In our last post, 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. Today we will explore the factors that are considered in determining one’s status as a responsible person, as well as some planning options.

Personal Liability

It is important to note that the personal liability of a responsible person (like a corporate officer) for sales taxes is separate and distinct from that of the business – it extends beyond the business.   For example, a corporate bankruptcy does not affect the officer’s liability for the tax, since the latter involves a separate claim than one that is asserted in the corporate bankruptcy proceeding.  

Because the responsible person’s liability is distinct from that of the corporation, it has its own statute of limitations for assessment purposes. Thus, the extension of the corporation’s limitation period does not automatically extend the limitation period for assessing tax against the responsible person. 

Decisions, Decisions

Before reviewing the factors that the State and the courts have found relevant in the past in considering individuals’ status as responsible persons, it will be helpful if the taxpayer places them in the proper context. In order to “set the scene,” the taxpayer has to weigh his desire to have some control over his investment against the tax exposure that such involvement may bring. If a person wants to be involved and have a say in the business, he or she must be prepared to act responsibly, including looking at records, inquiring about taxes, etc.

It is not acceptable to say that you want to have the title of an officer, or that you want to receive a salary from the business, but that you are not responsible for the sales tax.

Determining Factors

            Once a sales tax liability has been asserted, it is important to appreciate that the notice of determination issued by the Tax Department is presumed to be correct. The burden of proof, therefore, rests on the taxpayer to present enough support regarding the taxpayer’s position as to the extent of his or her responsibilities and authority. This can be especially challenging where the owners of the business are at odds with one another (as will often be the case) and, thus, it may be difficult to obtain copies of documents and records that support one’s position.

As was mentioned earlier, the determination of one’s status as a responsible person is fact-specific.  However, a review of the case law highlights the factors that are routinely considered important, and many of the rulings reflect consistent themes that may be useful for planning purposes.

Among the questions that are asked in evaluating one’s status as a responsible person are the following:  Did the person receive a salary? What was his ownership (and percentage)?  Did he enjoy a return on his investment?  Did he have authority to hire or fire employees?  Did he have knowledge, control or discretion over business/financial affairs?  Did he participate in daily operation of the business or in shareholder/director meetings?  Were there prior tax assessments against him or the business?  Was he involved in the preparation of sales tax returns or the payment of sales taxes?  Did he sign sales tax returns?  Did he have authority to operate the business, review its books and records, and determine and authorize the payment of creditors?  Did someone else have complete control of daily operations, financial affairs and management of the business?  Did he have knowledge of the business’s industry?  Did he have check-signing authority?  Did he sign only in the absence of, and at the direction of, another person?  Was he listed as an officer or director of the business?  Did he and the business use the same CPA to prepare their returns?

An officer – shareholder may not be held responsible where his role was essentially that of a minority investor who was precluded from taking action with regard to the financial and management activities of the corporation. 

Look at the Federal Returns

In considering the nature and extent of the taxpayer’s involvement with a business, one must consider several factors including both the taxpayer’s federal income tax returns as well as the business entity’s returns.  The following factors, if present, can indicate that the taxpayer has significant involvement in the business.

  • Has the taxpayer described his participation in any business as active or passive?
  • Did the taxpayer claim an exemption from the 3.8% surtax on net investment with respect to his share of S corporation or partnership income, on the basis of having materially participated in the business?
  • How can he reconcile the exemption with his claim that he is not active in the business for purposes of determining his status as a responsible person?
  • Did he receive a W-2 from the business, reflecting significant compensation, which may also point to active participation in the business?

The same may be said as to “guaranteed payments” made to a taxpayer for services rendered by the taxpayer to a partnership or LLC, as reflected on a Schedule K-1 issued to the taxpayer.

  • Does the Schedule K-1 identify the taxpayer as a general partner or managing member?
  • Did the taxpayer complete Schedule SE, Self-Employment Tax, to Form 1040, with respect to any of the allocations made or any of the payments received from the business?
  •  Did the taxpayer execute these business entity returns and, if so, in what capacity?

These inquiries are directed at determining the taxpayer’s level of involvement in a business, as reflected on the taxpayer’s federal income tax returns, and whether it is consistent with the taxpayer’s assertion that he is not a responsible person.

Planning for the Penalty

The best way to protect someone from personal liability for sales taxes would be to have the business pay the taxes when due. It is amazing how quickly and how significantly these liabilities can grow if left unattended. If a business is unsure of the proper tax treatment of a transaction, it should immediately consult with an experienced tax adviser to ensure that the taxes are being properly collected, remitted and reported.   Unpaid sales taxes rarely occur in a vacuum.  Rather, they are only one of many signs that a business is in dire economic straits. They are often accompanied by unpaid employment taxes. Together, these can turn into an expensive proposition.

The next best way to avoid surprises is to plan. Taxpayers should review the assignment of duties, responsibilities and decision-making authority within the business. These may be reflected in the by-laws or shareholder agreements. In the case of a partnership or LLC, the partnership or operating agreement should similarly allocate responsibilities among the members. This should be done at the inception of the business, or at least before one enters an existing business.

Additionally, passive shareholders should consider an indemnity or contribution agreement to protect themselves from the expense of responsible person liability. They may also want to consider corporate resolutions confirming their lack of authority.   It is also critical that each shareholder report consistently for all tax purposes. If he is not active in the business, his federal return should not report his activity in, or his losses from, the business as nonpassive.

Spotting the Issue

Before engaging in any transaction, the sale tax consequences of which are unclear to them, the owners of a business should consult with their tax advisers so as to avoid or satisfy the tax liability in the first place.  Once they have engaged in a transaction, they need to ensure that the business can properly substantiate its tax treatment of the transaction. 

Once a sales tax problem is discovered, the taxpayer should act quickly to address it. One must take immediate and extensive steps to rectify the problem. With any luck, the corporation has sufficient assets with which to satisfy the tax, penalty and interest.

I learned early on that a tax practitioner should do his or her best to help clients to avoid surprises. Few tax events can be as surprising as the imposition of personal liability for sales taxes as a responsible person for a business. The foregoing advice should help to mitigate the likelihood of such a surprise.

Introduction

Many taxpayers fail to appreciate that any officer, director or employee of a corporation, and any employee or manager of a partnership or LLC, who has a duty to act for such entity in complying with any requirements of the sales tax law, may be held personally liable for the sales tax collected or required to be collected by the entity. They often also do not realize that any member of a partnership or LLC may also be personally liable for such sales tax. 

The Sales Tax

In general, the sales tax is a transaction tax, with the liability for the tax arising at the time of the transaction. It is also a “consumer tax” in that the person required to collect tax, the seller, must collect it from the buyer when collecting the sales price for the transaction to which the tax applies. 

The seller collects the tax as trustee for and on account of the State. The tax is imposed on the purchase of a taxable good or service, but it is collected from the purchaser by the vendor, and then held by the vendor in trust for the State, until the vendor remits the tax to the State.

All sales of property are deemed taxable until the contrary is established. The burden of proving that any sale is not taxable is upon the seller and the buyer.  In all cases, the parties to the sale transaction must maintain records sufficient to verify all sales tax-related aspects of the transaction.

The Responsible Person

New York State Tax Law (the “Tax Law”) imposes personal responsibility for payment of sales tax on certain owners, officers, directors, employees, managers, partners, or members (“responsible persons”).  More than one person may be treated as a responsible person.

A responsible person is jointly and severally liable for the tax owed, along with the business entity and any of the business’s other responsible persons.  This means that the responsible person’s personal assets could be taken by the State to satisfy the sales tax liability of the business. An owner can be held personally responsible even though the business is a corporation or LLC. 

Personal liability attaches whether or not the tax imposed was collected.  In other words, it is not limited to tax that has been collected but has not been remitted.  Thus, it will also apply where a business might have had a sales tax collection obligation, but was unaware of it.  Along the same lines, the personal liability applies even where the individual’s failure to take responsibility for collecting and/or remitting the sales tax was not willful.  In addition, the penalties and interest on the corporation’s unpaid sales tax passes through to the responsible person.

Corporations

Every officer or employee of a corporation who is under a duty to act for such corporation in complying with any requirement of the Tax Law is a responsible person required to collect, truthfully account for, and pay over the sales or use taxes.  Whether such officer or employee is a responsible person is to be determined in every case on the particular facts involved. Generally, a person who is authorized to sign a corporation’s tax returns or who is responsible for maintaining the corporate books, or who is responsible for the corporation’s management is under a duty to act.

In other words, holding a corporate office or being a shareholder does not, in and of itself, warrant the imposition of liability. Only those who were “under a duty to act” on behalf of the business may be assessed the penalty, with the main inquiry being whether the individual had sufficient authority and control over the affairs of the corporation.  Typically, owners are assessed personally, but ownership is not required in order to be found responsible.

Partnerships

Under the Tax Law, every person who is a member of a partnership is a person required to collect tax.  A strict reading of this provision concludes that any member of a partnership or of an LLC is per se liable for unpaid sales tax, plus interest and penalties, and this was, in fact, the Tax Dept.’s position for years.  One can imagine the surprise of a minority partner upon learning that he was being held responsible for taxes far in excess of his investment in the business.

Special Relief for Certain Partners

Although the Tax Law remains unchanged, beginning in 2011, New York provided partial relief to the per se personal liability for certain limited partners and LLC members.  Under the new policy, certain limited partners and LLC members who would be considered responsible persons under the statute may be eligible for relief from personal liability for the entity’s failure to remit taxes.  With regard to sales taxes specifically, a qualifying partner or member will not be personally liable for any penalties due from the business entity relating to its unpaid sales taxes, and his or her liability for sales tax will be limited to his or her pro rata share of the tax.

Limited partners may qualify if they demonstrate that they were not under a duty to act in complying with the Tax Law on behalf of the limited partnership, and LLC members who can document that their ownership interest and distributive share of the profits and losses of the LLC are less than 50% may qualify if they can demonstrate that they were not “under a duty to act” on behalf of the LLC in complying with the Tax Law.

In addition, in order to qualify for the relief, the limited partner or member must also agree to the terms and conditions that the State sets forth in a written agreement for limiting the limited partner’s liability, including cooperating with the State in providing information regarding the identities of other potentially responsible persons—particularly those persons who are involved in the day-to-day affairs of the business. 

It is important to note that a general partner of a general or limited partnership will not qualify for this relief, regardless of the partner’s ownership interest, nor will any member of an LLC that holds a 50% or more ownership interest in the LLC, or that is entitled to a distributive share of 50% or more of the profits and losses of the LLC.

Choice of Entity

The foregoing raises some interesting choice of entity issues. Notwithstanding the relief described above for members of partnerships and LLCs, the fact remains that those qualifying for the relief are nevertheless personally liable for their share of the unpaid tax, and those who do not qualify for the relief are per se liable for the tax, regardless of the level or quality of their activities.

The corporate form should be considered for a passive investor.  An investor who wants to limit his exposure may want to interpose a corporation between himself and the partnership or LLC.  However, this of course may present other tax issues (including income tax concerns).

Alternatively, the investor may want to encourage the incorporation of the partnership or LLC.  In reality, however, the investor may not have sufficient clout to compel such a change in business structure. And, of course, there are other tax considerations, including the aforementioned income taxes.  Where an incorporation is feasible, non-controlling shareholders should take steps to avoid personal liability.

In our next post, we will review the factors that are considered in determining one’s status as a responsible person. We will also discuss some planning options.

It’s great to be the chief executive of a business that is doing well. You are likely being paid well, in some combination of salary, bonus and distributions, you enjoy the many other perks that are attendant to the position, and, of course, there is the prestige that goes along with the job.

 Unfortunately, a business may sometimes struggle, and the chief executive may inadvertently disregard certain tax-related obligations in the process of trying to bolster the business. Oftentimes, the chief executive will fail to remit to the taxing authorities the income and employment taxes that the business had properly collected in respect of wages paid to its employees. The Tax Court recently considered such a situation.

Kirkpatrick 

Taxpayer served as the chairman of the board of directors for Corp. For the six quarters beginning in 2006 and ending in 2009, Corp. failed to pay income and employment taxes related to Forms 941, Employer’s Quarterly Federal Tax Return.

 On the personal side, Taxpayer ran into a similar issue when he filed a personal Federal income tax return for 2010, but failed to pay the tax owed. In late 2011, Taxpayer entered into an installment agreement with the IRS to pay off his 2010 personal income tax liability.

 Early in 2012, the IRS informed Corp. that its request to pay its Form 941 tax liabilities through an installment agreement had been approved.

 At the same time, the IRS determined that Taxpayer was a “responsible person” of Corp. for purposes of the Form 941 tax liabilities The IRS thus assessed trust fund recovery penalties against Taxpayer in March 2012. Because of these additional assessments, the IRS also terminated Taxpayer’s installment agreement for his 2010 personal income tax liability. The IRS sent to Taxpayer a Notice of Intent to Levy, informing him that he owed trust fund recovery penalties and advising him that the IRS intended to levy to collect these taxes.

 In response, Taxpayer submitted a Request for a Collection Due Process or Equivalent Hearing (a “section 6330 hearing request”). In the section 6330 hearing request, Taxpayer indicated, among other things, that he wanted an installment agreement and that he disagreed with the proposed levy action because he believed that the installment agreement as to his 2010 taxes had been “terminated for no reason” as he was “not in default on the installment agreement.” Taxpayer further argued that the collection of the trust fund recovery penalties should be suspended because Corp. was paying off its liabilities through its own installment agreement.

Settlement Conference

The settlement officer scheduled a conference for December 2012 at which Taxpayer would be offered the opportunity to explain why he disagreed with the collection action and to discuss possible collection alternatives. The letter from the IRS stated:

“On your request for a [section 6330] hearing, you indicated your installment agreement terminated for no reason. Our records indicated your installment agreement was established [in December 2011] and only included your outstanding tax liability for your Form 1040 for calendar year 2010. One of the terms of an installment agreement is that while the installment agreement is in effect, you will pay any federal taxes you owe on time. On [March 2012], you were assessed civil penalties for failing to pay the withheld taxes for [Corp] * * *. When the civil penalties were not paid, you did not meet terms of your installment agreement and your installment agreement defaulted.”

In January 2013, a conference took place between the IRS settlement officer and Taxpayer’s representative. The representative indicated that Taxpayer was not challenging the underlying tax liabilities and agreed to the civil penalties assessment. Taxpayer’s representative also indicated that Taxpayer wanted to pay in full the balance of his 2010 income tax liability in order to suspend collection of the trust fund recovery penalties.

The settlement officer explained that even if the 2010 income tax liability was resolved, collection of the trust fund recovery penalties against Taxpayer would not be suspended simply because Corp. was paying off those liabilities pursuant to its own installment agreement.

Taxpayer remitted the funds to fully pay his 2010 personal income tax liability.

Upon review of the Taxpayer’s financial documentation, the settlement officer determined that Taxpayer had the ability to the outstanding trust fund liabilities through a collection alternative, but Taxpayer would not agree to do so. In February 2013, the Appeals Office sustained the proposed levy action.

Section 6330

Section 6330 generally provides that the Commissioner cannot proceed with levy on a taxpayer’s property until the taxpayer has been given notice of and the opportunity for a section 6330 hearing and, if dissatisfied, an opportunity for judicial review of the administrative determination. At a section 6330 hearing, a taxpayer may raise any relevant issue relating to the collection action, including challenges to the appropriateness of the collection actions and possible collection alternatives. Sec. 6330(c)(2)(A). A taxpayer may contest the validity of the underlying tax liability, but only if the taxpayer did not otherwise have a prior opportunity to dispute the tax liability. Sec. 6330(c)(2)(B).

Taxpayer’s Position

In this case, the underlying liabilities were assessed under section 6672, which imposes penalties for failure to collect, account for, and pay over income and employment taxes of employees—“trust fund recovery” penalties. Taxpayer did not dispute these underlying tax liabilities, nor did he argue that he was wrongfully denied a collection alternative or that his prior installment agreement was wrongfully terminated. Instead, Taxpayer’s position was that he was originally covered under the installment agreement entered into by Corp. for the trust fund recovery penalties, and, now that he was in compliance with his 2010 income tax obligation, he should be “re-covered” under Corp.’s installment agreement. Taxpayer did not, however, produce the Corp. installment agreement or any documentary corroboration of this position.

 Instead, Taxpayer attempted to support his position by arguing that the settlement officer failed to consider relevant parts of the Internal Revenue Manual (“IRM”). He asserted that the IRM “clearly” states that the collection of trust fund recovery penalties “from responsible persons should be suspended so long as the primary business entity has an Installment Agreement and is current.”

 The Court stated that even a liberal reading of these provisions did not suggest that collection should be “suspended” on previously assessed trust fund recovery penalties of a responsible person. The Court pointed out that these sections provide procedural guidance for initiating a “business taxpayer, trust fund-related installment agreement.” They address a general rule of nonassessment of trust fund recovery penalties when commencing such an installment agreement. They do not address suspension of collection after assessment with respect to an already established installment agreement.

 Section 6330 provides due process protections for taxpayers in tax collection matters. The IRM provisions relied upon pertain only to assessment of trust fund recovery penalties. However, as Taxpayer did not challenge his underlying tax liabilities, there was no reason for the settlement officer to consider the IRM with regard to assessment.

 Moreover, the settlement officer acknowledged and considered Taxpayer’s argument. The applicable test is not whether or not other resolutions could have been reached by the settlement officer or by the Court, but whether the settlement officer’s determination was arbitrary, capricious, or without sound basis in fact or law. In view of the record, the Court stated that it could not conclude that the latter was the case.

 Thus, the Court found that Taxpayer remained subject to trust fund recovery collection even where he was in compliance with his personal obligations and Corp. was current with its installment agreement.

Conclusion

The foregoing evidences just how difficult it is for a so-called responsible person to avoid the economic consequences of the trust fund recovery penalty. It also illustrates one of the surprises that may follow an IRS determination of a taxpayer’s status as a responsible person. While certain defenses may be available to the taxpayer, these are fact-specific and cannot be relied upon from a planning perspective.

 Of course, the best way for a “responsible person” to avoid the trust fund penalty is by making sure that all employment taxes are collected, accounted for, and paid to the IRS when required.  Where that is difficult to accomplish, economically-speaking, the business should at least remit the trust fund portion of the employment taxes (i.e., the employee’s share), and it should specifically designate that payment as being made in respect of such trust fund portion.

 Inevitably, there will be situations where the penalty will likely be unavoidable. In such a case, it will behoove a responsible person, who is aware that the company-employer is not satisfying its trust fund obligations, to voice his or her objections to such failure, and to take immediate and extensive steps to rectify the problem, including, if necessary, by ceasing business operations.

 Much of the foregoing may be avoided if those who would be responsible persons were educated, from the beginning of their involvement in the business, as to what their duties entailed with respect to employment taxes, and the real risk of personal liability in the event those taxes go unpaid.

 Last month we considered a situation in which the recapitalization of the equity in a family-controlled business resulted in a taxable gift. Today we will consider how a family-owned corporation’s redemption of shares from a parent-shareholder may be treated as a taxable gift from the parent, and may result in some unexpected consequences for the beneficiaries of such gift.

  Parent “Makes” A Gift 

In 1995, Parent sold his stock in Company back to Company. Because he sold the stock back for a price below its fair market value, this sale increased the value of the stock of the remaining stockholders. At the time of the sale, there were five other Company shareholders including Parent’s Ex-Wife, other individuals, and trusts that held Company stock. Parent passed away later that year.

  The IRS audited Parent’s 1995 gift taxes and determined that Parent had made an indirect gift to the Company shareholders when he sold his stock back for below market value and issued a notice of deficiency. Parent’s Estate challenged the deficiency. After several years of negotiation over Parent’s tax liability for this indirect gift, the IRS and Parent’s Estate entered into a stipulation that determined the value and recipients of the indirect gifts.  However, Parent’s Estate still did not pay the gift tax.

 IRS Seeks to Collect

In 2008, the IRS assessed gift tax liability for Parent’s unpaid gift tax against the donees. Under the Code, a donor’s unpaid gift tax for a period becomes a lien upon all gifts made during that period. If the tax is not paid when due, the donee of any gift shall be personally liable for such tax to the extent of the value of such gift.

In 2010, the IRS brought suit against the donees, seeking to recover the unpaid gift taxes and to collect interest from the beneficiaries. In a series of orders issued in 2012, the district court held for the IRS.

The Court Supports the IRS

The Code imposes a tax on a “transfer of property by gift.” The gift tax applies “whether the gift is direct or indirect,” and includes transfers of property (like stock) when the transfer was “not made for an adequate and full consideration.” When the gift tax is not paid when it is due, the Code imposes interest on the amount of underpayment.

Pointing to IRS Regulations, the Court stated that “[i]t is well-settled that a transfer of property to a corporation for less than adequate consideration is to be treated as a gift to the shareholders to the extent of their proportionate interests in the corporation.” (“A transfer of property by B to a corporation generally represents gifts by B to the other individual shareholders of the corporation to the extent of their proportionate interests in the corporation” where the transfer was not made for adequate and full consideration in money or money’s worth.)

 The Court acknowledged that “[t]he donor, as the party who makes the gift, bears the primary responsibility for paying the gift tax.” However, if the donor fails to pay the gift tax when it becomes due, the Code provides that the donee becomes “personally liable for such tax to the extent of the value of such gift.” The term “tax” includes interest and penalties and, so, the donee can be held liable for the interest and penalties for which the donor is liable.

 The donees argued that the district court erred when it found both that this creates an independent liability on the part of the donee to pay the unpaid gift tax, and further disputed that the donee can be charged interest until the gift tax is paid.

The Court disagreed with their arguments and held that interest accrued on a donee’s liability for the unpaid gift taxes and, moreover, that the interest is not limited to the extent of the value of the gift.

 An Interesting Aside

 One of the “beneficiary-shareholders” – the Ex-Wife – claimed that the “ordinary course of business exception” applied because the IRS did not prove that there was donative intent. She argued that whereas in other cases involving indirect gifts, the ordinary course of business exception did not apply because, given the close family relationship between the donor and the shareholders, courts were able to infer donative intent, Parent and Ex-Wife here had been divorced for many years and each had remarried. Thus, according to Ex-Wife, the IRS failed to prove that there was a close family relationship and that this was a gift.

The Court disagreed. Though under the ordinary course of business exception, “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 and full consideration in money or money’s worth,” here the Court found it clear that Parent intended to make a gift.  

  Context Can Be Everything

 A stock redemption provides a means by which a parent may “shift” value to children-shareholders (without actually transferring anything to them), by reducing the parent’s percentage interest in the redeeming business entity and increasing that of the children-shareholders. 

If the redemption is effected for FMV (unlike in the situation considered above), there is no gift to the other shareholders—even though their relative interests increase.  The removal of some of the parent’s equity in the business freezes the value thereof by replacing it with cash that may be spent. The reduction in his or her percentage interest of the total equity may also put the parent in a less-than-controlling position, allowing for a minority discount at the time of his or her death.

Of course, a redemption may also eliminate the ability of the parent’s estate to pay the estate tax attributable to the business in installments, by reducing the percentage of the value of the gross estate that is represented by the business.

Where the redemption is not for FMV, the resulting reduction in estate tax value for the parent’s remaining shares may justify some current gift tax liability. However, the parent needs to be mindful of the fact that a redemption is generally an income-taxable event to the parent, though the specific consequences will depend upon several factors.  In any case, the income tax expense must be weighed against the potential transfer tax savings.

Even where the stock redemption is not made strictly made for FMV, gift treatment may still be avoidable. For example, given the difficulty of valuing closely held stock, a purchase price adjustment clause in the redemption agreement may defeat gift characterization of the transfer in the face of an IRS challenge to the redemption price.

Similarly, the redemption of a parent’s stock as part of the settlement of a bona fide family/shareholder dispute may also be deemed to have been made for adequate and full consideration in the context of the overall settlement.

 What the parent-shareholder, the redeeming corporation, and the other shareholders need to keep in mind is that there are many factors to consider before undertaking a redemption of the parent’s stock. With proper planning, any unpleasant surprises should be avoidable.

 In most acquisition transactions, one company will purchase the assets of another company. An asset deal has the benefit of allowing the acquiring company to select only those assets or lines of business of the target company that it wants to acquire. It enables the acquirer to recover its purchase price through depreciation and amortization, and it also allows the acquiring company to assume only those liabilities that are associated with those assets and that it affirmatively chooses to assume. For the same reason, an asset acquisition affords the acquirer the greatest flexibility in selecting the acquisition vehicle(s) – for example, a corporate subsidiary or a wholly-owned LLC  – and, so, the “residence” for the acquired business. 

 Stock Sales

Notwithstanding the benefits of asset sales, however, there are times when the acquiring company has little choice but to purchase all of the outstanding shares of stock of the target company, as where the target has difficult-to-transfer assets, where the acquirer wants to retain certain tax attributes of the target, or where the target’s shareholders insist upon a straight stock sale (and have sufficient leverage to extract it from the acquirer without a deemed asset sale election).

 How to Hold the Acquired Assets

Those situations sometimes prompt the readjustment of the ownership of some portion of the acquired company. For example, the target company may own assets that the acquirer does not want to keep, or the acquirer may determine that some portion of the target’s assets would be better housed in another entity controlled by the acquirer. The IRS recently addressed one such situation.

 Parent was the parent of a group of entities, including an affiliated group of corporations. Parent was directly engaged in Business A, Business B, Business C, and Business D.

 Subsidiary was a wholly-owned subsidiary of Parent that was acquired by Parent in a taxable transaction. Subsidiary was a holding company that owned all of the stock of Target, a subsidiary that was engaged in Business A.

 Following the acquisition of Subsidiary, Parent desired to integrate Target’s Business A with Parent’s Business A to achieve certain synergies expected from the combination.

 While Parent’s management worked to determine the best structure for permanent integration, Parent entered into certain Lease Arrangements with Target to lease the assets associated with Target’s Business A. Within a few months, the Lease Arrangements proved to be less than optimal.  As a result, Parent proposed to restructure the ownership of Target as a potential long-term solution for combining Target’s Business A with Parent’s Business A.

 In order to integrate Target’s Business A with Parent’s Business A, Parent proposed to form a new limited liability company (“LLC”) that would be disregarded as separate from its owner for federal income tax purposes. Pursuant to state law, Target would merge with and into LLC, with LLC surviving and with LLC receiving all the assets and liabilities of Target (the “Merger”). The separate corporate existence of Target would cease, and Subsidiary would receive solely Parent stock in exchange for its Target stock. The fair market value of the Parent stock received by Subsidiary in the Merger would be approximately equal to the fair market value of the Target stock surrendered in the exchange. Following the Merger, Parent would continue Target’s Business A and use a significant portion of Target’s historic business assets in such business.

 The IRS ruled that the Merger would qualify as a “reorganization” within the meaning of the Code. Consequently, no gain or loss would be recognized by:

–        Target on its transfer of its assets to Parent in exchange for Parent stock and Parent’s assumption of Target’s liabilities in the Merger;

–        Target on the transfer of Parent stock to its shareholder, Subsidiary, in the Merger;

–        Parent on the receipt of the Target assets in exchange for Parent stock in the Merger; or

–        Subsidiary on the receipt of shares of Parent stock in exchange for Target stock in the Merger.

 Other Post-Stock Acquisition Issues

The post-stock acquisition transaction considered in the above ruling was fairly straightforward. Other situations will present much more difficult issues. For example, how may the acquiring company dispose of unwanted assets that are owned by the target? A taxable sale of such assets is always possible, but it may generate significant tax liability. An immediate tax-free spin-off of the assets to the acquiring company’s owners will not be possible. The acquirer may try to isolate the unwanted assets in another entity (which amounts to kicking the can down the road).

 As always, in structuring and in pricing a stock transaction, the acquiring company has to consider the economic burden of not being able to recover its purchase price through depreciation. Less obviously, it should also consider the cost of having to subsequently adjust the holding structure for the indirectly purchased assets, as well as the economic burden of acquiring unwanted assets (through the purchase of target stock) and of subsequently disposing of them. Ideally, these economic realities should be reflected in the purchase price.

Once Upon A Time . . . 

a corporation, Corp, was founded.  The year was 2006, and Employee immediately was hired as Corp’s chief technology officer and received restricted stock grants from Corp. As a “founder” of Corp, Employee initially owned 9.8% of Corp’s stock. However, each time investors infused capital into Corp, Employee’s interest was diluted, and he threatened to leave Corp should his interest ever fall below 3%. In deference to Employee’s concerns, Corp agreed to increase his stock ownership by issuing to him additional restricted stock to satisfy his minimum 3% equity “requirement.”  Nevertheless, by 2011, Employee’s equity in Corp had fallen to less than 1%.  

Earlier in 2011, Google had begun merger negotiations with Corp to acquire Corp as a wholly-owned subsidiary. As part of the merger, Google required that Employee turn over all his intellectual property related to Corp and become a Google employee.

In explaining the merger to Employee, Corp’s chairman informed him that Corp was being sold for $93 million and that his stock holdings were worth approximately $800,000. Employee disagreed with the latter amount because, in keeping with his desire to have at least a 3% ownership interest in Corp, he expected to receive 3% of the cash consideration paid by Google.

Hogs Go To Market . . .

To address his concern, Corp prepared a letter agreement pursuant to which, following the merger, Corp would pay Employee $3.1 million, of the $93 million purchase price offered by Google, in exchange for all of  his shares, warrants and options of  Corp stock, and for his execution of a “Key Employee Offer Letter and Proprietary Information and Inventions Assignment Agreement with Google as required in the Merger Agreement” (the “Employment and Assignment Agreement”).  This agreement also provided that Employee would “not be entitled to the Consideration, except for any amount you would be entitled to receive in exchange for your shares * * * in the absence of this Agreement, if you do not comply with the terms of the Merger Agreement.”

Employee signed a consent of the shareholders assenting to Corp’s entering into the merger agreement, and thereby agreed to be bound by the terms of the merger agreement.  Under the Employment and Assignment Agreement, he also agreed to become a Google employee after the merger. Furthermore, as a condition of his employment with Google, Employee would assign his rights, titles, and interests in certain Corp-related intellectual property to Google.

The merger was consummated in 2011. The total value of Employee’s Corp stock was determined to be almost $800,000. As a result of the merger, Employee became entitled to approximately $3 million and became an employee of Google. However,  he received a paycheck showing “stock compensation pay” of approximately $1.88 million and, because of the tax withholdings, he realized that Corp was treating this amount as ordinary income. Employee contacted Corp to complain about the ordinary income characterization. 

Employee outlined his opinion that the transaction at all times was capital in nature, but that Corp miscast it as ordinary. He stated that he would challenge the tax treatment of Corp’s reporting by providing a detailed explanation on his income tax return as to the erroneous position taken by Corp. His legal advisers suggested that he sue Corp, but, fortunately for Corp, he ignored this advice.

As part of his 2011 Federal tax return, Employee included a substitute Form W-2, reporting amounts different from the Form W-2 issued by Corp. He included an explanation that the $1.88 million of “Stock Compensation” wages was actually part of the stock purchase and not compensation. The IRS disagreed with him.

 The Tax Court Responds

Employee maintained that the income that he received as a result of the merger represented funds derived wholly from the sale of his stock, and thus qualified for long-term capital gain tax treatment. The IRS acknowledged that Employee’s section 83(b) elections with respect to those stock grants issued to him by Corp that were not immediately vested permitted any subsequent appreciation in his Corp stock to be taxable as capital gain, and that any gain recognized from the exchange of stock for consideration in an acquisition is capital in nature. However, the IRS argued, and the Court agreed, that the Taxpayer’s merger-based income in excess of the determined value of his Corp stock was taxable as ordinary income.  

The Court noted that Employee’s aim throughout the merger process was to reduce his tax liability by structuring the amount he would receive as deriving entirely from a stock sale and deserving of preferential tax treatment. In general, the Court stated, though tax reduction is an acceptable goal, it does not allow a taxpayer to ignore relevant information.

Employee chose to ignore a lot of relevant information. He executed the merger agreement, the shareholder’s consent, and the Employment and Assignment Agreement. He disregarded both the $800,000 determined value of his stock and the Corp’s consistent position that treated the balance of the payments as compensation for services. He also did not make himself aware of the merger terms between Corp and Google, which reflected the intent of the two parties that generated the income at issue to have Employee receive both deferred compensation and capital gain income from his execution of the Employment and Assignment Agreement and the sale of his Corp stock. Instead, Employee relied on his letter agreement with Corp, arguing that through the letter agreement, he had negotiated a higher share price than other shareholders and that the $3 million he received was all consideration for the sale of his Corp stock. However, he gave no persuasive reason why Corp would be willing to pay more for his stock than its determined value.

Moreover, the letter agreement was silent as to a specific amount being paid for the stock. Instead, it provided that to receive the merger-based income from Corp, Employee had to fulfill two requirements: (i) he had to sell his stock; and (ii) he had to sign the Employment and Assignment and Agreement. While Employee contended that he gave up only one asset of any value—the stock—Corp obviously considered his employment and assigns to have considerable value with respect to its merger negotiations.

The preponderance of the evidence, the Court concluded, was that Employee received the value of his stock and compensation for service previously rendered or to be rendered in the future. Accordingly, The IRS’s determination was sustained.

And the Moral of Our Story . . .

If you are like me, you are probably thinking, “How did this matter get as far as the Tax Court?” After all, it appears as though the Employee had no leg to stand on.  Nevertheless, he believed, based upon discussions with Corp, that he was to be treated as a shareholder for purposes of participating in the benefits, and beneficial tax treatment, from the sale of the business, and he could have caused Corp some real trouble had he acted more strategically or aggressively. 

            Incentives

First of all, though an employer is not required to provide any sort of change-in-control benefit to its key employees, it may ultimately determine that it would behoove the employer and its owners to do so.   It is not unusual for an employer to incentivize its key employees to remain with and help to grow the business by promising them an interest in the proceeds from the ultimate sale of the business. The “promise” may take the form of unrestricted or restricted shares, a phantom stock plan, or some other form of deferred compensation that is triggered by the sale of the employer’s business. Though most employers will shy away from granting equity to an employee, there of course will be situations where the employee has sufficient leverage to demand and receive equity.

Assuming an employer is inclined to provide such an incentive to an employee, then whatever form the incentive takes, it is imperative that the employee understand the benefit to which he or she may be entitled upon a sale of the business—including the tax treatment thereof. There is no reason for the employee to be surprised; he or she should know in advance whether the benefit will be taxed as ordinary income, and the employer should ensure that the arrangement complies with Code Sec. 409A.

As described above, there will be situations where the acquiring company will require that the key employee, either because of his or her personal goodwill or technical expertise, agree to stay on after the sale as a condition to the sale. In other situations, a portion of the purchase price may be contingent upon the performance of the business after the sale (for example, in an earn-out). These situations may provide the well-advised key employee with a measure of leverage with respect to the employer that, in effect, may enable him or her to draw value (purchase price) away from the employer.

            Conditions on the Incentive

At the same time, the incentive should be coupled with certain conditions or restrictions as to the employee’s behavior, such that the employee’s continued right to the “promised” benefit is contingent upon the employee’s compliance therewith; for example:

–        The employee must have been continually employed by the employer, at the same or at a higher position, during the ten-year period ending with the date of the sale;

–        He/she must have attained certain significant performance goals; or

–        He/she must execute a shareholders agreement (which includes buy-out provisions and a drag-along).

In this way, the employer assures itself of the employee’s commitment and cooperation.

Of course, the employer cannot lose sight of the fact that the compensation arrangement will be less costly from the employer’s perspective if the payment(s) are deductible against its business income or if they reduce the amount realized on the sale of the business. Among other things, that requires that the amount paid must represent reasonable compensation. An employer that is a C corporation (or a partnership with C corporation owners) must be mindful of the deduction disallowance under the so-called “golden parachute rules.”

Conclusion

At the end of the day, the goal is to increase value of the business for the benefit of the employer and its owners. If the business’s reasonably anticipated “return” on the incentive granted to a key employee is significant enough, then the incentive arrangement should be documented so as to ensure the achievement of its goals.  These goals should include protecting the employer from a disgruntled employee’s uncooperative behavior during the course of the sale of the business. In any case, the employee has to understand what is being asked of him/her and what he/she stands to gain.

During their life cycles, most closely held businesses will face the unpleasant task of dealing with a difficult, or otherwise unwanted, minority shareholder.  Family-owned businesses as well those in which the owners are unrelated are likely to encounter this issue. At some point in its existence, the original owners of the business will: have a major disagreement, transfer equity to members of their family (who may not be involved in the business), otherwise dispose of some portion of their interests (e.g., by sale to a third party or divorce), or admit new owners.

 Many businesses owners try to plan for at least some of these events through their shareholder or operating agreements. These agreements may include rights of first refusal, call rights, periodic put rights, other transfer restrictions, special quorum, voting or other governance-related restrictions, and/or rules as to distributions (e.g., as to taxes), and they will generally be binding upon any subsequent owners. It is difficult, however, to foresee every contingency, and it simply may be impossible for the owners to settle upon a “complete” set of mutually acceptable provisions.

 In that case, the issue of the unwanted minority shareholder may linger, and may eventually become a real problem. Business owners have been very creative in how they deal with such persons. In some cases, for example, they may stop declaring dividends, thereby depriving the minority owner (who is usually not employed by the business) of any economic benefits from the business; indeed, where the business is a pass-through entity for tax purposes, like an S corporation, the minority owner nevertheless will be stuck with a tax liability in respect of its share of the business profits.

 One Company’s Solution

The IRS recently addressed the approach taken by one corporation (“Corporation”). Corporation was treated as an S corporation for tax purposes. In order to increase the operational flexibility of  Corporation, and to reduce costs and eliminate certain administrative burdens associated with Minority Shareholder, the Continuing Shareholders and Corporation undertook the following transaction, a form of “squeeze-out”:

  • The Continuing Shareholders formed a new corporation (“Newco”) solely for the purpose of effecting the removal of Minority Shareholder.
  • Each of the Continuing Shareholders contributed all of their shares of Corporation to Newco in exchange for shares of Newco in equal proportions (the “Contribution”). They do not appear to have contributed any cash to Newco, though they certainly could have.
  • Newco merged into Corporation, with Corporation as the surviving entity (the “Merger”).
  • In connection with the Merger, the Minority Shareholder received a specified cash amount per share in exchange for the Minority Shareholder’s Corporation stock, and such stock was cancelled.
  • If the Minority Shareholder had objected to the proposed transaction, the Minority Shareholder would have had the right to exercise dissenter’s rights under state law and receive the fair value of Minority Shareholder’s shares.
  • Also in connection with the Merger, the Newco shares owned by the Continuing Shareholders were cancelled and each received shares of Corporation stock in the same proportions as the shares they held in Newco in exchange for their previously held Newco stock (the “Share Exchange”).
  • After the completion of the proposed transaction, each of the Continuing Shareholders held a number of shares in Corporation equal to the proportions that those Continuing Shareholders held immediately before the transaction.

 The IRS ruled that the creation of Newco, followed by the merger of Newco into Corporation, would be disregarded for Federal income tax purposes; in other words, the IRS would pretend that Newco never existed. Instead, the transaction would be treated as if the Continuing Shareholders had never transferred their Corporation stock for Federal income tax purposes, and thus the Continuing Shareholders would not recognize any gain or loss from the transaction. The transitory ownership of Corporation by Newco would not cause the termination of Corporation’s S corporation election (a corporation is not a qualified S corporation shareholder).

 The IRS further ruled that the cash received by the Minority Shareholder in the transaction would be treated as a distribution by Corporation in redemption of the Minority Shareholder’s stock. Because Minority Shareholder’s equity would be completely eliminated, and assuming Minority Shareholder was unrelated to Continuing Shareholders, Minority Shareholder would likely recognize capital gain as a result of the transaction.

  Planning?

The net result of the overall plan described above was the forced removal of the minority shareholder, effected by the purchase of such shareholder’s shares for cash, and the preservation of the corporation’s “S” election (and other tax attributes). While the tax structure was “right on,” and the enumerated steps seem straightforward enough, they undoubtedly belie, and were preceded by, a long period of turmoil within the business that probably included legal posturing by both sides (plus the attendant costs), threats by the minority shareholder of stock transfers to non-qualified S corporation shareholders and/or threats of “informing” the IRS as to perceived violations of S corporation requirements (e.g., the “single class of stock” rule), not to mention a lot of anguish.

 Additionally, the ruling did not seem to involve other complicating factors, for example, the disposition of any life insurance that the corporation may have held on the life of the departing shareholder, the tax treatment of any deferred compensation-like payments that could have been required if the shareholder had also been an employee, or the future involvement in the business of any members of the departing shareholder’s family.

 A “business divorce,” as one of my colleagues describes such a situation, can be a drawn-out, messy and very expensive process. It is also one that may be addressed, at least in part, by a well-thought out and well-drafted shareholders agreement. In putting together such an agreement, the original owners will have to address various governance, distribution and transfer-related topics; they will not be able to foresee every scenario; they will have to negotiate with one another; and they will likely disagree on certain items.  The agreement will not be perfect, and they will have to engage tax and other legal counsel to assist them in the process. 

 However, the original owners must not be deterred by the process. Many problems may be avoided, and their impact on the business and the cost of addressing them (including tax costs) may be significantly reduced, by properly planning for them in advance. It just makes economic sense.

A Common Fact Pattern

Partner One and Partner Two started LLC in 2002. LLC was treated as a partnership for tax purposes. They contributed a good deal of their savings and labor, but LLC lost money for the first several years of operation. Another partner, deep-pocketed Corporation, was willing to contribute almost one million dollars to keep LLC afloat, but it wanted Partners One and Two to put themselves at greater risk. This was a problem because neither Partner had the liquidity to contribute cash.

As a result, the Partners agreed to freeze their salaries. After speaking to their “longtime attorney” (who did some “cursory research” to as to the tax implications), the Partners also contributed their own promissory notes to LLC in 2007 and 2008. LLC recorded the notes on its books as additional capital and accrued interest on them–but neither Partner funded them during either year. LLC generated losses in both years.

The notes were unsecured, term-balloon notes that bore annual interest. Neither Partner assumed any LLC debt. Indeed, strapped for cash, neither Partner made interest payments, either.  Instead, LLC reported unpaid accrued interest on the unpaid notes.

This was enough for Corporation.  Satisfied that the Partners were “all in,” Corporation provided LLC with an additional $900,000 to sustain its operations and, in exchange, received $450,000 in equity and $450,000 in convertible debt.

Corporation’s money did its job, and LLC became profitable in 2012 and continued to grow in 2013.

Everyone loves an almost happy ending.  

Partners’ Outside Bases

The IRS audited Partner One’s and Partner Two’s personal income tax returns for 2007 and 2008, and issued notices of deficiency to each Partner, asserting that they failed to generate bases in their LLC interests when they contributed their personal promissory notes. The IRS said that LLC’s basis in each note was zero because the Partners’ bases in the notes were zero and, so, the Partners’ bases in their membership interests were zero. Because a partner’s distributive share of partnership loss is allowed as a deduction only to the extent of the partner’s adjusted basis for his or her partnership interest (so-called “outside basis”) at the end of the tax year in which the loss was incurred, the deductions claimed by each Partner for his share of LLC’s 2007 and 2008 losses were disallowed, resulting in an income tax deficiency. The disallowed deductions would then be carried forward by the Partners until they had sufficient outside basis to absorb the losses.

The Partners argued that the contribution of their promissory notes increased their bases in their LLC interests by amounts equal to the face value of the notes, which would allow the Partners to claim greater pass-through losses from the 2007 and 2008 tax years on their individual returns. The Partners claimed that the notes put them at substantial financial risk and that should have been enough to create outside basis.

Do Promissory Notes Generate Basis?

The Tax Court agreed with the IRS, stating that the contribution of a partner’s own note to his or her partnership is not the equivalent of a contribution of cash and, without more, it will not increase the partner’s basis in his or her partnership interest. It stated that the contribution of a note by itself does not increase a partner’s outside basis because the partner has a zero basis in the note. Similarly, a partner’s capital account is not increased with respect to a note issued by that partner until there is either a taxable disposition of the note by the partnership or the partner makes principal payments on the note.

The Court distinguished the Partners’ situation from one in which a partner directly assumes a partnership’s recourse indebtedness and becomes obligated to make additional capital contributions. While it was true that the contribution of the notes in the present case was necessary to persuade Corporation to provide more funding to cash-strapped LLC,  neither Partner was guaranteeing a preexisting LLC debt to a third party, nor did they directly assume any of LLC’s outside liabilities–these notes represented the Partners’ liability to LLC, not an assumption or guaranty by the Partners of LLC’s debt to a third party.  Moreover, there was also no evidence that the Partners were personally obliged under LLC’s operating agreement to contribute a fixed amount for a specific, preexisting partnership liability.
Thus, the Court concluded, the Partners had no adjusted basis in their notes and, until they were paid, the notes were only a contractual obligation to LLC. Thus, the Partners’ bases in their promissory notes during the 2007 and 2008  tax years were zero, LLC’s basis in the contributed notes was zero, the Partners’ bases in their LLC membership interests were zero, and the deductions claimed by them were properly disallowed.

 Alternatives?

 What is a partner to do when faced with the prospect of insufficient outside basis? Every situation is different, but there are a number of options to consider.

  • A cash contribution is obvious, as is a loan of cash to the partnership or the payment of a partnership debt, but as we saw above, these options may not be feasible. A contribution of other property (including a third party note) would do the trick, but only to the extent of the partner’s basis in the contributed property (not its fair market value).
  • If a partner owns another business entity, he or she may be able to cause that entity to make a loan to the partnership, thereby generating additional outside basis.
  • A partner may consider borrowing money from a third party and then contributing or lending it to the partnership, provided a willing lender can be found.
  • In addition, a partner’s personal guarantee or assumption of a partnership liability to a third party may generate outside basis, but the partner may not be in a position to effect these options.
  • The partner who purchases a partnership interest from another partner, even for an installment note, will receive a cost basis in such interest against which partnership losses may be deducted.
  • Finally, the acceleration of partnership income or the deferral of deductions or distributions may assist in giving the partner outside basis for purposes of absorbing losses.

In reviewing the available alternatives, it will behoove a partner that is facing the possible disallowance of loss deductions to consult with his or her tax adviser (unlike the Partners in the decision, above). In doing so, the partner must not forget the taxpayer’s mantra: before you pursue a course of action to achieve a particular tax goal, be certain that it makes sense from a business perspective.

From a tax perspective, partnerships and limited liability companies are, by far, the most flexible of business vehicles. Among other benefits, they have no restrictions as to ownership or as to classes of equity; special allocations and disproportionate distributions may be provided for in the partnership or operating agreement; and there is pass-through tax treatment.

However, once you introduce the element of related partners, the structural and contractual flexibility that is so important to arm’s-length business dealings can turn into a dangerous tool, as one unsuspecting taxpayer recently discovered.

Donor and her sons, A and B, formed Company, a limited liability company. Donor’s capital contribution consisted of real property. Donor, who was the sole member to make a capital contribution, thereafter made gifts of membership interests to her sons. The gifts caused Company to be treated as a partnership for tax purposes.

A Textbook Situation

Things started out well. Under Company’s operating agreement, each member’s capital account was credited with the amount of the member’s capital contribution. (In the case of A and B, they took a proportionate share of Donor’s capital account.) Profits and losses were then allocated to a member’s capital account pro rata based on the member’s ownership interest. A member’s ownership interest was the proportion that a member’s capital account bore to the aggregate positive capital accounts of all members. Distributions were made based on a member’s ownership interest. No member had priority over any other member as to participation in profits, losses and distributions or the return of capital contributions. No member had the right to withdraw a capital contribution.  Textbook.

In the event that an asset was distributed in kind, the asset was deemed to have been sold as of the distribution date, and each member’s capital account adjusted to reflect the member’s share of the deemed gain or loss.  Textbook.

In the event of Company’s dissolution, its assets were to be sold and each member’s capital account adjusted to reflect the member’s share of gain or loss. In the event that an asset was distributed in kind, the asset was deemed to have been sold as of the dissolution date, and each member’s capital account adjusted to reflect the member’s share of the deemed gain or loss. Upon completion of dissolution, the balance of each member’s capital account was then to be distributed to the member.  Textbook.

 The Recap

Later, however, at a time when Donor held an M percent ownership interest, and A and B each held an N percent ownership interest, Company was recapitalized. Specifically, in exchange for the agreement of A and B to manage Company, the operating agreement was amended to provide that, thereafter, all profit and loss, including all gain or loss attributable to Company’s assets, would be allocated equally to A and B. After the recapitalization, Donor’s sole equity interest in Company was the right to distributions based on her capital account balance as it existed immediately prior to the recapitalization.

A recapitalization may be used to accomplish various estate planning goals by shifting ownership interests within a partnership or corporation. For example, it may be used to incentivize younger members of the family to assume greater managerial responsibilities. However, a recapitalization often presents a number of income and gift tax traps.

The Code imposes a tax on the transfer of property by gift by any individual. It provides that the tax shall apply whether the transfer is in trust or otherwise, whether the gift is direct or indirect, and whether the property is real or personal, tangible or intangible. Thus, any transaction in which an interest in property is gratuitously passed or conferred on another, regardless of the means or device employed, constitutes a gift subject to gift tax.

According to the IRS, the terms “property,” “transfer,” “gift,” and “indirectly” are used in the broadest and most comprehensive sense; the term “property” reaches every species of right or interest protected by law and having an exchangeable value.

Likewise, the words “transfer by gift” and “whether direct or indirect” are designed to cover most transactions whereby, and to the extent that, property or a property right is donatively passed to or conferred upon another, regardless of how it is accomplished.  For example:

(1) a transfer of property by corporation Y, without consideration, to person X would constitute a gift from the stockholders of corporation Y to X.

(2) A transfer by X to a corporation owned by his children would constitute a gift to X’s children.

It follows, then, that the capitalization or recapitalization of an entity may constitute a gift. IRS regulations provide that donative intent on the part of the transferor is not an essential element in the application of the gift tax to the transfer. The application of the tax is based on the objective facts of the transfer and the circumstances under which it is made, rather than on the subjective motives of the donor.

IRS regulations provide further that a gift is complete as to any property, or part thereof or interest therein, of which the donor has so parted with dominion and control as to leave in him/her no power to change its disposition, whether for his/her own benefit or for the benefit of another.

Special Rules

The Code provides special valuation rules that apply to determine the existence and amount of a gift when an individual transfers an equity interest in a family controlled corporation or partnership to a member of the individual’s family, whether or not the transfer would otherwise be a taxable gift. In other words, a transfer that would not otherwise be a gift because it was a transfer for full and adequate consideration may still be treated as a gift in certain circumstances.

Under the special valuation rules, a contribution to capital, or a redemption, recapitalization, or other change in the capital structure of a family-controlled corporation or partnership may be treated as a taxable transfer of an interest in such entity if, pursuant to such transaction, a taxpayer holding an “applicable retained interest” in the entity surrenders an equity interest therein that is subordinate to the applicable retained interest and, in exchange, receives property other than another applicable retained interest.

An applicable retained interest is an interest with respect to which there is a distribution right. A subordinate interest is an interest as to which an applicable retained interest is a senior interest. A senior interest is an interest that carries a right to distributions of income or capital that is preferred as to the rights of the transferred interest. The term “property” includes every species of right or interest protected by law and having an exchangeable value.

Here, at all relevant times, Donor and her family controlled Company. Company was recapitalized and Donor surrendered her right to participate in future profit and loss, including future gain or loss attributable to Company’s assets. Both before and after the recapitalization, Donor held an equity interest in Company coupled with a distribution right (an applicable retained interest). Donor’s original interest, which carried a right to distributions based upon an existing capital account balance, was senior to the transferred interests, which carried only a right to distributions based on future profit and gain. In exchange, Donor received property in the form of the agreement of A and B to manage Company—not an applicable retained interest.  Accordingly, the recapitalization constituted a transfer by Donor for purposes of the gift tax.

 Lessons

Even where a transfer of equity in a business appears to reflect arm’s-length consideration – as in the ruling, where the sons received an enhancement to their membership interests in exchange for their agreement to manage the Company – the Code may nevertheless create a taxable gift transfer where the business entity is controlled by the transferor’s and transferee’s family. The members of a family business must be careful of what may appear to be an innocuous exchange of equity. While these may be necessary or desirable from a business perspective, one must consider the associated tax risks in order to appreciate the potential economic cost of the transaction, and to thereby measure the net benefit. As always, it will behoove the family members to first consult with their tax advisers.

A taxpayer has the legal right to minimize his or her taxes, or to avoid them completely, by any means that the law allows. However, this right does not give the taxpayer the right to structure his or her affairs by using “business entities” that have no economic reality and that are employed only to avoid taxes. One business owner recently learned this lesson the hard way: the Tax Court was his teacher.

Wheeler v. Commissioner

In Wheeler v. Comr., Taxpayer owned and operated a business out of an S corporation from the late 1980s until 2002, when the corporation (“Corp”) was liquidated and distributed its assets to Taxpayer.  Corp’s assets, which Taxpayer presumably took with a fair market value basis, consisted primarily of equipment and inventory, and Corp operated in a factory building owned by Taxpayer. After Corp liquidated, its business continued in the same location through a separate limited liability company (“LLC”) that was managed by one of Taxpayer’s daughters. In late 2002, an entity that purported to be a “business trust” (“Trust”) was formed, and its capital units were issued to Taxpayer’s daughters.

In early 2003, Taxpayer and Trust entered into an agreement by which Taxpayer purported to grant Trust the option to purchase Taxpayer’s factory and equipment. The exercise price for the option was $1.65 million, payable with two promissory notes. The agreement was contingent upon a separate rental agreement between Trust and LLC for the latter’s use of the factory and equipment. Both agreements were drafted by Taxpayer, who also unilaterally determined their economic terms.

Notwithstanding the fact that Trust did not exercise the option to purchase the factory and equipment until 2004, LLC began making significant rental payments to Trust in 2003.  Trust in turn paid the exact same amounts to Taxpayer, presumably in partial satisfaction of the promissory notes.

In mid-2004, LLC stopped making rental payments to Trust, and Trust stopped making note payments to Taxpayer. In fact, Taxpayer explained that the remaining payments owed to him under the option notes were “gifted” to Trust.

After examining the foregoing arrangement, the IRS asserted that Taxpayer’s sale of the factory and equipment to Trust should be disregarded because Trust was a sham entity and the lease payments from LLC to Trust were merely lease payments to Taxpayer.

According to the Court, the “true earner” of income is the person or entity who controls the earning of such income, and not necessarily the person or entity who receives the income. “‘The crucial question,” the Court stated, “[is] whether the assignor retains sufficient power and control over the assigned property or over receipt of the income to make it reasonable to treat him as the recipient of the income for tax purposes. . . . An anticipatory assignment of income from a true income earner to another entity by means of a contractual arrangement does not relieve the true income earner from tax and is not effective for Federal income tax purposes regardless of whether the contract is valid under State law.”

The Court concluded that Taxpayer was the true earner of the rental income paid from LLC to Trust. First, Taxpayer owned the assets that Trust leased to LLC throughout the period at issue up until March 2004, when he deeded the assets to Trust. Therefore, at a minimum, LLC’s 2003 rental payments and its first few 2004 rental payments were properly allocable to Taxpayer as the owner of that property.

Second, Trust acted as a mere conduit for the flow of income from LLC to Taxpayer. Trust received income attributable to Taxpayer’s assets and subsequently paid petitioner the same amounts it received from LLC. When LLC suspended rental payments to Trust in June 2004, Trust ceased making payments to Taxpayer.

Finally, there was no separation of Trust administration from the operation of LLC, and Taxpayer retained substantive control over Trust. Taxpayer drafted the contract between Trust and LLC. Neither Trust nor LLC negotiated the terms of the contract, and Taxpayer set the price for the lease. When LLC ceased its rental payments, Trust did not take any action to enforce the lease terms because the trustee felt that it was a “family matter” and he could not take action. Similarly, Taxpayer testified that the remaining payments owed to him under the option contract were a “gift” to Trust. Taxpayer failed to provide persuasive evidence that the option contract and the lease were entered into in good faith and that the parties to these contracts intended to be bound by their respective agreements and expected to have to honor them. Instead, the Court concluded that the agreements were shams.

Because Taxpayer had sufficient power and control over Trust’s receipt of income from LLC, he was the true earner of the income. As the payments were rental payments to Taxpayer in substance, Taxpayer could not use the alleged basis he had in the assets to offset this income. Consequently, the rental income paid by LLC to Trust was taxable to Taxpayer in its entirety.

The Economic Substance Doctrine 

The foregoing discussion highlights one application of the economic substance doctrine. Under this doctrine, a court may deny a taxpayer any tax benefit arising from a transaction that does not result in a meaningful change to the taxpayer’s economic position other than a reduction in federal income tax.  In other words, a transaction that would otherwise result in beneficial tax treatment for a taxpayer will be disregarded if the transaction lacks economic substance.

The tax advisers to closely held businesses need to familiarize themselves with the economic substance doctrine. It is in the context of such a business (as in Wheeler) 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 question should be whether the transaction that generated the claimed tax benefit also had economic substance and/or a business purpose in order for the transaction to withstand IRS scrutiny. In making that determination, it may help to compare the transaction at issue with transactions between unrelated parties in a bona fide business setting.

In all cases, these inquiries should be made, and the responses thereto should be memorialized, in advance of the transaction. The taxpayer and his or her advisers should never forget that the taxpayer will bear the burden of proof in any examination by the IRS.