Our last post examined what are commonly thought of as the most “direct” income tax consequences arising from a the buy-out of a departing shareholder by way of a cross-purchase or redemption of his or her shares. However, there are a number of other tax consequences to be considered that are no less direct, and that may be equally significant.

 The Other Shareholders

In many closely-held corporations, the remaining shareholders may be contractually obligated, under the terms of a shareholders agreement, to buy the shares of a departing shareholder. In many (if not most) cases, the funding for this cross-purchase arrangement will come from the corporation, for example, by way of loans made or dividends paid to the acquiring shareholders. Oftentimes, these shareholders will simply cause the corporation to purchase the shares from the departing shareholder, without thought as to their own tax consequences. Where the other shareholders are primarily obligated to purchase the shares themselves, the corporation’s satisfaction of that obligation, by redeeming those shares, may result in the deemed payment of a taxable dividend to the other shareholders—a constructive cash distribution.

Constructive Stock Dividend

The remaining shareholders may also realize a form of constructive stock dividend, taxable to them as a cash dividend, where the departing shareholder’s shares are not redeemed all at once but, rather, over a period of years.  In that case, if the redemption of the departing shareholder is treated as a dividend (for example, because the attribution rules prevent a complete termination of his or her interest), the remaining shareholders, by virtue of the relative increase in their equity interests over that same period, may be treated as having received a dividend distribution.

A Gift?

In a family-controlled corporation, a cross-purchase or redemption of stock for an amount other than fair market value may be construed by the IRS as a taxable gift.  For example, if a parent is redeemed for a below-market price, the remaining shareholders may be treated as having received a taxable gift from the departing parent for which gift tax may be imposed, unless it can be shown that the redemption was a bona fide, arm’s length transaction, and free of donative intent (for example, it was negotiated to settle a family dispute).  Conversely, an excessive purchase price may reflect a gift to the departing shareholder from the other shareholders in the context of a family corporation.

 S Corp. Considerations

In addition to the tax consequences that arise directly from the sale of a taxpayer’s shares in an S corporation, there are a number of ancillary considerations, for example, the allocation of S corporation income to the shareholder for the year of the sale (and the possible closure of the corporation’s books as of the sale date), the determination of his or her stock basis through that date, his or her right to “tax distributions” for the preceding tax year, the seller’s right to participate in the tax audit of S corporation tax periods preceding and including the year of sale, and the impact of any adjustments resulting therefrom. These and other factors have real economic consequences to the departing S corporation shareholder and should be addressed before the purchase of his or her shares.

 The Corporation

Generally speaking, from the perspective of the corporation, the redemption of the departing shareholder should not have any adverse tax consequences, though there are some important exceptions.

NOLs

Where the resulting change in stock ownership is significant enough (an “ownership change”), it will trigger certain limitations on the corporation’s ability to use its net operating losses to offset its taxable income.  In that case, it may possible for the corporation’s carryforward period for such losses to expire before the losses have been fully utilized.

In-Kind Distributions

When the corporation buys back the shares of the departing shareholder, the corporation will not realize any gain unless it distributes appreciated property to the shareholder in consideration for the shares.  In that case, the corporation will be treated as having sold the distributed property.  Depending upon whether or not the corporation may be characterized as a “controlled entity” with respect to the shareholder (either before or after the transaction), and if the property is depreciable in the hands of the  former shareholder, the gain realized may be ordinary or capital in nature.  If the corporation is an S corporation, the gain will pass through, and be taxed, to all of the shareholders, including the seller.

AAA

Where the redeeming corporation is an S corporation, a redemption of the shares of a departing shareholder will reduce a proportionate amount of the corporation’s accumulated adjustments account (“AAA”) where the redemption is treated as an exchange (as opposed to a “dividend” distribution) (see Part I). Because the AAA is a corporate account, its reduction will limit the S corporation’s ability to make future distributions to shareholders that will not carry out any C corporation earnings and profits taxable as dividends.

Amortizable Payments?

In addition to the consideration paid to the departing shareholder for his stock, the corporation may pay an additional amount in exchange for the former shareholder’s promise not to compete against the corporation.  This amount will usually be reflected in a separate agreement.  Provided the amount paid for the non-compete is reasonable, it may be amortized by the corporation over 15 years; to the extent it is unreasonable, it may be recharacterized by the IRS as additional purchase price for the stock and, so, would not be amortizable.  Unless it is so recharacterized, the non-complete payment will be taxed as ordinary income to the shareholder.

If the departing shareholder (for example, the parent in a family-owned corporation) enters into a consulting arrangement with the redeeming corporation, the amount paid to him thereunder will be taxable as ordinary income (compensation for services).  If the amount paid is reasonable, it may be deducted by the corporation.  If it is excessive, the excess may be recharacterized by the IRS as payment for a non-complete, amortizable by the corporation over 15 years (not currently deductible).

 Charitable Planning?

In some cases, the departing shareholder may have charitable inclinations and will seek to secure a charitable contribution deduction for the full value of the stock he or she is about to sell, while at the same time avoiding the recognition of the gain to be realized from such sale. These goals may be incompatible where the charity sells the stock shortly after the contribution pursuant to a prearranged plan (under which the charity either is legally bound, or can be forced, to surrender the shares for redemption). In that case, the donor-shareholder will be treated as having sold the stock for cash (thereby recognizing taxable gain), and then contributing the proceeds to the charity (generating a deduction the tax benefit from which may be limited).

IRD and Basis Step-Up

It is often the case that the impetus for the buyout of a shareholder is the latter’s deteriorating health. The timing of such a buyout can have significant consequences for the selling shareholder’s family. For example, if the shareholder were to pass away prior to the execution of a definitive purchase and sale agreement, the fair market value of the deceased shareholder’s shares would be included in his or her gross estate and would receive a step-up in basis.  As a result of such basis increase, the subsequent sale of the decedent’s shares (whether by way of a cross-purchase or by way of a redemption that is treated as an exchange) should not generate any taxable gain.

On the other hand, if the purchase and sale agreement was finalized, but the sale was not completed, prior to the decedent’s death, then the decedent’s estate would not be entitled to a basis step-up in his or her shares. In this scenario, the shares would represent income in respect of a decedent – with the decedent having effectively exchanged his or her  stock ownership for the sales proceeds to be received – and, so, the gain inherent in the shares would be recognized and taxed.

 Planning Ahead

The foregoing discussion highlights some of the many tax considerations that are attendant to the buy-out of a shareholder from a closely-held corporation.  There are others. The manner in which each of these is addressed can have a significant impact on the net economic benefit of the buy-out transaction.  It is imperative that they be planned for prior to the sale.

An especially important factor to be considered is the valuation of a deceased shareholder’s shares and how it may be impacted by the buyout of those shares. This item will be the topic of another post.

No, this post is not “Part II” to last week’s piece on the tax consequences of a stock redemption. That being said, it describes an interesting redemption-related ruling that was recently issued by the IRS. The ruling considered a redemption plan proposed to be adopted by a closely-held business. The context for the plan is one that is very common.

Corp was an S corporation. As such, it had only one class of stock outstanding, with all of its shares having identical voting, distribution and liquidation rights. Corp’s stock was owned equally between Shareholder A and A’s family and Shareholder B and B’s family. stock

Corp amended its articles of incorporation in order to create non-voting common stock.

It then declared and issued a dividend of “X” number of shares of non-voting common stock per each share of Corp’s outstanding voting common stock.

Corp next proposed to adopt a stock redemption plan (“Redemption Plan”). The Redemption Plan was voluntary, meaning that a shareholder could, at his or her discretion, decide to offer his or her shares to Corp for redemption on an annual basis. The amount that could be redeemed, however, was capped at a specific cash limit.

Although not stated in the ruling, the purpose for the arrangement was to offer shareholders an opportunity to monetize their non-marketable, closely-held shares (by creating a “market” for them), while at the same time not putting the business in a cash crunch.

The Redemption Plan provided that any shareholder who desired to have his or her Corp stock redeemed had to have his or her non-voting and voting shares redeemed in the ratio of “Y” (non-voting) to “Z” (voting), unless Corp’s board of directors, in its discretion, approved the stock redemption in a different ratio.

This redemption ratio was intended to ensure that the voting power and economic ownership in Corp remained approximately equal between Shareholder A and A’s family and Shareholder B and B’s family. It was also intended to prevent an individual shareholder from owning a disproportionate amount of voting versus nonvoting common stock.

Corp represented to the IRS that, under the Redemption Plan, the redemption price for the stock would be the appraised value of the voting and nonvoting common stock (determined on a minority basis) as shown on the most recent independent appraisal. However, if no independent appraisal had been made within a certain time frame of the redemption, then Corp’s board of directors could determine the value, in good faith, based upon the methodology used by the independent appraisal.

Corp represented that the Redemption Plan was not designed or intended to circumvent or otherwise violate the second class of stock rule. Corp also represented that the Redemption Plan did not establish a purchase price for the stock that, at the time the agreement was entered into, was significantly in excess of or below the fair market value of the stock.

A small business, or “S” corporation, means a domestic corporation that, among other things, does not have more than one class of stock.

IRS Regulations provide that a corporation that has more than one class of stock does not qualify as a small business corporation.  In general, a corporation is treated as having only one class of stock if all of the outstanding shares of stock of the corporation confer identical rights to distribution and liquidation proceeds. Differences in voting rights among shares of stock of a corporation are disregarded in determining whether a corporation has more than one class of stock.

These Regulations further provide that buy-sell agreements among shareholders, agreements restricting the transferability of stock, and redemption agreements are disregarded in determining whether a corporation’s outstanding shares of stock confer identical distribution and liquidation rights, unless: (1) a principal purpose of the agreement is to circumvent the one class of stock requirement, and (2) the agreement establishes a purchase price that, at the time the agreement is entered into, is significantly in excess of or below the fair market value of the stock.

Agreements that provide for the purchase or redemption of stock at book value, or at a price between fair market value and book value, are not considered to establish a price that is significantly in excess of, or below, the fair market value of the stock and, thus, are disregarded in determining whether the outstanding shares of stock confer identical rights. For purposes of this rule, a good faith determination of fair market value will be respected unless it can be shown that the value was substantially in error and the determination of the value was not performed with reasonable diligence.

Based on the foregoing, the IRS concluded that the Redemption Plan would be disregarded in determining whether the outstanding shares of Corp stock conferred identical distribution and liquidation rights. Thus, the Redemption Plan would not cause Corp to be treated as having a second class of stock.

So what’s the big deal? Nothing really. The ruling reminds us, however, that there are many possibilities available to the closely-held business for creating a “liquidity market” for its owners. It also demonstrates that, with proper planning, it may be possible to accomplish important business goals, such as preserving the “balance of power” between two families (or shareholders) without necessarily sacrificing tax efficiencies. You just need to think it through.

Part II of the stock redemption series will appear next week.

 

Every owner of a closely-held corporation has certain property rights, arising from his or her status as an owner, that have economic value to the owner.  At the inception of the business, the owner may count among these rights the ability to share in the profits generated by the business, whether in the form of compensation or distributions.  Taking a longer-term perspective, the owners may contemplate the ultimate sale of the business to a third party, at which point each owner would share in the sale or liquidation proceeds.

 As so often happens, however, the ownership of a closely-held corporation does not remain static.  Sometimes, an owner will leave of his or her own volition; at other times, the owner will be “asked” to leave.  In either case, the business relationship is formally terminated upon the former owner’s disposition of his or her equity interest in the business.

 Although several factors may be considered in determining the “purchase price” for this interest (including the shareholder’s agreement, if any), when the parties ultimately do arrive at a price, this price inevitably will reflect a pre-tax economic result.  The after-tax and true economic result will usually depend upon both the corporation’s tax status and the structure of the disposition.  Nevertheless, it is often the case that insufficient thought is given to this structure, and thus to the tax treatment of the disposition; consequently, the economic cost of the transaction becomes more expensive than it otherwise could have been.

 In disposing of his or her equity in a closely-held corporation, an owner has two basic choices:  a sale to some or all of the other owners (a cross-purchase) or a sale to the business itself (a redemption of the shares of stock).  In some cases, these two structures may be combined.  In others, additional elements may be added to the structural and economic mix.

 Cross-Purchase

A shareholder departing from either a C corporation or an S corporation may sell his or her shares of stock to some or all of the other shareholders.  He or she will realize gain equal to the amount paid for the shares over his or her adjusted basis in the shares.  (Thus, if the seller had inherited the shares with a basis step-up, it is possible that little or no gain may be realized.)  Provided the selling shareholder has held the shares for more than 12 months, the gain recognized will be treated as long-term capital gain.  (Inherited property is deemed to satisfy the long-term holding period.)

 In general, the selling shareholder will recognize, and be taxed on, the gain realized on the sale when he or she receives cash or other property in exchange for his or her shares.

 A shareholder who receives a term-note from the buyer(s), providing for payments after the year of the sale, will recognize a pro rata portion of the gain realized as payments are made on the note.  The gain may thus be deferred under installment method reporting.  If the note bears interest, the receipt of the interest will be taxed as ordinary income.  If the note does not provide for interest, the IRS will impute interest, thereby converting some of the principal payments (otherwise capital gain) into interest (ordinary income). 

 It should be noted that installment reporting is not always available to the selling shareholder (as where the note received is a demand note).  Additionally, even where such reporting is available, certain actions on the part of the seller may accelerate recognition of the otherwise deferred gain (for example, by pledging the note to secure a debt).  Moreover, where the installment obligation exceeds $5 million, a special interest charge will be imposed by the IRS, for the life of the note, which will effectively negate the tax benefit of installment reporting. 

Redemption

Instead of selling his or her shares to the other shareholders, the corporation itself may buy back the departing owner’s shares.  In the case of most closely-held businesses that are not family-owned, the redemption of all of the seller’s shares should be treated as a sale of the stock, with the seller realizing gain equal to the purchase price for the shares over the seller’s adjusted basis for the shares. The gain recognized should be treated as capital gain (though a special rule applies to the redemption of preferred stock, which may result in some dividend treatment).  If the corporation issues an installment note in consideration for the shares, gain recognition may be deferred under the installment method.

 In the case of a C corporation, these results may change significantly if the redeeming corporation is owned, at least in part, by persons that are “related” to the seller. A redemption in which the seller’s ownership in the corporation is completely terminated is typically treated as a sale. If the seller’s interest  is treated as not having been completely terminated, however, the corporation’s payment may be treated as a dividend distribution to the extent of the corporation’s earning and profits.  In that case, the entire distribution amount may be taxed to the seller; it is not reduced first by the seller’s basis in the redeemed shares.  Moreover, since the redemption is not treated as a sale or exchange for tax purposes, any note distributed by the corporation to the seller is likewise treated as a dividend distribution, in an amount equal to the fair market value of such note; there is no installment reporting.  Thus, the results are less favorable than exchange treatment.

 Attribution Rules

In distinguishing between a sale-redemption and a dividend-redemption, certain attribution rules must be considered.  Under these rules, a selling shareholder disposing of all of his or her shares is nevertheless deemed to own the shares that are actually owned by another, “related” shareholder.  By virtue of this attribution of ownership, the selling shareholder will have failed to terminate his or her interest in the corporation and, so, may be subject to dividend treatment.  However, where the related person is a family member, it may be possible for the redeemed shareholder to “waive” the family attribution rule, provided he or she satisfies certain conditions; for example, immediately after the redemption, the former shareholder cannot be an officer, director or employee of the corporation, though he or she may be a creditor of the corporation.  If these conditions cannot be satisfied (for example, a redeemed parent wants to remain on the board of directors), then waiver of family attribution is not available.

 S Corps

Where the corporation is an S corporation, the tax consequences to the departing shareholder from the sale of her stock in a cross-purchase is the same as described above.  As in the case of a C corporation, the complete redemption of a departing shareholder’s stock is taxable as either a distribution or as a sale, depending upon the application of the ownership attribution rules.  If the S corporation was previously a C corporation with earnings and profits (or if it had acquired a C corporation in a tax-free reorganization), some portion of the redemption proceeds will be taxable as a dividend, as described above, if the redemption fails to qualify as a sale or exchange.  However, if the S corporation has no earnings and profits from a C corporation, the redemption proceeds will be treated first as a tax-free return of stock basis; and then as gain from the sale of the stock, even where the redemption fails to be treated as a sale or exchange.  Thus, in the case of a corporation that has always been an S corporation, the distinction between a dividend-type and a sale-type redemption may be less important. 

Anything Else?

The foregoing is not to say that the only two buyout choices are a cross-purchase or a redemption.  In fact, the two structures may be combined such that the remaining shareholders will purchase some of the departing shareholder’s shares while the corporation redeems the balance.  The tax analysis is the same as set forth above.  However, the tax analysis of a shareholder-buyout is not limited to the actual sale transaction. There are a number of other economic and tax considerations, some of which will be the subject of our next post.

Related parties, be they family members or commonly-controlled business entities, must be careful when transacting business with one another.  They, and their advisers, must recognize that these transactions will be subject to close scrutiny by the IRS. The parties must treat each other, as much as possible, as unrelated persons, and they must be able to support the reasonableness of any business transactions between them.

The advisers to the related parties in such transactions must be familiar with the various common-law doctrines by which the IRS and the Courts may re-characterize a related party transaction. Among these are the economic substance, substance-over-form, and step transaction doctrines, under which a transaction that would otherwise result in a beneficial tax result for a taxpayer will be disregarded if the transaction lacks economic substance.

As one taxpayer recently learned, the complexity of a series of transactions among several related companies will not ensure the result sought to be achieved; in fact, it may only invite closer scrutiny. Barnes Group, Inc. v. Comr., 2d Cir. No. 13-04298, Nov. 5, 2014.

  Funding Expansion . . .

Taxpayer was a manufacturer and distributor that operated separate business segments through domestic and foreign subsidiaries. Taxpayer’s strategic objective was to expand its business primarily through acquisitions, which it financed through debt.

This increase in debt transformed Taxpayer from a relatively low-leveraged firm to one with significantly above-average leverage for companies within its industry, and also increased its cost of borrowing and debt-to-equity ratio.

After the initial phase of acquisitions, Taxpayer and its domestic subsidiaries had relatively few cash reserves, while its foreign subsidiaries had significant reserves. One subsidiary in particular (“Asia”) was generating cash well in excess of its operating needs, which enabled it to make loans to other subsidiaries and also allowed it borrow funds from an unrelated bank (“Bank”) at a preferential interest rate.

Accounting for all of the bank deposits held by Taxpayer’s domestic and foreign subsidiaries, Taxpayer was earning approximately 3% interest on its aggregate cash holdings. Conversely, Taxpayer had external borrowings with interest rates ranging between 7.0% and 9.50%.

Accessing Subsidiary Funds

Consistent with Taxpayer’s “growth by acquisition strategy,” Taxpayer sought to use Asia’s excess cash and borrowing capacity to finance one or more international acquisitions. However, Taxpayer understood that either a dividend or a loan from Asia to Taxpayer would trigger a federal income tax liability under the controlled foreign corporation rules.

Taxpayer and several of its subsidiaries, including Asia, hatched an investment plan that was structured so that Taxpayer would receive Asia’s excess cash, Asia’s receivables from foreign affiliates, and the proceeds of a loan from Bank.

Asia’s receivables related to Taxpayer’s UK and French subsidiaries; however, neither had the funds to repay its respective loan. Therefore, Taxpayer lent the funds to them, and they repaid their loans to Asia. Thereafter, Taxpayer’s Canadian subsidiary made alleged equity investments in the UK and French subsidiaries, and they repaid the loans from Taxpayer.

For purposes of implementing the reinvestment plan, Taxpayer formed a Bermuda and a Delaware subsidiary (“Bermuda” and “Delaware,” respectively).  Bermuda was a controlled foreign corporation.

The reinvestment plan was structured to involve a similar series of transactions, to occur in the following order: (1) Asia (using its own reserves plus amounts borrowed from Bank) and Taxpayer would transfer foreign currency to Bermuda in exchange for Bermuda common stock; (2) Bermuda and Taxpayer would transfer foreign currency and Bermuda common stock to Delaware in exchange for Delaware common and preferred stock; and (3) Delaware would convert the foreign currencies into U.S. dollars and then lend the funds to Taxpayer which, in turn, used the funds to pay off its own debt.

As mentioned above, Bermuda and Delaware were formed for the purpose of participating in the reinvestment plan. Bermuda had only nominal amounts of income and deductions during the periods in question. Accordingly, Bermuda had no earnings and profits. Bermuda had no paid employees and had very little cash.

Bermuda’s board of directors included Taxpayer’s assistant treasurer, its CFO, and its treasurer. Taxpayer’s assistant treasurer  was also Bermuda’s treasurer. In accordance with instructions from Taxpayer’s senior management, he signed many if not all of Bermuda’s corporate documents in order to implement the reinvestment plan, and was responsible for the movement of all cash under the reinvestment plan.

Delaware’s board of directors consisted of the same individuals. Like Bermuda, Delaware had no paid employees and nominal amounts of cash during the periods in question. Furthermore, Delaware’s function appears to have been limited to the currency conversions  and subsequent lending transactions with Taxpayer.

The Courts Step In

In a notice of deficiency, the IRS increased Taxpayer’s taxable income by an amount equal to the aggregate transfer from Asia.

 The IRS claimed, and the Tax Court and the Second Circuit agreed, that the “form” of Taxpayer’s transactions did not control the determination of their tax consequences. According to the Courts, one cannot ignore the effect of the step transaction doctrine, under which the individual steps in the integrated series of transactions (Taxpayer’s reinvestment plan) should be disregarded.  

 The step transaction doctrine, the Court stated, is a manifestation of the broader tax principle that substance should prevail over form. “By emphasizing substance over form, the step transaction doctrine prevents a taxpayer from escaping taxation. [It] treats the steps in a series of formally separate but related transactions involving the transfer of property as a single transaction, if all the steps are substantially linked.”

 In deciding whether to invoke the doctrine, the Court applied the so-called “interdependence test.” This test focuses on whether a series of transactions are “so interdependent that the legal relations created by one transaction would have been fruitless without a completion of the series.”

 The Court then applied the step transaction doctrine to collapse the series of transactions through which Taxpayer obtained the funds of its Asia subsidiary by channeling the funds through the Bermuda and Delaware subsidiaries, both created solely to facilitate the transfer. Each transaction in this series was completed pursuant to a plan of reinvestment that effectively acknowledged these transactions comprised “a single integrated plan.” The transactions contemplated “would have been fruitless without a completion of the series” of transactions culminating in a transfer of the funds to Taxpayer. Indeed, that transfer was the entire purpose of the series of transactions from the beginning. Thus, the steps by which Asia’s funds were transferred to Taxpayer were correctly treated as one transaction.

 Taxpayer argued that application of the step transaction doctrine was inappropriate because the channeling of Asia’s funds through Bermuda and Delaware, rather than directly to taxpayer, served a valid business purpose. The Court found that Taxpayer failed to establish a valid business purpose for the circuitous structure of these transactions and it even failed to respect the bona fides of its own structure (for example, no interest payments to Delaware or dividend payments to Bermuda were ever made).  The sole purpose was to transfer Asia’s funds to Taxpayer in a manner that had the appearance of a non-taxable transaction.

 Given Taxpayer’s failure to establish that any of Asia’s funds were repaid, or that these transactions were bona fide investments, the Court found that the series of investments was “in substance dividend payments from Asia to” Taxpayer.  

 Careful What You Do

The tax adviser to a closely held business needs to familiarize him- or herself with the common-law doctrines described above. It is in the context of such a business that one will frequently encounter transactions between the business and its owners, or between the business and a related entity.

As a general rule, the relevant inquiry should be whether the transaction that generated the claimed tax benefit also had economic substance or a business purpose in order for the transaction to withstand IRS scrutiny. One must be especially diligent where the “transaction” actually involves a series of related steps. Although each step, standing on its own, may appear, at least superficially, to be bona fide from business perspective, a critical examination may lead to the conclusion that the steps had meaning only as part of a larger transaction.

In that case, the ultimate tax result may differ significantly from, and be much more expensive than, what the taxpayer hoped to achieve. The point is to understand the risk and to quantify the exposure.

Installment Sale of Business

Why Defer Receipt of Purchase Price?

Generally speaking, the seller of a closely held business would prefer to be paid in cash at closing. There are situations, however, in which the seller may prefer to dispose of the business in exchange for some combination of cash and an installment note, especially where the buyer is creditworthy and the note is secured. It that case, the seller will be entitled to periodic payments of interest in respect of the unpaid principal. In addition, the seller will be able to defer recognition, and taxation, of the gain realized on the sale of the business.

Specifically, and unless the seller elects otherwise, under the installment method of reporting the seller will report – and be taxed on – a proportionate part of the total gain realized on the sale only as the seller receives principal payments. Thus, the taxation of the sale gain may be spread out over several years.

Conversely, the buyer may prefer to acquire the business in exchange for its promissory note where the buyer must immediately satisfy certain liabilities of the seller, or where the buyer must invest capital in the newly-acquired business. In addition, the buyer may prefer to issue a note in order to secure itself against any breaches of the seller’s representations and warranties in respect of the business; in the event of any such breach, the buyer may simply reduce the outstanding principal amount of the note.

Rationale

Although the installment method of reporting is generally viewed as a beneficial tax deferral mechanism for the seller, in reality it is simply a recognition of the inverse economic relationship that exists between, and that theoretically justifies the different tax treatment of, one who receives immediate value in a sale transaction, versus one who receives only a promise of payment in the future and the credit risk that it entails.

Limitations on Installment Reporting

Assuming that a seller is comfortable with the credit risk (whether because the buyer’s note has been guaranteed by another person, bears sufficient interest, and/or has been secured by a stand-by letter of credit), and that the gain from the assets to be sold qualifies for installment reporting, there are still a number of limitations on the seller’s continued use of the installment method of which the seller’s tax advisers must be aware. For example, if the holder of an installment note (the seller of the business) pledges the note to secure a debt incurred by the note holder, the holder will have to recognize the gain inherent in the note to extent the note has, thus, been monetized. 

Dispositions

Similarly, if the holder of an installment note disposes of the note, the holder will generally have to recognize the deferred gain from the sale that is inherent in the note. Thus, gain is recognized upon the satisfaction of an installment obligation at other than its face value, or upon the distribution, transmission, sale, or other disposition of the installment obligation. 

There are several exceptions to this “acceleration-of-gain-on-disposition” rule. The IRS recently proposed regulations relating to one such exception. 

IRS Proposal: Capital Contributions and Debt Satisfaction

In general, under the proposed regulations, a seller will not recognize gain on certain dispositions of an installment note if gain would not be recognized on the disposition of the note under another provision of the Code. The exceptions identified in the regulations include certain capital contributions to corporations and to partnerships.

The IRS had previously ruled that these exceptions to recognition of gain under the installment sale rules do not apply to the transfer of an installment obligation that results in a satisfaction of the obligation — after all, the obligation ceases to exist. Thus, the IRS ruled that the transfer of a corporation’s installment obligation to the issuing corporation in exchange for stock of the issuing corporation resulted in a satisfaction of the obligation. In that case, the transferor must recognize gain on the satisfaction of the obligation to the extent of the difference between the transferor’s basis in the obligation and the fair market value of the stock received, even though gain or loss generally is not recognized on such capital contribution transfers, and even though the equity interest represents an illiquid asset.

The proposed regulations provide that this general “non-acceleration-of-recognition” rule does not apply to the satisfaction of an installment obligation. They incorporate the IRS’s earlier holding to provide that a seller recognizes installment gain when the seller disposes of an installment note in a transaction that results in the satisfaction of the note, including, for example, when an installment obligation of a corporation is contributed to the corporation in exchange for an equity interest in the corporation.

They also expand the exception to the non-recognition rule to cover the satisfaction of an installment obligation of a partnership when it is contributed to the partnership in exchange for an equity interest in the partnership.

What’s a Note Holder To Do?

Notwithstanding the fact that these regulations are proposed to apply to satisfactions, distributions, transmissions, sales, or other dispositions of installment obligations after the date the regulations are published as final regulations, taxpayers would be well-advised to start abiding by these rules now.

Moreover, sellers who receive installment notes in exchange for the sale of a business should be aware that the “acceleration-of-gain-on-disposition” rule may apply to a number of common situations, including the transfer of the note by gift. And while distributions by a partnership to its partners are generally excluded from the recognition rule (subject to certain exceptions), distributions by a corporation-seller will result in acceleration of gain recognition.

The bottom-line: before a note holder does anything other than collect the scheduled interest and principal payments with respect to an installment note that has been received in exchange for the sale of the holder’s business, the note holder should consult with its tax advisers. Only in this way can it avoid a situation where it will have to recognize the gain inherent in the note before the note has been paid and satisfied, or otherwise monetized.


Nonqualified Deferred Compensation

In general, a nonqualified deferred compensation plan allows an executive to defer the “receipt” and income taxation of a portion of his compensation to a tax period after the period in which the compensation is earned (i.e., the time when the services giving rise to the compensation are performed). 

The payment of the compensation is generally deferred until some specified event, such as the individual’s retirement, death, disability, or other termination of service, or until a specified time in the future (e.g., ten years).

When the deferred compensation is ultimately paid out to the executive, it will then be subject to income tax as compensation.  However, that pay-out period may extend over several years, at which time the executive’s effective income tax rate may also be lower.

In general, nonqualified deferred compensation arrangements are contractual arrangements between the employer and the executive.  They may be structured in whatever form achieves the goals of the parties and, so, may vary greatly in design.

Income Tax

The determination of when amounts deferred under a nonqualified deferred compensation arrangement are includible in the gross income of the executive earning the compensation depends on the facts and circumstances of the arrangement.  A variety of tax principles and Internal Revenue Code (“IRC”) provisions may be relevant in making this determination, including:

–        The doctrine of constructive receipt;

–        The economic benefit doctrine,

–        The provisions of  IRC Section 83 (relating to transfers of property in connection with the performance of services); and

–        The provisions of IRC Section 409A.

Generally, the compensation is includable in income when it is actually or constructively received by the employee  (as when it is made available so that he could draw upon it at any time, without substantial limitations), when the employee realizes the economic benefit of the compensation (as when he can pledge it to secure a loan), or when the deferral plan fails to satisfy the requirements of Section 409A.

FICA Tax

Nonqualified deferred compensation is generally taken into account as wages for FICA purposes at the time when the services giving rise to the compensation are performed (thereby giving rise to the right to a deferral). At that time, as a rule, employers are generally required to withhold and remit FICA taxes.  However, if the deferred compensation is subject to a substantial risk of forfeiture (not vested), it will not be included in FICA wages until it becomes vested.

A federal district court recently considered the case of an employer that failed to timely withhold FICA taxes.

 The Plan

 Executive participated in Employer’s Deferred Compensation and Supplemental Retirement and Investment Plan (the “Plan”), a nonqualified retirement plan.

The Plan was designed to provide a supplemental retirement benefit for a select group of management or highly compensated employees. This was to be accomplished by permitting the Participants to defer a portion of their compensation, which was not taken into account under the normal Employer’s Retirement Plan. Under the Plan, the participants would defer their compensation until the time of their retirement. Presumptively, at retirement, the participants would be taxed in a lower tax bracket, thereby decreasing their overall tax liability.

Executive retired in 2003 and began receiving his monthly supplemental benefit under the Plan. Eight years later, in 2011, a letter was sent from the Employer to all participants, informing them that Employer had “determined that [FICA] payroll taxes associated with [their] nonqualified retirement benefits [were not] properly withheld.”  The letter further stated: “At the time of your retirement, FICA taxes were payable on the present value of all future non-qualified retirement payments [the “Special Timing Rule”]. Therefore, you are subject to FICA Taxes on your non-qualified retirement payments on a ‘pay as you go’ basis for 2008 and beyond, which are the tax years that are still considered ‘open’ for retroactive payment purposes.”

In the letter, Employer also informed participants that Employer: (1) remitted the full payment of FICA tax owed to the IRS on behalf of Plaintiffs; (2) did not deduct the entire amount owed for FICA taxes from the participants’ accounts, but instead reimbursed itself by reducing the participants’ monthly benefit payments for a 12 to 18 month period; and (3) planned to adjust participants’ monthly payments under the Plan, effective January 2012.

 Executive commenced an action against Employer to challenge the change to his benefits resulting from the Employer’s having failed to withhold FICA taxes at the time of vesting, based upon the actuarial present value of his benefits under the Plan, and asserting damages in the amount of the additional FICA taxes withheld by the Employer from the actual payment of benefits under the Plan.

Executive asserted that Employer’s administration of the Plan resulted in a reduction of his benefits. He did not seek to enjoin the ongoing collection and payment of his FICA taxes, nor did he dispute that FICA taxes were owed based on the distribution of his benefits. Rather, he maintained that his promised benefits were reduced because of Employer’s mistake in failing to timely withhold the FICA taxes. That reduction, Executive asserted, should have been borne by Employer.

Executive sought summary judgment on its claim that Employer committed a FICA error in violation of the Plan. After reviewing the Plan and the evidence presented, the Court found that Executive was entitled to summary judgment.

The Court found that while nothing in the Code mandates the use of the Special Timing Rule (which allows the Employer to use the present value of future payments, at the time of vesting, for purposes of determining the FICA tax due), the failure to take advantage of the Special Timing Rule in this case  resulted in higher taxes.  Despite the fact that Employer did not violate federal law, the Court found that Employer violated provisions of the Plan and the Plan’s purpose because the Plan vested Employer with control over executive’s funds and required Employer to properly handle tax withholding from those funds.

The undisputed facts of this case indicated that Employer did not timely withhold the Executive’s taxes while the funds were within Employer’s control as required by the Plan. It was undisputed that Employer did not properly withhold and pay FICA taxes at the time they were initially due under the Code (in this case, in the year of retirement based on the value of amounts to be paid to from the non-qualified retirement plan).

Rather than properly withholding the Executive’s taxes as required by the Plan, Employer paid these taxes at the time of each benefit payment. Employer then placed the Executive on a pay-as-you-go basis, which, at that point, was the only way to adhere to the law. This approach resulted in the Executive’s owing more in FICA taxes than he would have owed had Employer properly and timely paid taxes when they were due.

Accordingly, the Court found that the Executive was entitled to summary judgment because Employer failed to adhere to the purpose and terms of the Plan resulting in a reduced benefit to the Plaintiffs.

Lessons

One of the most common reasons employers use deferred compensation arrangements is to induce or reward certain behavior; e.g., to retain the services of an employee, or to encourage the employee to attain certain performance goals.

In order to attain these goals, however, it is important that the employer abide by the terms of the deferred compensation plan and by the applicable tax rules. The failure to do so may not only defeat the purpose of the plan, by adversely affecting the executives covered by the plan, but may also result in additional economic costs to the employer when it is forced to hold those executives harmless from the consequences resulting from such failure.

Deferred Payments

It goes without saying that when a taxpayer disposes of property in a taxable sale or exchange, the gain realized on the sale will be subject to tax. Depending upon the nature of the asset disposed of, the gain may be taxable at ordinary or at capital gain rates.

It is also generally understood that if the property is sold for one or more deferred payments—payments of purchase price that are made after the year in the which the disposition occurs—the taxpayer’s recognition of the gain realized on the sale may be deferred, under the installment method, until such time as the payments are actually received (regardless of the seller’s method of accounting).

In many cases, these deferred payments are evidenced by a promissory note. The note will be payable over a term of years, may be secured by the property sold, and may be guaranteed by another person (typically, the buyer’s parent corporation).  Generally, it will bear a rate of interest that may or not be payable currently. The interest is taxed as ordinary income (up to a rate of 43.4% for individuals), while the principal is usually taxed as capital gain (up to a rate of 23.8% for individuals).

 Imputed Interest

In other cases, the deferred payments of purchase price are not accompanied by a payment of stated interest (though in the case of an escrow account, the earnings thereon will typically follow the “principal”). Taxpayers are often surprised to see that, in these situations, the IRS will treat part of the purchase price (part of the principal, if you will) as interest for tax purposes. In other words, they are surprised to see that what otherwise would have been taxed to them as capital gain purchase price is, instead, treated as ordinary interest income. This interest is referred to as “imputed interest.”

Their surprise sometimes turns to shock when interest is imputed despite the fact that the sales price is not only deferred, but is, in fact, contingent on future events. They are incredulous that interest would be imputed under such circumstances. After all, they say, the reason for a contingent purchase price arrangement was because the parties could not agree upon the total sale price as of the sale date. This will often be the case in the sale of a closely held business; for example, parties will often provide for adjustments to, and subsequent payments of, purchase price based upon an earn-out because they cannot agree on the level of performance that the business will attain during the years immediately following the sale. How then, they say, can interest be imputed when the payment was not even determinable at the sale? This shock is exacerbated when a well-advised buyer issues an information return to the seller reflecting the seller’s receipt of ordinary interest income (the payment of which may be deductible by the buyer).

 The IRS Considers Contingent Payments

The IRS considered a complex contingent payment arrangement in a recent ruling.  In accordance with a merger agreement, Acquiring merged with and into Target (“Merger”), with Target as the surviving corporation (a stock sale). Before the Merger, Acquiring was a wholly-owned subsidiary of Taxpayer. Pursuant to the merger agreement, Target became a wholly-owned subsidiary of Taxpayer, and the equity interests of its members (“Record Date Members”) were cancelled and automatically converted into the right to receive consideration representing a portion of the purchase price.

Taxpayer agreed to pay Purchase Price to the Record Date Members. The Purchase Price was payable over five years. The Purchase Price would be adjusted upward or downward (based upon certain performance criteria) on each of five adjustment dates (“Adjustment Dates”), producing five adjusted purchase prices (“Adjusted Purchase Prices”).

Each Record Date Member would receive a percentage of each of the five Adjusted Purchase Prices (“Future Payments”) annually on or before five corresponding payment dates (“Payment Dates”).

Simple interest would be computed on Adjustment Date 5 as if it had accrued on the five unpaid balances of the final Adjusted Purchase Price determined immediately before the five Future Payments. The Interest would be computed as if it had accrued over five computation periods (one for each Payment Date at five variable annual rates (one for each computation period) with each rate based on the ten-year United States Treasury bond rate.  The Interest would be paid in a balloon payment as part of the fifth Future Payment on or before Payment Date 5.

The IRS stated that, in the case of any payment under any contract for the sale or exchange of property that provides for one or more payments due more than one year after the date of the sale or exchange, where the contract does not provide for adequate stated interest, there shall be treated as interest that portion of the total unstated interest under the contract which is properly allocable to such payment (so-called “imputed interest”).  Thus, the unstated interest is not treated as part of the amount realized from the sale or exchange of property (in the case of the seller), and is not included in the purchaser’s basis in the property acquired in the sale or exchange (though it may be deductible by the purchaser).

As a rule, a contract has adequate stated interest if the contract provides for a stated rate of interest that is at least equal to the “test rate” – generally, based upon the AFR – and the interest is paid or compounded at least annually.

However, because the merger agreement provided for one or more contingent payments, even if it had provided for adequate stated interest, the IRS concluded that the imputed interest rule applied to the merger agreement. Thus, all of the non-contingent payments under the overall contract would be treated as if made under a separate contract (as a separate debt instrument), with the imputed interest being accounted for annually on the basis of the so-called “OID rules.” On the other hand, each contingent payment under the overall contract would be characterized as principal and interest.  Specifically, a contingent payment would be treated as a payment of principal in an amount equal to the present value of the payment determined by discounting the payment at the test rate from the date the payment was made to the issue date. The amount of the payment in excess of the amount treated as principal under the preceding sentence would be treated as a payment of interest, and would be taken into account by the seller under its regular method of accounting.

 It’s Just Dollars – Plan For It

As we have said many times, every sale transaction is about economics– the seller decides to sell a property because the seller expects to end up with a certain level of net proceeds. Toward that end, the tax liability arising out of the sale must be considered in pricing the transaction. Only in this way can the seller hope to arrive at the desired net economic result.

In considering the tax cost of a transaction, it is imperative that the seller consider the application of the imputed interest rules, especially where the seller is an individual, an S corporation, or a partnership/LLC with individual owners. As to these taxpayers, the 19.6% differential between the capital gain and ordinary income rates can have a significant economic impact that must not be overlooked. While it would appear simple enough to provide for the actual payment of interest in respect of the contingent purchase price, buyers will rarely agree to such interest (and a seller’s attorneys rarely ask for it).

At the end of the day, it’s all about dollars and negotiation – which means there may be a way to reduce the impact.

 It is relatively easy for an S corporation to inadvertently lose its tax status. For example, a disgruntled shareholder may transfer all or a portion of his or her shares to a person that is not qualified to hold S corporation shares, such as a C corporation or a nonresident alien. Upon the occurrence of such an event and the subsequent automatic termination of its S election, the corporation becomes a taxable C corporation.  Well-advised shareholders may prevent an inadvertent termination of a corporation’s S election by means of a shareholders’ agreement that restricts the transfer of stock.

 However, there are times where the shareholders of an S corporation may decide to deliberately revoke the corporation’s S election; for example, where the individual income tax rate is greater than the corporate tax rate, and the circumstances are otherwise “right” (as where a sale of the business is not reasonably foreseeable), a particular corporation and its shareholders may determine that it makes economic sense to give up the S election.

 Shareholder Considerations in Giving up “S”

Aside from the change in flow-through treatment and the application of certain other rules (for example, the application of the surtax on net investment income ), the loss of “S” status should not impact the corporation’s shareholders. They retain the same adjusted basis and holding period for their shares.

 Before revoking the S election, however, there are still a number of factors that shareholders should consider. Most important, perhaps, is the fact that the former S corporation may not again file an S election until the fifth taxable year after the year in which the revocation was effective. In addition, when a new S election is eventually made, the corporation’s assets become subject to the built-in gains tax.

 Another factor to consider, and one that is often overlooked, is the treatment of any S corporation income that had previously been taxed to the shareholders (under the S corporation flow-through rules ) but had not been distributed to them. This income will be reflected in the corporation’s accumulated adjustment account (“AAA”) and in the adjusted basis of the stock held by the shareholders.

 In a recent advisory ruling, the IRS considered the case of an S corporation that sought to distribute or, more accurately, to preserve its AAA.

 Ruling Requested

Taxpayer was incorporated as a C corporation, and it operated as such until it made its first election to be treated as an S corporation. At that time, Taxpayer had accumulated earnings and profits (E&P) from its operations as a C corporation. After making its S election, Taxpayer continued to generate profits. Taxpayer had a positive AAA balance when its majority shareholders later revoked its S election. It also carried forward its E&P from the C corporation period preceding its first S election.

 During the Taxpayer’s post-termination transition period (“PTTP”), Taxpayer distributed some, but not all, of its AAA to its shareholders, leaving some undistributed AAA related to its initial S period.

 In general, the PTTP is the one-year period that follows the end of the corporation’s S period. During the PTTP, a former S corporation may distribute cash (and only cash) to its shareholders on a tax-free basis.  Taxpayer represented that it did not distribute all of the AAA during the PTTP; it did not have available cash equal to its AAA to distribute because it needed to retain cash to capitalize new market growth opportunities.

 Taxpayer subsequently made a second S election. Taxpayer represented that it had converted from C to S to C and back to S to take advantage of individual and corporation tax rates available at the time of each conversion. Taxpayer requested a ruling regarding whether its AAA balance from its first S period survived the period between the end of the PTTP for the first S period and the effective date of its second S election.

 The IRS Responds

An S corporation’s AAA is an account of the S corporation. It is not apportioned among the shareholders. (Contrast this to the individual capital account of a partner in a partnership.)

 All S corporations start with a AAA balance of zero on the first day of their S status. For S corporations with E&P from a prior period as a C corporation or a merger with a C corporation, the AAA tracks the corporation’s ability to make tax free distributions (of S corporation earnings) to its shareholders. To the extent that a corporation has a positive AAA, and the distribution does not exceed a shareholder’s basis in his or her stock, the S corporation can make tax-free distributions to that shareholder.

 That portion of a distribution that remains after the AAA has been eliminated is treated as a C corporation dividend to the extent it does not exceed the E&P of the S corporation.

 When a corporation’s S status terminates, the IRS explained, the corporation goes through a PTTP. During this period, the former S corporation can continue to take advantage of some of the benefits associated with its S status. Specifically, the shareholders will be able to receive tax-free distributions from the former S corporation to the extent the corporation has a positive AAA balance.

 Any distribution of money by a corporation with respect to its stock during a PTTP is applied against and reduces the adjusted basis of the stock, to the extent that the amount of the distribution does not exceed the AAA.

 The question addressed by the advisory was whether the corporation’s remaining positive AAA disappears forever after the PTTP, or if it reappears upon a subsequent S election.

 After reviewing the statute and the legislative history, the IRS concluded that an S corporation’s AAA is reset to zero after the PTTP and remains zero going into any subsequent S period for the corporation.

 The IRS also noted that a shareholder’s adjusted basis in his or her S corporation stock generally will reflect taxable income of the corporation while it is an S corporation, and that basis will not disappear when the S corporation status changes. Even though, at first blush, it might appear that a corporation that fails to distribute its AAA during the PTTP will lose the ability to make tax-free distributions of previously taxed income when it re-elects S corporation status in a subsequent period, the IRS pointed out that the corporation retains the ability to make tax-free distributions from the shareholder’s basis, though it must first distribute its C corporation E&P. (Similarly, the gain on a subsequent sale, liquidation or redemption of the stock would be reduced by this stock basis.) Thus, the IRS reasoned, the question becomes one of a timing difference, not a permanent difference in the taxability of corporate distributions.

 Planning

According to the IRS, the PTTP is the only time during which a corporation may draw down its AAA on a  tax-free basis by making distributions after the revocation of its S corporation status. 

 In most cases, the “timing difference” to which the IRS referred in the advisory will be of small comfort to shareholders, notwithstanding its technical accuracy. Rather, shareholders will likely wonder why they are being taxed on the distribution by the C corporation of monies on which they have already been taxed during the corporation’s S period.

 If the corporation does not fit within the special AAA distribution rule during the PTTP, the regular C corporation distribution rules will apply: the distribution is treated as a dividend to the extent of the corporation’s E&P, then as a return of basis in the stock, then as capital gain. Under current rules, both the dividend and the capital gain would be subject to the 20% federal tax rate for capital gains and to the 3.8% surtax on net investment income (without regard to the shareholder’s level of participation in the business). 

 Of course, Taxpayer could have distributed its entire AAA, tax-free (but with a reduction in stock basis) while it was still an S corporation, without regard to the “PTTP cash distribution” rule. This may have been accomplished by a distribution of available cash plus other, in-kind (preferably non-appreciated) property.

 If the corporation ended its S period with insufficient cash, it may have been able to accelerate the generation and collection of cash receipts during its C period, which cash would then be available for effecting a PTTP distribution of AAA.

 Alternatively, Taxpayer may have been able to borrow the necessary funds from which to distribute the AAA, either before the revocation of the S election or during the PTTP.

 If an S corporation and its shareholders are aware of the AAA and PTTP distribution rules, they should be able to plan accordingly and will, thereby, avoid the loss of the AAA on the revocation of the corporation’s  S election.

Installment Reporting: Sale of Corporate Stock v. Sale of Partnership Interest

Most advisers understand that if a taxpayer sells his or her shares of stock in a corporation in exchange for a promissory note, the taxpayer generally can defer recognition of the gain realized on the sale until principal payments are received on the note (“installment reporting”).

Although installment reporting is subject to various limitations (for example, the note cannot be a demand note, and the seller cannot be a dealer in securities), the composition of the corporation’s assets does not, generally speaking, affect either the nature of the gain (as capital or ordinary) arising from the sale of the stock, or the timing of its recognition.

Many advisers assume that the same tax treatment applies to the sale of an interest in a partnership or LLC. The Code provides that, in the case of a sale of a partnership interest, the gain recognized to the selling partner shall be treated as gain from the sale of a capital asset, which should qualify for installment reporting. However, the Code goes on to provide that any consideration received by the selling partner that is attributable to the seller’s share of the unrealized receivables or inventory items (“so-called “hot assets”) of the partnership shall be treated as ordinary income. 

Assets Excluded from Installment Reporting

The installment method of reporting is not available for the sale of certain types of assets, including (among others) marketable securities, depreciation recapture, inventory, and unrealized receivables.

IRS’s Position re Hot Assets

The IRS has long taken the position that the gain from the sale of a partnership interest is not eligible for installment reporting to the extent of the selling partner’s pro rata share of the partnership’s “hot assets.”  However, until recently, there did not appear to be any direct judicial support for the IRS’s position. The Fifth Circuit’s decision in Mingo v. Comr., earlier this month, affirmed the Tax Court and, thereby, provided the necessary support.

Tax Court & Fifth Circuit Join the IRS

The Facts

Taxpayer was a partner in Firm’s management consulting business (“consulting business”) until tax year 2002, when Firm  sold its consulting business to Corp.

As an initial step in the transaction, partnership LP was formed in early 2002. It was owned by certain subsidiaries of Firm. As part of the transaction, Firm transferred its consulting business to LP. Among the assets Firm transferred to LP were its consulting business’s uncollected accounts receivable for services it had previously rendered. Firm then transferred to each of the consulting partners, including Taxpayer,  an interest in LP and cash in exchange for the partner’s interest in Firm.

The value of Taxpayer’s partnership interest in LP as of October 2002, was $832,090, of which $126,240 was attributable to her interest in Firm’s unrealized receivables. On that date, Firm caused its subsidiaries to sell their respective interests in LP to Corp. At the same time, the consulting partners sold their respective interests in LP to Corp in exchange for convertible promissory notes. At the end of the transaction, Corp owned 100% of the consulting business.

Corp gave Taxpayer a convertible promissory note for $832,090 in exchange for her interest in LP. The $126,240 attributable to her interest in partnership unrealized receivables was included in that face value. The note provided that, unless the note was converted into Corp stock, Corp would pay interest on the unpaid principal balance semiannually; and the outstanding principal amount of the note and any accrued and unpaid interest was due and payable on the fifth anniversary of the transaction’s closing (i.e., October 1, 2007).

 Taxpayer’s Return

On her 2002 Federal income tax return, Taxpayer reported the sale of her partnership interest in LP as an installment sale. The selling price, gross profit, and contract price were listed as $832,090. Taxpayer did not recognize any income relating to the note, other than interest income.

The IRS issued a notice of deficiency, contending that the $126,240 Taxpayer had received in exchange for the partnership’s unrealized receivables was not eligible for reporting under the installment method. Accordingly, the IRS concluded that Taxpayer should have reported this amount as ordinary income in 2002 and paid taxes on it then.

 Taxpayer challenged both of the IRS’s deficiency determinations before the Tax Court. The central dispute raised by Taxpayer was the legal question of whether the installment method can be used to report the portion of the partnership interest attributable to unrealized receivables, given its status as ordinary income.

 The Tax Court

The Tax Court found in favor of the IRS, stating that “the gain realized on [Taxpayer’s] partnership interest, to the extent attributable to partnership unrealized receivables, was . . . ineligible for installment method reporting.” Accordingly, the Tax Court concluded that Taxpayer should have properly reported an additional $126,240 of ordinary income on her 2002 Federal income tax return instead of reporting it under the installment method.

The Court of Appeals

The Fifth Circuit reviewed the relevant provisions of the Code. It noted that Section 741 specifically provides that gain from the sale of a partnership interest shall ordinarily be considered gain from the sale or exchange of a capital asset, with some exceptions. Those exceptions include gain from unrealized receivables.  The Court stated that the gain resulting from the unrealized receivables on the sale of a partnership interest should not be reported as gain from the sale or exchange of a capital asset. Because the gain from the sale of Taxpayer’s partnership interest attributable to unrealized receivables could not be reported as gain from a capital asset, the Court continued, it was required to be reported as gain from ordinary income. The purpose of this exception, the Court said, is to prohibit the transformation of ordinary income, arising from services, into capital gain (which is taxed more favorably) simply by being passed through a partnership and sold.

Thus, the Court concluded that the gain attributable to the unrealized receivables– classified as ordinary income– was not eligible for installment method reporting because it did not arise from the sale of property, and the installment method did not adequately reflect the income that Taxpayer received from the unrealized receivables.

 Planning for A Sale

Every sale transaction is about economics. In analyzing the economic results of a sale, the seller and his or her advisors need to consider the impact of taxes. The nature of the sale gain as ordinary or capital, and the timing of its recognition – either immediately, or over time under the installment method – will determine the tax consequences of the sale.

Where the seller has agreed, for valid business reasons, to accept an installment note in exchange for the partnership interest being sold, he or she has presumably considered the credit risk associated with the deferred payment of the sale price. An appropriate interest rate and collateral will make the seller more comfortable with the arrangement.  

 However, the seller also must consider the nature of the partnership’s underlying assets. Where the assets include unrealized receivables, based on the foregoing discussion, the seller may be facing phantom income – the inclusion, in the year of the sale, of the value attributable to the receivables notwithstanding the deferral of the buyer’s payment therefor. (The same seems to be true in the case of depreciation recapture, and it may also be true as to other partnership assets not eligible for installment reporting.)

 It is imperative, therefore, that the seller of a partnership interest ascertain his or her share of such receivables, and the value thereof, well before the sale. Armed with this information, the seller may, for example, be able to negotiate a cash payment up-front, so as to provide sufficient liquidity with which to pay any resulting income taxes. (Query whether it may be possible to allocate this cash payment to that portion of the partnership interest that does not qualify for installment reporting?)  With the necessary information and some planning, a seller can avoid the surprise that befell the taxpayer in Mingo, and can thereby preserve the desired economic result of the transaction.

In our last two posts, we described the concept of the “responsible person” under NY’s sales tax law, and how such an individual may become personally liable for the unpaid sales tax of a business. We also explored the factors that are considered in determining one’s status as a responsible person, as well as some planning options.

 Today we end our discussion of the “responsible person” concept with a recent decision that illustrates the practical application of the concept and affirms how difficult it can be to avoid personal liability.

 In particular, it considers whether an officer and shareholder may not be held responsible where he or she was precluded from taking action with regard to the financial and management activities of the corporation. The significance of one’s officer and shareholder status, in other words, may be offset by the circumstances relating to control of the corporation – could he or she have acted but chose not to, or was he or she precluded from acting altogether? Did the facts show that others effectively precluded this person from exercising any authority?

In the Matter of Patrick Kieran 

New York (“NY”) assessed Corp.’s sales tax deficiencies against Taxpayer as a responsible person. Corp. operated a GM car dealership. Taxpayer had extensive experience with car dealerships. His involvement with Corp. began when he and some investors bought a franchise from GM with financing by GMAC. At that time, Taxpayer executed a dealer sales and service agreement with GM, pursuant to which he was required to engage GMAC, or some other creditworthy financial institution reasonably acceptable to GM, to support Corp.’s floor plan line and its purchase of new vehicles. Corp. opted to finance its purchases through a financing agreement with GMAC, along with additional working capital financing. The financing agreement included a “sweep arrangement” that afforded GMAC access to Corp.’s general bank account. This account held payments by customers for the purchase of vehicles, parts, accessories, and repair services. It also held sales taxes collected from customers.

 Corp. failed to timely file its sales and use tax returns for several quarters. As a consequence, NY issued notices of determination to Taxpayer as a responsible officer of Corp. The notices also assessed penalties and interest.

 In support of its position, NY demonstrated that Taxpayer  was a shareholder and the president of Corp., that he was responsible for the day-to-day operations of Corp., that he dealt with GM and GMAC on all significant business matters, that he ordered inventory and hired and fired employees, and that he signed tax-related and other checks, sales tax returns and bank documents.

 NY subpoenaed GM, requesting the production of documents concerning Corp. Pursuant to that request, NY received a GMAC dealer sales and service agreement signed by Taxpayer, pursuant to which the parties agreed that Taxpayer would be the dealer operator of Corp. and that he would provide personal services in this regard by exercising full managerial authority over dealership operations.

 A dealer statement of ownership for Corp. was also submitted as part of the record. It listed Corp.’s owners, including Taxpayer. Each of the owners of Corp. except Taxpayer were described as a “financial investor.” Taxpayer was the only owner listed as “dealer owner/operator.”

 When the business met with financial troubles, Corp.’s general account was effectively controlled by GMAC through the sweep arrangement. GMAC exercised its rights under the sweep arrangement, collecting what was due from the dealership directly from Corp.’s general bank account, including amounts representing sales taxes collected from customers. GMAC would contact Corp.’s controller to determine how much money would be needed to cover payroll and essential bills, such as insurance and utilities, and would make funds available to cover those costs.

 Taxpayer testified that GMAC’s sweeping of  Corp.’s general account resulted in the dealership’s nonpayment of sales tax collected from customers. However, the Court noted that there was no evidence in the record that Taxpayer ever contacted GMAC in an effort to gain access to the sales tax collected from customers in order to pay such tax over to NY. Nor was there any evidence that Taxpayer took any other affirmative steps to protect the sales taxes collected from customers.

 An ALJ reviewed the relevant criteria for determining whether an individual is a person required to collect tax on behalf of a corporation and therefore personally liable for the sales tax obligations of that corporation. Applying such criteria to the present matter, the ALJ determined that Taxpayer was a person required to collect tax on behalf of Corp. and, therefore, personally liable for Corp.’s sales tax obligations.

 Taxpayer argued that the ALJ was wrong, asserting that the taxes at issue accrued after GMAC began to take control under the sweep arrangement. Taxpayer argued that he lacked the requisite control over the affairs of Corp. to be liable as a responsible officer.

 The ALJ rejected this contention, and noted that Taxpayer voluntarily entered into the arrangement with GMAC and therefore could use the arrangement to shield himself from any sales tax liability arising as a consequence thereof.

 The Tax Appeals Tribunal (the “Court”) affirmed the determination of the ALJ.

According to the Court, NY Tax Law imposes personal liability upon any person required to collect the sales tax. A person required to collect tax is defined to include, among others, corporate officers who are under a duty to act for such corporation in complying with any requirement of the sales tax law. Regulations provide that “[e]very person required to collect any [sales tax] . . . acts as a trustee for and on account of the State with respect to taxes collected by such person.” Among other things, such trustees are required to “properly safeguard the interests of the State with regard to such taxes” and to “remit the taxes with timely filed returns.”

 Taxpayer, the Court said, had to show, by clear and convincing evidence, that he was not a person required to collect tax. Whether a person is responsible for collecting and remitting sales tax for a corporation so that the person would have personal liability for the taxes not collected or paid depends on the facts of each case. The Court looked to various factors in making this factual determination. It found that the facts in the present matter strongly supported the ALJ’s conclusion that Taxpayer was a responsible person and, therefore, personally liable for sales taxes due from Corp. He had knowledge of and, at least until GMAC began to sweep the operating account, unquestioned control over its financial affairs.

 Taxpayer contended that, upon GMAC’s exercise of its rights under the sweep arrangement, he no longer had control over Corp.’s finances, and his check-signing authority and authority to pay creditors was under the direction and control of GMAC. Taxpayer thus asserted that he was precluded from exercising his authority and, consequently, was not a responsible person.

 The Court recognized that Corp.’s economic difficulties were the root cause for its failure to remit sales tax collected from customers. Such economic difficulties led to GMAC’s sweeping of the general account, which diverted the collected sales tax to other purposes. In the Court’s view, neither of these related causes for Corp.’s failure relieved Taxpayer from his duty as a responsible person to see that sales tax collected by the dealership was turned over to NY.

 It is well settled, the Court said, that economic difficulties do not excuse an individual from his or her responsibility to collect and remit sales tax on behalf of a corporation. As to the sweep arrangement, a consequence of the dealership’s economic problems, the Court noted that individuals may not continue to operate a business “at the expense of ensuring that sales tax was paid.”  Here, the sweep arrangement had that very effect, as it allowed a creditor, GMAC, to divert collected sales taxes to pay other liabilities while the business continued to operate.

 The Court noted further that Taxpayer petitioner voluntarily entered into the sweep arrangement on behalf of Corp. and thereby “voluntarily created the scenario which led to [the dealership’s] inability to pay . . . sales and use taxes. The sweep arrangement in the present matter also may be viewed as a responsible officer’s dereliction of duty. That is, [Taxpayer], on behalf of the dealership, gave a creditor the authority to determine which corporate liabilities would be paid and to use trust fund taxes to pay such liabilities. Such a grant of authority was in direct contravention of [Taxpayer’s] duty as a trustee to “properly safeguard the interests of the State with regard to such taxes.” Taxpayer’s failure does not relieve him of responsibility, for “an officer cannot relieve himself of his responsibility for operating his corporation and expect that he will be relieved of sales tax liability.”

Taxpayer voluntarily entered into the agreement with GMAC and acceded to its terms at all times, notwithstanding his knowledge that, under the arrangement, GMAC was using sales taxes collected from customers for other purposes.

 The Court noted that there was no evidence in the record that Taxpayer took any affirmative steps to ensure that the sales taxes collected by the dealership were paid over to NY. It noted further that the sales taxes were to be “held in trust for and on account of the State.” Finally, it noted that it did not appear that GMAC ever took legal control of the dealership and its funds, and that the power to sign checks remained with the dealership (not GMAC).

 Accordingly, the Court rejected Taxpayer’s claim that GMAC’s sweeping of the general account relieved him from his duty as a responsible person to see that sales tax collected by Corp. was turned over to NY.

Conclusion

Was the Court’s decision unexpected?  No. Was it harsh? In light of the sweep arrangement, probably. However, it does highlight the very difficult choice that confronts the responsible person in  a struggling business: either pay the sales tax and give up the business, or continue to operate and risk personal liability. I would hate to be in those shoes.