For the owner of a closely-held business, and especially one with a limited support staff, it can be easy to drift into carelessness or, worse, neglect, when it comes to maintaining detailed records of the business’s expenses.  However, as one taxpayer recently learned the hard way, such inattention to detail can come back to haunt you when it comes time to file your tax returns.

In Nguyen v. Commissioner, tax deficiencies were assessed upon the taxpayer, an owner of a hardwood floor installation business (the “Taxpayer”), for the years 2009 and 2010.  The IRS also determined accuracy-related penalties for the same period.  The crux of the case turned on the Taxpayer’s lack of substantiation for the amounts claimed for cost of goods sold as well as for supplies.

 Taxpayer’s Practice    

In conducting his business, Taxpayer generally purchased the flooring necessary for each job as he was hired, rather than maintaining an inventory of flooring materials.  At times, Taxpayer also installed flooring already purchased by his customers.  In addition to purchasing flooring materials, Taxpayer purchased supplies in connection with the business, including wood, paper, glue, and nails.  He made these purchases using his debit card, checks, and cash.

Taxpayer’s practice for both 2009 and 2010 was to keep business bank statements in the drawer of his desk, and receipts for business expenses in a bag in his basement.  However, due to a flood in Taxpayer’s home in 2009, some of the receipts for that year were destroyed.  (At least the dog didn’t chew his homework.)

The 2009 and 2010 Returns

Taxpayer’s returns for 2009 and 2010 were prepared by two different tax professionals.  The preparer for the 2009 return reviewed Taxpayer’s bank statements and the receipts that remained after the flood over the course of an hour-long meeting.  The IRS determined that about 40% of the cost of goods sold claimed on Taxpayer’s Schedule C had been substantiated, and asked for an explanation of the discrepancy.  A review of additional documents provided by the Taxpayer only substantiated a small portion for cost of goods sold.

Taxpayer’s 2010 return was prepared by a different tax professional, who was given the 2009 return as a guide but no other documentation.  On the 2010 return, $39,894 was claimed as a deduction for supplies, which the IRS determined had been about 60% substantiated.  A review of additional documents provided by the Taxpayer substantiated an additional $178.26.

Court’s Analysis

In its analysis, the Court highlighted the fact that “[d]eductions are a matter of legislative grace, and taxpayers bear the burden of establishing entitlement to any claimed deduction.”  In this instance, in addition to the limited documentation provided by the Taxpayer to substantiate the claimed deductions for cost of goods sold and supplies, Taxpayer failed to provide any testimony regarding specific expenditures related to flooring jobs for which deductions should be allowed but were denied, or for supply expenses in excess of the amount determined as allowable, in either 2009 or 2010.  As a result of his inability to back up the amounts on his returns, Taxpayer was not entitled to any more deductions, for either cost of goods sold or supplies, than the IRS had already determined as allowable.

The Court also found in favor of the IRS in upholding the accuracy-related penalty of 20% under Code § 6662, which penalty applies, among other things, to the portion of an underpayment attributable to negligence.  For purposes of this rule, negligence includes any failure to keep adequate books and records or to substantiate items properly.  The burden is on the IRS to produce evidence of such negligence, and was met in this case with the showing that the Taxpayer lacked adequate records to substantiate fully the amounts claimed.

Although there is a good faith exception to the § 6662 penalty under Code § 6664 if the Taxpayer can establish that there was reasonable cause for the underpayment and that the Taxpayer acted in good faith, the Taxpayer provided no evidence that he fell within this exception.  Therefore, the accuracy-related penalty was upheld.

 Conclusion

For all businesses, but especially for a business that routinely purchases goods and supplies, it is critical to keep meticulous records of purchases throughout the year.  While many of these purchases may seem insignificant at the time—in the instance of the Taxpayer here, for example, purchases of  glue and nails—in the aggregate, if documented correctly, they are likely to result in a significant tax benefit and thus be well worth the headache of cataloging them along the way.

Small, closely-held businesses must especially be diligent if they are to reduce their tax liability and avoid penalties.  The tax savings will warrant the cost of recordkeeping.

When a parent hires a child in the family business, makes them an officer in that business, or grants them an equity interest in the business, the parent’s goal in doing so is to help the child. Unfortunately, those same acts may place the child in harm’s way. Similarly, when a child seeks to assist a parent in the family business, the child may be exposing him- or herself to significant financial risk.

 A recent U.S. District Court opinion highlights a common scenario. In Webb-Smith v. U.S., the IRS assessed civil penalties against Daughter based on her involvement in Dad’s business, which had failed to account for employment taxes withheld from its employees’ wages. Daughter paid the penalties, filed a claim for refund, and, once the refund claim was rejected, then commenced a refund action against the IRS in federal district court. The IRS subsequently filed a motion for summary judgment, which the Court denied.

The Court’s opinion provides a good summary of the factors that are considered in determining whether someone possesses the requisite authority to be treated as a “responsible person.” More importantly, it illustrates how easily personal liability may attach to an employee-family member in respect of so-called “trust fund taxes.”

The Issue:  Was Daughter Liable for Business’s Unpaid Taxes?

Pursuant to federal law, employers must withhold income and social security taxes from employee wages, and hold these amounts in trust for the IRS. These taxes are commonly referred to as “trust fund taxes.” The Code imposes personal liability for failure to remit trust fund taxes to the IRS.

An individual will be personally liable for unpaid taxes if (1) the individual was “responsible” for collection and payment of trust fund taxes; and (2) the “responsible person” acted “willfully” in his or her failure to comply with the statute.

In determining “responsible person” status, the critical question is “whether the person had the ‘effective power’ to pay the taxes—that is, whether he had the actual authority or ability, in view of his status within the corporation, to pay the taxes owed.” More than one person in a corporation may be deemed a “responsible party,” and a person’s title alone is insufficient to establish him or her as such a party.   Rather, courts focus on the substance of that person’s duties.

Courts have developed a non-exhaustive list of factors that assist in determining whether a person possessed the requisite authority to be considered a “responsible person.” Factors to consider include whether the employee:

(1) served as an officer of the company;

(2) controlled the company’s payroll;

(3) determined which creditors to pay and when to pay them;

(4) participated in the day-to-day management of the corporation;

(5) possessed the power to write checks; and

(6) had the ability to hire and fire employees.

No one factor is determinative, and the court will consider the totality of the circumstances.

Daughter was a founding officer of Dad’s business (“Business”) and, at Dad’s request, acted as Treasurer beginning in March 2003. Dad was the sole shareholder of Business.  In December of 2004, Daughter resigned as Treasurer because she had a separate, full-time job that required substantial out-of-state travel. After her resignation, however, she continued to assist Business by calculating payroll, preparing and signing tax returns, and writing checks to creditors at Dad’s direction.

The government argued that Daughter’s title as Treasurer “speaks powerfully to her role within the business.” She disputed this contention, stating that “[her] duties never included those of a corporate treasurer,” despite her title. She characterized her role as more akin to a bookkeeper than a corporate treasurer.

Although Daughter possessed the title of Treasurer of the Business between March, 2003 and December, 2004, she pointed to evidence that gave rise to a genuine dispute as to whether she actually carried out the duties and possessed the authority of a corporate treasurer. All of her actions – calculating the Business’s payroll, preparing and signing tax returns, and writing checks to pay the bills – were taken at the direction of Dad who, according to Daughter, controlled access to the company checkbook. She did not write checks or file tax returns on behalf of Business without Dad’s permission. Additionally, she had no office at Business and was away from Business for substantial periods of time during the time frame in question.   Thus, while the government argued that Daughter was “given responsibility for calculating the company’s payroll, issuing payroll checks, and preparing and signing payroll tax returns,” Daughter countered that performing payroll calculations at Dad’s direction and acting as bookkeeper were insufficient facts to establish that she had control of the Business’s payroll.

Again, while Daughter prepared the company’s payroll and signed payroll checks, these actions were taken at Dad’s request and direction, often while Daughter was working full-time out-of-state. Employee salary was determined by Dad, and he was in charge of making sure payroll taxes were paid. Daughter’s lack of control over the payroll was supported by her testimony that she did not learn that Business had failed to remit trust fund taxes until 2006.

The government argued that Daughter “had the ability to determine which creditors to pay because she had access to the company’s checkbook and had full check-signing authority on the company’s account.” She contended that because she “was only allowed to write checks for bills that were [pre-authorized] by her father,” she had no authority to determine which creditors to pay.

Though Daughter possessed full check-signing authority, as no co-signor was required, and thus her signature alone would be sufficient for the bank to cash a check, whether she had access to the checkbook was in dispute. Nevertheless, even assuming Daughter had access to the checkbook, that fact combined with her full check-signing authority was insufficient to show there was no dispute as to whether she determined which creditors to pay and when to pay them. Her actual authority was circumscribed by Dad’s control over the process; she was only allowed to write company checks with the permission and at the direction of Dad. She testified that Dad would tell her what specific bills to pay and that she never questioned his decision or offered advice on the issue. Daughter testified that Dad “was the only person that could authorize anything at [the Business].”

While the power to sign checks is an important factor in the “responsible person” inquiry, the Court said, the power “can exist in circumstances where the individual in reality does not possess significant control over corporate finances.”  The Court here found that Dad exerted such control over the process as to divest Daughter of any meaningful authority.

The government also argued that, based on Mom’s testimony, there was no dispute that Daughter had authority to hire and fire employees. (Mom?!) Daughter maintained that she had no such authority. In outlining Dad’s duties, Daughter testified that “[h]e hired all of the employees . . . [and] fired any employees.” She stated that she had no role in hiring and firing at Business at any point.   Although Daughter did not testify explicitly that she lacked ability to make hiring and firing decisions, her testimony gave rise to a reasonable inference that she lacked such ability.

The government did not contend that Daughter participated in the daily management of Business. She testified that she was working full-time out-of-state during most of the time period in question. She never had an office or even a designated workspace at Business. While Daughter performed several tasks for Business between 2004 and 2008, the record showed no evidence that she was involved in the company’s day-to-day management, and therefore, this factor favored a finding that she was not a responsible person.

Based on the foregoing, the Court found that the record presented genuine questions as to the amount of actual, substantive authority that Daughter possessed over the control of Business finances and the scope of her decision-making authority, and thus, whether she was a responsible person.

Escaping Liability

Daughter was fortunate. She had a full-time job that kept her away from Business and she had no office at Business.  Had these facts differed even slightly, the Court may have not have assigned as much weight to Daughter’s testimony regarding Dad’s control over check-writing and hiring. In other words, the result could have been very different.

The lesson: although a child’s involvement in the family business can be a starting point for succeeding to control over, and ownership of, the business, the economic benefits and opportunities bestowed upon a child come with a great deal of responsibility, much of which– as in the case of trust fund taxes– may not be readily apparent to many. It will behoove a child who finds him- or herself in a position of authority in the family business to understand the attendant legal responsibilities and to ensure that the business remains compliant with its own.

             Every now and then, a case comes along that is just chock-full of lessons, not only for taxpayers, but for their advisors as well.  The Tax Court’s decision in Cavallaro v. Comr.  describes such a case.  It involves closely held corporations, related party transactions, a tax-free reorganization and, oh yeah, a huge taxable gift.

             Mom and Dad owned a custom tool manufacturing business, Knight Tool, Inc.  Their sons were employed by the corporation.  In order to diversify their operations and provide another source of revenue, Knight began development of a liquid dispensing machine (the “technology”).  The development process proved to be expensive and not very profitable.  Mom and Dad decided that Knight should revert to its original line of business.  Their sons, however, believed that they could develop a successful liquid-dispensing machine and find a market for it.  Mom and Dad assented.

The sons formed a new corporation, Camelot Inc., to which they made a nominal capital contribution in exchange for all of its shares.  At no time, however, did Knight grant to Camelot the right to produce or sell Knight’s technology.

As the sons continued to develop the machine, Knight continued to compensate them as Knight employees, and Knight personnel (using Knight equipment) assisted them with implementing their development ideas.  In time, Knight was manufacturing the machines based on the technology, and Camelot sold and distributed them.  The Camelot business became so successful that it eventually represented 90% of Knight’s business.

Unfortunately, however, Knight and Camelot never took a consistent approach to the overall allocation of income and expenses between them.  Instead, it appeared that profits were disproportionately allocated to Camelot, which the Court attributed either to the “deliberate benevolence” of Mom and Dad, or else to “a non-arm’s length carelessness born of the family relationships.”

The lax approach to the relationship between the two corporations was also reflected in the fact that no documentation existed that memorialized any transfer of the technology from Knight to Camelot.  Indeed, the documents affirmatively showed that Knight continued to own the technology; when the question of tax credits came up, Knight reported that it owned the technology.

Several years into their “relationship,” Knight and Camelot decided that they would need to merge, with Camelot as the surviving entity, if they wanted to expand their European market.  They retained an appraisal firm that valued the combined entity at between $70 and $75 million.  The two corporations merged in an income tax-free merger, with the sons receiving 81% of the surviving corporation, based upon the appraisal’s incorrect assumption that Camelot owned the technology.  Slightly before the merger, the attorney for both corporations prepared a “confirmatory” bill of sale that reflected an earlier purported transfer of the technology from Knight to Camelot despite the lack of any evidence as to Camelot’s ownership.

The IRS determined that Mom and Dad made significant gifts to their sons by merging the parent’s company (Knight) with and into the sons’ company (Camelot) and allowing the sons an 81% interest in the merged entity.  The Court agreed.

The Court began by noting that donative intent on the part of the donor is not an essential element for gift tax purposes.  The application of the gift tax, it said, is based on the objective facts and circumstances of the transfer rather than the subjective motives of the donor.  The Court quoted from IRS regulations:  “Where property is transferred for less than an adequate and full consideration …, then the amount by which the value of the property exceeded the value of the consideration shall be deemed a gift.”  Such taxable transfers, the Court said, include exchanges between family members.  Indeed, when a transaction is made between family members, it is “subject to special scrutiny, and the presumption is that a transfer between family members is a gift.”

The taxpayers argued that the transaction should be considered one that was made for “an adequate and full consideration” because it was made in the “ordinary course of business” and was “bona fide, at arm’s length, and free from donative intent.”  Unsurprisingly, the Court disagreed with the taxpayers.  It pointed out that if an unrelated buyer had approached either Camelot or Knight, it would have demanded to see documentation regarding the ownership of the intangible, and it would have acted accordingly.

The instant case, the Court said, did not involve a hypothetical unrelated party; instead, it involved parents “who were benevolent to their sons,” and it involved “sons who could … proceed without the caution that normally attends arm’s length commercial dealing between unrelated parties.”  Throughout the process of developing the intangible, the Court found that the parents gave no thought to which corporation would own it, and they gave no thought to which corporation would pay for its development.

Thus, the Court concluded that there was a gift, the amount of which would be based upon a 60%-40% split of values between Knight and Camelot, respectively (as opposed to the 20%-80% split claimed by the taxpayers in the merger)

There are many lessons to be learned here.  First and foremost, any related parties, be they family members or commonly-controlled business entities, must be especially careful when transacting business with one another.  They must recognize that these transactions will be subject to close scrutiny by the IRS, and that they have to “build their case” contemporaneously with the transactions.  They must treat each other as unrelated parties as much as possible, by conscientiously documenting all intercompany business dealings, and they must be able to support the reasonableness of any exchanges or transactions between them.

Taxpayers also must recognize that taxable gifts can occur in a business setting.  Mom & Dad had the right idea when they sought to shift the appreciation in the Camelot business to their sons.  They were right to retain the services of an appraiser to determine the relative values of the two corporations at the time of the merger. However, their failure to properly and formally transfer the technology at a time when its value was low and its future was unknown—to act at arm’s length—and their failure to treat with Camelot as they would have with any unrelated person, ultimately made their gift more costly.

Sometimes, the U.S. Tax Court will rule on a matter the outcome of which would seem – at least to an outsider, or on some visceral level – to have been a foregone conclusion. Indeed, one is often left wondering how such a matter was allowed to progress through an IRS audit, IRS Appeals, the issuance of a notice of deficiency, the filing of a petition with the Tax Court, probably more discussions with IRS Appeals and with IRS Counsel, and finally a Tax Court trial. The process is lengthy and can be expensive.

Upon closer examination, however, it may turn out that the taxpayer’s position may be more supportable than a cursory review indicates.  Alternatively, the magnitude of the tax exposure may justify the taxpayer’s effort.

Vanney

In Vanney Associates Inc. v. Comr.,  the Tax Court encountered such a case when it considered whether a corporate taxpayer (the “Taxpayer”), a C corporation, could deduct the portion of officer compensation related to a year-end bonus to its sole shareholder. The bonus was paid by a check that the Taxpayer could not have honored and that was returned to the Taxpayer. The IRS disallowed the deduction, and the Court agreed with the IRS.

Facts

The Taxpayer was a personal service corporation that used the cash method of accounting. The sole shareholder (the “Shareholder”), a licensed professional with over 39 years of experience, was the taxpayer’s chief executive officer, chief financial officer, vice president of marketing, vice president of operations, and director of human resources. He was also the one responsible for marketing, bringing in new business, and signing documents.  The Taxpayer employed about 25 other individuals including the Shareholder’s spouse, who was the Taxpayer’s bookkeeper.

The Taxpayer paid the Shareholder a monthly wage. At the end of each year, it was the Taxpayer’s practice to determine its remaining profit after paying any outstanding bills and paying bonuses to employees. After determining this amount, the Taxpayer would prepare a check to pay the remaining profit to the Shareholder as a year-end bonus. The Shareholder testified that his intent behind the year-end bonus was only to pay out the remaining profit; it was not to zero out the tax liability of the Taxpayer, even if that was the effect.

At the end of 2008, the Taxpayer paid the Shareholder a bonus totaling $815,000. After withholding and paying to the IRS the appropriate Federal income, Social Security, and Medicare taxes, the Taxpayer wrote a check to the Shareholder for $464,183.  The Shareholder signed the check on behalf of the Taxpayer and then endorsed the check in his own name and made it payable to the Taxpayer. He never attempted to cash the check. The payment was recorded on the Taxpayer’s books as a loan from the Shareholder and the Taxpayer repaid the loan in 2009.

Although the Taxpayer wrote the Shareholder a check for over $460,000, the total balance in the Taxpayer’s bank accounts at the end of 2008 was only $389,604. The Shareholder testified that he “believe[d]” he knew that [the Taxpayer] did not have the funds necessary to honor the check. However, he maintained that the Taxpayer could have gotten a loan to cover the check, though it did not want to incur the related costs. Further, he testified that the Taxpayer was a strong company with considerable receivables.

The Taxpayer’s 2008 corporate income tax return reflected no taxable income or tax liability. It showed claims for various deductions, among them over $1 million for compensation of officers.

The IRS selected the Taxpayer’s return for examination and issued a notice of deficiency, disallowing $815,000 of the deduction for compensation of officers.

Analysis

Income tax deductions, according to the Court,  are “a matter of legislative grace, and the burden of proving entitlement to any claimed deduction rests on the taxpayer.” The Code allows a deduction for “ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.”

A payment by check, the Court said, is known as a conditional payment because it is subject to the condition subsequent that the check be paid upon presentation to the drawee. Once the condition subsequent is fulfilled, it is generally reasonable to conclude that the payment relates back to the time when the check was given.

Thus, the allowance of a deduction is dependent on proper payment of the check. The Court noted that it had previously disallowed a deduction where a check was not ultimately paid because of insufficient funds and, further, that it had also held that the relation-back doctrine was inapplicable where the payee knows the payor has insufficient funds and, therefore, refrains from cashing the check.

Transactions between related entities, the Court said, are subject to special scrutiny.  “The economic reality of a transaction will prevail over its form, and a finding of economic reality depends on whether the transaction would have followed the same form if the parties were unrelated.”  Further, the Court said, “we have previously disallowed deductions where there was no actual economic outlay” and the payments were “wholly circular”.

Because the Shareholder was the sole owner of the Taxpayer and his spouse was its bookkeeper, the Court pointed out that he either knew or should have known that the Taxpayer did not have the funds to cover his bonus check.

The Taxpayer countered that the payment was unconditional and that payment occurred when the Shareholder took possession of the check. The Court disagreed, stating that the Shareholder did not have “unrestricted use” of the money; the amount was not “unqualifiedly his, to do with as he wished.” If anything, the Shareholder had only restricted use of the check. He could not cash it at the bank, use it to pay a debt, or use it to make a loan to someone other than to the taxpayer. In fact, his only option to make use of the money at that time was to lend it back to the Taxpayer because the check could not be honored.  Accordingly, the Court sustained the IRS’s disallowance of a portion of the Taxpayer’s deduction for officer compensation.

In Summary

The foregoing is yet another illustration of why a taxpayer needs to conduct an “economic reality check” before embarking upon a transfer of funds or other transaction with his or her closely-held business. In the instant case, the Taxpayer could not transfer what it did not have. Interestingly, it could have borrowed the funds with which to make the payment. Indeed, corporations with earnings and profits, but insufficient liquidity, will sometimes borrow funds with which to pay a dividend to shareholders. The Taxpayer’s reluctance to do so in this case cost it dearly.

 

Equity compensation is attractive to employees and employers alike.  Because the opportunity to participate in the growth of a company provides potentially unlimited compensation to employees, its incentive value is quite powerful to employers.   In this last post in this series on Section 409A, we will sort through the types of equity compensation that are and are not subject to Section 409A and focus, in particular, on the importance of proper equity valuation as a key step in Section 409A compliance.

First, the good news!  Treasury Regulations provide that restricted stock is not subject to Section 409A.   However, while this fact may result in a lower Section 409A compliance burden for employers, a grant of restricted stock is a “full value” award; the recipient of an award of restricted stock will, upon vesting of the award, be entitled to the full value of a share of the employer’s stock.

Contrast this with other types of stock rights that are “appreciation” awards, such as stock options and stock appreciation rights.  These awards provide only the increase in value of a share of stock from the date of grant through the exercise or settlement date.    Here, the employee is not given the benefit of the preexisting value of the company at the time of the award.  From the perspective of a closely-held business owner, this may be a more sensible approach to incentivizing key employees while not excessively diluting their ownership.

These types of appreciation awards are subject to Section 409A, unless certain additional requirements are met.

Stock Rights – Nonqualified Stock Options and Stock Appreciation Rights

A nonqualified stock option (“NQSO”) provides the recipient with the right to purchase shares of company stock for a stated exercise price upon exercise of the vested NQSO.   In effect, the grant of an NQSO provides the recipient with an amount of compensation equal to the increase in value of the company’s stock from the date of grant through its exercise date (i.e., the “spread” of the NQSO).  A stock appreciation right (“SAR”), like an NQSO, provides the recipient with an amount of compensation equal to the increase in value of the company’s stock from the date of grant through the settlement date, when payment is made.  Unlike an NQSO, however, no exercise price is paid in connection with this award; it is simply settled by the company through delivery of an amount of cash, or a number of shares of stock with a fair market value, in each case, equal to the spread.

An NQSO or SAR will be subject to Section 409A (i.e., may only be exercised/settled upon a permissible Section 409A payment event) unless it satisfies each of the following requirements:

The shares covered by the NQSO/SAR qualify as shares of “service recipient stock” (defined, generally, as common stock of the entity for which the award recipient is performing services, or another corporation within the same controlled group);

  • The exercise price of the NQSO/SAR is equal to or greater than the fair market value of the underlying shares on the date of grant;
  • The NQSO/SAR covers a fixed number of shares as of the date of grant; and
  • The NQSO/SAR does not provide for the deferral of compensation past the exercise/settlement date.

If each of the above requirements is met, a NQSO and/or SAR will be exempt from Section 409A.

One issue to keep an eye on is the right to receive dividends or dividend equivalents with respect to an NQSO/SAR, as this may cause an otherwise excludible stock right to become subject to Section 409A.  The Treasury Regulations provide that the right to receive dividends or dividend equivalents upon exercise/settlement of an NQSO/SAR will be treated as an indirect reduction in the exercise price of the award, which would result in a stock right with an exercise price below the fair market value of the stock on the date of grant.  In order to steer clear of this inadvertent exercise price reduction, the right to receive dividends must not be contingent upon the exercise of the stock right but, rather, should be drafted to comply with Section 409A as a separate deferred compensation arrangement.

Fair Market Value – The Importance of Proper Valuation

A stock right need not be drafted to be exempt from Section 409A but, in reality, the grant of an NQSO or SAR that is only exercisable upon a Section 409A permissible event, and which must be exercised on the first such enumerated event to occur, is far less attractive to a key employee who would like the opportunity to monetize their award freely once vested.   In this respect, proper pricing of a stock right on the date of grant is crucial to delivering a freely exercisable stock right because, as stated above, only stock rights with exercise prices at or above the fair market value of the underlying stock will be eligible for exemption from the requirements of Section 409A.

The importance of this valuation is not to be taken lightly.  Awarding a key employee with a stock right that is not designed to comply with Section 409A, relying on the mistaken belief that it was exempt from Section 409A, will result in a twenty percent (20%) penalty on the amount of the spread, as well as inclusion of the spread in the employee’s income as of the date that the award vests, whether or not the award is ever actually exercised/settled.

Treasury Regulations require that a private company use a “reasonable application of a reasonable valuation method” in determining the fair market value of its stock for purposes of Section 409A.  Whether a valuation method is deemed reasonable by the IRS will depend on the facts and circumstances, but, in order to be considered reasonable, the method employed must take into consideration all material information available at the time of the determination.  Certain factors that may be appropriately factored into this analysis are mentioned in the Treasury Regulations, including recent arm’s length transactions, control premiums, discounts for lack of marketability and the value of tangible and intangible assets.

For those looking for certainty, the Treasury Regulations provide that an independent appraisal calculated no more than twelve months period to the date of the award can be used as a safe harbor, provided all available information material to the company’s valuation has been taken into consideration (i.e., a material change in the business would invalidate a prior independent appraisal conducted in that same year).

Another safe harbor, which does not require an independent appraiser, applies solely to illiquid start-up companies.  Such companies may safely rely on an internal valuation that is made reasonably and in good faith, provided it is (i) prepared by a person experienced and knowledgeable in the company’s line of business, (ii) evidenced by a written report, and (iii) takes into account relevant valuation factors.  For this purpose, Section 409A defines an illiquid start-up company as a company:

  • that has been conducting business for less than ten years;
  • that does not have a class of securities that are traded on an established securities market;
  • that does not reasonably anticipate that it will be acquired within 90 days or will be publicly traded within 180 days; and
  • the common stock of which is not subject to put or call rights or other obligations to purchase such stock (other than a right of first refusal or a “lapse restriction,” such as the right of the company to repurchase unvested stock held by the employee at its original cost).

Many closely-held businesses may fit within this definition of an illiquid start-up company and will be able to provide their employees with stock rights priced in reliance on a safe harbor valuation without incurring the expense of an independent appraisal.   On the other hand, valuation of a start-up is a complicated endeavor and should be undertaken with care, particularly if there is an expectation of providing stock rights that will not be subject to Section 409A.  It may well be worth the time and expense involved in securing an independent appraisal to provide a greater level of certainty with respect to Section 409A compliance.

Modification or Extension of Stock Rights

Modifications and/or extensions of a stock right may also subject an otherwise excludible award to Section 409A.   Generally speaking, a change in the terms of a stock right is treated as a new grant, which may or may not constitute a deferral of compensation based on the facts and circumstances as of the new deemed grant date.    Once a stock right is designed to be exempt from Section 409A, caution should be exercised with respect to making material modifications to that award.

Our last post described the portions of an executive employment agreement that may be impacted by Section 409A.  However, Section 409A may also impact the structure of other, less traditional compensation paid to key employees.  In the context of a closely-held business, two commonly-encountered alternative compensation arrangements used outside of the context of an individual employment agreement are (1) a stand-alone deferred compensation plan and (2) phantom equity arrangements.

(1) Nonqualified Deferred Compensation Plans

Nonqualified deferred compensation plans are often used to supplement retirement savings for those executives who have maxed out their contributions to qualified retirement plans.  An example of such a plan would be a supplemental executive retirement plan (“SERP”), under which the company would agree to provide a stated amount of supplemental retirement income to the executive and/or his/her family once certain vesting conditions are met by the executive. Amounts are typically paid out of a SERP upon a stated retirement age or upon the death or disability of the executive.   In terms of Section 409A compliance, the burden at the outset on the Company is relatively low, as SERPs typically provide for payment upon otherwise permissible Section 409A payment events.    If kept fairly simple and straightforward, and operated strictly in accordance with the terms of the plan, a SERP will generally comply with Section 409A.

On the other hand, if the executive is given flexibility with respect to elective salary deferrals, deferrals of amounts otherwise payable under the SERP, or acceleration of payments scheduled to be made from a SERP, Section 409A will once again provide a fairly stringent roadmap for how to draft these additional pieces of the plan.   For example, the Treasury Regulations under Section 409A provide specific rules as to the timing of both initial and subsequent deferrals of deferred compensation.   There are also restrictions on an executive’s ability to accelerate payments under a plan subject to Section 409A.  If these provisions are not carefully drafted, all amounts under the plan may be subject to penalties under Section 409A, whether or not the executive ever actually receives the payments.

 (2) Phantom Equity

Sometimes, the closely-held business owner wants the ownership of the company to stay within the hands of a small group, particularly in the context of a family-owned business.  Notwithstanding that desire, savvy business owners often recognize that the best way to incentivize a key member of their staff is to provide them with a share in the economic growth of the company.   The issuance of phantom equity often bridges this gap.   Phantom equity provides a contractual right to the economic equivalent of equity ownership in a business, without the issuance of an actual equity interest.   When granted to a service provider, phantom equity results in compensation to the individual that, when payable in future years, falls squarely within the definition of deferred compensation for Section 409A purposes.

Phantom equity must be structured to comply with, or be exempt from, Section 409A.  An advantage to drafting deferred compensation to be exempt from Section 409A is that the executive and the company will have greater flexibility in subsequently deferring and/or accelerating these amounts, as the restrictions contained within Section 409A will not apply to amounts that are not subject to Section 409A.    The short-term deferral exception can be used to exempt payments in respect of phantom equity if the executive must be employed by the company on, or closely within proximity of, the specified payment date, as this employment condition gives rise to a substantial risk of forfeiture.   In that instance, payment will always be made within the short-term deferral window (i.e., within 2 ½ months following the end of the calendar year in which the substantial risk of forfeiture lapses).

If the goal is provide for an incentive that can be earned and vested over some period of time, regardless of the executive’s provision of services through the payment date, phantom equity will become deferred compensation and must be paid only on a permissible Section 409A payment event.  Change in control, separation from service, death and disability are common permissible Section 409A triggers for payments in respect of phantom equity.   Other events, such as the occurrence of an IPO or the achievement of a revenue threshold, are not among the stated permissible Section 409A triggers and thus cannot be used for this purpose.

In our final post, we will move to Section 409A considerations for traditional equity incentive awards, with a discussion of the importance of proper valuation in this context.

Closely-held businesses often rely heavily on a small group of key employees to help their businesses succeed.   Given the value of these key employees to the business, it is not uncommon for the business to offer them certain types of additional executive compensation, in addition to standard base salary and participation in typical employee welfare benefits and qualified retirement plans.  It is in these other arrangements where Section 409A issues may arise.  Businesses should be warned that entering into such arrangements without a basic understanding of how and when to comply with Section 409A may lead to unintended tax consequences for the exact group of employees that they are trying to incentivize.

In this post, we will focus solely on executive employment agreements, as there are a number of areas embedded within these types of contracts that may result in Section 409A compliance issues.

Severance   

Severance payments are the most prevalent form of “deferred compensation” found in an employment agreement.   As a reminder, any amount to which a service provider has a legally binding right and which is or may be payable in a subsequent calendar year will be “deferred compensation” for purposes of Section 409A, unless a statutory exception applies.  An executive who is party to an employment agreement providing for severance payments upon a termination of employment has a legally binding right to those payments in the year in which the employment agreement is entered into, notwithstanding the fact that the payments will not be triggered until sometime later following an actual termination of employment.  Therefore, by definition, severance payments are deferred compensation and must comply with Section 409A. 

Most severance payments fit within one of two exceptions for Section 409A purposes.

Short-Term Deferral

The short-term deferral exception provides that amounts payable within 2 ½ months of the end of the year in which they become vested are excluded from Section 409A.   When an agreement provides for a lump sum severance payment or a short stream of installment payments, severance will typically be exempt from Section 409A under this exception.

Separation Pay Exemption

The “separation pay exemption” provides a Section 409A safe harbor for any amount payable solely upon an involuntary separation from service to the extent (i) it does not exceed two times the lesser of the employee’s annualized compensation for the year prior to the year of termination or the Code section 401(a)(17) limit for the year of termination, and (ii) it is required to be paid no later than the last day of the second taxable year of the employee following the year of termination.

While it would seem that most severance arrangements would safely fit within one of these two exceptions, their application may depend on two other concepts that are typically found in executive employment agreements: termination for “good reason,” and a release of claims requirement.

Considering the latter first, severance pursuant to an employment agreement is often conditioned upon the execution of a release of claims by the executive.   An agreement that provides for payment of severance upon the execution of a release, without further specifying the deadline for execution of that release, will remove a lump sum severance payment from the short-term deferral exception because the payment of severance is now dependent on the employee taking an action which may or may not result in payment within the short-term deferral window.   Such a severance provision will also fail to comply with Section 409A because, as described in our prior post, the payment schedule for deferred compensation must be objectively determinable at the time the parties entered into the agreement.   This is a perfect example of a typical drafting error in a post-409A executive employment agreement.

A properly drafted release requirement under Section 409A should provide for a limited time for return of an executed release.  It must, then, either hardwire a date for payment of the severance thereafter or, alternatively, provide for a payment during a period of ninety (90) days or less following termination, further specifying that if this period spans two calendar years, the payment will be made in the second calendar year.  This approach would provide for severance payments that are either exempt from Section 409A under the short-term deferral exception or that comply with Section 409A, as they are now payable upon a separation from service (i.e., a permissible Section 409A trigger event) at an objectively determinable time.

In addition to navigating the release language requirements, if an agreement provides for a “good reason” termination by an executive resulting in severance payments, amounts payable on a termination of employment may or may not be deemed to be payable solely on an “involuntary termination of employment” depending on how closely the definition of “good reason” lines up with the definition contained in the Treasury Regulations under Section 409A.  If the IRS deems a “good reason” definition to be too lenient, the severance will be deemed “vested” when the agreement is entered into and will not be deemed payable solely upon an “involuntary termination of employment” such that neither the short-term deferral exception, nor the separation pay exemption, will be applicable to these severance payments.

Bonuses

Bonuses may also present Section 409A issues.  Bonuses that are purely discretionary do not give rise to a legally binding right to deferred compensation and thus do not present a problem.  On the other hand, an agreement drafted to entitle an executive to a bonus to be determined in accordance with a performance metric or upon the occurrence of an event that is not a permissible Section 409A payment trigger may give rise to deferred compensation.  If no payment timing is provided in the agreement, or if the agreement provides for open-ended timing such as “upon completion of the applicable year’s audit,” this bonus payment will not comply with Section 409A.  At a minimum, a calendar year of payment should be specified in order to assure that this payment is made at a fixed time.

Additionally,  payment of a bonus upon the occurrence of an event such as upon the completion of an IPO, will not satisfy Section 409A because an IPO is not a permissible payment event.    This latter issue can be solved by including some language to the effect that this payment will be paid in the discretion of the Company upon the occurrence of the event, though this approach may not give the executive enough comfort.   An alternative is to require the executive to remain employed through the date of the event, which is likely the intent of such a bonus provision in any event.  Why does this solve our problem? Because now you have converted vested deferred compensation payable on an impermissible trigger into an unvested amount that can satisfy the short-term deferral exception to 409A if the bonus is required to be paid within 2 ½ months of the end of the calendar year in which the IPO takes place (i.e., the “vesting date”).

Taxable Health Insurance and Reimbursements 

Taxable health insurance and reimbursement arrangements are also subject to Section 409A, and thus must be drafted accordingly.  Some required provisions include an objective period for payment, an outside date for payment following the date the expense was incurred, and language that a right to reimbursement is not subject to liquidation or exchange for another benefit.

As you can see, an employment agreement can become a virtual Section 409A obstacle course if careful attention is not paid to the concept of deferred compensation.    In our next post, we will focus on other forms of nonqualified deferred compensation.

Ask most closely-held business owners what words come to mind when they hear the names “Enron” and “Worldcom” and many would say things like “bankruptcy,” “failure,” “scandal” and “greed.”    Ask those same business owners what impact those two names had on the ways they are able compensate their key employees and most would likely say there couldn’t possibly be a connection between these two multibillion dollar collapses and their own businesses.     They would be wrong.

Shortly before each of Enron and Worldcom declared bankruptcy, executives of each withdrew their account balances from nonqualified deferred compensation plans, accelerating these companies’ bankruptcies while simultaneously leaving the rank and file employees, as well as the companies’ shareholders, with little or nothing.  In 2004, in order to prevent similar abuses in the future, Congress enacted Section 409A of the Internal Revenue Code.  Section 409A imposes a significant series of restrictions on a broad variety of compensation arrangements that fit within the definition of “nonqualified deferred compensation,” with harsh consequences for failure to comply with this complicated new regime.

What is Section 409A?

The IRS spent over 400 pages describing the intricate workings of Section 409A in detailed Treasury Regulations that became final on January 1, 2010.  Simply stated, under Section 409A, certain requirements relating to the timing of payments of deferred compensation must be satisfied.  If they are not, all amounts deferred under a nonqualified plan (for all taxable years) are currently includible in the service provider’s gross income to the extent they are not subject to a “substantial risk of forfeiture” (i.e., the service provider’s rights to the compensation are conditioned upon the performance of substantial services or upon the occurrence of a condition related to a purpose of the compensation, such as the attainment of a prescribed level of earnings).

Those payment timing requirements provide that if a service provider has a legally binding right to compensation that is, or could be, payable in a future taxable year, that compensation must be required to be paid, and may only be paid, upon one of six permissible payment triggers:

  • (i) death,
  • (ii) disability,
  • (iii) a “separation from service”,
  • (iv) a “change in control”,
  • (v) an unforeseeable emergency or
  • (vi) on a fixed date or pursuant to a fixed schedule, each as specifically defined for purposes of Section 409A.

This seems simple enough and, yet, the sheer volume of the applicable Treasury Regulations should serve to alert any tax practitioner that complying with Section 409A is anything but simple.

There are per se, definitional and statutory exceptions and exemptions to Section 409A, such as tax-qualified plans, “short-term deferrals” and “separation pay plans.”

Furthermore, there are the all of the additional nuances embedded within these central concepts – rules applicable to key employees of public companies only, provisions that must be contained in writing in order to be operative, documentary failures, operational failures, permissible accelerations, rules surrounding initial and subsequent deferrals, and aggregation rules among different types of plans.   The list goes on and on.

 What Types of Arrangements are Subject to Section 409A?

Rather than amend the Bankruptcy Code, or draft targeted regulations to address the bad acts of a select few in positions to wreak havoc on public company shareholders, Congress took a “one size fits all” approach to answering this question.   Painting with a broad brushstroke, Congress swept up a variety of compensation arrangements into the panoply that is the domain of Section 409A.  These include:

Employment agreements providing for severance

  • Bonus plans
  • Stock options and other types of equity compensation
  • Post-retirement reimbursements
  • Supplemental executive retirement plans
  • Change in control arrangements
  • Retention bonuses
  • Employee elective salary/bonus deferrals

Any of the above may give rise to nonqualified compensation which must be paid in accordance with Section 409A.

What happens is I get it wrong?

A violation of Section 409A results in immediate taxation to the executive of all vested rights under any covered compensation arrangement prior to payment, in addition to a 20% penalty and premium interest charges.  This draconian result is even harder to swallow in light of the following two points:  (i)  compliance with Section 409A can be a daunting task, requiring strict adherence to detailed regulations which little or no room for error; and (ii) despite the fact that the company usually dictates the terms of payment, it is the service provider who is hit with the lion’s share of consequences for failures to comply with Section 409A.

Looking Ahead

Closely held businesses are uniquely challenged to incentivize and motivate key employees, particularly when subsequent generations may not be interested in, or capable of, managing the company.    Unfortunately, Section 409A is often overlooked by many smaller, privately held companies, as there is still, a decade after its enactment, a pervasive misconception that Section 409A only applies to publicly traded companies.  In our next post, we will touch upon some typical executive compensation structures with an eye toward compliance with Section 409A.    Thereafter, we will focus on equity compensation and, in particular, the role of proper valuation in Section 409A compliance.

In several previous posts, we have emphasized the importance of educating oneself about the tax consequences of any given business transaction well before that transaction comes to life.  In many situations, such forethought gives a taxpayer the opportunity to weigh the costs and benefits of different courses of action and, as a result, to act thoughtfully in the events leading up to the transaction.  This will minimize any surprises resulting from a close look at the transaction by the IRS, and thus ensure that the taxpayer receives the economic result that he or she is expecting.

The Tax Court recently considered a case in which taxpayers apparently did not act pursuant to a carefully considered plan, and, as a result, were assessed a significant deficiency as well as an accuracy-related penalty.

 Boree v. Commissioner

 The Facts

In Boree v. Commissioner, husband and wife taxpayers (the “Taxpayers” or “Mr. and Mrs. B.”) and their partner, through an LLC, purchased almost two thousand acres of undeveloped land in Florida for approximately $3.2 million.  Between 2002 and 2006, the LLC sold several lots each year, representing over one-third of the property in the aggregate; most of the lots sold during that time comprised approximately ten acres, and were sold for between $3,000 and $6,000 each. 

In 2003 the LLC began building an unpaved road, and submitted to the county’s local board of commissioners (the “Board”) a conceptual map of a planned residential development consisting of one hundred lots.  It also applied for, and received, exemptions from certain county subdivision requirements that called for interior roads and the submission of plans to the Board prior to the sale of lots, and executed a declaration of covenants, conditions, and restrictions on the land that defined the LLC as the “developer.”

In 2004, the Board adopted one-year moratoriums relating to permits for the development of certain subdivisions and lots.

In 2005, the Taxpayers became the sole owners of the property when the LLC purchased their partner’s interest.  Also during that year, the LLC proposed to the Board that almost 1,000 acres of the property be rezoned as a planned development unit (“PUD”), and Mr. B. and his representative attended several Board meetings relating to that application.

In 2006, following the Board’s adoption of a requirement that developers pave certain public roads leading to subdivisions, the LLC entered into a purchase and sale agreement with Development Co., pursuant to which Development Co. obtained an option to purchase most of the remaining property.

In 2007, the LLC sold just over one thousand acres to Development Co. for $9.6 million.

 The Tax Returns    

On their Forms 1040, U.S. Individual Tax Return, relating to 2005, 2006, and 2007, the Taxpayers indicated on their Schedule C, Profit or Loss from Business, that Mr. B.’s principal business or profession was “Land Investor.”  For 2005 and 2006, the Taxpayers reported income from the LLC’s lot sales as ordinary income and deducted expenses relating to the property.

On their 2007 Form 1040, however, the Taxpayers listed Mr. B.’s occupation as “Real Estate Professional” and reported long-term capital gain relating to the transaction with Development Co.  Between 2005 and 2007, the LLC did not engage in any significant activity that was unrelated to the property.

 The IRS Disagrees

 In 2011, the Service sent Taxpayers a notice of deficiency relating to 2007, indicating that the gain relating to the transaction with Development Co. did not qualify for capital gains treatment.  In addition to finding a deficiency of $1,784,242, the Service determined that the Taxpayers were also liable for a section 6662(a) accuracy-related penalty.

The Tax Court Weighs In

 The Court stated that to determine whether or not an asset is “capital,” it considers, among other factors, “the number, extent, continuity and substantiality of sales… and the extent of subdividing, developing, and advertising.”  While no specific factor is controlling, the Court highlighted that the “frequency and substantiality of sales” is often the most important factor because “the presence of frequent sales ordinarily belies the contention that property is being held ‘for investment’ rather than ‘for sale.’”

The Court emphasized that the Taxpayers consistently treated the LLC as a real estate business, representing it as such to buyers of the property, the Board, and on their 2005, 2006, and 2007 returns, and spending significant time and money on zoning activities.  Additionally, the Court underscored the frequent and substantial sales of property between 2002 and 2006, and the fact that the Taxpayers deducted, rather than capitalized, expenses related to the real estate activities.  Each of these factors contributed to the Court’s conclusion that the transaction with Development Co. resulted in ordinary income to the Taxpayers.

Finally, the Court held that because the Taxpayers had understated their tax liability in 2007 by over $1,780,000—over 10% of the tax required to be shown on their return for that year—they were subject to the accuracy-related penalty under section 6662(a).

 Conclusion

 As Boree demonstrates, a taxpayer that wishes to be taxed on a sale of real property as an investor, thereby receiving capital gains treatment on the sale, must be careful to, in fact, hold that property as an investor.  If Mr. B. had determined at the outset that it was a priority for him to avoid recognizing ordinary income on an eventual sale of his property, then he could have structured his actions accordingly to ensure that he was holding the property only as an investor.  Bear in mind, however, that it is quite possible that it was Mr. B.’s regular participation in and dedication to his investment that made the transaction with Development Co. as profitable as it was; a taxpayer in the same situation should carefully consider and compute the economic benefits of such participation against that of capital gains treatment in determining how best to hold his or her investment.

In several previous posts, we noted the importance of determining, in the case of a family or other closely-held business, where the goodwill for the business resides: in the business, in the shareholder-employees,  or in another employee.  In the absence of an employment agreement or non-compete, we noted that it may be possible to demonstrate that some portion of the goodwill does not belong to the business.  Rather, we have seen that the  “attributes” of goodwill may be personal to a shareholder or other individual.

 In a recent decision,Wade v. Commissioner, T.C. Memo 2014-169, the Tax Court considered a different manifestation of  individually-owned “business goodwill.” The issue examined by the Court did not involve the sale or other transfer of such goodwill, nor did it explicitly require the determination of where such goodwill resided. Nonetheless, the factors on which the Court based its decision were the same factors that would have been considered in any other dispute concerning the situs of the goodwill of a business.

Wade v. Commissioner

In 1980, the Taxpayer founded Company in Louisiana to conduct the business of acquiring plastic waste from chemical companies and converting it into usable products. The Taxpayer developed the manufacturing processes used by  Company and established and managed its industrial facilities.

Many years later, in 1994, Taxpayer’s son (“Son”) began helping Taxpayer with the management of the business. Son periodically received stock in Company and, by 2008, owned a significant portion of the issued and outstanding shares. Taxpayer owned the remaining shares. With Son there to handle day-to-day management, Taxpayer became more focused on product and customer development. He did not have to live near the business operations to perform these duties, so Taxpayer moved to Florida. After the move, he continued to make periodic visits to the facilities in Louisiana and regularly spoke on the phone with plant personnel.  At no point did the Court state that Taxpayer was party to an employment agreement with Company.

In 2008, the business began struggling financially as prices for its products plummeted and revenues declined significantly. Taxpayer’s involvement in the businesses became crucial during this crisis. To boost employee morale, he made trips to Company’s industrial facility in Louisiana, during which he assured the employees that operations would continue. He also redoubled his research and development efforts to help the business recover from the financial downturn. In addition to his research efforts, Taxpayer ensured Company’s financial viability by securing a new line of credit. Without his involvement in Company, the business likely would not have survived.

In 2008, the Taxpayer claimed a deduction for non-passive losses from flow-through entities (including Company) totaling almost $4 million. In 2009 Taxpayer requested a refund for the 2006 and 2007 tax years resulting from the carryback of the 2008 losses.

The IRS determined that the losses were passive losses. Accordingly, the IRS disallowed the deduction claimed by the Taxpayer.

Under Sec. 469 of the Code, individuals may not deduct passive activity losses for the year in which they are sustained. A “passive activity loss” is the amount by which the aggregate losses from all passive activities for a taxable year exceed the aggregate income from all passive activities for such year.

A “passive activity” is any activity that involves the conduct of any trade or business in which the taxpayer does not materially participate. IRS Regulations provide a series of tests under which one may evaluate whether a taxpayer materially participated in a given trade or business. In Wade, the IRS argued that Taxpayer did not satisfy any of these tests with respect to Company and, so, did not materially participate in its activities.

Taxpayer claimed that he satisfied two of the regulatory tests. First, Taxpayer claimed that he spent more than 500 hours in 2008 working on Company’s activities. Second, Taxpayer contended that he participated in Company’s activities on a regular, continuous, and substantial basis during 2008.

The Court agreed with Taxpayer’s second contention.

According to the Court, a taxpayer materially participates in an activity for a given year if, “[b]ased on all of the facts and circumstances * * * the individual participates in the activity on a regular, continuous, and substantial basis during such year.” A taxpayer who participates in the activity for 100 hours or less during the year cannot satisfy this test, and more stringent requirements apply to those who
participate in a management or investment capacity.

The record reflected that Taxpayer spent over 100 hours participating in the business during 2008, and his participation consisted primarily of non-management and noninvestment activities. Son managed Company’s day-to-day operations, while Taxpayer focused more on product development and customer retention.

Although Taxpayer took a step back when Son became involved in Company’s management, he still played a major role in its 2008 activities. He researched and developed new technology that allowed the business to improve its products. He also secured financing for Company that allowed it to continue operations, and he visited the industrial facilities throughout the year to meet with employees about their futures. These efforts were continuous, regular, and substantial during 2008. Accordingly, the Court held that Taxpayer materially participated in the business.

The Court noted that Company was a complex business that Taxpayer had built from the ground up and in which he continued to play a vital role. He was not merely a detached investor, as has often been the case when the Court has found that a taxpayer did not materially participate. The Court said that Taxpayer “brought something to Company that no one else could have, and the business could not have continued to operate without his contacts and expertise.” Accordingly, the Court held that the IRS erred in classifying Taxpayer’s losses from Company as passive.

The foregoing analysis has implications on many different fronts, some more obvious than others. Clearly, for purposes of the passive loss rules, a founder’s or parent’s continued involvement in the business may be critical. In the context of a sale of the business, how will the buyer approach the situation of a founder who has withdrawn to some extent from the business, but whose contacts, etc., remain vital to its well-being? The same issue may arise for estate valuation purposes as to an interest in the business. Finally, how will a state taxing authority view a founder, like Taxpayer, who has moved away from the state yet continues to play an important role in the business?  As is so often the case in tax planning, what may be good for one issue may be bad for another. It is usually impossible to foresee every eventuality, so it behooves a taxpayer to do what makes the most business or personal sense and to “tax plan” around that.