Back to Basics

As we mark the “end” of the tax season (it never really ends), it may be helpful to remind folks that not every expense incurred by a business may be claimed as a deduction in determining the taxable income of the business.

While that may seem obvious, tax practitioners are forever encountering closely-held businesses that appear to be (willfully?) ignorant of the rule. In many cases, the non-business expense is reported on the “other deductions” line of the relevant tax return, and the required attached statement (intended to identify the specific expense) describes the expense simply as “miscellaneous.”  receipts

By claiming the expense as a business deduction, the taxpayer is, of course, reducing the taxable income of the business and, perhaps, of the owners. In those situations, the disallowance of the deduction by the IRS will create a tax deficiency, and may also result in the imposition of penalties.

What is the expenditure, really?

In cases of more accurate reporting, the business may report the expenditures as distributions made to one or more of its owners, or as compensation paid to such persons. In those situations, the business is not claiming that the expenditures, in and of themselves, are ordinary and necessary business expenses. Rather, it is recognizing that they are of a different nature, that they are being paid on behalf of the owners and, so, that they represent something else as to the owners – a constructive distribution or payment—that may still be deductible (e.g., reasonable compensation).

Unfortunately, the latter situation occurs relatively infrequently. Moreover, even that treatment may not be available if the business cannot substantiate the actual payment.

An Example

The Corporation’s  Business

In 1992, Taxpayer started a company called SLS, which elected S corporation status. Taxpayer operated this business out of his home. An outside contractor, SLS offered services to various clients chiefly by conducting training seminars at the client’s place of business. SLS was engaged by a principal client through 2003, but that client stopped using SLS in 2004. SLS had one or two other clients, but their work also began to dry up; by 2006, the SLS business had diminished to the point where it involved little more than ad hoc consulting that Taxpayer personally performed. SLS had no other employees.

The IRS Asks for Proof

After SLS filed its 2007 return, the IRS requested additional information with respect to certain claimed deductions.  Taxpayer provided the IRS with documentation for a portion of the allegedly SLS business-related expenses incurred in 2007.

The IRS allowed some of the deductions for the expenses substantiated, chiefly those for office supplies and computer-related items.

The remaining  balance of the substantiated expenses, however, were attributable to (among other things) a camcorder, a treadmill, a wireless router, music CDs, luggage, museum membership fees, a cell phone charger kit, candles, and a Microsoft Office software package. The IRS disallowed the deduction for these expenses on the ground that they were not “ordinary and necessary” expenses of SLS’ trade or business. The IRS accordingly reduced the allowable Schedule E loss claimed by the Taxpayer.

 The Code, of course, allows the deduction of “all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.” A necessary expense is one that is “appropriate and helpful” to the taxpayer’s business, whereas an ordinary expense is one that is common or frequent in the type of business in which the taxpayer is engaged. Personal, living, and family expenses are generally not deductible.

The Taxpayer Fails

The Tax Court reminds us, first, that “deductions are a matter of legislative grace, and the taxpayer bears the burden of proving that claimed expenses are ordinary and necessary.” The Court reminds us further that “[the] taxpayer also bears the burden of substantiating claimed deductions by keeping and producing records sufficient to enable the IRS to determine the correct tax liability. The failure to keep and present such records counts heavily against a taxpayer’s attempted proof.”

According to the Court, the IRS did not dispute that SLS was engaged in a “trade or business” during 2007. But, the Court noted, the scale of its business had declined considerably since 2004 and was extremely limited during 2007 and the immediately preceding years. In fact, its gross receipts during 2007 were minimal and were derived from ad hoc consulting that Taxpayer personally performed. According to the Court, an assessment of what expenses were “ordinary” and “necessary” for this business had to take into account “its relatively moribund state.”

Many of the disallowed expense deductions were for obviously personal items. Taxpayer did not carry its burden of proving that these represented “ordinary and necessary” expenses of the SLS business as opposed to “personal, living, or family expenses” that are not deductible under the Code.

In sum, the Court concluded that the IRS had properly disallowed the Taxpayer’s claimed deductions for lack of substantiation or as “personal, living, or family expenses.”

Looking Forward

We have all advised business clients that they should not pay the personal expenses of their owners from the accounts of the business (e.g., to avoid “piercing the veil” arguments). We have told them that they should not deduct such expenditures against their business income for tax purposes unless they are willing to treat the expenditures as compensation or as distributions.

Notwithstanding our directives, many clients have chosen to view them as well-intentioned “guidance,” rather than as “commandments.” They are basically willing to accept the audit risk.

Given this predisposition on the part of so many clients, it is imperative that each client understand the impact of its decision on the outcome of any future audit. Not only will the taxpayer lose the benefit of the deduction at issue, it will also give the auditor an unfavorable impression of both themselves – as someone who may not be trusted – and of the tax professional defending them (oftentimes, the return preparer). This, in turn, will make it more difficult for the taxpayer to successfully carry defensible positions that are not necessarily on all-fours with the general position of the IRS. It will also make the imposition of penalties more likely.

The bottom-line: the foregoing consequences must be discussed with clients in detail before the client makes the decision to “gamble.”

Own your own business, decide your own salary… right?

Wrong.

The Tax Court recently upheld corporate tax deficiencies and accuracy-related penalties assessed by the IRS after it disallowed as a business expense deduction half of $2 million in bonuses paid by an eye care center (the “Center”) to its sole shareholder.  The sole shareholder, who also worked as a surgeon at the Center, served as the Center’s Medical Director, CEO, CFO, and COO (“Dr. A.”).  For the two years at issue (“Year 1” and “Year 2”), Dr. A. received in compensation salaries of $780,000 and $690,000, respectively, and bonuses of $2 million and $1.1 million, respectively. doc

The Center operated four different locations, and employed around fifty people during the years at issue, including surgeons, optometrists, and support staff.  Dr. A. was responsible for about one-third of the Center’s billings in Year 1, and his surgical responsibilities during those years increased with the sudden departure of one fellow surgeon and the gradual departure of another to begin her own practice.

The IRS and the Center’s Tax Returns

On its return for Year 1, the Center claimed a compensation deduction for salary and bonus paid to Dr. A. for more than $2.7 million, but claimed a net operating loss.  For Year 2, using a net operating loss carryforward, the Center did not report any taxable income.  Additionally, despite the sizeable salary and bonus paid to Dr. A. that year, the Center reported gross operating receipts in excess of $6 million.

The IRS disallowed $1 million of the claimed bonus compensation deduction for Year 1, determining that this was a disguised dividend rather than bonus compensation.  As a result of this disallowance, the IRS also disallowed certain deductions for claimed taxes and license expenses, as well as the net operating loss carryforward that was ultimately used in Year 2.  The IRS also determined that the Center was liable for an accuracy-related penalty under Code section 6662.

Standard for Deducting Compensation Expenses

 Generally, there is a presumption, rebuttable by the taxpayer, that determinations in a notice of deficiency are correct.  Additionally, with respect to deductions, it is the taxpayer’s responsibility to maintain sufficient records to substantiate each claimed deduction so that the IRS can determine the correct tax liability.

Section 162(a)(1) of the Code allows taxpayers to deduct “ordinary and necessary expenses,” including a “reasonable allowance for salaries or other compensation for personal services actually rendered.”  Therefore, compensation is deductible if it is (1) reasonable in amount, and (2) paid for services actually rendered.

The regulations under section 162 state that in order for compensation for personal services to be deductible, it “may not exceed what is reasonable under all the circumstances.”  Thus, the Center was required to establish that the bonuses paid to Dr. A. were reasonable.

Reasonable compensation is generally “only such amount as would ordinarily be paid for like services by like enterprises under like circumstances.”  The Tax Court also cited the Court of Appeals for the Seventh Circuit, which has held that “other factors besides the percentage of return on equity have to be considered, in particular comparable salaries.”  The Court highlighted, however, that evidence of comparable salaries is helpful only to the extent that such evidence accounts for the details of the compensation package for the compared executives, and not just the final number.

The Center’s Argument

Such detail turned out to be irrelevant, as the Center produced no evidence of comparable salaries, instead arguing that its enterprise was so unique that there were no “like enterprises” under “like circumstances” from which it might draw comparisons.  The Center emphasized Dr. A.’s increased workload after the departure of his colleagues, as well as the various capacities in which Dr. A. served the Center.  The Center did not, however, explain how it arrived at the specific amounts paid to Dr. A. as bonuses.

The Tax Court’s Holding

 Because the Center did not “provide any methodology to show how [Dr. A.’s] bonus was determined in relation to his [managerial and medical] responsibilities,” the Court held that the Center had not shown that the compensation paid to Dr. A. was reasonable.  As a result, it upheld the IRS’s deficiency determinations.

Furthermore, as a result of this holding, the Court also upheld the 20% accuracy-related penalty for Year 1, which was imposed as a result of the Center’s “substantial understatement” of income in that year.  (That penalty can be challenged if a taxpayer can show that it had reasonable cause for, and acted in good faith regarding, the underpayment; however, the Center provided no such explanation.)

The Lesson: Your Corporation is Not Your Personal Piggy Bank

 piggy bankDr. A. undoubtedly felt entitled to whatever salary he had decided to pay himself.  After all, as the 100% owner of the Center, he was the person who would ultimately reap the benefits of the Center’s profits and losses.  Moreover, the Center was not what one might call a capital-intensive business—it involved the provision of personal services, though not exclusively those of the sole shareholder.  This case, however, highlights the inexactitude of this mindset.  While Dr. A. was entitled, speaking broadly, to receive excess profits from the Center, he was not entitled to manipulate his receipt of those profits to result in the most tax economically tax advantageous position possible, Tax Code notwithstanding.

Two of our recent posts considered the IRS’s recent successes in applying the transferee liability rule to collect the federal income tax liability owing by the corporation from the sale of its assets from a corporation’s shareholders. In both cases, the shareholders had employed sham transactions in an attempt to avoid the corporate tax liability.

 

This week, we review yet another situation in which shareholders sold their shares in a C corporation with a large unpaid federal income tax liability. In furtherance of collecting the unpaid liability from the shareholders as transferees of the corporation’s property, the IRS sought to recharacterize the stock sale as a liquidating distribution in which the shareholders received cash in redemption of their shares.

 

The Transaction

The “selling” shareholders included Corp’s officers and directors. Corp sold its assets and realized substantial gain. After the sale, it did not engage in any business activity. Its only asset was the cash from the asset sale.

 

During Corp’s negotiations for the asset sale, it was contacted by Investor (sound familiar?), which described itself as a company interested in purchasing the stock of C corporations that have sold their assets and that, as a result, have realized a significant taxable gain. Investor  represented that it would purchase the Corp shares from the shareholders and would pay them more than the shareholders would receive if they were to dissolve Corp and receive the proceeds of the sale in redemption of their shares.

 

Investor proposed to acquire all of Corp’s outstanding shares for  a price “equal to the cash in [Corp] as of the [closing date] reduced by [a percentage] of [Corp’s] combined state and federal corporate income tax liability for its current tax year . . .”  Investor also agreed “that it shall cause [Corp] to pay [its deferred tax liability] to the extent that [it] is due given [Corp’s] post-closing business activities and shall file all federal and state income tax returns on a timely basis related thereto.”

 

The shareholders sold their Corp shares to Investor. At closing, they caused Corp to transfer all of its cash to a trust account maintained by Investor’s lawyer. Investor then immediately provided funds to its lawyer’s trust account for the entire purchase price. Upon receipt of the cash from Corp into the trust account, Investor’s lawyer directed the purchase price to the trust account for the shareholders’ lawyer, who then distributed the “purchase price” to the shareholders.

 

After the receipt of the cash from Corp, Investor’s lawyer caused that amount to be transferred to another account in the name of Corp. On the next day, this amount was transferred from Corp’s account to another account at the same bank entitled “[Investor] Credit Corp. Accounts Payable.” Corp recorded the transfer on its books as a receivable due from its new shareholder (Investor). Corp’s year-end balance sheet showed the amount owing, but no promissory note was prepared.

 Corp reported taxable income on its tax return for the year of the asset sale, and showed a tax due, but it made no payment with the return. It reported  a loan due from Investor on its balance sheet, and no other assets or liabilities.

 

On its return for the immediately following year, Corp reported a bad debt deduction resulting from the “worthlessness” of its loan to Investor. The bad debt deduction produced a net operating loss that Corp carried back to, and deducted for, the year of asset sale, offsetting the gain from the sale.

 

The IRS and the Tax Court Agree

IRS disallowed the bad debt deduction and the loss carried back, and determined a deficiency in Corp’s federal income tax for the year of the asset sale.

 

The parties eventually stipulated that Corp was not entitled to either deduction, and the IRS assessed a deficiency in tax, plus penalties. tax court

 

After unsuccessfully attempting to collect the unpaid tax from Corp, IRS sent notices to the former Corp shareholders stating that, as transferees of Corp’s property, they were liable for its unpaid income tax for the year of the asset sale. IRS explained that it was recasting the transaction by which shareholders disposed of their shares in Corp as a liquidating distribution of all of Corp’s cash to its shareholders in redemption of its outstanding shares. The Tax Court agreed.

 

State Law and Transferee Status

The Court noted that the Code does not independently impose tax liability upon a transferee, but provides a procedure through which the IRS may collect unpaid taxes owed by the transferor of property from a transferee if an independent basis exists under applicable State law, or State equity principles, for holding the transferee liable for the transferor’s debts. Thus, State law determines the elements of liability, and the Code provides the remedy or procedure to be employed by the IRS to enforce that liability.

 

According to the Court, the IRS bears the burden of proving that the transferee is liable as a transferee of property of the taxpayer. A transferee’s liability for Federal taxes of the transferor of property, it said, includes any additions to tax, penalties, and interest that have been assessed with respect to the tax. Moreover, transferee liability is several, and the IRS is free to proceed against one or more of any number of potential transferees.

The question of whether a person or an entity is a “transferee” for purposes of the Code, the Court said, is separate from the question of whether the transfer was fraudulent for State law purposes; first, the IRS must establish that the target is a transferee within the meaning of the Code; second, it must establish the transferee’s liability under State law.

In reviewing the facts in light of the relevant State law, the Court found that Corp did not receive reasonably equivalent value on account of the transfer. It also agreed with the IRS that Corp became insolvent upon its transfer of all its cash (its only asset) to the trust account of Investor’s lawyer: “As its liabilities exceeded its assets (which were then zero) [Corp] was rendered insolvent immediately before petitioners purportedly sold their shares.”

The Court noted that Corp was not a going concern at the time of the stock transfer. It would, therefore, have been unreasonable at that time to believe that Corp could, from its business operations, satisfy its tax debt when that debt came due.

Consequently, the Court found that the transfer of Corp’s cash was fraudulent with respect to the IRS, within the meaning of State law, and that the IRS could recover a judgment under State law equal to the lesser of the value of the asset transferred or the amount necessary to satisfy its claim.

Having determined that the IRS was entitled to a judgment against the shareholders to satisfy a portion of its claim against Corp for its unpaid tax, the Court then determined that the shareholders were transferees within the meaning of the Code. The Court held: “[T]he [IRS] may proceed . . . against any ’transferee’ who is liable under state law for the debts of the transferor/taxpayer.”

The Court noted the expansive reading that has been given the term “transferee” under the Code. A person can be a transferee if he is an indirect transferee of property, a constructive recipient of property, or if he merely benefits in a substantial way from a transfer of property. The determinative factor is liability to the IRS for the tax debt of another (the transferor) under a State fraudulent conveyance or similar law.

Thus, the Court held, the shareholders were collectively liable to the IRS as Corp’s transferees within the meaning of the Code.

 Redux

There appears to be no limit to the variety of schemes in which taxpayers are willing to participate in order to avoid taxes that are properly owed. These schemes, however, do share some very important traits of which the taxpayers and their advisors must be aware: they involve multiple and complex steps, and their promised results are almost unbelievable. As the court in last week’s blog put it: “This should have called to mind the warning that ‘if something seems too good to be true, then it probably is.’ But alas, it did not.”

Last week’s posts described a situation in which the IRS was able to collect a deficiency in corporate income tax from a minority shareholder of the taxpayer-corporation on the basis of transferee liability under state law. Recently, another decision addressed the question of transferee liability, this time in the instance of a dissolved corporation’s unpaid federal taxes.

The Sale

The “transferees”  were the former shareholders of a closely held “C” corporation (“Corp”) that had been owned and operated by the same family for many years. The latest generation, however, had no interest in continuing to run the business, and the shareholders – all descendants of its founder – were approaching, or had already reached, retirement age. They decided it was time to sell.

Selling the business raised a number of concerns. In particular, the shareholders anticipated that Corp would incur significant tax liability. Corp’s assets had been purchased long ago, and their bases had been depreciated, so an asset sale would give rise to a large taxable gain.

The shareholders attempted to negotiate a stock sale of Corp to Buyer, but Buyer rejected it out of hand and insisted on an asset sale.

The shareholders eventually accepted Buyer’s terms and the transaction closed, netting a substantial amount of cash, resulting in a large taxable gain, and generating significant corporate income tax liabilities.

After the asset sale, Corp ceased carrying on any active business. It was basically  an “empty shell” holding only the sale proceeds.

Have I Got A Bridge for You

However, while the asset sale was still pending, Corp’s shareholders were approached by Shelter, who specialized in structured transactions designed to avoid or minimize tax liabilities.no tax

Through an intricate tax-avoidance transaction, Shelter offered to purchase the stock of C corporations like Corp that had recently experienced a taxable asset sale, promising to pay more for the shares than they were worth in a liquidation. Then, using bad debts and losses purchased from credit-card companies, Shelter would offset the unpaid tax liabilities of the  acquired corporation by way of a net-operating-loss carryback. Billed as a “no-cost liquidation,” Shelter proposed this strategy to Corp’s shareholders as an attractive tax-avoidance alternative to liquidating the corporation.

Corp’s board of directors opted to pursue the tax-avoidance strategy, and its shareholders ultimately approved it.

The closing involved a number of steps in quick succession, at the end of which the shareholders held the proceeds from Corp’s asset sale.

Corp, however, never paid federal taxes on the gain from the asset sale. Its federal tax return for the year of the sale to Buyer showed a tax due based on the gain from the asset sale, but no amount was paid with this filing. Corp’s tax return for the following year claimed a net operating loss that was then carried back to the sale year, reducing Corp’s federal tax liability to zero.

Not So Fast

The IRS issued a notice of deficiency to Corp for the year of the asset sale. The IRS had determined that the net operating loss was based on sham transaction and was part of an illegal distressed asset/debt tax shelter. Corp never responded.

The IRS then sent notices to the former shareholders, seeking to hold them responsible for Corp’s unpaid taxes and penalties as transferees of the defunct corporation under federal and state law of fraudulent transfer and corporate dissolution.  The amount of the proposed individual assessments varied according to each shareholder’s ownership interest.

The shareholders petitioned the Tax Court seeking to overturn the IRS’s determination. The Tax Court sided with the IRS and found the shareholders liable for the unpaid taxes and penalties. The Court of Appeals affirmed.   At trial before the Tax Court, the shareholders stipulated that the tax shelter was illegal, but contested transferee liability.

The Court Speaks

The Court held that the “stock sale” transaction with Shelter was in substance a liquidation with no purpose other than tax avoidance, making the shareholders transferees of Corp under State law governing fraudulent transfers and corporate dissolutions.

The Court noted that the Code authorizes the IRS to proceed against the transferees of delinquent taxpayers to collect unpaid tax debts.  However, the Code provides only a procedural device for proceeding against a taxpayer’s transferee. Substantive liability is governed by state law. Accordingly, the Court explained, transferee-liability cases proceed in two steps.

  1. The IRS must establish that the target is a “transferee” of the taxpayer.
  2. The IRS must establish that the transferee is liable for the transferor’s debts under some provision of state law.

Transferee-Shareholders?

The term “transferee” in the Code is defined broadly to include any “donee, heir, legatee, devisee, and distributee.” The Court found that the stock sale was structured to avoid the tax consequences of Corp’s asset sale, which the shareholders would have had to absorb had they pursued a standard liquidation.

Formally, the shareholders sold their Corp stock to Shelter, but the Court looked past these formalities to the substance of the transaction – using a “substance over form” and “economic substance” analysis – to recast it as a liquidation. In other words, the court found that Shelter did not actually pay the shareholders for their stock; instead, each shareholder received a pro rata distribution of Corp’s cash on hand— the proceeds of the asset sale—making them “transferees.”

The Court noted that from the beginning Shelter had characterized the transaction as a “no-cost liquidation.” The Corp, it said, had no active business at the time of the transaction. To the contrary, it was a shell corporation, and the transactions were “a mere accounting device, devoid of substance,” that were “all about creating tax avoidance” and thus lacked any valid nontax business purpose. Looking past the form of the transaction to its substance, the Court found that the stock sale was in reality a liquidation, and that the funds received by the shareholders came not from Shelter but from Corp’s sale proceeds.

Liability Under State Law

Establishing transferee status under the Code, the Court said, was only the first step in the analysis. The next step required an independent determination of transferee substantive liability under State law. Here, the Court found the shareholders liable under two constructive-fraud provisions of State law.

A transferee, the Court said, is liable to a creditor whose claim arose before the transfer if the debtor made the transfer “without receiving a reasonably equivalent value” and “the debtor was insolvent at that time or the debtor became insolvent as a result of the transfer or obligation.”

The Court found the shareholders liable for Corp’s tax debt. The asset sale—the triggering event for the tax liability—occurred before the transfer of Corp’s cash to the shareholders, and the cash from the asset sale was transferred to the shareholders “without receiving a reasonably equivalent value.” Indeed, Corp received nothing. The Court also found that the transaction left Corp insolvent, a requirement for liability under State’s law. Finally, the tax court found that the shareholders knew or should have known that Corp’s federal tax liability could not and would not be paid. What was left in Corp’s bank account after the transaction was insufficient to cover the tax liability. And the entire transaction was premised on the assumption that Shelter would offset the tax liability by a net-operating loss carryback; in other words, the transaction was premised on the assumption that the taxes would not be paid. Accordingly, the Court concluded that the shareholders were liable for Corp’s tax debt under State law, and that this conclusion was sufficient to sustain transferee liability under the Code.

Too Good to be True

What were Corp’s shareholders thinking? Even on a visceral level, one would be hard-pressed to argue that the shareholders of a corporation can strip the corporation of its assets through a liquidation, and then avoid responsibility for the corporation’s outstanding liabilities. The very complexity of the transaction with Shelter supported the finding that its sole purpose was tax-avoidance.

It is a fact of business life that there will be times when taxes simply cannot be avoided. They may be reduced or deferred, perhaps, but not avoided. The goal is to manage the tax exposure and to plan for it as best and as early as possible. Subchapter S election, anyone?

See yesterday’s post for the background on the liability of the minority shareholders discussed today.

Transferee Liability

Taxpayers argued that the IRS’s installment agreement with Corp cut off their transferee liability, and that the IRS’s failure to exhaust its collection options against Corp precluded the IRS from seeking to recover from them as transferees. They also argued that they were not liable as transferees because the IRS failed to exhaust collection efforts against more culpable parties.

According to the Court, although payments under the installment plan may eliminate or reduce the amount that may be collected from a transferee, the IRS may still take action to collect from any person who is not named in the installment plan agreement but is liable for the tax which relates to it. Thus, the installment plan between Corp and the IRS did not preclude Taxpayers from facing transferee liability.

Next, the Court determined that under State law the IRS does not have an obligation to pursue all reasonable collection efforts against a transferor before proceeding against a transferee. Therefore, the IRS was not required to exhaust collection efforts against Corp, and Taxpayers may be held liable.

Taxpayers argued that the IRS may not collect from them because it did not exhaust collection efforts against Insiders. The Court held that the IRS may proceed against any or all transferees in no particular order. Therefore, the IRS was permitted to pursue Taxpayers without first exhausting collection efforts against Insiders.

Fraudulent Transfer

The IRS asserted that Taxpayers were liable as transferees because the transfers they received were fraudulent. In doing so, it grouped together both the transfers Taxpayers received and the transfers Insiders received because, the IRS claimed, Corp made all of the transfers as part of a comprehensive scheme to defraud the IRS.

Although the facts established that Insiders organized a scheme to defraud the IRS, they did not establish that the payments Taxpayers received were part of this scheme, and the Court refused to impute that intent to the distributions to Taxpayers.

During the years at issue,  Taxpayers’ hard work was instrumental in Corp’s success and, according to the Court, they likely would have become suspicious if they had not been compensated fairly. Insiders wanted to take money for themselves; they devised a scheme from which Taxpayers incidentally benefited, but the payments they received were not made with the same intent as those Insiders received.

State Law

The Court next examined whether the transfers to Taxpayers were fraudulent as a matter of State law. According to the Court, if the debtor did not receive “reasonably equivalent value,” the transfer would be fraudulent if:

  1. The debtor was engaged or was about to engage in a business or a transaction for which the remaining assets of the debtor were unreasonably small in relation to the business or transaction;
  2. The debtor intended to incur, or believed or reasonably should have believed that it would incur, debts beyond its ability to pay as they became due; and
  3. The debtor was insolvent at the time of the transfer or became insolvent as a result of the transfer.

The Court considered whether Corp received reasonably equivalent value from Taxpayers for the transfers at issue. To resolve this issue, the Court first determined what Corp received in return for the transfers at issue.

2003 and 2004 Transfers

Corp suspended its bonus program after 2002. To offset the financial hardship resulting from the suspension of the bonus program, Insiders made advances to Taxpayers, which they were told were loans that did not have to be reported as compensation.

Taxpayers argued that each transfer was compensation and that the work they performed for Corp constituted reasonably equivalent value. The IRS contended that the payments were not compensation but, rather, that they were dividends.

The Court agreed with Taxpayers, finding that the “advances” were compensation that Taxpayers  received in lieu of bonuses, and Corp never expected repayment.

Because taxpayers gave reasonably equivalent value for the 2003 and 2004 transfers, they were not fraudulent.

2005, 2006, and 2007 Transfers

Taxpayers argued that the transfers they received in 2005, 2006, and 2007 were compensation for services performed and that they gave reasonably equivalent value for them. The IRS argued that the transfers were dividends and that, consequently, Taxpayers did not give reasonably equivalent value for them.

If the 2005, 2006, and 2007 transfers were dividends, Corp did not receive reasonably equivalent value for them. Under State law, a distribution of dividends that is not compensation for services rendered is not a transfer in exchange for reasonably equivalent value.

The Court found that Corp did not benefit from the dividends it paid to Taxpayers, that the dividends were not compensation for their work, and that neither Corp nor

Taxpayers treated the payments as compensation. Accordingly, the Court held that Corp did not receive reasonably equivalent value for the 2005, 2006, and 2007 transfers at issue.

Consequently, the Court stated that it would find any of the transfers during these years fraudulent if Corp was insolvent at the time of the transfer or became insolvent as a result of the transfer.

After reviewing the facts and expert valuation reports, the Court noted that the parties agreed that the transfers to Insiders contributed in large part to Corp’s insolvency. They disagreed about when Corp became insolvent. The IRS argued that Corp was insolvent when each payment was made. Taxpayers argued that Corp did not become insolvent until 2007, after they had received the last of the transfers at issue.

The Court found that Corp was solvent for the years 2003 and 2004 and insolvent for the years 2005, 2006, and 2007. Thus, the transfers Taxpayers received in 2003 and 2004 were not fraudulent under State law because Taxpayers gave reasonably equivalent value for them. Taxpayers did not give reasonably equivalent value for the transfers they received in 2005, 2006, and 2007, and Corp was insolvent when it made those transfers. Accordingly, those transfers were constructively fraudulent under State law.

The Court next considered the IRS’s argument that Corp made the transfers to Taxpayers with actual intent to hinder, delay, or defraud the IRS. This argument, that the transfers at issue were actually fraudulent, depended on grouping these transfers together with the transfers to Insiders.

The Court declined to do so, finding that:

  • Taxpayers were not “insiders;”
  • Corp was not threatened with suit when the 2003 and 2004 transfers occurred;
  • The amounts distributed to Taxpayers did not constitute substantially all of the Corp’s assets;
  • The 2003 and 2004 transfers were not a removal of assets;
  • While the 2003 and 2004 transfers to Taxpayers were not properly disclosed, they were not concealed;
  • The transfers made to Taxpayers in 2003 and 2004 were reasonably equivalent to the value of the assets transferred;
  • Corp did not became insolvent shortly after the transfers were made in 2003 and 2004 but, instead, became insolvent because of the transfers starting in 2005;
  • and the transfers to Taxpayers did occur shortly after Corp incurred tax liabilities.

After weighing these factors, and recognizing that no one factor is dispositive,

the Court concluded that the IRS did not show that the 2003 and 2004 transfers were made with intent to hinder, delay, or defraud the IRS.

The Court concluded that Taxpayers were liable as transferees under State law for the years 2005, 2006, and 2007; thus, under the Code, the IRS could seek to collect Corp’s income tax liability from them.

Advice?

What is a minority shareholder to do? The foregoing discussion highlights the fact that the privilege of ownership also entails a number of burdens. A key employee who is eager to own equity in its employer would be well advised to consider these.

Under the above circumstances, the compensation received was not recoverable by the IRS, while the dividends received were. What if the minority shareholders had already spent that money, or invested it in an illiquid asset, or made a gift?

Alas, there are times when there is little that a minority shareholder can do to protect him or herself from the IRS. Hopefully, state law (or a shareholders agreement) affords them some relief in seeking reimbursement from the insiders who brought the corporation to this point. Alternatively, the minority shareholder may seek an installment payment arrangement with the IRS. None of these is optimal.

In prior posts, we have considered the “plight” of minority shareholders in various contexts. We have reviewed their inability to influence corporate decisions, to compel a dividend distribution or a redemption of their shares.

In spite of these shareholders’ non-controlling status, we have seen situations in which the taxing authorities have, nonetheless, held them personally liable for a corporation’s sales taxes and employment taxes.

Last week, the U.S. Tax Court found that certain distributions by a corporation to its minority shareholders were fraudulent transfers, on the basis of which the Court concluded that these shareholders could be held liable for the corporation’s federal income taxes.

Setting the Stage

During the years at issue, four individuals owned all of Corp’s stock: the two taxpayers (the “Taxpayers”) owned a total of 9.78%, and Corp’s president and board chairman (the “Insiders”) each owned one-half of the remaining shares. distributions

Insiders were involved in all aspects of Corp’s business, and as the majority shareholders they controlled the direction and management of the company. The Taxpayers were not involved in Corp’s financial matters.

Between 2001 and 2007, Corp experienced a period of growth and profitability, but failed to report any income.

Ultimately, the IRS audited Corp and determined that it owed significant tax, penalties, and interest for the years at issue. After trying to collect Corp’s liability but finding that Corp could not pay, the IRS agreed to let Corp pay its liability in installments.

In the meantime, the IRS sought to collect as much of the liability from

other parties. The IRS reached agreements with Insiders to recoup some of the transfers they received during the years to which the liability relates.  The IRS next sought to recover many of the transfers Taxpayers received.

Stripping the Corporation

During the years at issue, Insiders systematically transferred all of Corp’s pretax profits to themselves. As Corp received payment for services, Insiders would transfer cash from its operating account to a secret account, from which they would then transfer the money to their personal accounts or to the accounts of corporations they owned. Corp’s accounting staff recorded the amounts as loans receivable and eventually wrote them off as operating expenses.

While Insiders were transferring money from Corp, they also made sure that Corp did not file accurate income tax returns. Corp filed returns for 2003 and 2004, but fraudulently reported losses. Corp did not file returns for 2005, 2006, or 2007.

In addition to the dividends they received, Insiders received “interest” payments from Corp in 2005, 2006, and 2007.  The interest was based on a fictitious loan Insiders had recorded on Corp’s balance sheet in their names. These interest payments were separate from the dividend payments all four shareholders received.

Taxpayers received several transfers during the years in which Insiders stripped Corp including, in addition to their usual salaries, certain “advances” and dividends.

Until 2003, Corp had a bonus program, under which Taxpayers earned significant compensation. Their bonuses depended on their performance, and petitioners routinely received significant income under the program. Corp  suspended the bonus program for 2003 and 2004. However, because Insiders understood that Taxpayers had become accustomed to receiving significant bonuses, they decided to give them bonus “advances” in 2003 and 2004. When Taxpayers asked Insiders how they should report the advances on their returns, they were told that they were loans and did not have to be reported. Insiders told Taxpayers that they would eventually have to repay the advances. Taxpayers did not sign loan agreements or discuss loans terms with Insiders, nor did they pay interest on the loans. Corp forgave the loans in 2009.

In 2005, 2006, and 2007 Corp declared and paid dividends to its shareholders. Each shareholder’s dividends were based on his percentage of stock ownership. Corp issued Forms 1099-DIV reflecting these amounts, and Taxpayers reported these amounts as dividends on their individual returns.

Corp was a thriving business until 2007, but by the end of 2007 it had become insolvent. Because Insiders hid a number of transfers, Corp’s financial statements did not reliably indicate when Corp became insolvent. Although Insiders left enough cash in the business to allow it to pay its usual creditors on time, Corp did not pay its federal or state income tax during the period.

Corporate Shield? Not Always

In general, the creditors of a corporation cannot recover the corporation’s debts from its shareholders—the shareholders enjoy the benefit of limited liability protection.

However, a creditor may be able to “pierce the corporate veil” in appropriate circumstances, as where the corporation’s shareholders do not respect it as a separate entity, or where their withdrawal of funds from the corporation renders it insolvent.

The IRS is a creditor of a corporation that owes federal income taxes. In the right circumstances, the IRS may pursue the corporation’s shareholders in order to satisfy a corporate tax liability. Indeed, the Code provides a procedural tool by which the IRS may collect taxes from shareholders to whom “transferee liability” for corporate taxes has attached as a matter of state law. While the Code does not create the substantive tax liability as to a transferee-shareholder of a transferor-corporation’s property, it does provide the IRS with a remedy for collecting from the transferee-shareholder the transferor-corporation’s existing tax liability.

Stay tuned tomorrow to find out how these minority shareholders fared when the IRS came after them.

insuranceIn yesterday’s post, we provided an overview of captive insurance entities.  Today, we will consider the specific facts of two different so-called captives, and whether or not they qualified as such according to the Tax Court and the IRS, respectively.

The Captive Arrangement in the Tax Court

In Rent-a-Center v. Commissioner, the Court decided that payments made by a subsidiary corporation to the captive formed by its parent corporation were properly deductible as insurance premiums (ordinary and necessary expenses incurred in carrying on a trade or business).

 

The Court found that the captive was a bona fide insurance company, and that the arrangement shifted and distributed risk to constitute “insurance in the commonly accepted sense.”

The captive was formed to reduce premium costs, improve efficiency, and obtain otherwise unavailable coverage. The parent corporation “made a business decision premised on a myriad of significant and legitimate nontax considerations,” and the captive entered into bona fide arm’s-length contracts with the parent, charged actuarially determined premiums, was subject to regulatory control, met minimum statutory requirements, paid claims from its separately maintained account, and was adequately capitalized. The Court concluded that there was indeed risk shifting, and that the captive “was a separate, independent, and viable entity” that “reimbursed [the parent’s] subsidiaries when they suffered an insurable loss.” The Court thus determined that, under the facts and circumstances of these case, the policies at issue were insurance, and the parent was entitled to deduct the premiums as reported on its returns.

The Captive Arrangement in the IRS Ruling

Taxpayer Group manufactured and marketed products and services. Taxpayer Group included a captive insurance company (Captive), which was regulated under state law. Captive provided coverage to the Taxpayer Group for automobile liability, products and general liability workers’ compensation, product warranty, credit guarantee insurance, earthquake damage coverage, retiree medical cost coverage, and guaranteed renewable accident and health insurance.

Because Taxpayer Group conducted business throughout the world, “sales and purchases in currencies other than the U.S. dollar expose [Taxpayer Group] to fluctuations in foreign currencies relative to the U.S. dollar and may adversely affect [Taxpayer Group’s] results of operations and financial condition.”

Taxpayer Group began to explore avenues for mitigating this risk, including the possibility of insuring earnings losses arising from foreign exchange fluctuations through Captive.

Parent entered into contracts with Captive on behalf of various members of the Taxpayer Group regarding the risk arising from fluctuations in the rate of exchange between the U.S. dollar and certain foreign currencies.

Captive agreed to indemnify, up to a stated limit, the participating members of the Taxpayer Group for the amount of “loss of earnings” connected to a decrease in the value of each specified foreign currency relative to the U.S. dollar. Captive also agreed to indemnify the participating members for the amount of “loss of earnings” connected to an increase in the value of each specified foreign currency relative to the U.S. dollar up to a stated coverage limit.

The contracts had many features commonly found in insurance policies. Many members of the Taxpayer Group participated in the arrangement. It was anticipated that no one participant would account for more than 15 percent of the premiums paid to Captive. There was no mention of any parental guarantee, premium loan back, or other aspect of the arrangement that would be inconsistent with a bona fide insurance arrangement.

The IRS’s Position

In general, neither the Code nor the Regulations issued thereunder define the terms “insurance” or “insurance contract” for income tax purposes. Rather, the standard for evaluating whether an arrangement constitutes insurance for federal tax purposes is a nonexclusive facts and circumstances analysis. The courts have described “insurance” as an arrangement involving risk-shifting and risk-distributing of an actual “insurance risk” at the time the transaction was executed.

Cases analyzing “captive insurance” arrangements have described the concept of “insurance” for federal income tax purposes as having the following three elements:

  1. An insurance risk;
  2. shifting and distributing of that risk; and
  3. insurance in its commonly accepted sense.

The test, however, is not a rigid three-prong test.

The predicate of insurance is “insurance risk.” The risk must be the risk of an economic loss. The failure to achieve a desired investment return is an investment risk, not an economic loss giving rise to an insurance risk, at least for tax purposes.

The IRS conceded in prior rulings that insurance premiums paid between related corporations may be insurance for tax purposes. In one ruling, The IRS held that an arrangement between a licensed insurance subsidiary of parent, and each of the 12 of parent’s operating subsidiaries constituted insurance where, among other factors, no one subsidiary accounted for less than 5 percent nor more than 15 percent of the total risk insured by the insurance subsidiary. In the ruling the insurance subsidiary was adequately capitalized, it charged arm’s length premiums established according to customary industry rating formulas, there was no parental guarantee or premium loan backs, and the parties conducted themselves in a manner consistent with the standards applicable to an insurance arrangement between unrelated parties.

Insurance Risk?

The IRS concluded that the arrangement at issue in the ruling was not insurance because it lacked insurance risk and were not insurance in its commonly accepted sense.

According to the IRS, not all contracts that transfer risk are insurance policies, even where the primary purpose of the contract is to transfer risk. For example, a contract that protects against the failure to achieve a desired investment return protects against investment risk, not insurance risk.

Insurance risk requires a fortuitous event or hazard, and not a mere timing or investment risk. A fortuitous event (such as a fire or accident) is at the heart of any contract of insurance – the risk must contemplate the fortuitous occurrence of a stated contingency, not an expected event.

When evaluating whether an arrangement constitutes insurance for tax purposes, the IRS said, the first inquiry is whether the subject risk is properly viewed as an “insurance risk” or as a risk of another nature, such as investment or “business” risk.

The IRS addressed the question: “What is an investment or business risk?” Someone buys stock with the intent to make a profit. That risk of success is an investment risk. A business owner invests capital in a business enterprise with the intent to make a profit. The IRS noted that a business has an unlimited number of economic risks. Are all of these economic risks insurance risks? Is a business risk an investment risk of a business?

In deciding whether a contract does not qualify as an insurance contract for federal tax purposes because it involves an investment or business risk, the IRS submitted that all of the facts and circumstances associated with the parties in the context of the arrangement should be considered. One should take into account such things as the ordinary activities of a business enterprise, the typical activities and obligations of running a business, whether an action that might be covered by a policy is in the control of the insured within a business context, whether the economic risk involved is a market risk that is part of the business environment, whether the insured is required by a law or regulation to pay for the covered claim, and whether the action in question is willful or inevitable.

The IRS concluded that the risk involved in the arrangement under consideration was an investment-type risk as it was solely the manifestation of currency valuation.

The participants were primarily interested in selling their goods and services at a profit. They had an economic risk that they would not make a profit on the sale of those goods and services (without regard to foreign currency exchange rates). This risk was an economic risk which was an investment (or business) risk.

The existence of foreign currency exchange rate protection did not change the investment risk of making a profit on the sale of goods or services. It only reduced that risk. Thus, the IRS noted, a seller of goods or services can purchase options on the open market to protect against currency fluctuations or enter into a contract arrangement similar to the contracts at issue. The economic effect is the same. The investment risk was not an insurance risk and therefore the contracts were not insurance.

Taxpayer’s obligation did not arise because of an event that damaged or impaired the protected asset or its income stream. The contracts explicitly limited Taxpayer’s liability if there was damage or impairment to the asset commonly associated with a casualty event, such as losses covered under property insurance or business interruption insurance.

The contracts indemnified for the amount of loss of earnings sustained due to an increase (or decrease) in the value of specified foreign currency relative to the U.S. dollar. Various market forces can affect foreign currency exchange rates, but the occurrence of these events was not the casualty event.

Planning Ahead

The ruling and other authorities described above are instructive. They recognize that a captive arrangement may be accepted for tax purposes, provided it is structured and maintained in an arm’s length manner, and it addresses bona fide business-related insurance risks.

Thus, a taxpayer who is genuinely looking to manage its casualty exposure and insurance costs may be well-served in considering the creation of a captive arrangement.

A taxpayer whose primary purpose for utilizing a captive arrangement does not fit within these parameters should think twice before doing so.

The IRS recently considered whether an arrangement between members of a corporate group and its affiliated insurance company, involving foreign currency fluctuations, constituted insurance for Federal tax purposes. For reasons that we will describe, the IRS concluded that the arrangement did not constitute insurance. captive

Before getting into the details of the IRS’s holding, however, a brief description of captive insurance, and of the IRS’s scrutiny of such arrangements, may be in order.

What is it? How does it work?

Assume that Acme Co. pays commercial market insurance premiums to commercial insurers to insure against various losses. These premiums are deductible in determining Acme’s taxable income. As in the case of most P&C insurance, the premiums are “lost” every year as the coverage expires.

Businesses will sometimes “self-insure” by setting aside funds to cover their exposure to a particular loss. Self-insurance, however, is not deductible.

The Code, on the other hand, affords “smaller” businesses the opportunity to establish their own captive insurance company—indeed, it encourages them to do so —and provides for the deductibility of reasonable premiums paid to such companies by the businesses.

Additionally, the captive may receive up to $1.2 million of annual premium payments from the business free of income tax. Of course, the business cannot simply choose to pay $1.2 million of premium to the captive; the amount paid must be reasonable for the loss being insured.

The captive, which is created as a C corporation, will set aside appropriate reserves and will invest the balance of the premiums received. Any investment income and gains recognized by the captive will be taxable to the captive.

Captive As True Insurance Company

From a tax perspective, the key is that the captive actually operate as a bona fide insurance company. It must insure bona fide risks. It must not be a risk that is certain of occurring; there must be an element of “fortuity” in order to be insurable.

In order to be respected as insurance, there must be “risk-shifting” and “risk distribution.” Risk shifting is the actual transfer of the risk from the business to the captive. Risk distribution is the exposure of the captive to third-party risk (as in the case of traditional insurance). The IRS has issued several rulings over the years regarding these requirements.

To achieve the status of real insurance (from a tax perspective), the captive pools its premiums with other captives (not necessarily from the same type of business).

These pools are managed by a captive management company for a fee. The management company will conduct annual actuarial reviews to set the premium, manage claims, take care of regulatory compliance, etc. This pool will pay on claims as they arise.

The captive should lead to a reduction of the commercial premiums being paid by the business; for example, by covering a larger deductible. Down the road, however, the captive may serve some other important business functions. For example, it may be possible to borrow from the captive to fund a business project.

Proceed With Caution

Too often, taxpayers use captives for personal, nonbusiness planning. Indeed, many promoters tout the captive arrangement as an ultimate retirement, compensation or estate planning device.

Earlier this year, the IRS released its list of “dirty dozen” tax scams. Among the abusive tax structures highlighted was a variation on the so-called “micro” captive insurance company, discussed herein. The IRS characterized the scam version as an arrangement with “poorly drafted ‘insurance’ binders and policies to cover ordinary business risks or esoteric, implausible risks for exorbitant ‘premiums.’ ” According to the IRS, promoters in such scams received large fees for managing the captive insurance company while assisting unsophisticated taxpayers “to continue the charade.” [Link?]

On the other hand, stay tuned for tomorrow’s discussion of a Tax Court ruling from early last year in which the Court decided that payments made by a subsidiary corporation to the captive formed by its parent corporation were properly deductible as insurance premiums (ordinary and necessary expenses incurred in carrying on a trade or business).

A recent decision touched upon a theme that has been considered in several of our blogs: the “substance over form” doctrine, under which the legal form of a transaction – that would otherwise result in a beneficial tax result for a taxpayer – will be disregarded in order to give effect to its “true” economic substance. The case involved what purported to be a like kind exchange of tangible personal property, which in itself makes the case interesting because so many readers think of such exchanges only in the context of real estate.

A Like Kind Exchange Program

Taxpayer sold equipment for a major manufacturer, “Legs Corp.” Prior to Year X, Taxpayer also conducted a rental and leasing business in conjunction with its retail sales business. In Year X, however, Taxpayer formed Subsidiary to take over Taxpayer’s rental and leasing operations.

Although separate entities, Taxpayer and Subsidiary were closely related and were ultimately controlled by the same family, members of which were board members of both corporations. Taxpayer shared building space with Subsidiary, performed accounting and equipment-ordering functions for Subsidiary, and even initially paid the wages of Subsidiary’s employees, though Subsidiary would eventually reimburse Taxpayer on an allocated basis for the shared services. Legs Corp. assigned separate dealer codes to each entity, which enabled each entity to independently purchase its own equipment from Legs Corp.; however, Taxpayer used its own dealer code to order equipment for both itself and Subsidiary.

images67P2JRT1At issue in the case was Taxpayer’s like-kind-exchange (LKE) program, which commenced after Taxpayer formed Subsidiary. The LKE program allowed Subsidiary to trade used equipment for new equipment and, in the process, defer tax recognition of any gains from the transactions. Under the LKE program, Taxpayer sold its used equipment to third parties, and the third parties paid the sales proceeds to a qualified intermediary (“QI”).  QI forwarded the sales proceeds to Taxpayer, and the proceeds “went into [Taxpayer’s] main bank account.” At about the same time, Taxpayer purchased new Legs Corp. equipment for Subsidiary and then transferred the equipment to Subsidiary via QI. Taxpayer charged Subsidiary the same amount that Taxpayer paid for the equipment.

Taxpayer’s use of LKE transactions in this fashion facilitated favorable financing terms from Legs Corp. (referred to as “DRIS” financing terms). Legs Corp. advised taxpayer before it established either Subsidiary or the LKE program that such a transaction structure would enable Taxpayer “to take full advantage of [Legs Corp’s] DRIS payment terms.” The DRIS payment terms, among other things, gave Taxpayer up to six months from the date of the invoice to pay Legs Corp. for Subsidiary’s new equipment. During that time, Taxpayer could use the sales proceeds it received from QI for essentially whatever business purposes it wanted. In other words, Taxpayer essentially received an up-to-six-month, interest-free loan from each exchange.

A Like Kind Exchange?

In a representative transaction, Subsidiary agreed on or before June 30, 2004, to sell Truck 1 to a third party for $756,500. Subsidiary’s adjusted tax basis in Truck 1 was $129,372.70 at the time. The third party paid QI the $756,500 in sales proceeds, and Subsidiary transferred to the third party legal ownership of Truck 1.

On or about August 13, 2004, Taxpayer identified and purchased the replacement Legs Corp. equipment, Truck 2. Taxpayer’s total acquisition price for this new property was $761,065.60. Taxpayer then transferred legal ownership of the replacement property to Subsidiary through QI on August 27, 2004. On September 10, 2004, QI transferred the $756,500 in proceeds from the sale of Truck 1 to Taxpayer. Subsidiary and Taxpayer then adjusted a note between the two companies to compensate Taxpayer for the $4,565.60 difference between the $756,500 in sale proceeds and the $761,065.60 that Taxpayer paid for the replacement equipment.

Thus, in the immediate aftermath of the transaction, (1) a third party owned Truck 1; (2) Subsidiary held its replacement property (Truck 2) and an adjusted note reflecting its new $4,565.60 debt to Taxpayer; and (3) Taxpayer possessed the $756,500 in sale proceeds from Truck 1 and an adjusted note reflecting its new $4,565.60 credit to Subsidiary. Subsidiary deferred recognizing the $627,127.30 gain it realized from the transaction (the difference between the $756,500 in sales proceeds from Truck 1 and Subsidiary’s $129,372.70 adjusted basis in Truck 1), claiming the gain was entitled to nonrecognition treatment under IRC §1031. And Taxpayer, per Legs Corp’s DRIS financing terms, had essentially unfettered use of the sales proceeds from Truck 1 for nearly six months before it was obligated to pay Legs Corp for the replacement equipment.

The IRS Disagrees

From 2004 to 2007 Subsidiary claimed nonrecognition treatment of gains from almost 400 LKE transactions pursuant to §1031. The IRS issued determined that the transactions were not entitled to nonrecognition treatment. The IRS concluded that Subsidiary structured the transactions to avoid the related-party exchange restrictions provided under §1031(f). The district court found, among other things, that the transactions were not entitled to nonrecognition treatment because they were “structured to avoid the purposes of §1031(f).” In so holding, the court analyzed Taxpayer’s “receipt of cash in exchange for equipment, together with its unfettered access to the cash proceeds,” as well as the relative complexity of the transactions. The district court ruled in favor of the IRS, and Subsidiary appealed to the Eighth Circuit.

As a general rule, taxpayers must immediately recognize the gain they realize from the disposition of their property. Taxpayers can defer recognizing such gains, however, when they exchange “property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment.” IRC §1031(a)(1). This LKE exception distinguishes a taxpayer who conducts an LKE from a taxpayer who liquidates or “cashes in” on his or her original investment. With an LKE the taxpayer essentially continues his or her original investment via the like-kind property.

However, after Congress enacted the LKE exception, sophisticated parties exploited the exception in a manner inconsistent with its purpose. Some related entities agreed to structure transactions such that they could actually cash in on their investments while nevertheless claiming nonrecognition treatment under §1031.

Section 1031(f)(1) generally prohibits nonrecognition treatment for exchanges in which a taxpayer exchanges like-kind property with a “related person,” and either party then disposes of the exchanged property within two years of the exchange. Moreover, in an attempt to thwart the future use of more complex transactions that technically avoid the provisions of §1031(f) but nevertheless run afoul of the purposes of the law, Congress also enacted §1031(f)(4), which broadly prohibits nonrecognition treatment for “any exchange which is part of a transaction (or a series of transactions) structured to avoid the purposes of” §1031(f).

 The Court Finds for the Government

The Court began by noting that an exchange may be suspect where it involves unnecessary complexity and unnecessary parties. As discussed above, the transactions each involved an intricate interplay between at least five parties: Subsidiary, QI, Taxpayer, Legs Corp., and the third party who buys Subsidiary’s used equipment. Of course, Subsidiary, Legs Corp., and the third-party customer were indisputably necessary for the sales and purchase transactions to occur. Taxpayer and QI, however, were not.

In fact, Subsidiary acknowledged in its briefing, Taxpayer functioned “as a passthrough of both the cash and the property.” This begged the question of why Taxpayer was involved at all in the transactions. Subsidiary proffered several alternative reasons for Taxpayer’s involvement, including that it made the transactions administratively easier and more efficient. None of these arguments, however, convinced the Court. After all, Subsidiary already had its own dealer code, and it could have placed the exact same equipment orders directly to Legs Corp. Injecting Taxpayer into the transactions added unnecessary inefficiencies and complexities to the transactions, including, among other things, additional transfers of payment and property.

A more plausible explanation for Taxpayer’s involvement, the Court said, was that Taxpayer financially benefitted from what amounted to six-month, interest-free loans under the DRIS financing terms, analyzing “the actual consequences” of the transactions to ascertain the parties’ intent, and noting that related parties should be treated as an economic unit in this inquiry. As discussed above, the DRIS financing gave Taxpayer up to six months to pay its invoices to Legs Corp. In the meantime, the sales proceeds from the relinquished equipment were deposited into Taxpayer’s “main bank account,” and Taxpayer was able to use the proceeds as it pleased.

Taxpayer attempted to downplay the benefit it derived from these de facto interest-free loans by asserting that Subsidiary would have received the same financing terms if it had ordered directly from Legs Corp. The officers of QI, however, testified that QI would have paid the sales proceeds from the relinquished property directly to Legs Corp. if the new equipment were not purchased via Taxpayer. In other words, if Taxpayer was not involved in these transactions, neither Taxpayer nor Subsidiary would have received the de facto interest-free loans.

In sum, though Taxpayer was not necessary to the transactions at issue, it acquired access to significant, freely usable cash proceeds as a result of the transactions. Subsidiary argued that Taxpayer did not have indefinite access to the sales proceeds from each transaction. The Court responded that it simply could not ignore the significant and continuous financial benefits taxpayer derived from these hundreds of de facto interest-free loans.

QI was also an unnecessary party to these transactions. Taxpayer and Subsidiary could have exchanged property directly with each other without QI’s involvement. This extra layer of complexity lent support to the finding that the exchanges were structured to sidestep IRC §1031(f).  Notably, if Taxpayer and Subsidiary had exchanged the property directly with each other, they, as related parties, would have had to hold the exchanged-for property for two years before the exchanges could qualify for nonrecognition treatment. Hence, their need for QI.

 Repetition is the Mother of Learning?

Related party transactions will be subject to close scrutiny by the IRS. Related party transactions will be subject to close scrutiny by the IRS. Related party transactions will be subject to close scrutiny by the IRS.

It appears that many taxpayers, and some advisers, firmly believe that this basic tenet of tax law does not apply to them – at least until they are selected for audit. But why wait for that? There’s nothing like thoroughly examining a proposed transaction before undertaking it. It is worth the time and expense.

Here We Go Again

It is a common theme of these posts that a transaction has to make sense from a business perspective, that it should not be undertaken primarily for tax purposes, and that the goal of tax planning should be to maximize the economic benefit of the transaction by reducing the resulting tax burden.

Another theme of our posts is that transactions between related persons will be subject to special scrutiny by the IRS to ensure that they comport with arm’s length dealing. If a transaction is not conducted on an arm’s length basis, the government will be free to recharacterize the nature of the transaction so as to realize the appropriate tax result.

The IRS recently ruled on a situation involving the sale of a property by two trusts to a purchaser that was controlled by one of the trust beneficiaries.  The IRS considered  a number of transfer tax issues, some of which may not have been evident to an inexperienced adviser, but the implications of which would have been serious without proper planning. imagesEYV8Z3EW

The Trusts

Grantor 1 had established an irrevocable trust (Trust 1) for the benefit of himself, Spouse, and his lineal descendants. Grantor and Spouse were both dead at the time of the sale.

Grantor 2 had established two equal trusts, one for the benefit of his daughter (Spouse) and her descendants (Trust 2).

Both Trust 1 and Trust 2 were irrevocable prior to September 25, 1985, and no additions were made to either trust after September 25, 1985.  Thus, distributions from the trusts were not subject to the generation-skipping transfer tax (“GSTT”).

The beneficiaries and terms of the two trusts were essentially the same. Trust 1 provided that the trustees were to pay the net income for the benefit of Grantor 1’s issue, per stirpes. Trust 1 was to terminate twenty-one years after the death of the survivor of Grantor 1’s three children (the so-called “perpetuities period”). Trust 2 provided that the trustees were to pay the net income to Spouse’s issue, per stirpes. Trust 2 was to terminate twenty-one years after the death of the last surviving lineal descendant of Grantor 2 living at the time of Grantor 2’s death.

The Sale

Trust 1 and Trust 2 together owned Business Property. The trustees of both trusts decided it was in the best interest of the trusts to sell Business Property in a coordinated sale.

Business Property had been on the market for several years when the trusts found a purchaser: Limited Partnership, which was owned by A, a lineal descendant of both Grantor 1 and Grantor 2, who was the trustee of a trust that was a current beneficiary of Trust 1, and a contingent beneficiary of Trust 2. A was experienced in dealing with assets like Business Property.

An agreement of sale (the “Agreement”) was negotiated by the trusts, with some input from the beneficiaries. The trusts and the purchaser were represented by separate counsel. The agreed-upon sale price was consistent with two independent appraisals. Upon completion of the closing, Trust 1 and Trust 2 each received their proportionate share of the sale price.

The GSTT

The IRS considered whether the execution and/or the carrying out of the terms of the Agreement would constitute an addition to either trust that would cause the trust to lose its exemption from the GSTT.

The IRS also considered whether the entering into the Agreement, and the carrying out of the terms thereof, would cause any beneficiary of either trust to make or be deemed to have made a taxable gift to any other trust beneficiary or to A.

According to IRS Regulations, a modification of the governing instrument of a GSTT exempt trust, including a reformation that is valid under state law, will not cause an exempt trust to become subject to the GSTT if the modification does not shift a beneficial interest in the trust to any beneficiary who occupies a lower generation than the person(s) who held the beneficial interest prior to the modification, and the modification does not extend the time for vesting of any beneficial interest in the trust beyond the period provided for in the original trust. A modification that is “administrative” in nature will not be considered to shift a beneficial interest in the trust.

The trusts sought Court approval of the sale of Business Property. The trustees joined with all living beneficiaries of Trust 1 and Trust 2 in the proposed Court proceeding. The Agreement would only be binding on the trusts if the trusts received approval from Court. As part of the proceedings, the trustees petitioned the Court to appoint a guardian and trustee ad litem to represent the interests of minor, unborn, and unascertained descendants of Grantor 1 and Grantor 2. In addition, the Agreement would be binding only if Trust 1 and Trust 2 received from all their beneficiaries ratification and approval of the Agreement. As part of the court approval process, Court had to determine that the Agreement was fair and reasonable, which determination included the determination that the price reflected a fair market value and that the other terms of the sale were reasonable.

The IRS found that the execution and/or the carrying out of the terms of the Agreement and the sale of Business Property were administrative in nature and, so, would not shift a beneficial interest in Trust 1 or Trust 2 to any beneficiary who occupied a lower generation than the person or persons who held the beneficial interest prior to entering into the Agreement or the sale of Business Property. Further, the execution of the Agreement and the sale of Business Property would not extend the time for vesting of any beneficial interest in Trust 1 or Trust 2 beyond the period provided for in the original trusts.

Based on the foregoing, the IRS concluded that the execution and/or the carrying out of the terms of the Agreement would not constitute an addition to either trust or cause either trust to lose its GSTT exempt status.

 The Gift Tax

The IRS next considered whether or not there was a gift tax issues.  Transfers reached by the gift tax include sales, exchanges, and other dispositions of property in exchange for consideration, to the extent that the value of the property transferred by the donor exceeds the value in money or money’s worth of the consideration given therefor. However, the IRS Regulations also provide that a sale, exchange, or other transfer of property made in the ordinary course of business (a transaction which is bona fide, at arm’s length, and free from any donative intent), will be considered as made for an adequate consideration in money or money’s worth and, so, not subject to the tax.

After considering the fact that the trustees obtained two independent appraisals on the value of Business Property, that the Agreement had been negotiated at arm’s length by the corporate trustees of Trust 1 and Trust 2, that the beneficiaries of both trusts consented to the sale, that each of the trusts and the purchaser were represented by separate counsel, that the approval of Court was secured by the trustees demonstrating that the Agreement was fair, reasonable, and that the terms were arm’s length, and that the trustees have a fiduciary duty to act in the best interests of all of the beneficiaries, the IRS concluded that the entering into the Agreement and the carrying out of the terms thereof would not cause any beneficiary of either trust to make or be deemed to have made a taxable gift to any other beneficiary or to A.

It Pays to Plan

The ruling above had a happy ending for the taxpayers, as well it should have. After all, they anticipated, considered and planned for a number of tax issues.

However, what if the facts had been a little different? For example, what if the trustees had been related to the beneficiaries, including the principal of the buyer? What if the trusts did not have separate counsel? What if the purchase price for the property had not been supported by independent appraisals? What if the trustees had decided against seeking a court’s approval? Under those circumstances, the IRS could more easily have argued that the parties did not act at arm’s length and that the sale price did not reflect fair market value.

In that case, the IRS could have concluded that either too much or too little had been paid for the property.

On that basis, the IRS could have concluded that one trust benefited more than the other. One or both trusts may have been treated as having received an additional contribution, either from the related buyer, or from one another, thereby causing them to lose their GSST exemption and subjecting future distributions from the trusts to the 40% GSTT. The IRS could also have concluded that the beneficiaries had made a gift to the principal of the buyer. The surprises abound.

The point is that these “surprises” can and should be avoided. Taxpayers just need to plan ahead, and that means they need to speak to their advisers at the inception of the trust arrangement and at every subsequent event that is out of the ordinary course of business.