and the purchaser elected under IRC Sec. 338(h)(10) to treat the stock transaction as an asset sale for purposes of the federal income tax, the transaction would still be treated as a stock sale with respect to the nonresident shareholders. Because the gain derived by a nonresident from the sale of intangible personal property, such as stock, does not constitute income derived from NY sources (except to the extent that the property was employed in a business, trade, profession, or occupation carried on in NY), it was not subject to NY tax.

The next year, NY’s legislature amended the tax law – retroactively for all open tax years – to reverse this result. (Why should Congress have all the fun?) Specifically, the law was changed to provide that a nonresident’s share of the NY-source portion of the gain realized by a target S corporation as a result of a Sec. 338(h)(10) election would be taxable to the nonresident shareholder.

The Court of Appeals

The Court rejected Taxpayer’s constitutional challenge to the amended tax law and also upheld its retroactive effective date. (See also here.)

 The Court explained that an S corporation is structured so that its corporate income, losses, deductions, and credits pass through to its shareholders, based on their individual percentage ownership in the corporation. The shareholders, in turn, report their pro rata share of the income and losses on their personal income tax returns in accordance with federal and state tax laws, and are assessed taxes at their individual tax rates. Thus, the corporation does not pay corporate income taxes and avoids double taxation on both the corporation and the shareholders.

The Court noted that deemed asset treatment is not automatic or mandated by statute, but instead requires a voluntary election by both the selling shareholder and the purchaser to treat the transaction as an asset sale. Thus, Taxpayer freely chose to proceed with the Corp stock transfer as a deemed asset sale, presumptively aware of the income tax consequences of his choice.

A deemed asset sale, the Court stated, provides “counter-balanced advantages and disadvantages” for purchaser and seller.

On one side of the equation, the deemed asset sale makes possible significant future tax benefits to the purchaser because the assets are treated as sold at fair market value and the assets obtain a “stepped up,” rather than a carryover, basis for the purchaser’s future depreciation and amortization deductions .

On the other side, the deemed asset sale may result in negative tax consequences for the selling shareholders, who are responsible for personal taxes on their share of the gains. However, the Court added, even this can be offset by an agreement to a higher purchase price to account for the additional tax cost as compared to a stock sale without a Sec. 338(h)(10) election.

Turning to the constitutionality of the assessment, the Court recognized “as a foundational tenet” of NY tax law that NY seeks to achieve a certain amount of parallel treatment of state and federal taxation. Thus, NY S Corporation shareholders must report for state income tax purposes the same “income, loss, deduction and reductions … which are taken into account for federal income tax purposes.”

Furthermore, under both federal and state law, deemed asset flow-through income is taxed based on the character of the income when earned by the corporation, meaning the income is treated as coming from the same source as received by the corporation. Gains passed to the S corporation shareholders retain “the same character” for state income tax purposes as held for federal income tax purposes, the Court stated. Thus, if the corporation’s income source is located in NY, it is taxable to the extent allowed under NY law. For example, a nonresident’s pass-through income is taxed based on the percentage of the income “derived from or connected with New York sources.” (In contrast, the entirety of a NY resident’s pass-through income is taxable.)

The NY tax law further provides that nonresidents are subject to tax on income “derived from or connected with New York sources,” such as income derived from an S corporation.

As amended in 2010, the tax law includes as NY source income any gains from a deemed asset sale under IRC Sec. 338(h)(10). That section provides, in relevant part: “[I]f the shareholders of the S corporation have made an election under section 338(h)(10) of the Internal Revenue Code, then any gain recognized on the deemed asset sale for federal income tax purposes will be treated as New York source income allocated in a manner consistent with the applicable methods and rules for allocation under article nine-A of this chapter in the year that the shareholder made the section 338(h)(10) election.”

In accordance with these provisions, NY treated Taxpayer’s gain from Corp’s deemed asset sale as NY source income, and assessed taxes in proportion to the Corp income derived from NY sources. This assessment, the Court found, was wholly in line with the statutory scheme and, so, Taxpayer was without grounds to demand a refund.

Plan Ahead

Many readers of this blog may be tired of this refrain, but it pays to plan ahead. In the case of an investment in a closely-held business, that means that the investor has to educate him- or herself as to the tax consequences – federal, state and local – that may arise upon the investor’s disposition of the investment, and how these will affect the net economic return on the investment.

Armed with this knowledge, the investor will be in a better position either to structure the disposition in a more tax efficient manner, or to negotiate transaction terms to ameliorate any adverse economic impact caused by taxes.

We frequently hear about the many wealthy foreigners who acquire investment interests in New York real property, and the complex tax considerations relating to such investments. Yet, we sometimes forget that there are many US persons outside of NY (New Jersey is still part of the US, right? Oh well) who are drawn to an investment in NY real property for the very same reasons. nyc-lr_0_0

Every now and then, however, NY’s Department of Taxation (the “Tax Department”) reminds us that the tax rules applicable to such an investment by a US person who is not a NY resident can be just as daunting.

A recent advisory opinion illustrated the application of these tax rules. Taxpayer owned stock in an S corporation operating in NY. The S corporation owned NY real estate, and derived 69% of its income from an active parking operation and 31% from real estate rentals. The company had been in business for over twenty years and had no plans to liquidate. In 2012, Taxpayer, who had been a resident of another State (not NJ) and had never been active in the business, sold her entire 33% interest in the S corporation back to the corporation pursuant to a stock redemption plan and received an interest-bearing installment note from the corporation as part of the purchase price for the stock sale.

Taxpayer asked the Tax Department whether the gain from the stock redemption and the interest income on the installment note payments were subject to NY personal income tax.

Disposing of Intangible Property: An Interest in NY Real Property

In general, a non-NY resident is subject to NY personal income tax on his or her NY source income that enters into his or her federal adjusted gross income.

NY source income is defined as the sum of income, gain, loss, and deduction derived from or connected with NY sources. For example, where a non-NY resident sells real property or tangible personal property located in NY, the gain from the sale is taxable in NY.

Under NY tax law (the “Tax Law”), income derived from intangible personal property, including interest and gains from the disposition of such property, constitute income derived from NY sources only to the extent that the property is employed in a business, trade, profession, or occupation carried on in NY.

From 1992 until 2009, this analysis also applied to the gain from the disposition of interests in entities that owned NY real property.

However, in 2009, the Taw Law was amended to provide that items of gain derived from or connected with NY sources include items attributable to the ownership of any interest in NY real property.

For purposes of this rule, the term “real property located in” NY was defined to include 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 (“FMV”) that equals or exceeds 50% of all the assets of the entity on the date of the sale of the taxpayer’s interest in the entity.

Only those assets that the entity owned for at least two years before the date of the sale of the taxpayer’s interest in the entity are used in determining the FMV of all the assets of the entity on the sale date.

The gain or loss derived from NY sources from a nonresident’s sale of an interest in an entity that is subject to this rule is the total gain or loss for federal income tax purposes from that sale multiplied by a fraction, the numerator of which is the fair market value of the real property located in NY on the date of the sale and the denominator of which is the FMV of all the assets of the entity on such date.

For most non-NY residents, the rule before the 2009 amendment would have yielded the preferred tax result. Nonresidents who owned interests in partnerships, for example, and that had gains on the sale thereof could, in many cases, sell their partnership interests without triggering NY income tax.

The Department’s Opinion

The Tax Department determined that, if the valuation conditions in the Tax Law were satisfied, a portion of the gain on the redemption of Taxpayer’s stock in the S corporation, reflected in the principal payments on the installment note, would be NY source income subject to NY personal income tax. The portion of the gain that constituted NY source income would be determined by multiplying the amount of the gain by a fraction, the numerator of which was the FMV of the NY real property on the date of the redemption sale and the denominator of which was the FMV of all of the corporation’s assets (owned for at least two years) on the date of the redemption sale. To the extent that this gain was payable to Taxpayer under an installment payment agreement (the note), a portion of each installment payment would be taxed as NY source income when it was received (thereby deferring the tax liability). As to the interest paid on the note, the Tax Department concluded that the note, and not the corporation’s real property, was the income-producing property. Because the note was intangible personal property, and the interest received by Taxpayer was not income attributable to property employed in a business or trade carried on in NY, the interest was not subject to NY personal income tax.

What’s A Nonresident Seller To Do?

As in any sale transaction, a price must be established for a taxpayer’s interest in an entity. This may entail negotiations between the buyer and seller. In each case, it will behoove the seller to understand and to try to quantify the costs (including taxes) of the sale in advance of any discussions. This will enable the seller to settle on the appropriate sales price: one that will yield the desired after-tax economic result.

In the case of a non-NY resident with an interest in an entity that owns at least some NY real property, the taxpayer will need to determine whether the entity meets the 50% threshold described above. In some cases, depending upon the entity’s business or investment purpose, not to mention the level of authority possessed by the non-NY resident, it may be possible to periodically adjust the entity’s investment holdings – being mindful of the two-year “anti-stuffing rule” – so as to fall short of the threshold. Of course, any such adjustments must make sense from a business or investment perspective.

Where the nonresident has little control over the entity, it may be possible to “time” the sale of his or her interest, taking advantage of a drop in real estate values or of an increase in the value of other assets held by the entity (for example, securities). However, this option may be impractical in cases where, for example, a shareholders or operating agreement restricts the sale of interests in the entity.

The important point is to recognize at the inception of one’s investment in an entity that there may be an issue on a subsequent disposition of the investment, to try to account for the ultimate tax cost when pricing the acquisition of the investment and/or its later sale, and to try to secure the periodic valuation of the entity’s underlying assets so as to facilitate any decision as to a disposition, and to support one’s reporting position in the event of a sale.

A law suit was recently filed against the U.S. in which the Taxpayers seek a refund of gifts taxes and interest that they claim were erroneously assessed against them by the IRS for their 2007, 2008 and 2009 tax years (the “Tax Years”).

Although it may be some time before the Taxpayers’ claims are resolved, the factual setting upon which the disputed taxes are based is a commonly recurring one.

It is also one that highlights the importance of recognizing the various contexts in which the equity interests in a closely-held business are valued, how they may impact one another, and the importance of being able to distinguish among them.

Family Transfers

Taxpayers are shareholders of Company, an S corporation, the shares of which (the “Shares”) are owned by members of the Taxpayer Family and certain key employees and directors of Company.

Transfers of Company Shares by members of the Taxpayer Family are restricted pursuant to the terms of the Company’s bylaws. Under the bylaws (the “Bylaws”), the “Taxpayer Family” was defined as the issue and descendants of X & Y or trusts whose beneficiaries are members of the Taxpayer Family.

The Bylaws were intended to ensure continuity of ownership in that they provide that members of the Taxpayer Family can only transfer their Shares to other members of the Taxpayer Family. However, no price is established in the Bylaws for Shares that are transferred between members of the family.

A qualified, independent valuation firm (“Appraiser”) annually values the Company to determine the value of minority blocks of Company Shares.

Purchases and sales of Company Shares between Taxpayer Family members are transacted at the Appraiser’s valuation of those Shares.

Key Employee Transfers

According to the complaint filed by the Taxpayers (the “Complaint”), the Share ownership structure of Company has long had as one of its underlying principles the desire to create continuity of ownership for the Company and to give key employees and directors a stake in Company’s success. (This is a common theme in the closely-held business, especially where family members are no longer actively engaged in the business and, so, need to retain qualified employees.)

Historically, Company has offered certain of its key employees and its directors the opportunity, from time to time, to purchase Company Shares. The purchase price for Shares sold to such key employees and directors was set by the Company at the benchmark purchase price of 120% of the book value of such Shares. (Presumably, the service providers did not report any compensation income in connection with the purchase of the shares.)

Transfers of Shares by key employees and directors who are not Taxpayer Family members are restricted and subject to a right of first refusal in favor of the Company pursuant to the terms of the Company’s Bylaws and by restrictions contained in separate stockholder agreements entered into by such key employees and directors. Pursuant to the terms of the Bylaws and the separate stockholders agreements, key employees and directors desiring to sell their Shares back to Company may only do so at a price equal to 120% of the then-current book value of the Shares.

Taxpayers represented that the “120% of book value” purchase price for Company Shares was established by the Company for the purpose of ensuring that key non-Taxpayer Family employees and directors who wished to buy and sell their Shares would have an easily calculated purchase and sale price for those Shares. According to the Complaint, it is only a benchmark for purchases and sales by key employees and directors and bears no relationship to what a willing buyer and willing seller would establish for the price of Company shares.

The Gifts

During the Tax Years, Taxpayers gifted minority Shares to their children and grandchildren. The Taxpayers filed gift tax returns to report the gifts and stated a per share fair market value as determined by the Appraiser. The Appraiser’s valuation was based on a variety of factors including, but not limited to, Company’s historical earnings and financial data, current economic and market conditions, pricing for shares in comparable publicly-traded companies, dividend history, and the book value of all Company assets.

The Appraiser’s valuations included a significant discount for lack of marketability because the Company was a privately-held business lacking an active market for its shares.

Another reason for the lack of marketability discount, the Complaint stated, was the restriction on transfers of Company Shares between the Taxpayer Family members: the Bylaws prohibit Taxpayer Family members from transferring Shares except to other members of the Taxpayer Family. According to the Complaint, the restrictions on the Taxpayer Family transfers were a “bona fide business arrangement” and not a device to transfer shares to a family member for less than adequate consideration.

The Dispute

On the gift tax returns for the Tax Years, Taxpayers reported and paid almost $2.4 million of gift taxes with respect to the gifted Shares.

The IRS challenged the amounts reported on the returns, and eventually sent Taxpayers “30-day letters” proposing an alternative valuation of the Company Shares based upon 120% of the book value of the Shares (the same methodology established by the Bylaws to benchmark the purchase and sale price of Shares sold to and repurchased from key Company employees and directors).

Taxpayers subsequently received Notices of Deficiency (dated August, 2014) from the IRS alleging they owed additional gift tax as a result of the IRS’ fair market value determinations of the minority shares of Company for the Tax Years.

In November, 2014, Taxpayers paid to the IRS the additional amount of gift tax (plus interest) set forth in the Notices of Deficiency. (It is unclear why Taxpayers did not choose to contest the asserted deficiencies in the Tax Court; as a jurisdictional matter, a taxpayer may access the Tax Court without first paying the taxes asserted by the IRS.)

In February, 2015, the Taxpayers filed amended gift tax returns with the IRS for the Tax Years, claiming a refund of the federal gift taxes and interest paid in response to the Notices of Deficiency.

After more than six months had elapsed from the filing of such refund claims (a jurisdictional requirement), the Taxpayers filed a suit for refund in the U.S. District Court.

Which Valuation Standards?

We have heard it a million times: for purposes of the gift tax, the fair market value of an interest in a closely-held business is the amount that a willing buyer would pay for the interest to a willing seller, neither being under any compulsion to buy or to sell, and both having reasonable knowledge of the relevant facts.

Among these relevant facts, one would consider any transfer restrictions relating to the interest, provided that any such restriction is a bona fide business arrangement, is not a device to transfer such property to members of the donor’s family for less than full and adequate consideration, and its terms are comparable to similar arrangements entered into by persons in an arm’s length transaction.

We are also familiar with the following refrain: where property (including an equity interest in the service recipient) is transferred to an employee or independent contractor in connection with the performance of services by such individual, the fair market value of such property (less any amount paid therefor by the employee or independent contractor) shall be included in the gross income of such employee or independent contractor for the taxable year in which the property becomes substantially vested.

For purposes of this compensation rule, the fair market value of the equity interest for gift tax purposes is generally irrelevant. Rather, for compensation purposes, the fair market value of the transferred equity interest is determined without regard to any transfer restriction other than one which by its terms will never lapse.

Such a “non-lapse restriction” is a permanent limitation on the transferability of property that will require the transferee of the property (e.g., the employee) to sell, or offer to sell, the property at a price determined under a formula, and that will continue to apply and be enforced against the transferee or any subsequent holder (e.g., the employee’s estate).

As a result, in the case of property subject to a non-lapse restriction, the price determined under the formula for compensation purposes will be considered to be the fair market value of the property, unless the IRS establishes otherwise.

Thus, for example, if stock in a corporation is subject to a non-lapse restriction that requires an employee to sell such stock only at a formula price based on book value, the price so determined will ordinarily be regarded as determinative of the fair market value of such property for compensation purposes.

The Outcome?

Interestingly, it appears that the fair market value for the Company Shares as determined by the Taxpayers for gift tax purposes was less than the fair market value of such Shares as determined for compensation purposes – the “120% of book value” purchase price for the Company Shares is likely a non-lapse restriction.

Although, as was noted above, the valuation standards are different for each purpose, a taxpayer who is contemplating a gift of equity in his or her close business should be mindful of any equity-based compensation arrangements and the valuations thereunder, especially where the employee-participants are not related to the taxpayer.

The taxpayer must be prepared to defend the difference in values, especially insofar as such difference may call into question the bona fide business nature of the family-related restrictions, or may support the IRS’s characterization of such restrictions as a device for transferring property to members of the taxpayer’s family for less than full and adequate consideration.

Stay tuned.

 

 

 

What’s the first thing that comes to mind when you hear that someone has engaged in a like-kind exchange? Real property, right? A taxpayer who owns a rental building with commercial and/or residential tenants exchanges the building for another rental property, usually as part of a deferred exchange. Or, a taxpayer that owns a building in which it conducts an operating business exchanges that building for another in a different location.

A recent IRS ruling, however, serves as a reminder that like-kind exchanges are not just for real properties. After all, why should the “dirt lawyers” have all the fun?

Like-Kind Exchange Basics

Generally speaking, the gain that is realized from the conversion of property into cash, or from the exchange of property for other property differing materially either in kind or in extent, is treated as income. The amount realized from such a sale or exchange is the sum of the money received plus the fair market value of any other property received.

The Code provides an exception from the general rule requiring the recognition of gain upon the sale or exchange of property. Specifically, no gain will be recognized if property held for productive use in a trade or business or for investment is exchanged solely for property of a like kind to be held for productive use in a trade or business or for investment. Property held for investment may be exchanged for property held for productive use in a trade or business, and vice versa.

However, this exception to gain recognition does not apply to certain enumerated properties, each of which is an item of intangible property (e.g. partnership interests).

Like-Kind Intangibles?

In general, “like-kind” refers to the nature or character of the properties to be exchanged, and not to their grade or quality. One kind or class of property may not be exchanged for property of a different kind or class without triggering gain recognition.

Additional rules apply for determining whether personal property has been exchanged for property of a like kind or class. Personal properties of a like “asset class” or “product class” are considered to be of a like kind for purposes of the non-recognition rule.

However, no like classes are provided for intangible personal property. An exchange of such properties qualifies for non-recognition of gain only if the exchanged properties are of like kind.

Whether one intangible personal property is of like kind to another generally depends on the nature or character of the rights involved and also on the nature or character of the underlying property to which the intangible property relates.

The Properties Exchanged

Corp. was a member of an affiliated group of which Parent was the common parent. Corp. had two types of agreements: the Dual Activity Agreements and the Single Activity Agreements. The agreements were with Parent, and with certain parties unrelated to Parent.

Under the Dual Activity Agreements, Corp. had rights to manufacture and distribute AA, a group of Products of various different brand names. Products were non-depreciable tangible personal property. The Dual Activity Agreements granted Corp. the right to manufacture and distribute AA within Territory 1, Territory 2, or Territory 3.

Under the Single Activity Agreements, Corp. had rights to distribute BB, another group of Products of various different brand names that were different from AA, within the same three territories.

Just like Corp., Company had two types of agreements: the Replacement Dual Activity Agreements and the Replacement Single Activity Agreements. These agreements had the same set of counterparties as Corp.’s agreements.

The Replacement Dual Activity Agreements granted Company the right to manufacture and distribute AA within Territory 4 or Territory 5.

The Replacement Single Activity Agreements granted Company the right to distribute BB within these two territories.

For good business reasons, Corp. and Company entered into an exchange agreement, pursuant to which Corp. was scheduled to enter into two exchanges with Company.

In the first exchange, Corp. would simultaneously exchange its Dual Activity Agreements for Company’s Replacement Dual Activity Agreements as one exchange group. In the second exchange, Corp. would simultaneously exchange its Single Activity Agreements with Company’s Replacement Single Activity Agreements as another exchange group.

Corp. represented that:

  • The rights under the Dual Activity Agreements and the Single Activity Agreements were held by Corp. for productive use in a trade or business;
  • The rights under the Replacement Dual Activity Agreements and the Replacement Single Activity Agreements would be held by Corp. for productive use in a trade or business; and
  • To the best of its knowledge, the proportionate values of the manufacturing and distribution rights were roughly similar across both the Dual Activity Agreements and the Replacement Dual Activity Agreements.

The IRS’s Ruling

The IRS noted that an exchange of intangible personal property qualifies for non-recognition of gain only if the exchanged intangible properties are of a like kind. Whether intangible personal property is of a like kind to other intangible personal property generally depends on (i) the nature or character of the rights involved (e.g., a patent or a copyright) and (ii) the nature or character of the underlying property to which the intangible personal property relates.

The IRS illustrated the application of this rule with the following examples:

 

  • Example 1: Taxpayer K exchanges a copyright on a novel for a copyright on a different novel. The properties exchanged are of a like kind.
  • Example 2:  Taxpayer J exchanges a copyright on a novel for a copyright on a song. The properties exchanged are not of a like kind.

The Dual Activity Agreements and the Replacement Dual Activity Agreements were intangible properties that granted rights related to the manufacturing and distribution of AA. Because Corp. and Company would simultaneously exchange the agreements, the only issue was whether they were of a like kind. This depended, according to the IRS, on the nature or character of the rights involved and on the nature or character of the underlying property to which the agreements related.

The Dual Activity Agreements and the Replacement Dual Activity Agreements were both in the nature of AA manufacturing and distribution agreements.

Manufacturing and distribution, the IRS said, are two distinct business activities and the rights to each would not, absent some close connection between these activities, be of a like kind.

However, the IRS noted that, for economic and historical reasons, manufacturers of AA have long acted as distributors of AA. The inclusion of both business activities in the Dual Activity Agreements and Replacement Dual Activity Agreements reflected the underlying economics and longstanding historical relationship between the two.

Though not completely inseparable, manufacturing and distribution of AA was frequently best performed by a single entity as part of an integrated business process. Additionally, the manufacturing and distribution rights granted under the agreements could only be exercised in conjunction with each other under the agreements.

It was represented that proportionate values of the manufacturing rights and the distribution rights were roughly the same across all of the Dual Activity Agreements and Replacement Dual Activity Agreements.

Accordingly, although manufacturing and distribution were business activities of a different nature or character, the close economic and unique historical connection between the manufacturing and the distribution of AA demanded that they be treated as two aspects of a single business activity where the rights to manufacturing and distribution were contained within the same integrated agreement.

The terms of the agreements were broadly and substantially similar in granting rights to manufacture and distribute AA. Each agreement granted rights and created obligations related to a single business activity, the integrated manufacturing and distribution of AA.

The differences in the length of the term, renewable periods, geographical territories covered, quality control provisions, marketing activity obligations, restrictions on manufacturing and distribution of similar products, and termination events varied among the Dual Activity Agreements and the Replacement Dual Activity Agreements. These differences, however, were insubstantial, relating as they did to the grade or quality of the rights rather than to their nature or character.

Consequently, the nature or character of the manufacturing and distribution rights in the Dual Activity Agreements and Replacement Dual Activity Agreements were of a like kind.

The IRS next considered whether the underlying property subject to the Dual Activity Agreements and the Replacement Dual Activity Agreements was itself of a like kind. The underlying property to which the intangible rights to manufacture and distribute related was AA, a group of Products that shared substantially similar manufacturing and distribution processes. AA included Products with different brand names, appearances, ingredients, packaging, and marketing strategies. Nevertheless, all AA products were manufactured using a substantially similar process in facilities of a common design, and were distributed in a substantially similar manner to a largely common set of customers who resold them to end customers who, in turn, used each of the products of AA for a substantially similar purpose.

Any differences among AA that were relevant to manufacturing or distribution were differences in grade or quality, and not differences in nature or character. Accordingly, the underlying property to which the intangible rights granted by the Dual Activity Agreements and the Replacement Dual Activity Agreements related was of a like kind.

Similarly, the IRS found that the nature or character of the Single Activity Agreements and the Replacement Single Activity Agreements were of a like kind, and that the underlying property subject to the Single Activity Agreements and the Replacement Single Activity Agreements was of a like kind.

The IRS thus concluded that the rights under the Dual Activity Agreements and under the Single Activity Agreements to be transferred by Corp. were of a like kind with the rights under the Replacement Dual Activity Agreements and the Replacement Single Activity Agreements to be transferred by Company, and that no gain would be recognized by Corp. on the exchange of rights under the Agreements.

Planning for Dispositions?

What’s the first thing that comes to mind when you hear that the owners of a business are planning to sell the business or substantially all of its assets? An exchange for cash and maybe an installment note, right?

In some cases, the selling owners may be willing to accept some degree of equity in the buyer, whether in the form of stock in a corporation or an interest in a partnership or LLC, depending upon the buyer.

What about an exchange for other property in-kind? It’s not something that happens frequently in the world of closely-held businesses (other than real estate – back to those dirt lawyers, damn it), but there may be situations where the sale of a business can be structured, in part, as a like-kind exchange.

As the above ruling illustrates, it will behoove a seller and its advisers to be mindful of the like kind exchange rules.