Constructive Dividends

In the last several weeks, I have seen a number of examples of what are commonly referred to as “constructive dividends,” including a corporation’s satisfaction of the personal expenses of its shareholders.

dividend_dollarUnlike a regular dividend distribution, a constructive dividend does not involve the formal declaration of a dividend by the corporation, followed by the payment of such dividend to each of the corporation’s shareholders in accordance with their relative stock ownership.

Rather, a constructive dividend may arise as a result of a transaction between a shareholder and the corporation – for example, a loan, lease, sale, or compensation arrangement – in which the amount of the consideration paid to the shareholder by the corporation exceeds the fair market value of the consideration provided by the shareholder to the corporation. Thus, a below-market lease of corporate property to a shareholder may generate a constructive dividend, as may a corporation’s bargain sale of property, or its payment of excessive compensation to a shareholder.

A constructive dividend may also arise as a result of a transaction between a corporation and a third party with which a shareholder of the corporation has some sort of relationship. In these situations, the corporation does not make a direct payment of cash to the shareholder, but the corporation’s funds are still expended in a way that bestows a direct benefit upon the shareholder. For example, when a corporation satisfies a personal obligation of a shareholder, or provides a below-market loan to another entity owned by the shareholder, it has likely paid a constructive dividend to the shareholder, at least where the corporation has no expectation of repayment.

Close Corps Beware

By its very nature, the occurrence of a constructive dividend is, generally speaking, limited to closely-held corporations. For this reason, when examining the tax returns of such a corporation, the IRS will, as a matter of course, inquire into the arm’s-length nature of any transaction between the corporation and any of its shareholders, and it will inquire as to the business purpose behind certain expenditures by the corporation.

Accordingly, it will behoove the shareholders of a closely-held corporation to familiarize themselves with the types of transactions that the IRS looks for, and with their tax consequences should the IRS successfully recharacterize them, at least in part, as constructive dividends.

The shareholders of a closely-held corporation also must be attuned to various threshold issues – including who the actual obligor is in respect of a payment made by the corporation – the resolution of which may determine the risk of a constructive dividend. For example, is the shareholder required to reimburse the corporation as to a particular payment?

Whose Deduction?

In one recent decision, the court examined an “arrangement” between a shareholder (Taxpayer) and his wholly-owned corporation (Corp.) under which the corporation paid many of the shareholder’s personal expenses, and the shareholder then reimbursed the corporation.

During 2004 and part of 2005, Taxpayer maintained a checking account (Account) at Bank.

Corp. maintained a ledger account on its books to keep track of Taxpayer’s non-Corp. expenditures. To generate a ledger entry, Taxpayer would instruct Corp. to issue a check for a non-Corp. item, or he would charge a non-Corp. item to his Corp. credit card. Taxpayer would then instruct Corp. to charge the item back to his Corp. ledger account.

During the years in issue, various non-Corp. expenses were charged to Taxpayer’s ledger account, including various charitable contributions.

Corp.’s creditors required Corp. to ensure that all ledger accounts were paid off each month, and Taxpayer accordingly wrote checks drawn on Account to pay off his ledger at the end of each month. However, at the end of several months during the years in issue, Taxpayer had insufficient funds in Account to clear the checks drawn on Account. In those months, Taxpayer caused Corp. to (1) transfer sufficient funds from Corp. to Account to cover the check(s) drawn on Account; (2) record the charge on his Corp. ledger account; and (3) then cash the check(s) drawn on Account.

The Court as Solomon

Taxpayer claimed significant charitable contribution deductions on his Forms 1040 for 2004 and 2005, but the IRS disallowed these because it determined that the contributions were made by Corp.

Generally, a taxpayer bears the burden of proving that he is entitled to any claimed deduction, including one for a charitable contribution.

The Court acknowledged that a taxpayer’s charitable contribution may be effected through the efforts of an agent acting for the taxpayer-donor.

Taxpayer contended that he properly deducted the charitable contributions at issue because he bore the economic burden of the charitable contributions that were charged to his Corp. ledger account and, therefore, Corp. paid the amounts in question as Taxpayer’s agent.

The IRS countered that Corp., and not Taxpayer, bore the economic burden of the charitable contributions, and that Taxpayer did not show that Corp. acted as his agent.

According to the IRS, Taxpayer used a circular flow of funds to ensure that he did not bear the economic burden of the contributions. In particular, the IRS contended that Taxpayer would regularly (1) issue checks from Account at the end of the month to pay off his ledger; (2) advance sufficient funds from Corp. to Account at the beginning of the next month to cover the check drawn on Account ; and then (3) cause Corp. to cash the check from Account.

The Court rejected the IRS’s argument as too broad, stating that it failed to recognize that Taxpayer, at certain times during the years at issue, fully paid his Corp. ledger account balances with his own funds. The record showed that the alleged circular flow of funds of which the IRS respondent complained did not become a regular pattern until the second half of 2005. Moreover, the record showed that Taxpayer paid his Corp. ledger account balances as of December 31, 2004, and June 30, 2005, without the benefit of any advances from Corp. to cover the payments. Because Taxpayer’s Corp. ledger account balances were fully paid off at the end of December, 2004 and June, 2005 without an advance to cover those months’ payments, any previous advances were necessarily paid off. Accordingly, the Court concluded that Corp. did not bear the economic burden of the charitable contributions charged to Taxpayer’s Corp. ledger account before July, 2005.

The Court reached a different conclusion, however, with respect to the charitable contributions made from Taxpayer’s Corp. ledger account after June, 2005. From July, 2005 through at least November, 2005, Taxpayer caused Corp. to advance funds to Account to cover the checks drawn on that account to pay off his Corp. ledger balance for those months. This circular flow of funds resulted in Corp’s assumption of most, if not all, of the economic burden of the charitable contributions charged to Taxpayer’s Corp. ledger account after June, 2005.

Moreover, Taxpayer failed to prove what portion, if any, of the charitable contributions made after June, 2005 Taxpayer effectively paid with his own funds and not funds advanced by Corp. Taxpayer also failed to introduce any credible evidence that his Corp. ledger account balance at the end of 2005 represented bona fide indebtedness owing to Corp. Therefore, the Court concluded that Taxpayer failed to carry his burden of showing that he, and not Corp., bore the economic burden of the charitable contributions at issue that were made after June, 2005.

The IRS contended further that Taxpayer had not shown that Corp. acted as his agent in making the charitable contributions at issue. It noted that although an agency relationship does not require a written agreement, there still must be evidence that the agent assented to the undertaking. However, Taxpayer credibly testified that he directed Corp. employees to make the charitable contributions on his behalf. Moreover, his testimony was corroborated by the testimony of Corp. employees, and by the introduction of the ledger itself into evidence.

The Court recognized that by agreeing to act as Taxpayer’s agent in making the charitable contributions at issue, Corp. also agreed to advance the contributed amounts to Taxpayer – amounts that Taxpayer was expected to repay. Therefore, the Court found that Corp. acted as an agent of Taxpayer when it made the charitable contributions at issue.

What If?

Accordingly, the Court concluded that Taxpayer was entitled to deduct the charitable contributions at issue that were charged to Taxpayer’s Corp. ledger account before July, 2005 – Taxpayer bore the economic burden for these payments. It also sustained the IRS’s disallowance of the charitable contribution deductions at issue that were charged to Taxpayer’s ledger account after June, 2005, finding that these deductions properly belonged to Corp.

But what if Taxpayer had been obligated – for example, pursuant to a pledge – to make the charitable contributions at issue after June, 2005? Because Corp. assumed the burden for the contribution, and Taxpayer was not required to repay the amount of the contribution to Corp., Taxpayer would have been treated as having received a constructive distribution from Corp. that may have been treated and taxed as a dividend. The overall tax benefit that Taxpayer may have expected to achieve as a result of the contribution would have been reduced.

With some planning, however, and with the recognition of the risk of a constructive distribution by Corp., Taxpayer could have arranged for a bona fide loan from Corp.

Unfortunately, too many taxpayers fail to recognize the distinction between themselves and their closely-held corporation. They direct the corporation to pay all manner of personal expenses, including cars, utilities, credit cards, vacations, clubs, meals, and other items. The corporation then fails to reflect these payments as distributions or as compensation to the shareholders, and many even go one step further and claim these expenditures as business deductions against the corporation’s revenues.

Pigs get slaughtered? You can count on it.

At the beginning of every year, the IRS informs the public of those tax matters on which the IRS will not issue letter rulings. Typically, these are areas of the tax law that are under study at the IRS, and that the IRS hopes to address through the publication of a revenue ruling, a revenue procedure, regulations, or otherwise.

A couple of months ago, the IRS added the following item to the list:

Section 1014. Basis of Property Acquired from a Decedent. Whether the assets in a grantor trust receive a section 1014 basis adjustment at the death of the deemed owner of the trust for income tax purposes when those assets are not includible in the gross estate of that owner under chapter 11 of subtitle B of the Internal Revenue Code.

Although this addition to the no-ruling list may be disturbing to some, it is actually a welcome development insofar as it may lead to the resolution of a tax issue that accompanies a commonly-used estate planning technique for the transfer of interests in a closely held business: the sale to an “intentionally defective” grantor trust.

While many estate practitioners employ sales to grantor trusts to effect the transfer of interests in closely held business entities, many fail to explain to the client (and the client’s beneficiaries) the tax risks associated with this technique upon the premature death of a client.

To better appreciate the import of the IRS’s decision, the following outlines the basic tax consequences of the sale technique, and then discusses the addition to the “no-ruling” list.

Sale

The most common means for transferring  a business interest to someone is through a sale of the interest.  Thus, it not unusual for a parent to sell a business interest to a child. In fact, if the parent needs a flow of funds in respect of the business interest, a sale presents an attractive option.

A sale is also an effective tool where the parent wants to shift the future appreciation in the value of the business interest out of his or her estate, but the parent’s remaining gift tax exemption amount is insufficient to cover the transfer.   If a parent sells a business interest to his or her child for consideration in an amount equal to the value of such interest at the time of the sale, no gift occurs. Moreover, the sale allows the parent to effectively “freeze” the value represented by the interest at its sale price – by exchanging the interest for non-appreciating cash or other property – and to shift any future appreciation in the interest (above the sale price) to the child.

The Cost of a Sale

Such a sale of a business interest to one’s children will usually come with a cost: income tax. Where the interest sold was a capital asset (as is typically the case), the sale of which generates long-term capital gain, the 20% federal capital gains rate would apply to the amount recognized, and the 3.8% federal surtax on net investment income may also apply.

 Installment Sales

A sale may be structured as an installment sale in order to defer this income tax liability; i.e., in exchange for the child’s promissory note.

In order to avoid gift characterization of any portion of the sale transfer, the child’s installment obligation should:

  • Bear a statutorily prescribed minimum rate of interest;
  • Be memorialized in writing (with a note and sale agreement);
  • Be secured (at least by the transferred property);
  • Have a term not exceeding the seller’s life expectancy;
  • Require regular payments by the terms of the sale and note agreements; and
  • State the value of the business interest as established by an appraisal.

Using this approach, the gain realized on the sale would be recognized, and taxed as capital gain, as principal payments are made; interest would be taxable as ordinary income.

 Sale to Grantor Trust

While an installment sale may “freeze” the value of the parent-seller’s business interest for estate tax purposes, there are some disadvantages to consider:

  • The interest and principal that must be paid are taxable to the seller;
  • If the seller disposes of the note (or if the child disposes of the purchased property within two years after its purchase), the gain on the sale is accelerated;
  • If the principal of the note exceeds $5 million, a special interest charge will apply that defeats the deferral benefit of installment reporting; and
  • The sale of an LLC or partnership interest may result in immediate gain recognition (if the entity has any indebtedness).

However, there is another option that should be considered: a sale of the business interest to a grantor trust.  In order to use this technique, an irrevocable trust must be created and funded. The trust is structured as a grantor trust so that the parent is treated as the owner of the trust’s income and assets for income tax purposes. In general, the funding requires a seed gift equal to at least 10% of the FMV of the business interest to be sold to the trust.

The parent then sells the business interest to the trust in exchange for a note with a face amount equal to the value of the interest, bearing a minimum rate of interest and secured by the property acquired. The interest may be payable annually, and the note is typically satisfied with a balloon payment at the end of the note term.

The sale to the grantor trust is not subject to capital gains tax (because the parent-taxpayer is treated as dealing with him- or herself), and the issuance of the note prevents any gift tax (because there is adequate consideration). The value of the business interest sold to the trust is frozen in the parent’s hands in the form of the note; the cash flow from the interest and/or the appreciation in the value of the interest should cover the loan; and the remaining, excess value of the interest passes to the beneficiaries of the trust.

Death of the Seller

If the parent dies before the note is satisfied, the value of the note as of the date of death will be included in his or her estate for estate tax purposes. Thus, the FMV of the note at that time, plus the accrued but unpaid interest thereon, may be subject to estate tax. rip

Moreover, because it represents an item of “income in respect of a decedent,” the note will not receive a basis step-up (unlike most items of property that are included in a decedent’s gross estate), thus preserving the tax gain inherent in the note.

Gain on the Sale?

This brings us back to the IRS’s “no-ruling” list.

So long as the grantor retains those rights or powers with respect to the trust property that caused the trust to be treated as a grantor trust for purposes of the income tax (for example, the right to substitute property of equal value), the grantor will be treated as owning the trust’s assets, and any transfer of property by the grantor to the trust, whether or not in exchange for any consideration, will be disregarded for purposes of the income tax.

It is well established that, if a grantor were to release these rights or powers, and the trust thereby ceased to be treated as a grantor trust, any “transfers” of property previously made by the grantor to the trust will become effective – will be “completed” – for purposes of the income tax. Where such a transfer was made in exchange for a promissory note that remained outstanding at the time of the release, a sale will occur at that time.

What if the “release” of the grantor trust powers occurs as a result of the death of the grantor? It is clear, from an income tax perspective, that the trust ceases to be a grantor trust and that the transfer to the trust is completed at the death of the grantor. The question of gain recognition, however, has not been resolved.

Basis Step-Up? Jonathan v. the IRS

The basis of property acquired from a decedent is the fair market value of the property on the date of the decedent’s death. Property that is acquired by bequest, devise or inheritance, or by the decedent’s estate from the decedent, is considered to have been acquired from the decedent.

Many commentators argue that, for income tax purposes, the grantor owned the “trust assets” until the date of the grantor’s death and, so, these assets did not pass to the trust until the grantor’s death. At that moment, these commentators go on, these assets should receive a step-up in basis to the then-FMV of the assets (which will be greater than the original face amount of the note if the asset has appreciated). Upon the immediately subsequent sale of the assets to the trust, this step-up would offset the consideration received (i.e., the note) and eliminate any gain.

The IRS, on the other hand, has stated that because the property was transferred to a trust prior to the death of the grantor, the basis step-up rule should not apply unless the property was included in the grantor’s gross estate for purposes of the estate tax.

This is consistent with legislative measures that have been proposed over the last few years to “remedy” the lack of coordination between the income and transfer tax rules applicable to a grantor trust that, according to the IRS, creates opportunities to structure transactions between the deemed owner and the trust that can result in the transfer of significant wealth by the deemed owner without transfer tax consequences.

Under these proposals, if the grantor of a grantor trust engages in a transaction with that trust that constitutes a sale, exchange, or comparable transaction that is disregarded for income tax purposes by reason of the person’s treatment as a deemed owner of the trust, then the portion of the trust attributable to the property received in that transaction (including the appreciation thereon, net of the amount of the consideration received by the grantor) would be subject to estate tax as part of the gross estate of the deemed owner, which tax would be payable from the trust.

My Opinion

Gross income does not include the value of property acquired by bequest, devise or inheritance. The transfer is a gratuitous transfer – there is no consideration. But what if the property so acquired was encumbered by a mortgage or other indebtedness?

In the case of an intervivos gift, the transferor would be deemed to have received consideration equal to the amount of the indebtedness to which the property was subject: a part-sale, part-gift.

However, the IRS has never tried to argue that the transfer of encumbered property that occurs upon the death of the property owner should be treated as a sale of the property, one that would result in gain to the extent the indebtedness exceeded the owner’s basis in the property.

Similarly, it may be said that, upon the death of the grantor, the property transferred to the trust is “encumbered” by the promissory note, which becomes an obligation of the trust. The trust’s “assumption” of that note (that was the grantor “obligation” until his death) should not be treated as consideration for the testamentary transfer – there is no sale. Moreover, the basis of the property “passing” at the death of the grantor should be adjusted pursuant to the usual step-up rules.

What’s Next?

Hopefully, the IRS will resolve this issue sooner rather than later.

Until the issue is resolved, notwithstanding the IRS’s no-ruling position, estate practitioners should be able to proceed on the assumption that the property sold to the trust will receive a basis step-up on the premature death of the grantor and, so, no gain should be realized on the transfer that is deemed to occur upon such death while the note is still outstanding.

However, practitioners will have to educate their clients who are considering sales to grantor trusts. The clients have to be made aware of the IRS’s position and the uncertainty this creates as to the income tax consequences that may follow upon the death of the grantor. “An educated consumer is our best customer” – it is also the best protection for the practitioner.

Tax-Free? Not Quite.

In general, a C corporation may achieve pass-through treatment for income tax purposes, without triggering immediate income or gain recognition, by electing to be treated as an S corporation.

One caveat to this general rule, however, is the so-called “LIFO Recapture” rule. Under IRC Sec. 1363(d), an electing C corporation that inventoried goods under the LIFO accounting method for its last taxable year as a C corporation must include in its income for such year the amount by which its inventory, had it been maintained under the FIFO method, would have exceeded the amount under LIFO. The inventory amounts are determined as of the close of the taxable year prior to the taxable year in which the taxpayer’s S election becomes effective.

On its face, the application of this rule may seem fairly straightforward.

However, in a recent Field Attorney Advice, when the IRS considered the application of the recapture recognition rule in the context of an S corporation’s acquisition of a consolidated corporate group, its application was anything but straightforward.

The “Conversion”

Taxpayer was a C corporation and the common parent of a consolidated group that included Subsidiary. Two of the entities owned by Taxpayer used the LIFO inventory method: LLC (an entity treated as a disregarded entity for federal income tax purposes) and Subsidiary.

Taxpayer entered into a merger agreement with S CORP, which had been an S corporation since its formation. Pursuant to this agreement, Taxpayer merged with Merger Corp, a corporation wholly owned by S CORP, and the separate existence of Merger Corp ceased, leaving Taxpayer as the surviving corporation in the merger. The merger was effective on Date 1 (the “Closing Date”).

The transaction was treated as a stock purchase by S CORP for federal income tax purposes and, so, did not terminate Taxpayer’s tax year or that of the consolidated group. (The merger structure may have been used because Taxpayer had many shareholders or some of its shareholders were recalcitrant. But why purchase the stock?)

S CORP filed qualified subchapter S subsidiary (“Qsub”) elections for Taxpayer and its subsidiaries. The Qsub elections were effective on the date immediately following the Closing Date; i.e. Date 2.

Taxpayer filed a short-period consolidated Form 1120 for the period ending Date 1 (the “short-period return”). Effective Date 2, Taxpayer was included in the consolidated Form 1120S filed by S CORP.

Recapture – Yes, But By Whom?

The parties to the merger agreed that the Qsub elections triggered LIFO recapture. However, they disputed the proper reporting of the recapture amount; pursuant to the merger agreement, they consulted an arbitrator. (Query how the tax burden was allocated between the parties under the agreement.)

The short-period consolidated Form 1120 originally filed by Taxpayer excluded the LIFO recapture amount. However, pursuant to the arbitrator’s findings, Taxpayer later filed a non-consolidated return for a stated period beginning and ending Date 1 (the “single-transaction return”). Taxpayer reported 100% of the LIFO recapture amount, and paid the associated tax, on the single-transaction return.

The Taxpayer’s short-period consolidated return reflected a net operating loss that was carried back two years. Taxpayer thus filed refund claims for the carry-back years. These refund claims would have been reduced had the LIFO recapture income been included in the short-period consolidated return rather than the single-transaction return.

Because a C corporation that accounts for its inventory using the LIFO method and elects S corporation status must include a “LIFO recapture amount” in gross income for the last taxable year before its S election becomes effective, Taxpayer was required to include a LIFO recapture amount in gross income for its last taxable year before the Date 2 Qsub election date. Taxpayer’s last taxable year before the S election ended on Date 1. Thus, the LIFO recapture amount was reportable by Taxpayer for the year ending Date 1.

The additional tax that is attributable to the inclusion of the LIFO recapture amount in gross income is payable in four equal installments. The first installment payment must be made on or before the due date of the electing corporation’s last income tax return as a C corporation. The additional installments must be paid on or before the due date of the corporation’s return for each of the three succeeding taxable years.

The recapture date is the day before the effective date of the S corporation election, and the LIFO recapture amount is determined as of the end of the recapture date for such an election. In the case of a nonrecognition transaction, the recapture date is the date of the transfer to the S corporation, and the LIFO amount is determined as of the moment before the transfer occurs.

Q-Subs and Recapture

When an S corporation elects to treat a wholly-owned domestic corporation as a Qsub, all assets, liabilities, and items of income, deduction and credit of the Qsub are treated as items of the S corporation parent. In this case, S CORP elected to treat the Taxpayer consolidated group, including Taxpayer and Subsidiary, as Qsubs.

When a Qsub election is made, the subsidiary is deemed to have liquidated into the S corporation on a nonrecognition basis at the close of the day before the Qsub election is effective. When Qsub elections for a tiered group of subsidiaries are effective on the same date, the S corporation may specify the order of the liquidations; otherwise, the liquidations will be treated as occurring first for the lower-tier entity and proceed successively upward.

On its face, the LIFO recapture rule does not apply to an electing Qsub; it refers only to an “S corporation [that] was a C corporation.” However, the regulations support the conclusion that LIFO recapture also applies to a Qsub election.

In the instant case, the Qsub elections were effective on Date 2. Thus, Subsidiary was deemed to liquidate first, and transferred its inventory to Taxpayer, on Date 1. On this date, Taxpayer was still a C corporation. Therefore, LIFO recapture did not apply to the deemed liquidation of Subsidiary into Taxpayer, because the distributee in that liquidation was not yet an S corporation. However, the subsequent deemed liquidation of Taxpayer into S CORP on Date 1 did trigger LIFO recapture, because Taxpayer was deemed to liquidate into S CORP which was an S corporation at the time of the liquidation.

Consolidated Return Rules

The deemed liquidation of all the members of the Taxpayer affiliated group did not terminate the Taxpayer consolidated group. However, the liquidation of the goup’s common parent – Taxpayer – terminated the consolidated group. A consolidated return must include the common parent’s items of income, gain, deduction, loss and credit for the entire consolidated return year, and each subsidiary’s items for the portion of the year for which it is a member.

When a corporation becomes or ceases to be a member during a consolidated year, it becomes or ceases to be a member at the end of the day on which its status as a member changes, and its tax year ends for all Federal income tax purposes at the end of that day (the “end of day rule”). Taxpayer correctly filed a consolidated tax return for the period ending on Date 1, the date Taxpayer was deemed to liquidate and cease its existence as common parent.

In general, if the consolidated return includes the items of a corporation for only a portion of its tax year, items for the portion of the year not included in the consolidated return must be included in a separate return, in such a manner as to prevent the duplication or elimination of the corporation’s items. Although this provision does not directly address the situation at hand, it provides support for the filing of a separate return for a corporation’s income that cannot properly be included in the consolidated return.

Single-Transaction Return Requirement

Section 1363(d)(4)(D) does not operate to exclude the converting company from the consolidated group for all purposes, or for a specific date or period; rather, it provides that the converting company is not a member of the affiliated group “with respect to the amount included in gross income under paragraph (1).” Hence, Taxpayer properly filed a consolidated return, but also properly reported the LIFO recapture income on a return separate from the affiliated group’s consolidated income. However the regulations do not explain how this provision should be implemented in practical terms.

Because Taxpayer could not be treated as a member of an affiliated group with respect to the recapture amount, the arbitrator concluded that Taxpayer could not include LIFO recapture income on its final consolidated return and was therefore required to report the LIFO recapture income on a separate “single transaction” return. The IRS agreed with this treatment, noting that Congress intended that, in the case of a converting C corporation that was previously a member of an affiliated group filing a consolidated return, and whose last taxable year as a C corporation would for other purposes be its last taxable year as a member of the group, the converting corporation, and not the group of corporations with which it filed a consolidated return during its last taxable year as a C corporation, would be liable for any tax attributable to the recognition of the LIFO recapture amount.

The fact that Taxpayer was the common parent of the consolidated group and not just a member did not change the result, according to the IRS. Congress intended for the LIFO recapture tax to be imposed on the converting corporation, not on the affiliated group.

For purposes of the recapture rule, the IRS said, the electing corporation is not be treated as a member of an affiliated group with respect to the LIFO recapture amount. Thus, a converted C corporation that was a member of an affiliated group which filed a consolidated return cannot use a consolidated loss to offset any tax liability attributable to the LIFO recapture amount. (Compare this to an S corp’s ability to use NOL carryforwards to offset built-in gain from C-tax years.)

Not So Simple?

What? The acquisition by an S corporation of a target corporation’s stock, followed by a Qsub election for the target?

As the above FAA illustrated, there’s a lot more to this transaction than meets the eye. The FAA dealt with only some aspects of the deal: the application of the LIFO recapture rule in the context of a Qsub election, and the inability of the target to use consolidated losses to offset the recapture.

Each of these factors is plugged into the calculus that determines the economic consequences of a sale or acquisition, and it is imperative that the various players be able to anticipate these consequences. My usual refrain: seek out tax advice throughout the transaction process – don’t allow yourself to be surprised.

Davidson was dead to begin with. Dead as a door-nail. His death did not come as a great surprise, at least to some, though few (other than the IRS) expected him to go as quickly as he did. And that was the root of the problem. But I don’t want to get ahead of myself.

 

It Was the Best of Times . . .

During life, he had done well for himself. He had accumulated great wealth as the majority shareholder, President, Chairman and CEO of one of the world’s leading manufacturers of glass, automotive and building products. He was worth billions of dollars and, like so many other similarly-situated individuals, he indulged himself in acquiring professional sports teams.

 

moneyAlthough he was obviously not like most men in terms of the wealth he controlled and the power he derived from it, he was just like any other “Joe” in that, sooner or later, he’d have to meet his maker.

 

As his health began to deteriorate, and he started thinking about his death, he wondered how he could pass along his great wealth to his family. He became especially concerned about avoiding the significant estate tax liability that would be borne by his beneficiaries upon his passing.

 

He consulted some of the best minds in the country. The estate tax could be avoided, he was told, by removing assets from his estate. “OK,” he thought, “tell me something I don’t know.” One way to remove assets from his estate would be for him to make substantial gifts of property while he was alive. “Great. Let’s do it,” he said. “Unfortunately,” his lawyers told him, “gifts of the size being contemplated would themselves be subject to gift tax.”

“So what’s the alternative?” he asked them. “I’m paying you by the hour, and I’m not getting any younger.”

Sale to A Trust

A sale, they replied. He could sell shares of stock in his company to his family. Better yet, these sales could be made to trusts that would be created and operated for the benefit of his family. A sale would not be treated as a gift for gift tax purposes provided the trusts paid him an amount equal to the fair market value of the shares being transferred. The trusts could also provide some asset protection for the family.

Now this was sounding good. A transfer of stock to a trust for his family that would escape the estate tax and that would not be subject to the gift tax. But wait, he thought, wouldn’t a sale subject me to capital gains tax? And how will these newly created trusts be able to pay me anyway?

Again, he gave his lawyers a searching look. “What are they thinking?”

“You’re probably wondering what we’re thinking,” they said to him. “Each trust will be structured as a so-called ‘grantor trust.’ Although you will not have any beneficial interest in the trust, you will retain certain ‘rights’ or ‘powers’ in respect of the trust property such that you will continue to be treated as owning the trust and all of its assets for purposes of the income tax. Since you cannot sell property to yourself, the ‘sale’ will not result in any taxable gain.”

“So wait,” he stopped them, “you mean to tell me that I can sell property to these trusts, but that the sale will not be treated and taxed as a sale?”

“That’s almost correct,” the lawyers replied. “You need to understand that there are two types of taxes at work here: the gift tax and the income tax. There is a ‘sale’ for purposes of the gift tax – it provides the consideration that prevents the transfer from being treated as a taxable gift. However, because the trust is ‘ignored’ for purposes of the income tax – you are treated as owning it – there is no sale for purposes of the income tax.”

Hmm, he thought, these guys are pretty smart after all.

Sale to a Trust for a Note

The lawyers continued, “As for funding the purchase by the trust, the trust will issue a promissory note to you in exchange for the shares.”

“So let me get this straight, I sell my shares to a trust in exchange for a note? Don’t I own the note? If I die before the note is paid off, won’t the value of the note be included in my estate? Am I just substituting one asset in my estate for another?”

After a pause, he continued, “You know, I’m no spring chicken, I’ve had my share of health issues, some of them serious. You may have noticed that I’m sitting in a wheel chair? What would this note look like?”

The lawyers confirmed that, “without more,” the note would be included in his estate upon his death if it were still outstanding at that time. Of course, they added, if the shares appreciated at a rate in excess of the interest accrued on the note, the net result would be positive insofar as removing value from his estate was concerned.

Sale to a Trust for a Self-Canceling Note

After some further deliberation, the lawyers peppered him with all sorts of questions about his health. “I thought you guys were lawyers? You do know that it’s illegal to practice medicine without a license?”

“Medicine? No. We’re tax lawyers. We answer to a higher authority.”

“What if we told you that there was a way to exclude the note from your estate upon your passing?” they asked him.

Picture the cartoon thought bubble that appeared above his head at that point. “I sure hope the chauffer has the limo running. These guys have had too much Kool-Aid.”

“OK, I’m game,” he humored them, “how does the note disappear?”

“It doesn’t really disappear. It cancels itself if you die before the end of the note term. Based on your age, your life expectancy is almost six years. Assume the note has a term of 5 years (less than your life expectancy). You die in the second year of the term. The remaining balance of the note is canceled and never has to be satisfied. They’re called self-cancelling installments notes, or ‘SCINs’.”

The Devil is in the Details

Well, the planning moved pretty quickly from there. Davidson was stuck, poked, prodded and probed by four physicians, each of whom concluded that he had a greater than 50% probability of living for at least one year. According to the lawyers, this was a key factor. With that prognosis, he was not deemed to be “terminally ill” within the meaning of those IRS regulations that would be used to calculate the actuarial fair market value of the notes based upon his actuarial life expectancy. The regulations would not have been available otherwise.

The lawyers obtained appraisals for the shares to be transferred to the trusts, and prepared the documentation needed to effect the transfers, including the five-year SCINs.

Importantly, they also obtained valuations for the “premium” that each trust would have to pay in exchange for the self-canceling feature. After all, why would a note holder allow a self-cancelation provision in the note without being compensated for the actuarial risk of his or her premature death? In the case of some of the notes, this premium took the form of an increased amount of principal. In others, it was reflected as an increased rate of interest.

The notes were secured by the shares being transferred and by other assets that had been contributed to the trusts at their creation. They provided for annual payments of interest and a balloon payment of principal (either in cash or in kind) at the end of the five-year term.

Death Waits for No One

In December 2008, the various trusts were created and “seeded” with some assets. In January 2009, the stock transfers to the trusts were completed. In March 2009, Davidson died and, as per the terms of the SCINs, the notes were canceled. grave

His estate filed his 2009 gift tax returns (on Form 709), on extension, in May of 2010. These disclosed the transfers of stock in exchange for the SCINs. (The Form 709 for 2008 disclosed the creation of the trusts.) His estate tax return was filed (on Form 706), on extension, in June of 2010.

Death & Taxes

The IRS examined these returns. With respect to the estate tax return, the IRS determined an estate tax deficiency of over $1.87 billion (not a typo). It also determined gift tax and generation-skipping transfer taxes of approximately $846 million for 2009. Over $2.7 billion in the aggregate (plus interest and penalties) – did Davidson roll over in his grave?

The IRS arrived at this figure, in part, by challenging (practically a given) the reported fair market value for Davidson’s company.

It also refused to treat the SCINs as bona fide consideration equal in value to the Company stock he had transferred to the trusts in exchange for the SCINs.

The IRS asserted that the regulations utilized to calculate the actuarial fair market value of the notes were inapplicable because Davidson’s life expectancy was less than the terms of the notes. Instead, the IRS determined that his life expectancy was approximately 2.5 years. The IRS asserted that the SCINs should have been valued using this life expectancy, which would have significantly reduced their value.

According to the IRS, Davidson never intended or expected to collect all payments due under the SCINs. Moreover, the IRS said, the trusts would not have been able to make payments on the SCINs when due. Thus, the IRS concluded, the SCINs were not bona fide debt.

In June 2013, Davidson’s estate filed a petition with the U.S. Tax Court in which it challenged the IRS’s assertions.  Trial was set for April 2014, but was subsequently continued (often done where the parties are engaged in serious settlement negotiations) and stricken from the Court’s calendar. The Court, however, retained jurisdiction of the case, and required the parties to file a joint status report with the Court every three months.

And So I Face The Final Curtain

In July of 2015, Davidson’s estate and the IRS submitted a stipulated decision in which they agreed to deficiencies of gift tax for 2009 of approximately $178 million, of estate tax of approximately $153 million, and of 2009 GST tax of approximately $46 million. A total of $377 million, as opposed to the approximately $2.7 billion originally sought by the IRS.

Although the basis for the decision was not spelled out, it seems reasonable to surmise that the settlement was based upon a compromise regarding the valuation of the shares transferred – not at all unusual – and that the SCINs were otherwise not implicated in the decision.

The Hereafter?

The story set out in this post is based upon a real taxpayer. The narrative, of course, is pure conjecture. It is, however, based upon discussions that I have had with many clients (except the part about the Kool-Aid).

There’s a lesson in almost every story, fictional or not. The take-away here is straightforward: know all the rules, pay attention to the details, implement and document the plan completely, and educate the client. Having done this, you will be in a strong position to withstand any IRS scrutiny.

A closely-held business will often use deferred compensation arrangements to induce or reward certain behavior by its key non-shareholder executives; for example, to incentivize the executive to attain certain business performance goals or operational benchmarks.

Such an incentive arrangement will defer the payment of compensation such as a bonus until the compensation is earned, usually upon the satisfaction of the specified goal or upon the occurrence of some specified event, such as the sale of the business. wpid-thumbnail-bc8340ac3115e56fb42957431140aaeb

For the most part, these deferred compensation arrangements are contractual agreements between the employer and the executive. As such, they may be structured in whatever form achieves the goals of the parties; consequently, they may vary greatly in design.

Regardless of how the arrangement is structured, it must address two critical elements in order to successfully defer the employee’s tax liability: (A) the arrangement must comply with certain tax principles (i.e., constructive receipt, economic benefit, IRC Sec. 83), as modified by IRC Sec. 409A; and (B) this compliance must be ensured at the inception of the arrangement; otherwise – as we shall see in this post – the tax and economic results that the parties envisioned will not be attained.

IRC Sec. 409A

Under IRC Sec. 409A, all amounts deferred under a nonqualified deferred compensation plan – for all taxable years covered by the plan – are currently includible in the employee’s gross income to the extent they are not subject to a “substantial risk of forfeiture,” unless certain requirements are satisfied relating to the timing of the distribution of the deferred compensation.

A substantial risk of forfeiture exists when the employee’s rights to the compensation are conditioned upon the performance of substantial services or the occurrence of a condition related to a purpose of the compensation, such as the attainment of a prescribed level of earnings.

A deferred compensation plan is subject to the requirements of IRC Sec. 409A at all times during a taxable year.

If the plan fails to comply or to be operated in accordance with the rules under IRC Sec. 409A “at any time during a taxable year,” and there is compensation deferred under the plan that is not subject to a substantial risk of forfeiture (generally meaning the amount is vested as of the end of the taxable year), that compensation is includible in the executive’s gross income for the taxable year.

If the plan is not compliant, but the deferred amount is subject to a substantial risk of forfeiture at all times during the taxable year, it is not includible in income under Sec. 409A.

The IRS recently considered this compliance requirement in the case of an employer who attempted to correct its failure to comply with IRC Sec. 409A during a taxable year. Specifically, the IRS considered whether the correction of the plan’s failure to comply with Sec. 409A’s distribution rules would avoid income inclusion for an executive if the correction was made before the compensation vested, but during the executive’s taxable year in which it vested.

The Retention Agreement

Executive was employed by Corp. In October of Year 1, Corp. entered into a retention agreement with Executive. The retention agreement provided that, if Executive remained continuously employed until the third anniversary of the agreement (a “substantial risk of forfeiture” and the “Vesting Date,” respectively), Executive would receive a bonus.

The agreement provided for payment of the bonus in equal installments on the first two anniversaries of the vesting date (a fixed payment schedule, as permitted under IRC Sec. 409A). However, the agreement also provided that Corp., in its sole discretion, could pay the bonus as a lump sum payment on the first anniversary of the Vesting Date.

Corp. determined that the agreement failed to meet the time and form of payment requirements of Sec. 409A because it permitted Corp. to accelerate payment of the bonus. To correct the failure, Corp. amended the agreement in June of Year 3 (four months before the Vesting Date) to remove Corp.’s discretion to accelerate payment of the bonus. Executive continued providing services through October of Year 3, and the substantial risk of forfeiture thus lapsed. Corp. paid Executive the bonus in equal installments in October of Year 4 and Year 5.

Corp. asserted that the bonus should not be includible in Executive’s income under IRC Sec. 409A for any taxable year covered by the plan because the agreement was amended before the vesting date to provide for payment terms that complied with the time and form of payment requirements of Sec. 409A, even though the amounts were no longer subject to a substantial risk of forfeiture as of the end of Year 3.

The Law

The IRS explained that, with certain exceptions, a plan provides for the deferral of compensation and, so, is subject to the requirements of IRC Sec. 409A, if the employee has “a legally binding right” during a taxable year to compensation that, under the terms of the plan, is or may be payable to the employee in a later taxable year.

That the compensation deferred under the plan may be reduced or eliminated by operation of the objective terms of the plan – such as the application of a nondiscretionary, objective provision creating a substantial risk of forfeiture – does not remove the plan from the reach of IRC Sec. 409A. Stated differently, compensation that meets the general definition of deferred compensation, even if subject to a substantial risk of forfeiture (nonvested deferred compensation), is subject to the requirements of Sec. 409A regardless of the fact that it may never become vested and may never be paid.

IRC Sec. 409A provides that certain form requirements apply to a nonqualified deferred compensation plan; specifically, it provides rules for when a plan may make a distribution to an employee, and it provides that a plan may not permit the acceleration of the time or schedule of any payment to the employee except in limited circumstances.

The requirements of Sec. 409A generally are applicable from the time that the legally binding right to deferred compensation arises, regardless of whether the compensation is vested or not.

Corrections?

Deferred compensation is subject to the requirements of IRC Sec. 409A at all times during a taxable year, even though the deferred amount is not includible in income under Sec. 409A because it is subject to a substantial risk of forfeiture.

If the deferred amount is not subject to a substantial risk of forfeiture at all times during the taxable year, and the plan is not compliant with IRC Sec. 409A, the amount is includible in income, regardless of whether the failure is corrected during the taxable year, even if it is corrected before the risk of forfeiture lapses.

The IRS Rules

Executive acquired a legally binding right to the bonus on the date that Corp. and Executive executed the agreement during Year 1. To receive the bonus, Executive was required to remain continuously employed by Corp. until the vesting date, which was the third anniversary of the execution of the agreement. Executive’s legally binding right to the bonus was subject to a substantial risk of forfeiture because Executive’s right to receive the bonus was conditioned on Executive’s performance of substantial future services.

The bonus was deferred compensation, and the agreement was a nonqualified deferred compensation plan subject to the requirements of section 409A, beginning on the execution date of the agreement.

The agreement failed to meet the requirements of IRC Sec. 409A. Sec. 409A requires that a plan designate a specified time for payment of a deferred amount. The requirements of Sec. 409A are met if a plan designates that deferred amounts may be paid only at a time or pursuant to a fixed schedule specified under the plan. Such a fixed schedule may be based on a payment event that may include the lapse of a substantial risk of forfeiture. Therefore, the agreement’s provision for payment of the bonus in equal installments on the first two anniversaries of the vesting date would have complied with Sec. 409A, if the agreement had not also provided that Corp. in its sole discretion, could pay the bonus in a lump sum on the first anniversary of the vesting date.

The agreement’s provision for Corp.’s right to accelerate payment failed to meet the requirement that a plan may not permit the acceleration of the time or schedule of any payment, except as provided under regulations.

Although Corp. ultimately amended the agreement to remove its discretion to pay the bonus in a lump sum, the failure to meet the requirements of Sec. 409A began on the execution date of the agreement in Year 1and continued through Year 2, and into June of Year 3.

Notwithstanding the failure, no amount was includible in income under Sec. 409A for Year 1 and Year 2 because the entire deferred amount was subject to a substantial risk of forfeiture at the end of Year 1 and Year 2.

However, the entire deferred amount was vested (no longer subject to a risk of forfeiture) at the end of Year 3. Therefore, the entire deferred amount was includible in Executive’s income under Sec. 409A for Year 3, notwithstanding that it would be not be paid until October of Years 4 and 5.

No Time Like the Present

An employer adopts an executive incentive compensation plan with the best of intentions. However, if the plan is not implemented in compliance with applicable tax rules, including IRC Sec. 409A, the resulting tax consequences will thwart both the employer’s goals and the employee’s expectations.

Aside from the penalty imposed under IRC Sec. 409A, the situation in the ruling was not all that bad. After all, vesting occurred in Year 3 and payments were completed in Year 4 (the year in which the resulting tax was owed) and Year 5. It would have been worse if the distributions were payable at a later time, or spread out over more years. Under those circumstances, it is likely that the employer would have been “forced” to make the tax funds available to the employee, either by way of an additional bonus, or a no-to-low interest loan. But what if the funds therefor were not readily available because the employer had planned to fund the distributions through the cash value of life insurance?

The bottom line is that these consequences, and the decisions they force upon an employer, may be avoided if the employer consults with tax advisors who are familiar with the workings of deferred compensation plans prior to implementing such a plan.

It’s Not That Simple

The rules that govern the taxation of partners and partnerships are among the most complex in the Internal Revenue Code. This reflects, in part, the great flexibility that is afforded to partners in structuring their economic arrangements.

This complexity is often manifested in a difference of opinion between a taxpayer and the IRS regarding the income tax treatment of a particular item or arrangement. Sometimes, what may appear as a straightforward issue takes an unexpected turn, as one taxpayer recently discovered.

The disagreement between a partnership (the “Taxpayer”) and the IRS arose out of their differing conclusions as to whether a particular indebtedness was recourse or nonrecourse to the partnership. The resolution of this seemingly simple question would have important ramifications for the taxation of the partners.

The Taxpayer

Taxpayer was an LLC, taxable as a partnership for federal tax purposes.

Taxpayer was organized to purchase specified real property, and then to construct, market, and sell homes that it built on that property (“Property”). Taxpayer’s operating agreement provided that Taxpayer was a special purpose entity (“SPE”), which (i) was organized solely for the purpose of owning the Property, (ii) would not engage in any business unrelated to the ownership of the Property, and (iii) would not have any assets other than those related to the Property.

The Indebtedness & Its Cancellation

Taxpayer relinquished its last unsold parcel of real property from the Property to Bank in a non-judicial foreclosure. Bank had a loan to Taxpayer that was secured by the Property (“Senior Loan”). Bank cancelled the entire Senior Loan as part of the non-judicial foreclosure.

During Tax Year, Corporation, another of Taxpayer’s lenders, cancelled its outstanding loans (“Notes”) to Taxpayer. Notes were created in connection with loans made to Taxpayer in order to develop Property, and were secured by the Property, but were subordinated to the Senior Loan from Bank. They were further secured by a general assignment of Taxpayer’s rights, title, and interest in and to the Property; a general assignment of Members’ rights, title, and interest in and to the Property; pledges of their membership interests in Taxpayer; and unlimited, unconditional, and irrevocable guarantees by each Member of Taxpayer.

Notes did not contain express language providing that they were recourse or nonrecourse to Taxpayer, nor did they did expressly state whether Taxpayer, as borrower, would be unconditionally and “personally” liable for repayment if the collateral securing Notes was insufficient to fully repay the outstanding balance on Notes with interest. Because Notes constituted junior debt, Corporation did not receive any proceeds from the non-judicial foreclosure.

Taxpayer’s COD?

Taxpayer reported the income from the discharge of indebtedness from the cancellation of Notes as cancellation of debt (“COD”) income for the Tax Year, which was allocated among its Members. To the extent of their respective insolvencies, in accordance with the COD rules, Members excluded the COD from their gross income and, in turn, reduced certain tax attributes.

The IRS questioned whether the COD income should be reclassified as an amount realized from the sale or other disposition of the Property. It reasoned that, if the Notes that were discharged in connection with the disposition of Property were nonrecourse to Taxpayer, the full amount of the discharged debt would be included in the amount realized and, thus, the transaction would result in gain or loss, and not COD income. One result of this reclassification at the partnership level would be that Taxpayer’s Members would be unable to exclude part of the income under the COD rules at the partner level.

Some Tax Basics

Gross income includes income from discharge of indebtedness.

The gain from the sale or other disposition of property is the excess of the amount realized over the property’s adjusted basis. Generally, the amount realized from a sale or other disposition of property includes the amount of liabilities from which the transferor is discharged as a result of the sale or disposition.

The amount realized on a sale or other disposition of property that secures a recourse liability, on the other hand, does not include amounts that would be COD income. Accordingly, when property encumbered by recourse indebtedness is transferred in satisfaction of a debt secured by the property, the transaction is bifurcated into (i) an amount realized on a sale and (ii) an amount of COD income. The amount realized on sale is the fair market value (“FMV”) of the property, and any excess of the debt over FMV is COD income. The difference between the FMV of the property and its basis is recognized as gain or loss, and the excess of the debt discharged in the transaction over the FMV of the property is COD. The amount of COD could be excludible from income under the COD rules if the taxpayer were insolvent.

The sale or other disposition of property that secures a nonrecourse liability discharges the transferor from the liability. For property encumbered by nonrecourse indebtedness, the amount realized on its disposition includes the entire amount of the debt on the property. In determining gain or loss, the FMV of property is treated as not less than the amount of nonrecourse indebtedness to which the property is subject (the actual FMV does not matter). No part of such a transaction represents COD income and the exclusions under the COD rules do not apply to the transaction.

Recourse Debt or Not?

In general, for purposes of determining gain, a loan is recourse if the borrower is personally liable for the debt, and nonrecourse if the borrower is not personally liable for the debt. In other words, it depends on whether a creditor’s right of recovery is limited to a particular asset of the borrower. If a creditor’s right of recovery is limited to a particular asset securing the liability, the liability is nonrecourse. If a creditor’s right of recovery extends to all assets of a taxpayer, the liability is recourse.

In the case of a debtor that is a partnership, whether the partnership’s debt is recourse or nonrecourse is determined at the partnership level. Similarly, the nature of each partner’s share of income, gain, loss, deduction, or credit of the partnership is determined at the partnership level.

 The Source of Confusion

For purposes of determining a partner’s basis in a partnership, IRS Regulations provide that a partnership liability is recourse to the extent that any partner bears the economic risk of loss for that liability, and a partnership liability is a nonrecourse liability to the extent that no partner bears the economic risk of loss.

The Regulations provide that a partner’s share of a recourse partnership liability equals the portion of that liability for which the partner bears the economic risk of loss, and a partner bears the economic risk of loss to the extent that, if the partnership constructively liquidated, the partner would be obligated to make a payment and is not entitled to reimbursement from another partner. The Partnership Regulations recognize various payment obligations, including guarantees and other contractual obligations imposed outside the partnership agreement.

Taxpayer argued that Notes were recourse to it because its Members were personally liable for repayment under their guaranty agreements. Taxpayer reasoned that Members’ guarantees are payment obligations that represent an economic risk of loss to Members and, as a result, Notes met the definition of “recourse” loans under the Regulations. Taxpayer’s position was that these regulations also determined if partnership debt was characterized as recourse or nonrecourse to a partnership for purposes of determining gain from a disposition of property.

The IRS disagreed. The Regulations, it said, were limited to determining a partner’s basis in its partnership interest. The definition of a recourse liability found therein did not extend to issues under the gain recognition rules. The primary authority for this conclusion, the IRS said, was found in the regulatory text which states that the definitions found therein applied for purposes of determining basis.

The IRS stated that a partner’s guarantee of partnership debt, and thus the classification of that debt as recourse or nonrecourse under the Regulations, would not affect the determination of whether the debt was recourse or nonrecourse to the partnership for purposes of determining gain.

The IRS ended by stating that the determination of whether the Notes in the instant case were recourse or nonrecourse for gain determination purposes required a factual analysis of the operating and loan documents and any relevant state law. It referred this factual analysis back to the examining agent.

Observations

Taxpayer’s status as an SPE, its operating documents, and the loan documents limited Taxpayer’s assets to those related to developing Property. Any and all assets held by Taxpayer necessarily related to Property, and thus secured Notes. The lenders, therefore, had no further recourse against Taxpayer once Property and the assets related to Property were exhausted when the senior lender foreclosed on the property.

In addition, even though Notes lacked language expressly imposing an unconditional personal liability for repayment on the Taxpayer, Notes were secured by all assets Taxpayer would ever have. Notes also were secured by a pledge of Members’ interests in the Taxpayer and a general assignment of Members’ rights in and to Property. Thus, in the event of default, a lender could have acted on Members’ pledges and acquired Members’ rights in Taxpayer and thus acquire all assets held by Taxpayer.

Consequently, when dealing with an LLC that is also a SPE, all assets of the entity necessarily secure the loans used to acquire or construct such assets when Members pledge their interests in the entity to secure a loan. Express personal liability language may not be necessary to make the debt recourse to an entity under these facts. The combination of Members’ pledges, general assignment of rights, and guarantees, in addition to the loan being secured by all assets of the Taxpayer as a result of its status as a SPE, may be sufficient for the loan to be recourse to the entity.

One More Thing

It is not unusual, in tax practice, to come across a concept that has neither been directly addressed by Congress, nor fully developed by the IRS or the courts. In those instances, practitioners will often look to other areas of tax jurisprudence to see if any elements of the concept, or analogous concepts, have been better developed and, so, may provide some guidance. However, as the present case illustrates, the practitioner must step carefully.

 

Dr. Peter Venkman: This city is headed for a disaster of biblical proportions.

Mayor: What do you mean, “biblical”?

Dr Ray Stantz: What he means is Old Testament, Mr. Mayor, real wrath of God type stuff.

Dr. Peter Venkman: Exactly.

Dr Ray Stantz: Fire and brimstone coming down from the skies! Rivers and seas boiling!

Dr. Egon Spengler: Forty years of darkness! Earthquakes, volcanoes…

Winston Zeddemore: The dead rising from the grave!

Dr. Peter Venkman: Human sacrifice, dogs and cats living together… mass hysteria!

Mayor: All right, all right! I get the point!

-“Ghostbusters’”

 

What’s Going On?

In case you haven’t noticed, there has been a lot of press lately about the “imminent” issuance of proposed regulations by the IRS that, if adopted, may seriously impair the ability of a taxpayer who is transferring an interest in a closely-held business (whether by gift or by sale) to claim valuation discounts in determining the fair market value (FMV) of the interest.

Some of the commentary has gone so far as to urge taxpayers to make such transfers now, before the regulations are issued and the opportunity for a “favorable” valuation is foreclosed. After all, they say, the regulations will become effective for any transfers occurring after their adoption.

To all those people, I say: “Slow down, you move too fast.”

Goals of Gifting

The fair market value of property transferred, whether on the death or during the life of the transferor, generally is subject to estate or gift tax at the time of the transfer. Gift-money

Generally, a primary goal of gifting property to a child or other family member is not only to remove the value of such property from the transferor-parent’s estate, but also to remove any subsequent appreciation in the value of that property from the estate.

If the parent does not transferred the property during his or her life, the full value of that property as of his or her date of death will be included in the parent’s estate and be subject to transfer tax.

Another goal of gifting property is to position the remaining business interests held by the parent in a more favorable valuation posture for estate tax valuation purposes (for example, by putting the parent in a minority interest position).

Valuation – In General

If a transfer of a business interest is a completed gift, the amount of the gift (i.e., the amount on which the gift tax is imposed) is the FMV of the interest on the transfer date.

Generally, the valuation of property for gift and estate tax purposes is based upon the “hypothetical willing buyer and willing seller” standard. In other words, it does not consider the actual transferor and transferee, and their relationship to each other (e.g., family) does not matter. These hypothetical individuals are under no compulsion to buy or sell, and they are each deemed to have reasonable knowledge of all the relevant facts (including, in most cases, the fact that the other owners of the business may be related to one another).

In the case of stock in a closely-held corporation or partnership, however, the FMV of an interest depends on the relevant facts and circumstances of each case. The IRS has set forth many of the factors to be considered (e.g., economic outlook, earning capacity, goodwill, the size of the interest to be transferred, etc.). The courts have accepted appropriate discounts in valuing these interests where they represent minority positions for which there is no ready market.  Among these are the discounts for lack of control (LOC) and for lack of marketability (LOM).

Thus, if the interest being transferred by way of a gift is a minority interest in a closely-held entity for which there is no ready market, a hypothetical willing buyer will realize that he cannot easily realize the pro rata value of the entity to which the minority interest “entitles” him. Because he or she cannot force a dividend distribution, a sale or a liquidation, it will be difficult to convince another hypothetical party to purchase his or her interest. Under these circumstances, the courts and the IRS have recognized that various discounts may be applied to the so-called “normative” value of an equity interest in order to determine its FMV.

The IRS, Congress & Discounting

In accordance with these long-standing principles, taxpayers making gratuitous transfers of interests in closely held business entities have routinely claimed LOC (where appropriate) and LOM discounts on the valuation of such interests, and where the entity is engaged in an active business, the IRS has been willing to accept these discounts (though it may challenge the size of the discount claimed).

Many years ago, certain provisions were enacted into law to prevent the reduction of taxes through the use of “estate freezes” and other techniques designed to reduce the value of the transferor’s taxable estate and to discount the value of the taxable transfer to the beneficiaries of the transferor without reducing the economic benefit to the beneficiaries. Generally, under these provisions, certain “applicable restrictions” (that would normally justify discounts in the value of the interests transferred) are to be ignored in valuing interests in family-controlled entities if those interests are transferred (either by gift or on death) to or for the benefit of other family members.

The application of these special rules results in an increase in the transfer tax value of those interests above the price that a hypothetical willing buyer would pay a willing seller, because they generally direct an appraiser to ignore the rights and restrictions that otherwise would support significant discounts for lack of marketability and control.

According to the IRS, however, these special rules have fallen short of expectations in stemming abusive gift planning. Tax planners, the IRS says, have carried the above valuation concepts over into the family estate planning area, where it is now common for a taxpayer to contribute marketable assets to a family limited partnership or limited liability company and to make gifts of minority interests in the entity to other family members. Taxpayers then claim large discounts on the valuation of these gifts.

This disappearing value is illusory, the IRS says, because family members are not minority interest holders in any meaningful sense. Moreover, it is implausible that the donor would intentionally take an action (contribution of the property to an entity) if the donor really believed that such action would cause the family’s wealth to decline substantially.

Consistent with the IRS’s position, the Clinton administration proposed, unsuccessfully, to eliminate valuation discounts except as they apply to active businesses. Under its proposal, interests in covered entities would have been required to be valued for transfer tax purposes at a proportional share of the net asset value of the entity to the extent that the entity held readily marketable assets at the time of the gift or death. To the extent the entity conducted an active business, the reasonable working capital needs of the business would be treated as part of the active business (i.e., not subject to the limits on valuation discounts).

More recently, the Obama administration proposed (also unsuccessfully) to create an additional category of restrictions (“disregarded restrictions”) that would be ignored in valuing an interest in a family-controlled entity transferred to a member of the transferor’s family if, after the transfer, the restriction will lapse or may be removed by the transferor and/or the transferor’s family. Disregarded restrictions would include limitations on a holder’s right to liquidate that holder’s interest and any limitation on a transferee’s ability to be admitted as a full partner or to hold an equity interest in the entity. Regulatory authority would have been granted, including the ability to create safe harbors to permit taxpayers to draft the governing documents of a family-controlled entity so as to avoid the application of the new valuation provisions if certain standards were met.

The IRS Reacts (?)

As a result of these legislative failures to curtail what it views as valuation abuses in the transfer of family-owned business entities, the IRS recently announced that it would be issuing regulations that may limit minority interest and lack of marketability discounts when valuing certain family-owned business entities.

At this point, it unclear whether the proposed regulations will target only family limited partnerships and limited liability companies that primarily hold readily marketable assets (or other passive investments), and not actual operating companies.

The adoption of such regulations, however, would effectively make it more “expensive” to transfer interests in family-owned business entities, in that it may result in greater gift or estate tax liabilities (e.g., by limiting the size of the interests transferred by way of gift).

What To Do?

At the moment, we know nothing of these regulations. Questions and, worse, speculation abound. These can only lead to some irrational responses. Remember 2012, when taxpayers gave away assets that were not “disposable” and that they tried to reacquire after the extension of the increased exemption amount?

Based on prior legislative proposals, we may surmise that there will be additional categories of restrictions that will be ignored in valuing the transfer of an interest in a family-controlled entity to a member of the transferor’s family. In addition, the regulations may a provide safe harbor to permit taxpayers to draft the governing documents of a controlled entity so as to avoid the application of the new valuation provisions. It is also possible that the regulations will not apply to operating businesses.

In any case, taxpayers must not lose sight of the fact that they are now dealing with an increased exemption amount (currently set at $10.86 million per married couple), one that is adjusted annually for inflation. They must recognize that zeroed-out GRATs and grantor trusts remain valuable vehicles for leveraging gifts of close business interests. They should also recall that defined value clauses have gained greater acceptance in the courts as a means by which to avoid a taxable gift.

Finally, taxpayers should be reminded of the primary directive that the tax consequences alone should not drive their decision to transfer interests in a family business. Such a transfer first has to make sense from a personal perspective and from a business perspective.

In most cases, a financially troubled business will face some difficult choices, including which creditors to pay and which to defer. The Federal and State taxing authorities are often among these creditors. As we have seen on other occasions, a business’s decision to defer the payment of State taxes may have significant legal and, ultimately, economic consequences.

Unfortunately, these consequences may also be visited upon an otherwise healthy business that has inadvertently overlooked a State tax payment or filing obligation. One consequence that arises under these circumstances, and of which most tax advisers are aware, is the dissolution of the corporation by proclamation, at which point the legal entity of the corporation ceases to exist, as do any legal rights to which it was entitled as a corporate entity under State law.

I often encounter taxpayers and advisers who believe that a dissolution by proclamation results in the taxable liquidation of the corporation for Federal income tax purposes – in other words, that the administrative dissolution results in a liquidating distribution that is taxable to both the corporation and to its shareholders.  Fortunately, they are mistaken, as the IRS recently confirmed.

The Facts

Taxpayer incorporated under State A law on Date 1. Taxpayer was administratively dissolved by State A on Date 2 for failure to file a Year 1 annual report and to pay an annual franchise tax. During the period in which Taxpayer was unaware of this dissolution (the ruling does not tell us how this came to be, as the State presumably sent notices to the corporation),Taxpayer continued to file IRS Form 1120 (the Federal corporate income tax return) and to pay all corporate taxes as they came due. Following discovery of the dissolution in Year 2, Taxpayer reincorporated in State A on Date 3. dissolve-corporation
Dissolved in the Eyes of the IRS?

According to the IRS, the “core test” of corporate existence for purposes of Federal income taxation is always a matter of Federal law. Whether an organization is to be taxed as a corporation under the Code is determined by Federal, not state, law. A corporation is subject to Federal corporate income tax liability as long as it continues to do business in a corporate manner, despite the fact that its recognized legal status under state law is voluntarily or (as in the case of Taxpayer) involuntarily terminated.

Thus, because Taxpayer continued to act as a corporation for Federal tax purposes, its status as a corporation for such purposes was not terminated by reason of its having been administratively dissolved by State A.

It should be noted, however, that while the a corporation’s Federal tax status is determined under Federal law, its legal powers, rights, and privileges are determined by the law of the State under which the corporation was organized. When these powers are suspended by that State by virtue of the corporation’s administrative dissolution, the corporation cannot exercise these powers, including the right to prosecute or defend a Federal tax action.

Conclusion

The corporation in the above ruling was fortunate not to have known of its involuntary dissolution, and to have continued to act as a corporation, at least from a Federal tax perspective. Query how it would have acted if it had been aware of the dissolution. The fact that it felt compelled to request a private ruling from the IRS as to its continued corporate status probably evidences an unwarranted concern among its tax advisers, that is shared by many others, that a dissolution by proclamation may have resulted in the taxable liquidation of the corporation for Federal income tax purposes.

A little research could have saved them the uncertainty, time, and effort.

 

I’ll take My Chances

If I had a dollar for every time a client said to me “but they never audit real property transfer tax returns,” I’d be a client myself. I often hear this statement in the context of a transaction that a client insists should not be subject to the transfer tax, and it is often made in response to my analysis that the hoped-for result would not stand up to scrutiny. NYC The prospect of incurring the NYC Real Property Transfer Tax (RPTT) on the sale of an interest in real property is no small matter for a business. The applicable rate of 2.625% of the consideration for a taxable transfer (plus the NYS transfer tax of 0.40%) represents a significant reduction in the net proceeds retained by the seller. For that reason, businesses and their owners will often try to structure a deal so that its form does not fall within the literal definition of a taxable “conveyance.” Well, guess what? Transfer tax returns do get audited and, for one taxpayer, the audit turned into an expensive proposition.

The Contribution

In 2007, Taxpayer and Partner acquired Tenancy in Common (TIC) Interests of 45% and 55%, respectively, in Property. They also entered into a Tenants In Common Agreement, which governed their respective rights and obligations as to the Property. In 2010, Taxpayer and Partner entered into the following agreements and transactions: (a) LLC was formed; (b) Taxpayer and Partner executed a Contribution Agreement pursuant to which Taxpayer and Partner agreed to contribute to LLC their TIC Interests together with their respective interests in a ground lease for the Property in exchange for, in the case of Taxpayer, a 45% Membership Interest in LLC and, in the case of Partner, a 55% Membership Interest in LLC. The Contribution Agreement contained several provisions that reflected the intended sale by Taxpayer to Partner of its new Membership Interest in LLC. For example:

  1. as a condition to closing under the Contribution Agreement, Taxpayer was to be released from obligations under certain loan documents relative to Mortgage;
  2. Partner’s obligation under the Contribution Agreement was conditioned on a title insurance company’s commitment to inure LLC’s title to Property;
  3. under the Contribution Agreement, only Taxpayer’s conveyance had to satisfy certain title requirements;
  4. Taxpayer alone assumed responsibility for the payment of any transfer taxes arising under TIC Contribution Agreement; and
  5. the Contribution Agreement contained representations made by Taxpayer to Partner but not to LLC.

Taxpayer and Partner executed deeds conveying their TIC Interests to LLC in exchange for their respective 45% and 55% Membership Interests in LLC, and also executed LLC’s Operating Agreement. Pursuant to the Contribution Agreement, LLC assumed the Mortgage and the ground lease.  On their NYC RPTT returns, Taxpayer and Partner each reported that the transfer to LLC was exempt as a mere change of identity or form of ownership.

The Sale

At the same time, Taxpayer and Partner executed both a Membership Interest Purchase Agreement pursuant to which Taxpayer agreed to sell, and Partner agreed to purchase, Taxpayer’s Membership Interest for $XXX (an obscene amount), as well as an Assignment and Assumption Agreement whereby Taxpayer assigned its Membership Interest to Partner and withdrew as a member of LLC. Taxpayer filed an RPTT return which described the “condition of the transfer” of its Membership Interest to Partner as “Other. Transfer of 45% interest in LLC” and reported that no transfer tax was due.

The Audit (that never happens)

NYC asserted that Partner’s  ownership of 100% of the LLC resulted from a 55% non-taxable mere change and a 45% taxable change in beneficial ownership. The auditor calculated the taxable consideration based on the purchase price for Taxpayer’s Membership Interest plus a 45% pro-rata share of the Mortgage. Taxpayer asserted that the transfer of its 45% TIC Interest in exchange for its 45% Membership Interest was exempt from RPTT as a “mere change in form,” and that its sale of the Membership Interest to Partner was exempt from RPTT as a transfer of a non-controlling interest. NYC asserted that the contribution and sale (the Transactions) were subject to the step transaction doctrine. An administrative law judge (ALJ) agreed.

Mere Change in Form Exemption

NYC’s Administrative Code (the “Code,” with apologies to the one true Code, the IRC) imposes the obligation to pay the RPTT on the grantor. The Code provides an exemption from the RPTT where the deed conveying real property “effects a mere change of identity or form of ownership or organization to the extent the beneficial ownership of such real property or economic  interest remains the same . . .” Taxpayer owned a TIC interest before acquiring an interest in an LLC. The “mere change” exemption has been applied in situations involving the conveyance of TIC interests in real property to an entity in which, based on the facts and circumstances specific to the particular case, the beneficial ownership of the property remained the same after the conveyance as it was before the conveyance.   Thus, transfers of real property from TIC owners to LLCs are non-taxable mere changes in form where the beneficial interests of the parties remained the same before and after the transfer.

Controlling Interest

The Code imposes the RPTT on transfers of economic interests in real property. An “economic interest in real property” includes “the ownership of an interest or interests in a partnership . . . which owns real property.” When used in relation to an economic interest in real property, the term “transfer” includes the transfer of interests in a partnership whether made by one or several persons, or in one or several related transactions, which interests constitute a controlling interest in such partnership. A “controlling interest” in a partnership consists of “fifty percent or more of the capital, profits or beneficial interest in such partnership.”

Step Transaction Doctrine

Under the step transaction doctrine, “steps” in a series of formally separate but related transactions are treated as a single transaction if all of the steps are substantially linked. The purpose of the step transaction doctrine is to assure that tax consequences turn on the substance of a transaction rather than on its form, particularly if the form is without business purpose and “is merely a convenient device for accomplishing indirectly what could not have been achieved by the selection of a more straightforward route.” The tax consequences of an interrelated series of transactions, the ALJ said, are not to be determined by viewing each of them in isolation but by considering them together as component parts of an overall plan. Even where each step in the sequence, taken individually, may fit into “an untaxed transactional compartment,” the individual tax significance of each step is irrelevant when, considered as a whole, they amount to no more than a single transaction which in purpose and effect is subject to a given tax consequence. In order to determine whether the step transaction doctrine applies to a particular matter, courts have established two tests: an ‘interdependence test,’ and an ‘end result test.” Only one test must be satisfied in order for the step transaction doctrine to apply. The “interdependence test” inquires as to “whether, on a reasonable interpretation of objective facts, the steps were so interdependent that the legal relations created by one transaction would have been fruitless without a completion of the series.” The “end result test” establishes a standard whereby purportedly separate transactions will be amalgamated into a single transaction where it appears that they were really component parts of a single transaction intended from the outset to be taken for the purpose of reaching the ultimate result.

Analysis

Taxpayer owned a TIC interest from 2007 until 2010. Only in 2010 did Taxpayer execute the Contribution Agreement and convert its TIC Interest to a Membership Interest. That conversion occurred on the same day that Taxpayer executed the Operating Agreement, the same day it executed the Membership Interest Purchase Agreement, and the same day Taxpayer sold its newly created Membership Interest to Partner. The Contribution Agreement included provisions that extended beyond the mere exchange of a TIC Interest for a Membership Interest, addressing matters relating to the conveyance of real property. Recitals in the Membership Interest Purchase Agreement described a sequence of events consisting of the formation of  LLC, the execution and delivery of the Operating Agreement, the acquisition by LLC of the Property, and Taxpayer’s sale of its Membership Interest to Partner. Under these circumstances, since it was unlikely that either the conversion of Taxpayer’s TIC Interest to its Membership Interest, or the sale of its Membership Interest would have occurred without the other, the interdependence test was satisfied. It was also apparent that the events occurring in 2010 were components of one transaction, the end result of which was intended to achieve the sale by Taxpayer of its TIC interest to Partner while avoiding the payment of RPTT on such transaction and, so, the end result test is satisfied. The transfer of a less-than-controlling TIC interest (i.e., less than 50%) is subject to RPTT. Had Taxpayer directly conveyed its TIC interest to Partner, that conveyance would have been subject to RPTT.

What’s a Taxpayer To Do?

A central issue relating to the step transaction doctrine concerns the extent to which it is permissible for taxpayers to avail themselves of “planning possibilities.” Taxpayers have the legal right to structure a transaction to eliminate taxes to the extent permitted by law. The question is “whether the transaction under scrutiny is in fact what it appears to be in form.” Based on the facts in this matter, it did not appear to the ALJ that the Transactions were, in fact, what they appeared to be in form. In view of the body of law requiring taxes to be levied on the substantive transaction rather than on a series of formalized steps, Taxpayer was liable for the RPTT asserted by NYC, as the Transactions constituted step transactions and, as such, Taxpayer was not entitled to avail itself of either the mere change exemption or the exclusion applicable to the sale of a non-controlling interest.

Takeaway

The tax consequences of many transactions are determined by the form of the transaction, notwithstanding what the parties intended. In some cases, this may yield an unexpected taxpayer-friendly result. In most contexts, however, the substance of the transaction will control. The key is to assume that your transaction will be examined by the taxing authorities, to examine the transaction steps, to research the applicable legal authority, and to quantify the potentially adverse tax consequences. At that point, the client can make an educated decision.

Silly Question?

“Which do you prefer: a taxable or a non-taxable transaction?”

Most taxpayers would probably respond that they prefer a non-taxable transaction. After all, who wants to pay tax if they don’t have to?

 

Closer analysis, however, may reveal that given a particular taxpayer’s situation, a taxable transaction may yield a better result. For example, the taxpayer may have loss carry-forwards that a taxable transaction would enable the taxpayer to utilize, or the taxpayer may want to recognize the loss inherent in the property.

 

In most cases, a taxpayer that desires a taxable transaction should not have much difficulty in effecting that result. However, there have been a number of instances in which such a taxpayer has inadvertently stumbled into a non-taxable exchange.

Tax-Free By Mistake

How, one might ask, can a taxpayer “inadvertently” qualify for non-taxable treatment? tax free label

 

Easy: by satisfying the requirements for such treatment. For example, The Code provides that “no gain shall be recognized if property is transferred to a corporation” solely in exchange for stock in such corporation,” and “immediately after the exchange,” the transferor is in control of the corporation.

 

This provision is not elective – it is mandatory. It applies regardless of the taxpayer’s intent, so long as its requirements are satisfied. One taxpayer realized too late that this was the case.

 

Sale or Contribution?

A recent decision examined whether the Taxpayer’s transfer of assets to Corp was a sale or a capital contribution.  Taxpayer operated a real estate business (selling foreclosed properties on behalf of lenders) as a sole proprietorship for many years. In 2008, Taxpayer created Corp and, shortly thereafter, Corp’s board of directors authorized Corp to purchase Taxpayer’s sole proprietorship.

 

Corp and Taxpayer entered into a purchase agreement pursuant to which Taxpayer agreed to sell to Corp “[a]ll the work in process, customer lists, contracts, licenses, franchise rights, trade names, goodwill, and other tangible and intangible assets of” the sole proprietorship.

 

When the purchase agreement was signed, Corp had no capital, no assets, and no shareholders. Weeks after the purchase agreement was signed, Corp’s board of directors resolved to issue shares to Taxpayer in exchange for $X.

 

No appraisal was performed, so there was no way to establish the reasonableness of the $X. The purchase price was determined exclusively by the Taxpayer. The Taxpayer allocated a portion of  the purchase price to a franchise license agreement to which Taxpayer was a party and the balance of the purchase price was allocated to contracts between Taxpayer and various lenders.

 

The purchase agreement stated that the purchase price was payable in monthly installments and that the unpaid principal amount was subject to 10% interest each year. Corp did not provide any security for the purchase price, and a promissory note was not executed. The purchase price was eventually paid in full, but Corp did not make all payments timely.

 

Tax Return and the IRS

On his returns for the years at issue, the Taxpayer reported long-term capital gain from the transaction using the installment method. The Taxpayer also reported interest income. Corp reported substantially the same amounts as deductible interest payments on its returns for the years at issue. Corp also amortized the purchase price.

 

The IRS issued notices of deficiency for the years at issue to both Taxpayer and Corp, arguing that the transfer of the sole proprietorship’s assets to Corp was a capital contribution subject to section 351, not a sale. The IRS also argued that the payments made to Taxpayer were, in fact, taxable dividends and that the assets transferred to Corp may not be amortized.

 

The issue to be decided, the Court said, was whether the transfer was a capital contribution or a sale creating a debtor-creditor relationship.

 

Court’s Analysis

The Court began its analysis by stating that the substance of a transaction, not its form, is controlling for tax purposes. Transfers between related parties, such as Taxpayer and Corp, are subject to close scrutiny but do not necessarily lack economic substance.

 

According to the Court, when an overall plan is accomplished through a series of steps, it is the overall plan that must be evaluated for tax purposes, not each step.

“Where a series of closely related steps are taken pursuant to a plan to achieve an intended result, the transaction must be viewed as an integrated whole for tax purposes.” The sole purpose of Corp’s organization was to incorporate Taxpayer’s sole proprietorship. The inseparable relationship between Corp’s organization and the transfer of the sole proprietorship’s assets weighed in favor of finding that the transfer was a capital contribution, particularly in the light of the lack of evidence of a business reason for dividing the transaction.

 

Factors to Consider

The Court then applied a multi-factor test to determine whether Taxpayer’s transfer to Corp was a sale or a capital contribution. No single factor was controlling, it said, and the facts and circumstances of each case must be taken into consideration. The primary purpose of the factors is to help the Court determine the parties’ intent “through their objective and subjective expressions.”

The following factors were considered:

The issuance of a note evidences debt, and the issuance of stock indicates an equity contribution;

  • The lack of a fixed maturity date indicates that payment is linked to the success of the business and is evidence of an equity interest;
  • Payments that depend on earnings or come from a restricted source indicate an equity interest;
  • The right to enforce payment of principal and interest (as through a secured interest) is evidence of a debt;
  • An increase in a shareholder’s interest in a corporation as the result of a transaction indicates an equity interest;
  • Subordinating the right to repayment to rights of the corporation’s other creditors generally indicates an equity interest;
  • Thin capitalization tends to indicate that a transaction is a capital contribution;
  • Advances made by shareholders in proportion to their stock ownership indicate a capital contribution; and
  • The corporation’s ability to borrow funds from a third party indicates a debt.

The Court found that some of these factors were neutral, that others weighed in favor of finding that the transaction created a debtor-creditor relationship, and that others favored finding that it created an equity interest. Considering all of the factors together, the Court concluded that they weighed in favor of finding that the transaction was in substance a capital contribution.

Contribution and Dividends

Section 351(a) provides: “No gain or loss shall be recognized if property is transferred to a corporation by one or more persons solely in exchange for stock in such corporation and immediately after the exchange such person or persons are in control * * * of the corporation.” Person(s) have control if they own stock possessing at least 80% of: (1) the total combined voting power of all of the corporation’s voting stock and (2) the total number of shares of all of the corporation’s other classes of stock. The application of section 351 is mandatory when all of the requirements are met.

In substance, in order to incorporate Taxpayer’s existing business, the Taxpayer transferred a nominal amount of cash and all of the sole proprietorship’s assets to Corp solely in exchange for Corp’s stock. Taxpayer was in control of Corp immediately after the transfer of cash because taxpayer became Corp’s sole shareholder. Thus, section 351 governed the tax consequences of the transaction.

The Court then turned to the payments made by Corp to the Taxpayer pursuant to the “exchange agreement.” Money distributed to a shareholder out of a corporation’s E&P is considered a dividend and shall be included in gross income. To the extent that a corporation has E&P, they are generally considered the source of corporate distributions.

Since the Court determined that the Taxpayer’s transfer of the sole proprietorship’s assets to Corp was a capital contribution, Corp’s payments to the Taxpayer in the years at issue must be treated as distributions, not installment payments. Because Corp’s E&P in each of these years exceeded the amount distributed to the Taxpayer, the distributions should have been treated as dividends for tax purposes.

Lessons

Generally speaking, it will usually be more advantageous for a transaction to be treated as a non-taxable event. However, if the taxpayer’s overall tax consequences will be more favorable if the transaction were taxable, then the taxpayer must plan carefully—especially where the transaction involves a transfer to a closely-held business entity.

If a sale is to be respected as such, the taxpayer must be mindful of the factors set forth above to avoid recharacterization of the sale as a capital contribution and dividends. (Of course, even a “successful” sale must be careful to avoid the related party sale rules.)  Alternatively, a taxpayer may consider failing the “control” requirement referred to above though this may be unattractive from a business perspective.

The bottom line, as always, is: plan in advance. It is often the case that the business goals sought may be accomplished and reconciled, at least in part, with the desired tax consequences.