They’re Still Here

Once upon a time, before the advent of limited liability companies (“LLCs”), taxpayers would occasionally acquire real property in a corporation rather than in a limited partnership.

The corporation may have been created to hold the real property, or it may have been an operating company that, for some misguided reason, decided to hold both its operating assets and its real property under the same corporate umbrella.

If the shareholders did not think to make an “S” corporation election for the corporation  within the two-and-one-half month period after its creation, the corporation would be treated as a taxable “C” corporation at least until the beginning of its next taxable year. If the corporation was profitable, it would generate earnings and profits (“E&P”), the distribution of which would be taxable to its shareholders. s corp

Despite the shift to the LLC in recent years, many of these real property-holding S corporations are still with us. In many cases, the corporation has sold its operating business, but has retained the real property in order to generate a stream of rental income for its shareholders.  Often in these situations, the fair market value of the property has appreciated significantly. In the meantime, the corporation’s basis in the property has been reduced as a result of depreciation.

The shareholders of these corporations would certainly prefer to convert their form of ownership of the property from a corporation to an LLC that would be treated as a partnership for tax purposes. Unfortunately, under the circumstances described above, such a “conversion” would cause the corporation and its shareholders to realize significant gain, as if the corporation had sold the property at its fair market value. If the corporation is still within its so-called “recognition period,”  then the gain would be taxable at both the corporate and shareholder levels. Alternatively, if the built-in gain period has expired, the gain from the conversion might be taxed as ordinary income to the shareholders, rather than as capital gain, under certain related party rules.

 For these reasons, the S corporation will generally remain in place. However, that is not to say that the corporation can be complacent, at least not if it has E&P.

Passive Receipts

The Code imposes a corporate-level tax on an S corporation for a taxable year if:

  1. More than 25% of its gross receipts for the year are “passive investment income,” and
  2. The corporation has accumulated E&P from tax years in which it was a C corporation.

The tax is imposed at the highest corporate tax rate, 35%.

Moreover, the corporation’s “S” election will be terminated whenever the corporation:

In light of the foregoing, the shareholders of an S corporation that has accumulated E&P, and that generates rental income from real property, must take action if they hope to avoid the corporate tax and to preserve the corporation’s “S” status.

Pay A Dividend?

There are two elements to consider:

  • The presence of E&P, and
  • The nature of the rental income.

E&P

If the E&P can be eliminated, the issue will be moot. For example, an S corporation that makes a distribution to its shareholders may elect, with the consent of the shareholders, to treat it as a C corporation dividend to the extent of its accumulated E&P (rather than as a distribution of AAA, first, then as a dividend). In this case, the corporation’s S status will not be effected.

Nature of Rental Income

Similarly, if the rental income is not treated as passive for purposes of the above rules, the tax will not apply and the loss of S corporation status may be avoided.  Over the years, the IRS has considered many situations involving the possible characterization of rental income as passive investment income. Most recently, the IRS reviewed a situation involving an S corporation (Corp) that owned, leased and managed certain commercial real estate property (the “Property”).

Is the S Corp Active?

Through its officers, employees and independent contractors, Corp provided certain services with respect to the leasing of the Property. These services included daily janitorial and rubbish removal services, regular maintenance, repairs and inspection covering plumbing, electrical and drainage systems as well as roofing, landscaping and building improvements. The services also included daily security services and management and control of all common areas, including parking lots and picnic table areas. Corp additionally negotiated and executed leases with tenants, settled tenant disputes and collected rents and monthly sales reports, negotiated bank loans and insurance contracts for the Property and performed background checks on prospective tenants.

The IRS stated that the term “passive investment income” means gross receipts derived from royalties, rents, dividends, interest, annuities, and sales or exchanges of stock or securities.

It also noted that IRS regulations provide that “rents” does not include rents derived in the active trade or business of renting property. According to the IRS, rents received by a corporation are derived in an active trade or business of renting property only if, based on all the facts and circumstances, the corporation provides significant services or incurs substantial costs in the rental business. Generally, significant services are not rendered and substantial costs are not incurred in connection with net leases.

Whether significant services are performed or substantial costs are incurred in the rental business is determined based upon all the facts and circumstances including, but not limited to, the number of persons employed to provide the services and the types and amounts of costs and expenses incurred.

Based solely on the description of Corp’s activities, above, the IRS concluded that the rental income that Corp received from its operations was not passive investment income that would trigger the imposition of the tax.

The IRS also added, as an aside, that the S corporation rules considered in the ruling (and described above) are independent of the passive activity rules; unless an exception under those rules applied, the rental activity would remain passive for purposes of those rules notwithstanding the conclusion that they were not passive for purposes of the for S corporation tax.

What’s An S Corp To Do?

What if Corp’s rental activity had been treated as passive under the S corporation rules? What if not all the shareholders consented to elect to an E&P distribution? In those cases, the S corporation must monitor its active and passive receipts. It may have to reduce its receipts from passive investment income, or it may have to increase its receipts from an active trade or business (perhaps by investing in such a business through a partnership), so as not to run afoul of the 25% threshold.

What is certain is that the S corporation and its shareholders cannot simply ignore the issue and hope that it is never discovered.

 

Why Speak to the Tax Adviser?

I don’t know about you, but most tax advisers hate surprises. I certainly do. Many taxpayers, on the other hand, seem to invite them. While I doubt that they look forward to being surprised, they often go into transactions without first looking into what the income tax consequences will be.

Truth be told, some transactions seem straightforward or innocuous enough, and, so, the taxpayer will say to him- or herself: “Self, I can handle this on my own. Why pay that tax adviser to worry me?”

That may be what one taxpayer thought in a recent decision where the Tax Court  considered whether a $1 million lump-sum payment made by a tenant was rental income to its landlord and, if so, whether the landlord could allocate the payment proportionately over the life of the lease.

 The Project

Taxpayer was the sole shareholder of an S corporation (Corp) that operated as a real estate development company primarily in the business of acquiring and developing real estate for use as medical centers. Tenant operated medical collection centers throughout the country.

In 2006, Corp and Tenant entered into a development agreement wherein Corp agreed to acquire real property in a location acceptable to Tenant and to construct a center pursuant to Tenant’s specifications.

In 2007, pursuant to the terms of the development agreement, Corp acquired title to a parcel of real property in its wholly-owned LLC (a disregarded entity for purposes of the federal income tax).  In order to fund the acquisition of the property and to facilitate the subsequent construction of the center, Corp took out a commercial loan with Bank for which Taxpayer was personally liable. Tenant was not liable on or obligated to make payments under the loan.

The Lease

In 2008, LLC and Tenant executed a lease whereby Tenant agreed to lease the center from LLC for 10 years. The lease required Tenant to pay a monthly base rent to LLC that was determined by a formula based on the “project costs” that Corp incurred in acquiring and developing the center. The lease allowed Tenant, on or before the commencement date, to elect to pay or reimburse LLC in a lump sum for any portion of the project costs. If Tenant made such an election, then, for purposes of determining the base rent, the project costs would be reduced by the amount of such payment. Because rent was a function of project costs, a lump-sum payment would reduce project costs, and consequently, reduce the amount of rent that Tenant owed under the lease. It was within the sole discretion of Tenant to make an election.

Tenant made a $1 million lump-sum payment to LLC pursuant to the election set forth in the lease. Taxpayer applied the $1 million lump-sum payment to the outstanding balance of the Bank loan.

The Tax Mess

Tenant issued to LLC a Form 1099-MISC reporting the aggregate monthly rent for the center for 2008 along with the $1 million lump-sum payment pursuant to the election provided by the lease. Taxpayer filed a Form 1040, U.S. Individual Income Tax Return, for 2008. On one of the Schedules E attached to the return, Taxpayer reported rents received that included the $1 million. Among the deductions that Taxpayer claimed on this Schedule E was a $1 million “contribution to construct” expense. In 2010, the IRS examined Taxpayer’s 2008 tax return. Corp requested that Tenant  amend the original Form 1099-MISC issued to LLC to treat the $1 million lump-sum payment as a “buy-down reimbursement” of construction cost. Tenant complied with the request. In 2011, The IRS issued a notice of deficiency for 2008, disallowing the claimed $1 million Schedule E deduction, and increasing Taxpayer’s basis in the center and allowing additional depreciation (presumably recoverable over thirty-nine years). Taxpayer petitioned the Tax Court.

Although Taxpayer initially reported this amount as rental income on one of his Schedules E, he now argued that this reporting was in error and that the $1 million lump-sum payment did not constitute rental income for 2008. Specifically, Taxpayer argued that the $1 million payment was not intended as rent by the parties to the lease but rather was meant to reimburse Taxpayer for leasehold improvements to the center.

The IRS argued that the $1 million payment received by the Taxpayer was rental income and was properly reported as such on Taxpayer’s 2008 return.

The Court

As a general rule, if a lessee pays any of the expenses of his lessor, such payments are additional rental income of the lessor. Similarly, if a lessee places improvements on real estate which constitute, in whole or in part, a substitute for rent, such improvements constitute rental income to the lessor. Whether or not improvements made by a lessee result in rental income to the lessor in a particular case depends upon the intention of the parties, which may be indicated either by the terms of the lease or by the surrounding circumstances. However, when a lessee pays an expense or obligation incurred by the lessor in bringing the leased property into existence, there is a direct economic benefit to the lessor to the extent that the lessor is relieved of his or her financial obligations. Under these circumstances there is no ambiguity regarding the financial benefit that the lessor receives. That being the case, there need be no inquiry into the intent of the lessor and lessee unless the lessee’s payments were unrelated to the lease.

In the instant case there was no question that the $1 million lump-sum payment was:

  • Made pursuant to the terms of the lease;
  • Optional at the election of the lessee;
  • To “reimburse” the lessor for “project  costs” (including financing, hard and soft construction costs) incurred and paid by the lessor in bringing the property into existence; and
  • The cause of a reduction of the lessee’s future rents otherwise due.

Given these facts, the $1 million lump-sum payment constituted rent without the need to inquire into the subjective intent of the parties.

The Tax Adviser?

So much for simple and straightforward.

So, what might a tax adviser have said to the taxpayer in these circumstances? In the first instance, the advisor would have informed the taxpayer that the receipt of the lump sum payment was taxable. In effect, the lease provided that rents would be reduced in consideration of the lessee’s payment for the capital improvements constructed by the lessor.

The advisor might then have suggested some alternative options.

What if the lessee had agreed to make some of the improvements and there had not been an explicit reduction in the rent payable? As discussed above, the parties’ intent would then have to be determined.  Each of the parties will own certain improvements. Provided the lessee has no obligation to pay for the lessor’s improvements, and the lease does not treat the lessee’s improvement obligation as a rent substitute, the lessor should not realize additional rental income.

What if the lessor had offered the lessee a rent holiday? Provided it was not tied to the improvements to be made by the lessee, the lessor may escape the recognition of income.

What if the lessee’s payment was structured as “prepaid rent” within the meaning of IRC Sec. 467? For example, A and B enter into a rental agreement that provides for a 10-year lease beginning on January 1, 2015, and ending on December 31, 2024. The rental agreement provides for accruals of rent of $10,000 during each month of the lease term; $120,000 is allocated to each calendar year. The rental agreement provides for a $1.2 million payment on December 31, 2015.

The rental agreement provides prepaid rent because the cumulative amount of rent payable as of the close of a calendar year exceeds the cumulative amount of rent allocated as of the close of the succeeding calendar year. For example, the cumulative amount of rent payable as of the close of 2015 ($1.2 million is payable on December 31, 2015) exceeds the cumulative amount of rent allocated as of the close of 2016, the succeeding calendar year ($240,000). Accordingly, the rental agreement is a so-called “section 467 rental agreement.” As such, the prepaid rent may be accrued proportionally over the term of the lease, provided certain other requirements are satisfied.

The bottom line is: talk to your tax adviser. You may be pleasantly surprised (which is OK).

 

Yesterday we reviewed the IRS’s determination that a nonstatutory stock option (NSO) violated Section 409A. Today we will review the income tax consequences of such failure.

Taxes

Income Inclusion under Section 409A

Section 409A provides that, if at any time during a taxable year a nonqualified deferred compensation plan fails to meet certain distribution-timing requirements, or is not operated in accordance with such requirements, all compensation deferred under the plan for the taxable year and all preceding taxable years shall be includible in gross income for that taxable year to the extent it was not subject to a substantial risk of forfeiture (i.e., it was vested) and was not previously included in gross income.

If the NSO that fails under Section 409A remains unexercised and outstanding on the last day of the employee’s taxable year, the total amount deferred under the NSO for the taxable year is the excess of the FMV of the underlying stock on the last day of the taxable year over the sum of the NSO’s exercise price plus any amount paid for the option.

Any amount deferred that remains unvested as of the end of the taxable year of the section 409A failure is not subject to income inclusion under section 409A for the taxable year.

As we reviewed yesterday, an amount that is vested is includible in income under section 409A for a taxable year only if the plan fails to meet the requirements of section 409A during the taxable year. Whether a plan fails to meet the requirements of section 409A during a taxable year is determined independently of whether the plan fails to meet the requirements during a previous or subsequent taxable year. Accordingly, the consequences of a section 409A failure are determined independently for any particular taxable year during which the failure occurs or continues to occur, without regard to such consequences affecting any other taxable year.

The IRS Advisory’s Application of 409A

Returning to yesterday’s discussion, because Option failed to meet the requirements of section 409A, the total amount deferred under Option at the end of the taxable year of the Section 409A failure was includible in Employee’s income under section 409A to the extent it was not subject to a substantial risk of forfeiture (i.e., it was vested) as of the end of the taxable year and it was not included in income for a prior taxable year.

Here, the taxable year of the section 409A failure was Year 3, the year under exam. Although Option failed to meet the requirements of section 409A from the grant date, the statute of limitations on assessment had expired for Years 1 and 2. The consequences of the section 409A failure were determined independently for Year 3 without regard to the consequences affecting any other taxable year (except that Employee would receive credit for any amounts included in income under section 409A for a prior taxable year – none in this case).

By the end of Year 2, some of the Option Shares had vested and Taxpayer had partially exercised Option to purchase shares. Other Option Shares had vested and were purchased during Year 3.

The Option Shares that remained unvested at the end of Year 3 were subject to a substantial risk of forfeiture for purposes of section 409A as of the end of Year 3 and, therefore, were not subject to income inclusion under section 409A for Year 3.

However, because the section 409A failure would continue to occur until the end of the taxable year during which these Option were fully exercised or expired, the deferred amounts applicable to such Options Shares would be subject to section 409A inclusion beginning with the subsequent taxable year during which they vested.

Compensation related to Employee’s purchase of Year 2 exercised Option Shares was not subject to section 409A for Year 3 because it did not constitute an amount deferred (or a payment) under Option during Year 3. However, compensation related to Employee’s purchase of Year 3 exercised Option Shares was subject to section 409A for Year 3 because it constituted a payment of amounts deferred during Year 3.

Accordingly, the total amount deferred under Option for Year 3 that was subject to income inclusion under section 409A for Year 3 was comprised of two components: (1) the portion that was vested and deferred (that is, unexercised and outstanding, including any shares that had vested in Year 2 but were not exercised) at the end of Year 3, and (2) the portion related to payments of amounts deferred under the Option as the result of its exercise during Year 3.

For purposes of determining the amount includible in income under section 409A related to the portion that was vested and deferred (but not exercised) at the end of Year 3, calculate the excess of the FMV of Employer’s stock on the last day of Year 3  over the Exercise Price for the Option.

For purposes of determining the amount includible in income under section 409A related to payments of amounts deferred under the Option (that is, as the result of exercise) during Year 3, calculate the excess of the FMV of the Year 3 exercised shares on the date of exercise over the sum of the Exercise Price for the Option.

The Importance of Determining FMV

Pretty straightforward, right? (Take a deep breath, clear your head.)

Now, imagine the shock of a key employee upon learning that the vested NSO that he or she was granted is not compliant with Section 409A because its strike price is less than the FMV of the underlying share of stock at the time of its grant.

What was intended to be a benefit and incentive to the employee, for the purpose of aligning his or her interests with those of the business owners, turns out to be an expensive proposition. The option spread will be included in the employee’s income in the year the option vests (as will any “appreciation” in the spread in later years), thereby generating a tax liability. He or she must find the liquidity with which to pay the tax (plus an additional 20% penalty tax). If the option is exercised, will the employee be able to put the shares to the business in order to raise some cash? Ultimately, it is likely that the employer will have to bear this cost.

In light of the foregoing, it is imperative that the valuation of the option shares be taken seriously. According to IRS regulations, a private company may use a “reasonable application of a reasonable valuation method” in determining the fair market value of its stock for purposes of Section 409A.

Whether a valuation method is deemed reasonable by the IRS will depend on the facts and circumstances, but, in order to be considered reasonable, the method employed must take into consideration all material information available at the time of the determination.  A number of factors may be considered in this analysis. It would certainly behoove an employer to secure the assistance of a qualified appraiser (and tax adviser) to provide some certainty with respect to Section 409A compliance, and to avoid the tax consequences in the advisory described above.

Incentive Compensation

It is not uncommon for a closely-held business to provide an economic incentive to its key employee. Often, the incentive takes the form of an annual cash bonus. Alternatively, the business may provide the key employee with a longer-term incentive, in the form of a deferred compensation arrangement that may be payable on retirement or upon the sale of the business. In other situations, the key employee may be granted an equity interest in the business, or the right to purchase such an interest.

In each of these scenarios, both the employer and the employee must pay close attention to the rules and principles that govern the income tax treatment of the compensation arrangement. Only by doing so can the employee avoid being taxed prematurely on (i.e., before its actual receipt of) the value of the compensation provided. Where the incentive granted is an option to purchase equity in the business, the parties must be especially aware of IRC Sec. 409A.

Section 409A, In Brief

Under Section 409A, all amounts deferred under a nonqualified plan (for both the current and all preceding taxable years) are currently includible in the employee’s gross income to the extent they are not subject to a “substantial risk of forfeiture”—in other words, to the extent that 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 or the sale of the business – unless certain requirements are satisfied relating to the timing of the distribution of the deferred compensation.  Stock-Protection-Using-Stock-Options

The Options At Issue

A recent IRS advisory reviewed the income tax consequences of one equity-based compensation arrangement.  The advisory arose out of an examination of the “Employee’s” tax return for Year 3. Two years prior to the tax year under examination (Years 1 and 2), “Employer” had granted Employee a nonstatutory stock option (“Option”) to purchase a certain number of shares (“Option Shares”) of Employer’s common stock. These two tax years were closed at the time the IRS examined Year 3.

Employer and Employee executed an option agreement (“Agreement”) providing for the grant of the Option under the terms of a “Plan.” Plan provided that the Option would be granted on Date.

The consideration for the grant of Option was Employee’s provision of future services to Employer. Employee was not required to pay any additional amount in exchange for grant of Option.

The option agreement provided that “Exercise Price” was the strike price per Option Share.

Under the terms of the option agreement, a certain number of Option Shares would vest each year following the grant date. The vested Option Shares could then be exercised at any time during a specified number of years from the vesting date.

Two days prior to Date, Employer’s common stock began trading on an over-the-counter market.  Trades made on Day 1, Day 2, and on Date were on a “when, as and if issued” (commonly called a “when issued”) basis.

The lowest when-issued trading price for Day 1, Day 2, and Date was at least $X more than Exercise Price. On Date, the lowest when-issued trading price was over $Y more than Exercise Price.

Employee became vested in a number of Option Shares in Year 2 and in Year 3, and exercised Option as to these shares.

Section 409A Failure

The Section 409A regulations provide that an NSO to purchase a fixed number of shares of employer stock is not treated as a nonqualified deferred compensation plan subject to section 409A (and therefore is exempt from section 409A) if the exercise price is not less than the fair market value (“FMV”) of the underlying stock on the grant date of the option and certain other requirements are met.

Conversely, if the exercise price is less than such FMV, the option is treated as a nonqualified deferred compensation plan subject to section 409A that must meet the time and form of payment requirements under the section 409A regulations.

A nonqualified deferred compensation plan subject to section 409A(a) must provide, upon adoption of the plan, for a deferred amount to be paid at a time and in a form meeting the section 409A time and form of payment requirements. To satisfy the time and form of payment requirements, the plan must designate that a specified nondiscretionary and objectively determinable deferred amount may be paid only upon a specified (or the earlier or later of certain specified) permissible payment event (or events), such as a specified time or date, death, disability, separation from service, or a change in control event, or a permissible period following the applicable payment event.

For an NSO that is treated as a nonqualified deferred compensation plan, the terms of the option must designate the nondiscretionary and objectively determinable number of shares that may be purchased through full or partial exercise of the option upon a permissible payment event, or a permissible period following the payment event.

For purposes of determining the FMV of employer stock underlying an NSO intended to be exempt from section 409A, the regulations provide that, for stock that is readily tradable on an established securities market, the FMV of the stock on the grant date of the option is determined based on a reasonable method using actual transactions in the stock as reported by the established securities market.

The regulations further provide that, for employer stock that is not readily tradable on an established securities market, the FMV of the stock on the grant date of an NSO is determined based on the reasonable application of a reasonable valuation method, taking into consideration events occurring after the date of the calculation that may materially affect the value of the employer stock.

Employer’s common stock was traded on a when-issued basis on an OTC market on Date (the grant date of Option). According to the IRS, the OTC market on which Employer’s stock was traded was an established securities market for purposes of Sec. 409A. Therefore, the stock underlying the NSO was treated for purposes of section 409A as having been readily tradable on an established securities market on the grant date of Option.

However, the IRS found that the FMV of a share of Employer’s stock on Date, the grant date of Option, was higher than Exercise Price, the strike price per Option Share under the terms of the option agreement.

As a result, the Option did not meet the regulatory requirements for exemption from section 409A. Thus, the Option was treated as a nonqualified deferred compensation plan subject to section 409A from the grant date until the end of the taxable year during which the Option was either fully exercised or expired.

Because the Agreement generally provided that Option Shares could be purchased through Option exercise at any time following vesting, the Option terms did not designate a permissible payment event as the only time that Option Shares could be purchased. Therefore, Option failed to meet the requirements of Section 409A from the grant date.

Check in tomorrow for a discussion of the income tax consequences arising from this failure.

Part I of this post can be found here.

Potential Transferees

Now that the disgruntled shareholder has decided to transfer his or her shares to an ineligible shareholder, the transferee must be selected, as must the method of transfer.

This is a very critical point in the process because the shareholder must balance two competing desires:  on the one hand, the corporation’s loss of its “S” status and its impact upon the majority shareholders, and, on the other hand, the shareholder’s loss of his or her equity.

The transfer must be real and bona fide; it must have economic reality, and must represent a real transfer of beneficial (as well as legal) ownership. It cannot be a mere formal device; if it is, the IRS may disregard it as a sham or otherwise.

Furthermore, a state court may not respect the transfer (e.g., treating it as a breach of a shareholder’s fiduciary duty).  However, it is unclear how the IRS and the federal courts would react to that – there have been instances going both ways.

The Transferee

Turning to the nature of the transferee, there are several options to consider.

LLC

Transferring to a single member LLC would not work because the shareholder would still be treated as the owner of the stock (unless the LLC elected to be taxed as a corporation).

Partnership

Transferring to a partnership between the shareholder and his or her spouse could work since a partnership is not a permitted S corp. shareholder. However, if the partnership lacks any other business activity, it may be disregarded as a separate entity; instead, the spouses may be considered as joint-owners of the stock (which is generally permitted for S corps).

Trusts

A transfer to a revocable trust would not work because revocable trusts are treated as grantor trusts, and the shareholder would continue to be treated as the owner of the shares.

A transfer to an irrevocable trust may work, provided it is structured in a way so as to avoid grantor trust status (though the transfer may result in a taxable gift).

In the case of a transfer to an irrevocable trust, the extent of the trustee’s powers will depend, in part, upon the trustee selected, with an “independent” person allowing for more flexibility without triggering grantor trust status.   The shareholder generally cannot act as a trustee and also disqualify the trust as an S corp. shareholder – rather, the trust would likely be treated as a grantor trust, with the shareholder as the deemed owner of the stock.

It is also important to note that whoever the trustee is, he or she may be able (or may be required as a fiduciary) to make tax elections for the trust, including an ESBT election (which would defeat the shareholder’s goal of disqualifying the S corporation).

Conflicting Goals?

Most minority shareholders will typically want to eat their cake and have it too. They want to retain control and maximum flexibility over whatever vehicle owns the stock.

That leaves us with a corporation. The shareholder may be the sole shareholder of a newly-formed corporation, and may serve as its sole director and officer.

The new corporation may file its own S election.

A corporation, including an S corporation, cannot hold shares of stock in an S corporation without causing the loss of the latter’s S status.

The transfer of stock to the new corporation will terminate the S corp. election.

It will be important that the new corporation not be a mere nominee for the shareholder’s beneficial ownership of the stock.  Rather, it must have economic substance, which may be accomplished by having it acquire other investments.

Certainly, all of the corporate formalities in dealings between the shareholder and the new corporation must be respected.

Aftermath?

For the year of the lost election, the S corporation would have to “notify” the IRS of the loss of its status on its tax return. It would file a final S corporation return and an initial, short year C corporation return.

In the event the shareholder comes to a resolution with the majority shareholders, however, it should be possible to rescind the transfer of the stock, meaning the new corporation would return the stock to the shareholder and return him or her to their position as the owner thereof.

This must occur in the year of the “disqualifying” transfer if the shareholder is going to have a chance at arguing that the original transfer should be disregarded for tax purposes. A later return of the stock to the shareholder may be a taxable event as to the shareholder.

Corporation’s Response

In the absence of a resolution, the shareholder can count on the fact that the other shareholders will refuse to notify the IRS, or even sue to void the stock transfer. If they are well-advised, they will seek to attack the disqualifying stock transfer as a sham, as a transfer to a nominee, as a breach of fiduciary duty that should be revoked, etc.

It is difficult to predict the ultimate result. Generally, the minority shareholder is aiming for the threat and for the tax/economic uncertainty it will create for the other shareholders.

Shareholder’s Counter

What if the majority shareholders ignore the disqualifying transfer?

The minority shareholder may file an IRS Form 8082, “Notice of Inconsistent Treatment,” notifying the IRS that he or she is treating the corporation’s income in a manner that is inconsistent with the Sch. K-1 issued to the shareholder.  On that form, the minority shareholder would explain that the S corporation lost its tax status with the transfer of its stock to a non-qualifying shareholder.

The shareholder also may consider alerting the majority shareholders that he or she plans to file the Form 8082 to put the IRS on notice if they do not file a final S corporation return.

Conclusion

There is a lot to digest here, and there are a number of strategic decisions for the disgruntled shareholder to make, preferably in conjunction with his or her litigation and tax counsel.

The better, and ultimately less expensive, course would have been for the shareholders to have entered into well-drafted shareholder agreement at the inception of their relationship. An agreement that addresses distributions, rights of first refusal, put rights, stock valuation, and mechanisms for dispute resolution is priceless.

During the course of the year, we encounter a number of shareholder disputes. Sometimes we represent a minority shareholder; sometimes we represent the corporation or the majority shareholders. shareholderlit-300x263

Regardless of who the players are, the resolution of the dispute will involve some economic deal. The economic deal, in turn, will depend in no small part upon the tax consequences.

Today’s post will review some of the tax considerations that are unique to S corporations – in particular, those that may result from the loss of the corporation’s “S” status.

 S Corps

Most folks are aware of the requirements for an S corporation, including the limitation on who may be a shareholder.  Generally speaking, only the following persons may hold shares of stock in an S corporation:

Shareholders’ Agreement

Well-advised shareholders and their S corporations will have entered into agreements by which the shareholders are prohibited from transferring, and the corporation is prohibited from issuing, shares of stock to ineligible persons.

Not all shareholders, however, are well-advised.  In many situations, the shareholders are unable to agree on all of the terms of a proposed shareholder agreement – it becomes an “all-or-nothing” proposition – and, so, they fail to adopt any of them, including restrictions on the transferability of the corporation’s stock.

In other situations, they simply refuse to spend the time and money on preparing an agreement, relying instead upon their “relationships” with one another.

Disgruntled Shareholder

This state of affairs provides a potential weapon to a disgruntled taxpayer, as he or she may then be free to cause the corporation to lose its “S” status by the transfer of just one of his or her shares.

Sounds simple, right?   Not necessarily.

Give Up Rights

The shareholder must first resign him- or herself to a transfer of some or all of his or her equity in the corporation. This includes the transfer of any economic rights that the transferred shares may eventually realize (as, for example, on the sale of the S corporation’s business), as well as any voting rights (which may, in some circumstances, carry a potential swing vote).

Such transfer may be done by way of a gift to a related person, which may be subject to gift tax, or by way of a sale to a related person, which may be subject to income tax.

(Note that we are assuming related persons as transferees – after all, why would an unrelated person agree to step into a closely-held corporation as a minority shareholder and why, under the circumstances, would the transferor give up all potential influence over the shares?)

Trigger Event(s), Goals

In most cases, the impetus for the disqualifying disposition is the shareholder’s inability to control or benefit from his or her economic investment in the corporation.

The shareholder is a minority shareholder, is likely not an officer with decision-making authority, and may not even be an employee.

In contrast, the “insider” shareholders who control the corporation are directors and officers, and are being paid a salary.

There is no shareholders’ agreement and, so, there are no mandatory corporate distributions to the shareholders to at least enable them to pay their tax liabilities arising from the flow-through to them of their pro rata share of S corporation income, let alone realize an economic return on their investment.  This forces the shareholder to use his or her other assets to pay the income tax liability.

In these circumstances, there is no mechanism by which a shareholder can force the redemption or cross-purchase of some or all of his or her shares.  Again, in the case of a closely-held corporation, the only real market for its shares is among the other shareholders.

The foregoing scenarios typically do not arise in a vacuum.  They are likely coupled with other disagreements (family, personal, etc.) between the disgruntled minority shareholder on the one hand, and one or more controlling shareholders on the other.

“Revoking” the S- Election: Immediate Consequences

The minority shareholder eventually reaches the point at which he or she feels that there is no choice but to “attack” (or threaten to attack) the other shareholders.

An easy way to do this is to destroy the corporation’s “S” status.

By causing the corporation to become a C corporation, he or she will cause the corporation’s income and gains to be subject to two levels of tax, once at the corporate level, and a second when the after-tax corporate profit or gain is distributed to the shareholders (including the disgruntled shareholder).

This may not matter much where the corporation pays out significant (but “reasonable”) compensation to the controlling shareholders, where the corporation is not in the habit of making dividend distributions anyway, or where the corporation is not planning to sell its business.

On the other hand, cutting off the flow-through of S corporation income to the minority shareholder, and the resulting income tax liability and economic loss,  can be a significant benefit.

However, this benefit must be weighed against the potential exposure to the minority shareholder arising from the rules applicable to  the allocation of any corporate income or gain realized for the year in which the election is lost.  Specifically, the remaining shareholders could cause large taxable events later in the year, a portion of which will be allocated to the S-corp. portion of the year, thereby impacting the minority shareholder for that part of the year.  This may leave the minority shareholder with an even larger tax bill (closing the books is not an available option without the consent of the other shareholders).

Asset Sale

Where the corporation may be contemplating a sale of its business in the foreseeable future, the loss of its “S” election is likely going to have a significant impact.

In contast to an “S” corporation seller, a “C” corporation seller will be subject to a corporate level tax on its taxable income and gains. With zero-to-low basis assets like goodwill and going-concern value, this means a significant reduction in the net proceeds from the sale that may then be distributed to the shareholders.

Depending on the nature of the business, it may be possible to structure a sale in a way that avoids some of these adverse consequences.  Some examples include:  a stock sale, a sale of personal goodwill, or a compensation agreement with the key shareholder-officer—anything that bypasses the C corporation level.

The corporation’s distribution to its shareholders will be subject to federal tax at a 20% capital gain tax rate, plus a 3.8% surtax on net investment income. The latter may have been avoided in the case of an S corporation, at least as to its materially participating shareholders.

The loss of the S election will also deprive the corporation and some of its potential buyers of the ability to make a § 338 (h)(10) election or a § 336(e) election, to treat a stock sale as an asset sale and corporate liquidation. This may impact the sales price for a stock sale since it will restrict the buyer’s ability to recover its investment.

Other S-Corp. Tax Consequences

The shareholders may lose the benefit both of any suspended S corporation losses and any undistributed AAA.

If the election is lost, there is a five-year period before “S” status may be elected again.  Moreover, this second election would require the consent of the disaffected shareholder, assuming he or she is still around.

Finally, on the “re-election” of S status, the corporation’s assets would start a new built-in gain recognition period.

“Cutting Your Nose, . . .”

Of course, the disgruntled shareholder will be hurting him- or herself by causing the loss of the S election.  There are times however, where “rational” behavior is not to be expected; viewed differently, the course taken may actually be rational under the circumstances – the shareholder is using the potential loss of S status and the consequences therefrom as leverage in his or her negotiations with the corporation and the other shareholders.

Stay tuned for Part II, tomorrow, for what happens once the decision to “break” the election has been made.

For most closely-held businesses, and especially for those that are newly-formed, the infusion of capital is of paramount concern because it may be needed to fund start-up costs, operations and, eventually, expansion. In some cases, the capital may be obtained from investors in exchange for an equity interest in the business; in others, the capital may take the form of a loan. Either way, the parties to the financing transaction must agree as to the nature of their relationship or transaction, they must be aware of its potential income tax consequences, and they must structure and memorialize the transaction accordingly.

A recent decision of the Tax Court described an unusual set of circumstances in which an individual taxpayer borrowed funds that he then transferred to his start-up business.snoopyirscartoon

Popular Guy

Taxpayer cofounded Business in 1996. As cofounder, Taxpayer served in various roles, including president, chief executive officer, and director.

At about the same time, Corp was in desperate need of an experienced executive to manage its operations. Corp was impressed with Taxpayer and began courting him as a candidate for Corp’s executive position in late 1997.

Taxpayer met with Corp to discuss the executive position. Taxpayer explained that he intended to stay in Business because, as the cofounder, he owed a duty to its financial well-being and to its employees.

Unusual Arrangement

Despite Taxpayer’s initial hesitancy to join Corp, Corp did not stop pursuing him. In January 1998, in order to induce Taxpayer to join Corp, Corp made him an offer that included a salary, employee benefits, and a loan of $X (the Loan). The parties understood that, if Taxpayer accepted the offer, he would lend the $X to Business in order to support its operations. Corp required that the Loan be made to Taxpayer—and not to Business—because Corp did not want to have any financial dealings with Business’s board of directors.

Taxpayer met with Business’s directors to advise them of Corp’s proposal. Taxpayer also advised them that, in addition to providing the loan for Business, Corp was interested in contracting with Business for operations and technical support services. Up until this date, Business had sought and obtained equity investors but nevertheless still needed additional funds to continue and grow its operations. Business ‘s directors approved Corp’s arrangement, and Taxpayer accepted Corp’s offer.

Taxpayer and Corp executed an employment agreement in May 1998. The agreement allowed Taxpayer to continue to serve as a director and CEO of Business. Additionally, the agreement stated that the Loan would become due if Taxpayer’s employment with Corp was ever terminated.

In September 2000, Corp sold its interest in the Loan to its parent company (“Parent”).

As agreed in the employment agreement, after Taxpayer received the Loan, he lent $X to Business. Additionally, shortly after Taxpayer began his employment with Corp, Business began to receive sizable contracts from Corp. By the end of 1999 Business’s contractual arrangements with Corp generated approximately 60% of Business’s revenue.

However, in late 2000 it became apparent that Taxpayer was needed to manage Business full time because of its rapid growth. Consequently, in May 2001—with Corp’s approval—Taxpayer resigned his position with Corp. Taxpayer’s resignation from Corp triggered his repayment obligations as to the Loan under the employment agreement. Corp and Parent did not demand repayment of the Loan at that time, nor did Taxpayer receive a Form 1099-C, Cancellation of Debt, from Corp or Parent discharging the Loan. The “terms” of the Loan were not amended.

Taxpayer Runs Into Trouble

In 2001, Corp received significant government financing, with which it began to hire its own operations and technical staff, thereby reducing its reliance on Business. As a consequence, Business’s performance suffered, forcing Taxpayer to reduce expenses, cut salaries, and lay off employees.

In February 2002, Business filed a petition with the Bankruptcy Court. In July 2009, the Court entered its final decree ending the bankruptcy and Business was dissolved.

In February 2005, Taxpayer went back to work for Corp.

The IRS Audit

In October 2008, Taxpayer filed a Federal income tax return for 2007. In 2010, in connection with an audit of Corp’s return, the IRS commenced an audit of Taxpayer’s return for 2007. (Please note that the examination of the return of the unrelated lender led to the audit of the borrower’s return. You never know. You need to be prepared.)

In 2011, Corp met with Taxpayer and notified him that the Loan was still due and owing. Taxpayer then arranged to begin making payments on the Loan via payroll deductions from his Corp paycheck.

In March 2013, the IRS sent Taxpayer a notice of deficiency for 2007 determining that Taxpayer had failed to report cancellation of debt (“COD”) income as to the Loan. Taxpayer filed a petition with the Tax Court appealing the IRS’ determination.

Cancellation of Debt

The Code defines the term “gross income” broadly to mean all income from whatever source derived, including income from discharge of indebtedness. Whether a debt has been discharged depends on the substance of the transaction. As always, mere formalisms arranged by the parties are not binding in the application of the tax laws.

The moment it becomes clear that a debt will never have to be paid, that debt must be viewed as having been discharged. The test for determining that moment requires a practical assessment of the facts and circumstances relating to the likelihood of payment and often turns on the subjective intent of the creditor. Any identifiable event that fixes the loss with certainty may be taken into consideration.

The IRS argued that Taxpayer realized COD income in 2007 from forgiveness of the Loan. In support of that position, the IRS relies on Corp’s and Parent’s failure to take collection action after the Loan became due and before the period of limitations for collection expired (the period of limitations for collection of the Loan expired in 2007). Such inaction, the IRS argued, manifested the intention of Corp or Parent to forgive the Loan.

Taxpayer argued that the Loan was not discharged in 2007 because it was still outstanding and was being repaid.

Credible Testimony

Taxpayer and Corp’s president testified regarding the Loan. “Having observed their appearances and demeanors at trial,” the Court  found “their testimonies on this issue to be honest, forthright, and credible.” Corp’s president testified that Parent considered the Loan outstanding and that he was confident that Taxpayer would repay it. Additionally, Taxpayer testified that he was specifically told by the president that the Loan was still due and owing. Taxpayer further testified that he was currently repaying the Loan via payroll deductions from his paycheck. Furthermore, Taxpayer correctly pointed out that if the Loan had been forgiven, Parent would have a strong incentive to report the loan as discharged so that Parent could benefit from a bad debt deduction. Yet Taxpayer testified that he did not receive a Form 1099-C from Parent discharging the Loan.

Addressing the IRS’s statute of limitations argument, the court stated that although, under some circumstances, the expiration of a State limitations period can serve as an identifiable event, it is not conclusive as to when a debt has been discharged. This is because the expiration of the period of limitations generally does not cancel an underlying debt obligation but simply provides an affirmative defense for the debtor in an action by the creditor.

Because Parent and Corp never treated the Loan as canceled or otherwise forgiven, and in light of the fact that Corp’s president credibly testified that the Loan was still outstanding, the Court concluded that Taxpayer had no COD income in 2007 with respect to the Loan because it was still outstanding and was being repaid.

Consistent Treatment

The foregoing highlights the importance, from a tax perspective, of how the parties to a transaction each view the transaction. Both the Taxpayer and Corp acted consistently in their treatment of the Loan. They both understood the nature of the financial arrangement into which they entered: it was a loan to be repaid.

Although the Court’s opinion did not go into much detail, it appears that the Loan was not evidenced by a separate note (rather, it was part of the employment agreement). No mention was made of its bearing a reasonable rate of interest, of interest being paid (or even imputed for tax purposes), or of the Loan’s being secured. It also appears to have been a term loan, although the term was fixed only in reference to the Taxpayer’s period of employment, and not as a set number of years.  Additionally, the Loan does not seem to have been serviced prior to the IRS audit.

Lesson?

Against these facts, the intention and subsequent actions of the parties, as well as their credibility, was all-important. Without such factors, the Court could easily have found that there was COD income in 2007. Indeed, but for the fact that the 1998 tax year was long closed, the IRS would have argued and the Court would, I believe, have treated the Loan as compensation to the Taxpayer.

I wouldn’t want to rely upon these factors, alone. Give me something that is objectively determinable and contemporaneous with the transaction at issue, something that is consistent with what the transaction purports to be. If it’s supposed to be a loan, treat it like a loan.

Time For A Change?

At some point in its existence, a corporate-owned business– even one that is closely held– may have to reconsider its corporate structure. What may have started out as a single corporation, with one line of business, and operating at one location, has grown into a holding company with multiple corporate and LLC subsidiaries, each operating a separate function within a unitary business, or each operating a different line of business or out of a different location.

As the business develops, and as its shareholders change, as the relationships among the various subsidiaries and the owners evolve, the structure into which the business has grown may no longer be efficient or optimal from an operational or managerial perspective, from a profit-generating perspective, or from the perspective of a potential buyer.

Reorganizing

At that point, the corporation’s directors, officers and shareholders may decide (after consulting with their accountants, bankers and other advisers) to adopt a different corporate structure. This may involve the creation of new entities, the elimination of some entities, and the “relocation” of others. It also may involve the relocation, within the corporate structure, of certain assets or lines of business.

Whatever the form of the restructuring, provided it is undertaken for a bona fide business purpose, it may be possible to effect the desired change without incurring an income tax liability for either the entities involved or for their ultimate owners. Generally, this may be accomplished by complying with the statutory and regulatory requirements for a so-called “tax-free” reorganization. Simply put, these requirements seek to ensure that the taxpayer is not exchanging property for other property that differs materially in kind – rather, the taxpayer’s investment in the business is continuing, albeit in a different form.

Step Transaction

I say “generally” because, over the years, the IRS has often applied various judicially-developed doctrines that ignore the form of the transaction chosen by the taxpayer and, by doing so, disqualify the transaction, in whole or in part, from tax-free treatment. One doctrine, in particular, has played an active role in the reorganization arena: the step transaction doctrine. steps

Under this doctrine, a set of pre-arranged transactional steps (some of which may lack economic substance) may be collapsed or stepped together to arrive at the same end-result, though with a less favorable income tax outcome for the taxpayer.

The problem from the taxpayer’s perspective is the uncertainty inherent in the application of the doctrine. Those transactions that include steps that are undertaken solely for their tax consequences are clear candidates. Others are more difficult to ascertain, and that uncertainty as to tax result could have a freezing effect on bona fide business reorganizations .

The IRS Relents, A Bit

However, the IRS gave taxpayers some relief when it refused to apply the step transaction doctrine in a recently-issued public ruling.

In the ruling, corporate Taxpayer was a holding company that owned two direct subsidiaries (brother-sister corporations S1 and S2), one of which (S2) owned three direct subsidiaries (X, Y and Z, also brother-sister corporations). For good business reasons, Taxpayer decided to combine the operations of S1, X, Y and Z into a new subsidiary formed by S2 (Newco).

In furtherance of that plan, Taxpayer transferred all of the S1 stock to S2 in exchange for additional S2 shares. S1, X, Y and Z (all of which were owned by S2 at that point) then transferred all of their assets to Newco in exchange for Newco stock, and then liquidated, distributing Newco stock (their only asset) to S-2 (basically, a sideways merger of S1, X, Y and Z into Newco). Newco (now a subsidiary of S2) continued to operate the business formerly conducted by S1, X, Y and Z.

In an earlier ruling, involving identical facts, the IRS did not respect the Taxpayer’s transfer of the S1 stock to S2  as a tax-free contribution to S2’s capital [IRC 351]; instead, it ignored that step and treated the transaction as a direct acquisition by Newco of the S1 business assets in exchange for Newco stock. As a result, it became more difficult (though not impossible) for the recast transaction to qualify as a tax-free exchange.

In reversing its position, as set forth in the earlier ruling, the IRS held that a transfer of property to a corporation in exchange for its stock may be respected as a tax-free exchange even if it is followed by a subsequent transfer of the property as part of a pre-arranged, integrated plan.

The IRS quickly added, however, that the transfer will not be respected “if a different treatment is warranted to reflect the economic substance of the transaction as a whole” – for example, where an exchange is without substance for tax purposes and was entered into for the purpose of enabling a taxpayer to achieve a favorable tax result.

Planning

How much comfort can a taxpayer take from the IRS’s ruling? The ruling seems to say that the IRS will respect the form of a taxpayer’s transaction, and that it will not seek to recharacterize the transaction under the step transaction doctrine, except where it has a good reason to do so.

OK, so what has changed? The IRS will not ignore or collapse steps that have economic (as opposed to mere tax) significance solely because doing so may generate more revenue for the federal coffers.  That’s good to hear, but what guidance does this provide to the closely held business that is thinking about reorganizing its business structure?

As a general rule, the guiding principle for taxpayers and their advisers remains the same: Figure out what needs to be done from a business perspective first. Where do you want to end up? How can you get there? What is the economic, including tax, cost of doing so? Is there a transaction by which the tax cost may be reduced? If a certain transaction step generates a tax benefit, be certain that it also has independent economic substance, or a bona fide business purpose, in order for the transaction to withstand IRS scrutiny. One must be especially diligent where the transaction involves a series of related steps among related parties, as in the context of a non-acquisitive reorganization.

The bottom line, as always: consult your tax advisers early on.

Passive Activity Losses

The “passive loss rules” are aimed at preventing individual taxpayers from using their losses from passive activities to offset their income from active businesses. The rules operate by “disallowing” the current deduction of passive losses – the excess of an individual taxpayer’s losses from passive activities for the year over his or her income from such activities for the same year.

This excess is not completely disallowed; rather it is suspended and carried forward to such time as the taxpayer has passive income or disposes of his or her entire interest in the passive activity.

In most cases, a taxpayer would prefer not to have passive losses because they cannot be used to offset active income. Whether a trade or business activity is passive or active as to the taxpayer depends upon the taxpayer’s level of participation in the activity. If the taxpayer materially participates in the business, then the taxpayer’s share of losses arising from the business will not be treated as passive.

In the context of a closely held business, it is not unusual for one owner’s share of the losses to be treated as passive while that of another is not. active-passive

What Is A Passive Activity?

A passive activity is any trade or business in which the taxpayer does not “materially participate.” Generally, a taxpayer materially participates in a business if he or she is involved in the operations of the business on a regular, continuous, and substantial basis. Regulations promulgated by the IRS provide seven alternative tests to determine whether a taxpayer materially participates in a business activity.

In general, any work done by an individual (in whatever capacity) in connection with a business activity in which he or she owns an interest is treated as participation of the individual in the activity for purposes of these rules.

A taxpayer may establish the extent of his or her participation in an activity by any “reasonable means.” Although contemporaneous time reports, logs or similar documents are not required, they are worth the effort, as one taxpayer recently appreciated, to his relief.

Taxpayer’s Real Estate Activities

Taxpayer’s father funded three businesses for his children (including Taxpayer), and structured each business with one child as the 60% majority owner, and with the other two children each holding 20%.

Taxpayer owned 20% of KidCorp 1, an S corporation, and served on its board of directors. In early 2008, Taxpayer brought a derivative action against his sibling (the 60% owner) for mismanagement of the corporation. The litigation settled shortly thereafter, and during the balance of 2008 Taxpayer worked on behalf of KidCorp 1 to restore corporate assets to and to find additional investors for the corporation’s projects and to fill its capital needs.

In the latter half of 2008 the board of directors of KidCorp 1 named Taxpayer treasurer, made him an employee, and gave him an office at the company headquarters.

Taxpayer reported significant net operating losses (NOLs) arising out of KidCorp 1 on his 2008 personal income tax return, and carried them back to his 2006 return.

 IRS Audit

The IRS audited Taxpayer’s 2006 and 2008 returns, and determined no deficiency for 2008. However, it determined a deficiency for 2006 that was solely attributable to NOL carrybacks from 2008.

During the audit, Taxpayer’s sibling (the 60% shareholder against whom the derivative suit was brought) made inconsistent statements to the IRS about Taxpayer’s work for KidCorp 1, initially representing that Taxpayer “regularly and continuously works on behalf of the company,” then asserting that “[KidCorp 1] is a family owned company which does not create or maintain a record of the specific work activities, or the specific hours worked, by any Shareholder, Officer or Director,” and finally (after another dispute arose between the sibling and Taxpayer) submitting that Taxpayer did not perform any significant work for KidCorp 1.

The IRS issued a notice of deficiency for 2006 in which it recharacterized Taxpayer’s 2008 NOL from KidCorp 1 as passive instead of nonpassive. The Taxpayer had treated those losses as arising from a business in which he had materially participated. As permitted by the Code, he carried those losses back two years, to 2006, as a result of which he received a refund for that year. Passive losses cannot be carried back. Accordingly, the IRS’s notice of deficiency reduced the NOL for 2006, and denied the deduction for the NOL reported on Taxpayer’s 2008 return.

Taxpayer Goes to Court

The Tax Court considered whether Taxpayer had materially participated in KidCorp 1 during 2008. If he did, then the loss from that entity would not be subject to the passive loss limitation, described above, and would be respected as NOLs.

To establish the hours spent on an activity, the Court noted that taxpayers are not required to keep “[c]ontemporaneous daily time reports, logs, or similar documents” to substantiate their participation “if the extent of * * * [their] participation may be established by other reasonable means.”

Generally “reasonable means” includes “the identification of services performed over a period of time and the approximate number of hours spent performing such services during such period, based on appointment books, calendars, or narrative summaries.” Taxpayers cannot merely make a “ballpark guesstimate” of their participation, the Court said.

According to the Court, Taxpayer presented credible testimony and phone records to show that he worked almost 700 hours for KidCorp 1 during 2008. Witnesses testified that he worked restoring corporate assets and seeking potential investors for the corporation’s projects and capital needs. Taxpayer presented phone records that further corroborated the witnesses’ accounts.

Taxpayer also produced KidCorp 1 corporate board meeting minutes and resolutions from 2008 naming Taxpayer as a director and treasurer of the corporation. Finally, he produced a Form W-2, Wage and Tax Statement, and biweekly earnings statements issued by the corporation to Taxpayer for 2008, confirming he was an employee.

On the basis of this evidence, the Court found that Taxpayer satisfied the material participation requirement by having participated in the business activity for more than 500 hours during the taxable year. It also found that Taxpayer satisfied the material participation requirement because “[t]he activity [was] a significant participation activity * * * for the taxable year, and the * * * [Taxpayer’s] aggregate participation in all significant participation activities during such year exceeds 500 hours.”

It is worth mentioning that, in the course of deciding in favor of Taxpayer, the Court also rejected two other arguments made by the IRS that are often applicable in the context of a close business: (1) that the Taxpayer’s work was not of a kind customarily done by owners, and (2) that the Taxpayer’s participation was that of an investor.

All That Ends Well?

The best time to prepare for an IRS audit of a particular tax year is well before the return for that year is prepared – indeed, the preparation should occur during the course of the year, as the transactions that will be the subject of the tax return develop and occur. The key to this preparation is knowing in advance what the IRS and the courts will be looking for in the way of important factors and substantiation.

As a general rule, a taxpayer would be well-served to consult with his or her tax advisers during the course of any “business event” that may reasonably be expected to generate an economic result that will have to be reported on a return – being mindful, of course, not to lose sight of the business goal at issue.

This will enable the taxpayer to develop, on a contemporaneous basis, the appropriate back-up for a reporting position. After all, years may pass before a transaction or return is challenged by the IRS. During the interim, records may be lost or destroyed, people may disappear or die, people may forget, and relationships may sour. A taxpayer cannot leave it to chance that the appropriate support will be available when the time comes.

It’s great to be in business when things are going well. When things start to go badly, however, they can quickly cascade out of control, with reduced cash flow leading to the diversion of trust fund taxes, like sales and employment taxes, toward the payment of business expenses.  Additionally, a struggling business owner in need of operating capital will often forego the remittance of business income taxes in favor of satisfying trade debts. ostrich

When the “deferred” income taxes are owed by a corporate taxpayer to the State under the laws of which the corporation was formed, there may arise at least one serious Federal income tax consequence of which the corporation and its shareholders should be aware.

Dissolution by Proclamation

“Federal income tax consequence for failing to pay state taxes?” you may ask.

Most New York tax advisers are aware that if a New York corporation does not file franchise tax returns, or pay franchise taxes, for two or more years, the New York Secretary of State may dissolve 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 New York law. These lost rights include, of course, “the right to sue in all courts.”

Many taxpayers and advisers believe that a dissolution by proclamation must result in the taxable liquidation of the corporation for Federal income tax purposes.  Fortunately, they are mistaken. Unfortunately, however, as two recent Tax Court decisions show, these corporations will encounter other difficulties with respect to Federal tax consequences.

Just the Facts

In each of the decisions, the respective taxpayers were California corporations whose corporate privileges were suspended by the State for failure to pay State franchise tax.   Additionally, the IRS had mailed to each Taxpayer a notice of deficiency (a so-called “90-day letter”) determining Federal income tax deficiencies, penalties, and additions to tax. Each Taxpayer timely filed a petition (i.e., within 90 days of the notice) in the Tax Court challenging the IRS’s determinations.  In most cases, the timely filing of its petition with the Tax Court would have enabled Taxpayer to contest the asserted tax liabilities without having to first pay them; this is a major reason why most taxpayers opt to contest a tax liability in the Tax Court rather than in another forum in which payment would have to be remitted before a challenge could be made.

In each case, the IRS filed a motion to dismiss the Taxpayer’s petition for lack of jurisdiction, alleging that Taxpayer lacked the capacity to sue at the time the petition was filed. Also in each case, the CA Franchise Tax Board issued to each of the Taxpayers a certificate of reviver, retroactively reinstating the Taxpayers’ corporate existences (on account of the satisfaction of their respective past-due tax liabilities). However, these certificates were issued after the end of the 90-day period.

And the Court Says…

The Tax Court held for the IRS in both cases, reasoning that it lacked jurisdiction over the cases—notwithstanding the otherwise properly filed petitions.

According to the Court, whether a corporation has capacity to engage in litigation in the Court is determined by the law under which the corporation was organized. The Taxpayers’ petitions, the Court stated, were filed at a time when their corporate powers, rights, and privileges were suspended by the State of CA. A suspended corporation, it stated, cannot prosecute or defend an action while its legal status is suspended.  Furthermore, the Court stated, a revival will not restore a taxpayer’s capacity to litigate a Tax Court case when the date of the revival is beyond the 90-day period in which a petition in the Court was required to be filed.

The Tax Court noted that the CA courts have been clear that statutes of limitations create substantive defenses that may not be prejudiced by a corporate revival. As a result, the Court found that the Taxpayer lacked the capacity to file a valid petition that would confer jurisdiction over the matter on the Tax Court.

The Court further explained that the timely filing of a petition in response to a notice of deficiency is a statutorily-imposed jurisdictional requirement. The Taxpayer’s suspension under CA law deprived it of the capacity to sue, and thus prevented its corporate revival from prejudicing the IRS’s defense of lack of subject matter jurisdiction. Pointing out that it lacked the authority to relieve the Taxpayer from the jurisdictional requirement, the Court granted the IRS’s motion to dismiss for lack of jurisdiction.

What’s Next for Taxpayer?

As a result of its loss in the Tax Court, and as a matter of Federal tax law, the Taxpayer will be assessed the additional tax, interest and penalties asserted by the IRS. The IRS will then begin collection action against the Taxpayer by demanding payment. If the Taxpayer fails to pay after this demand, a lien will arise (as of the time the assessment was made) in favor of the IRS upon all of the Taxpayer’s property. The levy process will follow and the tax will be collected.

If the Taxpayer’s objection to the additional taxes is defensible, it may file a refund claim with the IRS, and then bring an action in U.S. district court.

Takeaway

A troubled business is faced with many choices. Whom does it pay? Whom does it defer, or just ignore? There are trade creditors, there are institutional lenders, and there are Federal and State taxing authorities.

Each decision will have consequences. In other posts, we have examined the personal liability that may be imposed upon the owner of a business in respect of the trust fund taxes owed by the business.  We recently considered an owner’s transferee liability for the income taxes of a corporate business that has been liquidated.

Almost invariably, the owners of the troubled business believe that, if they can just sustain the business a bit longer, it will turn the corner and become profitable again, at which point the business will either satisfy its creditors, including the taxing authorities, or work out a settlement (perhaps through a reduction of the amount owing and/or the implementation of a payment plan).

Most taxing authorities will suggest that such a business should cease operations altogether, rather than continue to neglect its tax obligations and allow them to grow exponentially (consider the power of daily compounded interest, plus penalties).

The ostrich is among my least favorite creatures. So is the ignorant or unrealistic taxpayer. Early realization of the tax issue is the key, shortly followed by planning, and immediate implementation of the plan. The preservation of options has to be one element of that plan, and should include the preservation of a corporation’s legal status. Without that, a corporate taxpayer cannot contest a liability in Tax Court, as we saw above. Nor can it pursue its own trade debtors – for example, customers who owe it money for services rendered or products delivered. This, in turn, will make it more difficult for the corporation to pay its own debts and turn that corner that its owners keep looking for.