When people hear about a family business dispute, what most often comes to mind are sibling rivalries and disagreements, or a falling out between a parent and a child, with each side seeking to go its own way.  In fact, these are the usual scenarios.  There is a set of circumstances, however, that arises with surprising frequency, and that requires an awareness for potential tax consequences that are often not appreciated:  the testamentary division of a decedent’s interest in a closely-held business between his or her family and a private foundation created by the decedent.

Assume Father started a business (Business) long ago.  It has done very well and, over the years, Father has made significant gifts of interests in Business to his children, Daughter and Son, of interests in Business. In the aggregate, however, their interests still represent less than 50% of Business’s equity and voting power. Daughter and Son have become the key employees in Business; they operate and manage Business.

Father has also established, and partially funded, a grant-making private organization (Foundation) through which he has pursued his charitable endeavors.  Foundation is exempt from income tax under Section 501(c)(3) of the Code.  It is treated as a private foundation (as opposed to a public charity), and Father and Mom serve as its directors.

When Father passes away, Business (which is very valuable) represents his estate’s (Estate) principal asset. His Will creates a credit shelter trust and a marital trust (Trust), which is funded with Father’s remaining assets, including his majority interest in Business.  On termination of his Estate, Father’s equity in Business will pass to Trust, along with the voting rights inherent in such equity.  Mom acts as executor of his Will and, with Mom’s brother (Uncle), as co-trustee of Trust.  The Trust provides for the entire net income of the Trust to be paid to Mom, at least annually, during her lifetime; on her death, the corpus of the Trust is to be distributed outright to the Foundation.

At the end of the day, Business will be owned by Son, Daughter, and Trust (with Mom and Uncle as trustees).  During the administration of Father’s Estate, however, the co-ownership of Business leads to friction between Daughter and Son, on the one hand, and Mom, on the other.  The former want to direct the operation of the business without interference from the Estate, and they also want to reinvest profits in Business, including for the expansion thereof and in satisfaction of Business’s debts.  As key employees, they are drawing down sizable, though reasonable, salaries.  The latter wants to see Business make more distributions, which would translate into more sizable distributions to Mom.

At the same time, Mom is concerned about the Foundation’s future exposure to the excess business holdings excise tax , which imposes a tax on a foundation that, together with disqualified persons, owns at least twenty percent of the voting stock in any corporation conducting a business.

After many negotiations, Daughter, Son and Mom, as executor of  the Estate, reach a settlement.  Under the terms of the settlement, Daughter and Son will purchase from the Estate, in exchange for cash and an interest-bearing note, the Mom’s interests in Business, thereby completely dissolving the co-ownership between the Estate/Trust and Son and Daughter, and leaving Son and Daughter with 100% of Business.  The parties engage independent, qualified appraisers to value Business and Estate’s interests therein, and agree to rely thereon in the disposition of those interests.

At this point, it may appear that the parties have resolved their differences as to the ownership of the business, and all that remains to effect their separation is the closing of the sale.  Unfortunately, that is not the case.

Pursuant to IRC Section 4941, an excise tax is imposed on each act of self-dealing between a so-called “disqualified person” and a private foundation.  The tax is imposed on an annual basis until the act of self-dealing is corrected.  The term “self-dealing” includes certain direct or indirect transactions, including the sale or exchange of property between a private foundation and a disqualified person –regardless of whether the foundation is the seller or purchaser, and regardless of whether the purchase price reflects fair market value.

Disqualified persons include “substantial contributors” to the foundation and “members of the family” of such substantial contributors.  Here, the proposed purchasers of the equity in the business (Daughter and Son) are disqualified persons as to the Foundation because they are the children of Father, who was a substantial (in fact, the sole) contributor to the Foundation.  Disqualified persons also include foundation managers, such as the Foundation’s directors.

Moreover, the sale or exchange of property to a disqualified person by an estate or trust in which a foundation has an interest or expectancy is an act of indirect self-dealing, particularly if a foundation is destined to be funded with such property, as is the case under Father’s Will and the terms of the Trust.

However, the transaction at hand may be salvageable:  Treasury Regulation Section 53.4941(d)-1(b)(3) creates an exception to the self-dealing rules, applicable to a transaction regarding a private foundation’s interest or expectancy in property held by an estate.  Such a transaction will not constitute self-dealing if, among other things:

  1. the estate executor either possesses a power of sale with respect to the property, has the power to reallocate the property to another beneficiary, or is required to sell the property under the terms of an option subject to which the property was acquired by the estate;
  2. the transaction is approved by the probate court having jurisdiction over the estate;
  3. the transaction occurs before the estate is considered terminated for federal income tax purposes pursuant to Treasury Regulation Section 1.641(b)-3(a);
  4. the estate receives an amount which equals or exceeds the fair market value of the foundation’s interest or expectancy in such property at the time of the transaction; and
  5. the transaction either

i.  results in the foundation receiving an interest or expectancy at least as liquid as the one it gave up;

ii. results in the foundation receiving an asset related to the carrying out of its exempt purposes; or

iii. is required under the terms of an option which is binding on the estate.

Here, as to the safe harbor’s first requirement, the particular powers conferred upon the executor of Father’s Will include the power to sell property.

As to the third requirement, Father’s Estate has not yet been terminated, and the proposed sale will take place before Estate is considered terminated for Federal income taxes under Treasury Regulation Section 1.641(b)-3(a).

As to the fourth requirement, the purchase price of the Business interests held by Trust has been determined by an independent, professional appraiser and set forth in writing.

As to the fifth requirement, the proposed sale will result in the Foundation’s expectancy interest being more liquid since the interest in Business – which represents an interest in a non-marketable, closely held corporation – will be exchanged for cash.

This leaves the second requirement:  the approval of the probate court.  In order to secure the benefit of the above exception to the self-dealing rules, Estate will have to petition the Surrogate’s Court for approval of the sale of Estate’s interest in Business to Daughter and Son.  Assuming the court approves the sale, then the parties may consummate the transaction without fear of the excise tax on self-dealing.

The foregoing highlights the importance of identifying potential private foundation excise tax issues during the administration of a decedent’s estate where the foundation is to be funded with equity interests in a closely held business. Indeed, it behooves the owners of the business to consider these issues while the older generation is still alive. In many cases, it may be difficult to avoid them completely; the only way to reduce the expected estate tax liability on the owner’s death may be to fund a family foundation. That being said, the relevant parties should consider adopting a course of action that is to be implemented after the decedent’s passing. In this way, they may be able to avoid the personal, familial, and business disputes that may otherwise arise.

In a previous post, we noted that individual shareholders often seek to reduce the double income taxation (at both the corporate and shareholder levels) that accompanies a sale of assets by, and liquidation of, a C corporation by arguing that they own personal goodwill.  By claiming goodwill as a business asset that is separate from the goodwill of the corporation, they thereby hope to avoid corporate level income tax on a sale of such goodwill.

Rarely, however, is the issue of personal versus corporate goodwill confronted in the context of the estate tax. That is not to say that personal goodwill is irrelevant in the valuation of an estate – far from it. Historically, appraisers and courts have considered the impact on the future earnings of a decedent’s business resulting from the loss of the “key man.”  Specifically, if the earning capacity of the  business will be substantially diminished due to the loss of the key employee (the decedent), an appropriate discount will be applied to reach the fair market value of the equity in the business.

The Tax Court recently considered a rather unique set of circumstances in determining the fair market value of a decedent’s business interests where the decedent was not the key man. In Estate of Adell v. Comr., the decedent’s gross estate included all of the equity in a C corporation. The decedent’s son served as president of the corporation, handled its day-to-day operations and, together with the decedent, served on its board of directors. The son never had an employment agreement or a non-compete with the corporation. Most of the corporation’s revenue was generated pursuant to a services agreement with a not-for-profit corporation, the sole employees of which were the decedent and his son. The not-for-profit’s primary source of revenue was from contracts that the son had secured in his capacity as a representative of the not-for-profit.

For purposes of the estate tax valuation of the C corporation, the estate’s appraiser valued the business as a going concern; he applied the “income approach,” which converts the anticipated economic benefits of a business into a present value. In doing so, he adjusted the corporation’s operating expenses to include a significant charge for the son’s personal goodwill. The appraisal report explained that the adjustment was appropriate because the success of the business depended heavily on the son’s personal goodwill. Moreover, the son did not have a non-compete with the corporation and as a result a potential buyer would acquire the business only to the extent that the business retained the son. This resulted in an increase in the projected operating expenses of the business and a decrease in its net cash-flow, which, in turn, reduced the valuation for the corporation.

The Court accepted the estate’s valuation. It recognized that a key employee may personally create and own goodwill independent of the corporate employer by developing client relationships. Though the employer may benefit from using the personally developed goodwill while the key employee works for the employer’s business, the employer does not own that goodwill and it is not considered an asset of the employer. The employee may, however, transfer his or her goodwill to the employer through an employment or non-compete agreement.  Absent such an agreement, the value of the goodwill should not be attributed to the employer.

In the present case, if the son had quit, the corporation could not have exclusively used the relationships that he cultivated. Thus, the Court found that the appraiser properly adjusted the corporation’s operating expenses to include an economic charge at an amount great enough to account for the significant value of the son’s business relationships. In contrast, the Court said, the IRS not only failed to apply a charge for the son’s personal goodwill, but also gave too low an estimate of acceptable compensation for his services.

What does this holding mean for the valuation of other closely-held businesses? For estate tax purposes, the fair market value of a property is the price at which that property would change hands between a hypothetical willing buyer and a hypothetical willing seller, neither being under any compulsion to buy or sell, and both having knowledge of the relevant facts. In the absence of an arm’s-length sale, the value of the business is determined by considering all relevant factors that would affect fair market value. These factors must be considered in light of the particular facts and circumstances of each case.

In the case of a family or other closely-held business, it is important to consider where the goodwill for the business resides: in the business, in the decedent, or in another employee?  In the absence of an employment agreement or non-compete—not an uncommon situation, at least for owner-employees and their family members who are in the business—it may be possible to demonstrate that some portion of the goodwill does not belong to the business. This would seem to argue in favor a parent’s transitioning the business to his or her child and allowing the child to develop independent business relationships. However, this assumes a level of trust, especially in the absence of an employment agreement, with which the parent, and perhaps other members of the family, may not be comfortable.

While personal goodwill may be a good result from an estate tax perspective (unless the goodwill is the decedent’s), query the impact on the income taxes of the business and its owners.  One must consider the loss of the basis step-up that the decedent’s property would otherwise enjoy if the goodwill were valued as part of the business, as well as the resulting amortization or depreciation deductions arising therefrom (in the case of an LLC or partnership with an IRC 754 election in effect), not to mention the reduced gain on a subsequent sale of the business. One must also consider whether the exclusion of “personal” goodwill from the value of the business may disqualify an estate from electing to make installment payments for that portion of the estate tax attributable to the closely held business.

Unfortunately, there is no “one-size-fits-all” answer, and taxpayers and their advisors will need to review all the relevant factors. Because proper planning may require the consideration of certain business factors and the making of certain business decisions (perhaps, for example, the execution of an employment agreement with a key employee), discussions should occur while the decedent is still alive. As always, the tax considerations should not overshadow the business and family consequences.

Income Tax Impact of Transfer Taxes

We noted earlier that state transfer taxes are often viewed as a “sideshow” to federal income tax considerations in structuring a deal.  Despite this perception, state transfer taxes represent real economic cost to the payor.  To appreciate their “true” cost, however, one must also consider their income tax consequences.

In the case of the seller or transferor who pays the tax, the transfer tax is treated, for income tax purposes, as a reduction in the amount realized in the sale, thereby reducing the income tax burden from the sale.

In the case of the buyer who pays the tax, the transfer tax is added to the basis of the property acquired.  Thus, it may be depreciable (and recoverable) over a period of time, depending upon the nature of the asset acquired.

In the case of a stock purchase (without an IRC Sec. 338(h)(10) or Sec. 336(e) election), it will reduce the gain on a subsequent sale of such stock.

That being said, on a net basis, it is generally better, if possible, to avoid the transfer taxes entirely.

The Purchase & Sale Agreement

There are a number of items to consider where the transfer tax on the sale cannot be avoided.  The issue of liability should be addressed.

In a state like New York, which imposes the payment obligation on the seller, practical impediments may prevent a buyer from collecting the tax from the seller after a transaction is closed.  It is good practice for the buyer to ensure that the tax is paid by the seller at closing, perhaps by holding back the amount of transfer tax determined to be owed. The purchase agreement should expressly provide for the seller’s timely payment of the tax, as well as for the preparation and timely filing of the transfer tax return, in accordance with the parties’ agreed-upon allocation of the purchase price (or, in a stock deal, their agreed value for the real property owned by the target entity).

It should be noted that nothing prevents a buyer and seller from allocating responsibility for the transfer tax in connection with a business acquisition.  For example, the purchase agreement may provide that the seller and its owners shall be responsible for any transfer tax liabilities arising out of the transaction, or that any transfer tax returns will be prepared by the buyer.  It is also not unusual for the parties to agree to split the costs (for example, 50-50).  Although a contractual provision will not prevent the taxing authority from proceeding against any party it can legally pursue, as between each other, the buyer and seller will be bound by their agreement.

The agreement may also include an indemnification provision for any breach thereof.  Be mindful, however, that  not all indemnifications are equal.  The value of the contractual protection will vary depending on the financial condition and the integrity of the seller.  A holdback (escrow) or deferred payment (installment note), or other form of security arrangement, can enhance the buyer’s protection.

If a significant transfer tax may be applicable to the sale transaction, it is generally advantageous, from a transfer tax perspective, to allocate purchase price away from taxable assets in order to reduce the liability.  Of course, the allocation must be supportable, and it must be consistent with the allocation made for income tax purposes (see, e.g., IRC Sec. 1060; IRS Form 8594).  Additionally, note that the preferences for one tax may be at odds with those of the other.

Conclusion

The foregoing highlights the importance of the real estate transfer tax in assessing the overall economic benefits and burdens of a purchase and sale transaction.  In evaluating such a transaction, it behooves both the seller and the buyer to consider, as early as possible, the amount and impact of such tax and to plan for it accordingly.

In contrast to the sales tax, which does not apply to a sale of real property or to a sale of equity in a company, the real estate transfer tax does apply to the former and may apply to the latter.  In the context of a deal, there may also be other situations in which the tax will be triggered.

The tax is imposed on each conveyance of real property or interest therein, at the rate of $2.00 for each $500 (0.40%) or part thereof, of consideration paid for the conveyance. (In NYC, the rate is 2.625% of the consideration where the consideration is more than $500,000; otherwise, 1.425%.)  

The real estate transfer tax is payable by the seller.  If the seller fails to pay the tax timely, the buyer must pay the tax; in that case, the tax is the joint and several liability of the seller and the buyer.

Where the buyer agrees to pay the tax as part of the consideration for the conveyance (not an unusual event), the tax is computed on (i) the consideration exclusive of this agreement, plus (ii) the amount of tax computed on the consideration in (i).

It should be noted that all conveyances of real property are presumed taxable.  When the consideration includes property other than money, the consideration is deemed to be the FMV of the real property or interest therein.

What is consideration?

 In general, “consideration” means the price actually paid or required to be paid for the real property or the interest therein, whether paid or to be paid by money, property, or any other thing of value, including stock in the buyer.

It includes the cancellation or discharge of a debt or obligation, as well as the amount of any mortgage or any encumbrance on the real property, whether or not the underlying indebtedness is assumed or taken subject to.

No exclusion is made by reason of deferred payments of the purchase price, whether represented by notes or otherwise.  There is no installment reporting for the transfer tax.

 What is a taxable conveyance?

A conveyance includes any sale or exchange of real property, as well as any sale or exchange of any “interest” in real property. An interest in real property includes a title in fee, a leasehold interest, and the transfer of a controlling interest in an entity that has an interest in real property.

 The creation of a lease is a taxable conveyance where the sum of the terms (length) of the lease, and any options for renewal, exceeds 49 years, and substantial capital improvements are or may be made for the benefit of the lessee, and the lease is for substantially all (90% or more of the total rentable space, exclusive of common areas) of the premises.  The consideration in that case is the present value of the right to receive rental payments, including rental attributable to any renewal terms.  The present value is determined using 110% of the mid-term AFR, and the discount rate is applied to “net rents” (taking into account operating costs).

The creation of a lease that is coupled with the granting of an option to purchase the real property (regardless of the lease term) is a taxable conveyance. (This will often occur where the seller retains the real property, either directly or in a related entity.) The consideration in that case is the present value of the rental payments plus the amount paid for the option.

The transfer of an existing leasehold interest (regardless of the remaining lease term), or the granting of an option to buy real property, are both taxable conveyances for which the consideration is the amount paid by the buyer (consideration does not include the present value of the remaining rental payments required to be made).  If the lessor pays an amount to the lessee to surrender a lease, the consideration is the amount paid. However, no tax is imposed when the lessee pays the lessor to get out of a lease.

In the case of an entity that has an interest in real property, the transfer or acquisition of a “controlling interest” occurs when a person or group of persons “acting in concert”, transfer or acquire: in the case of a corporation, either 50% or more of the total combined voting power of all classes of stock, or 50% or more of the capital, profits or beneficial interests in such voting stock; and, in the case of a partnership, 50% or more of the capital, profits or beneficial interests in such partnership. (Note that the value of the real property relative to the value of the entity’s other assets is irrelevant. This should be contrasted with FIRPTA, under which a transfer of corporate stock is subject to the FIRPTA tax and withholding only where the corporation is a “U.S. real property holding corporation” — in general, where the corporation’s U.S. real property exceeds 50% of the total fair market value of all of the corporation’s assets.)

In the case of the transfer of a controlling interest in any entity that owns real property, “consideration” means the FMV (gross, not net) of the real property, apportioned based on the percentage of the ownership interest transferred.

Exemption

By now, you have a sense of the variety of situations, in the context of a deal, that may trigger the real estate transfer tax.  The sale of real property in an asset sale, the sale of stock in an entity owning any real property, the assignment of a lease, the creation of a lease, the cancellation of a lease, the granting of an option to buy real property; all these must be considered in determining the exposure to the real estate transfer tax.

While most conveyances are presumed taxable, certain conveyances may not be (at least partially).  The most commonly encountered is one involving an income tax-free or partially income tax-free reorganization, or an income-taxable transaction where the seller or its owners accept some equity interest in the buyer in consideration for the transfer of the real property.

Specifically, under this exemption, to the extent that a conveyance effectuates a mere change of identify or form of ownership or organization, and there is no change in beneficial ownership of the underlying real property, the tax does not apply.

Note that a like-kind exchange of real property is a taxable conveyance, even though no income tax is imposed.

 Return

Whether or not a tax is due, the seller and buyer must file a joint transfer tax return for each conveyance.  If the conveyance is to be recorded (e.g., a deed), the return must be filed with the appropriate county’s recording office; any tax due may also be remitted there.

If the conveyance is not recorded (e.g., a stock sale), the return and tax must be filed with the State.

In either case, the return is due and the tax must be paid no later than the 30th day after the sale.

Both the seller and the buyer are required to sign the returns.

The next post (and the final in this series) will provide some practical considerations regarding the transfer tax.

In a prior post, we discussed the impact of the New York sales tax upon the economics and structure of a so-called “M&A” transaction. In this post, we will consider another transfer tax that is often encountered in an M&A deal: New York’s real estate transfer tax.

Deal Economics

Why are taxes so important to the sale of a business?  Economics.  Any deal, whether from the perspective of the seller or of the buyer, is about economics.  The deal involves the receipt and transfer of value.  The goal of each party is to maximize its economic return on the deal.

Few items will impact the economics of a deal more immediately or more certainly than taxes.  The reason is simple:  each party to the deal is looking at the structure of the deal in order to maximize its own economic return, and each party will report the deal, in some fashion, on its own tax return.  Simply put, the more that a party to the deal pays in taxes as a result of the deal structure, the lower that party’s economic return will be. In the case of a seller, the deal is more expensive if the seller must pay more tax – the seller keeps less of the proceeds from the sale. In the case of a buyer that bears the tax cost, depending upon the asset(s) being acquired, the additional cost may or may not be recoverable through amortization or depreciation (and, then, over varying of periods of time).

Depending upon the deal structure and the assets of the target business, several kinds of taxes may have to be paid and several kinds of returns may have to be filed, thereby making the taxing authorities de facto parties to the deal:  they, too, will have an opportunity to review its structure as well as its tax consequences after the relevant tax returns have been filed.

When many practitioners consider the taxes arising out of the purchase and sale of a business, they focus primarily upon federal and, perhaps, state and local income taxes.  Often overlooked are state and local transfer taxes, including real property transfer taxes.  These transfer taxes, however, can have a significant impact upon the economics of the deal.

Deal Structures

Before delving into the real estate transfer tax consequences of M&A transactions, it would be helpful to review some basic deal structures.

     Asset Sale

The selling corporation sells its business assets to the buyer.  The consideration received may be cash, assumption of liabilities, installment notes, other property (including equity in the buyer).  The asset sale may also be accomplished by way of a merger of the selling corporation with and into either the buyer or a wholly-owned corporate or LLC subsidiary of the buyer.

Depending upon the composition of the consideration and certain other items, the sale may be taxable or tax-free for income tax purposes.

     Stock Sale

The shareholders of the target corporation sell their shares of stock in the target to the buyer.  If there are many shareholders, or if some of them are recalcitrant, the stock sale may be effected through a “reverse subsidiary merger” (with the buyer’s newly-formed and wholly-owned subsidiary being merged into the target corporation, and the target surviving as a subsidiary of the buyer).

Again, the composition of the consideration can be varied, and will determine whether the transaction is or is not taxable for income tax purposes and, if taxable, when the tax would be owed.

     Real Property

Regardless of the form of the transaction, if the target (or a related entity) owns or leases real property, the transfer tax will have to be considered. Deeds may have to be recorded, mortgages may have to be satisfied, leases may have to be assigned, and consents to such assignments may be required (as in a change-in-control provision). New leases may have to be negotiated and entered into. Other leases may have to be cancelled, either by the owner or by the tenant.

 

Questions Re Transfer Taxes

In the context of these transaction structures, these questions need to be addressed:

(1)    Will the asset sale or stock sale trigger the imposition of the transfer tax?

(2)    What other deal-related transactions (see above) will trigger the transfer tax?

(3) Who will be liable for the transfer tax liabilities resulting from these events?

 

A summary of the relevant transfer tax provisions is in order. This will be covered in the next post.

Planning for the Surtax

The best time to plan for any tax event is well before it occurs, and this also applies to the surtax.  The trustee of a trust will almost always want the business income of the trust to be characterized as active income. The surtax may be addressed, at least partially, in a number of ways:  the trust’s level of activity may be adjusted, its stock may be shifted to lower-income beneficiaries, and/or its other investments may be used to offset NII.  While some of the planning alternatives may carry an economic cost, it behooves the trust to at least consider them since some combination thereof may help reduce the surtax.

For example, the owner of a business who materially participates therein will often create a grantor trust to hold interests in the business for the benefit of family members.  There are several ways by which a trust may be treated as a grantor trust without causing the inclusion of the trust in the grantor’s estate. The trust’s grantor trust status results in the owner being taxed on the trust’s share of the business income, thereby allowing the trust to grow in value without reduction for income taxes.  Because of the grantor’s participation in the business, the income from the business should be non‑passive as to the grantor and, therefore, should also not be subject to the tax.

Similarly, when faced with a choice between making a QSST or an ESBT election as to a trust, one must consider the participation of the trustee and of the beneficiary in the S corporation’s business.  If the trustee is a material participant, then an ESBT election may be advisable for purposes of the surtax.  If the beneficiary of the trust is a material participant (for example, he or she is an officer of the S corporation), a QSST election may be advisable.

In other circumstances in which the beneficiary of the trust (that would otherwise be a complex or simple trust) is a material participant in the business, the grantor may also want to consider giving the beneficiary a withdrawal right over net investment income so as to cause the trust to be treated as a grantor trust. [IRC §678]  Be aware, however, of the lapse of this power and its potential for creating a taxable gift.

In the case of non‑grantor trusts—complex, simple and ESBT trusts—the selection of the trustee may impact the application of the surtax to the trust’s share of the S corporation’s business income.  Because material participation for the trust is determined by looking to the trust, the grantor should consider the addition of a trustee who materially participates in the S corporation’s business.  Based on Aragona, discussed in our last post, at least one‑half of the trustees should be active in the business, and the trustees should not, in the aggregate, personally own a majority interest in the business.

In addition, notwithstanding the case law, it appears unlikely that the IRS will agree that a non‑grantor trust is materially participating in a trade or business activity unless the trustee is materially participating in the activity in his or her capacity as a trustee.  Focus, therefore, on the actions and involvement of the trustee. Query whether the trustee can be given a bona fide role to perform in the business in the trustee’s capacity as such?

The trustee should take affirmative actions to materially participate. Consider the appointment of a special trustee for the business (as in the TAM, also discussed in our last post), whose responsibility will be limited to the operation and management of the business, provided the trustee is given a measure of decision-making responsibility related to the trust’s business matters.

Where the trustee participates in the business in several capacities (not just as a trustee), the trust instrument should not excuse the trustee from fiduciary responsibility when acting in one of these other capacities.

Regardless, it will be vital for trustees to maintain accurate and contemporaneous records if they are to substantiate the trust’s material participation in an active trade or business and, thereby, avoid imposition of the surtax.  The burden will be on the taxpayer to establish the nature of his or her involvement, and the  amount of time spent, with respect to a business activity.

If a trustee is uncertain as to whether he or she has substantial authority for a reporting position on material participation, the trustee may want to consider paying the tax, but also filing a protective refund claim, pending the issuance of regulations.

The Dispositive Intent

In considering the various options set forth above, always be mindful of any other consequences that may flow therefrom.  Keep the surtax in perspective; the selection of a particular strategy may have tax consequences beyond the surtax. It may also produce economic or “business” results that are not in line with the grantor’s plans for disposing of his or her interests in the S corporation.  Don’t let the tax tail wag the dog.  Be mindful of the dispositive purpose of the trust.

 

Louis Vlahos recently participated in a national webinar in which he covered the foregoing topic.

The IRS’s Position on Material Participation by Trusts

According to the IRS, material participation for a non‑grantor trust should be determined solely by reference to the activities of the trustee acting as such; it should not include the trustee’s participation in any other capacity (e.g., as an employee of the corporation), nor should it consider the participation of any employees or agents of the trust. In other words, if the individual serving as trustee also participated in the activity in his or her personal capacity, that participation is irrelevant, according to the IRS, in determining the trust’s material participation.

See, for example, this TAM, in which the IRS concluded that the only way for a complex trust to establish material participation in the activity of an S corporation was the extent to which its trustees, in their capacities as such, were involved in the operation of the corporation’s business.  The ruling noted that the time spent by a special trustee as a corporate officer did not count toward determining the trust’s material participation, especially where the officer-trustee was unable to differentiate his time into different capacities. The IRS also stated that, in order to be treated as a trustee for tax purposes, the special trustee must be vested, under the trust agreement, with some degree of discretionary power to act on behalf of the trust.  Under the facts of the TAM, the special trustee’s powers were restricted (so that the trustee could not commit the trust to any course of action as to the trust property other than selling it) and, so, the material participation requirement was not satisfied by the trust.

The Courts Disagree

The courts have been more forgiving. In Mattie Carter Trust, the trust operated a business directly, using employees an agents of the trust. The court decided that material participation of a trust should be determined by evaluating not only the activities of the trust through its trustees, but also through its employees and agents.  It stated that material participation by the trust in the business should be determined by reference to the persons who conducted the business on behalf of the trust, not just the trustee.

More recently, in Aragona Trust , a complex trust owned several rental properties, both directly and through a wholly-owned LLC (a disregarded entity for tax purposes—not a true operating company).  There were six trustees. Three trustees worked full-time managing the properties in various capacities; they were employees of, and drew a salary from, the LLC (i.e., from the trust for tax purposes).  The LLC also had other employees.

The court concluded that the activities of the trustees as employees of the LLC should be considered in determining whether the trust materially participated in the real estate operations.  It noted that, under the applicable state law, each trustee had to act as a prudent person in dealing with the property of another person (the beneficiary) while administering the trust.  They were not relieved of their duties to the beneficiaries by conducting activities through a business entity owned by the trust.

The court rejected the IRS’s argument that, because two of the LLC employee-trustees also held minority interests in the same real estate operation, their efforts were attributable to such individual ownership and not to the trust’s ownership.  The court pointed out that the trustees’ combined personal ownership was not a majority interest and was never greater than the trust’s.  It also noted that their interest as owners were compatible with those of the trust.

At this point, it is unclear whether the IRS will appeal or just non-acquiesce in the Aragona decision.

It appears, under the Court’s decision, that the work performed in a business by individual trustees should count toward the determination of the trust’s material participation.  The selection of the trustee, therefore, will be an important consideration in the context of a family business where trusts are often created to hold interests in the business.

However, a number of questions remain. For example, would it matter to the court if the trustees were employees of an S corporation (rather than of a disregarded LLC, the business of which is deemed owned by the trust) – would all the trustees’ time spent as employees count toward the trust’s material participation? Should the actions of the trust’s non-trustee employees be counted in determining material participation?

Material Participation by S Corp. Trusts

Since the enactment of the “material participation” test, as part of the passive activity loss (“PAL”) rules, in 1986, the IRS has issued very little guidance on how the test applies to trusts. Neither the Code nor the Regulations are helpful.

When the IRS issued proposed regulations for the surtax, many commentators asked for such guidance. Nevertheless, the IRS punted, saying that the issue would be best addressed in future regulations under the PAL rules.

However, with the imposition of the new 3.8% surtax on the NII of trusts, the proper characterization of any S corporation business activity is vital.  Until such guidance is issued, there are only a few IRS rulings and two court cases to which taxpayers may refer.

In the case of a trust that owns an interest in a trade or business through an S corporation, the determination of whether an item of ordinary business income or of gain allocated to the trust from the S corporation is derived in a trade or business that is a passive activity with respect to the trust is made by applying the PAL rules to determine whether the trust materially participates in the S corporation’s trade or business.

The determination of whether an S corporation business is or is not passive as to a trust will depend on several factors. Among these factors are:

– the trustee’s participation in the corporation’s business;

– the grantor’s participation in that business;

– the beneficiary’s participation in that business; and

– the tax status of the trust, including the tax elections made by the trust or the beneficiary.

If the trust does not materially participate in the activity, the trust is deemed to be passive as to that activity. In that case, its income from such activity will be subject to the 3.8% surtax.

Generally, under the PAL rules, a taxpayer, including a trust, is treated as materially participating in an activity only if the taxpayer is involved in the operations of the trade or business on a regular, continuous and substantial basis.

In determining a trust’s material participation in a trade or business activity being conducted by an S corporation, one must first consider the type of trust that owns shares of stock in the S corporation.

Grantor Trust

A grantor trust is disregarded for federal income tax purposes.  The trust property is treated as being owned by the grantor.  Its income is not taxed as trust income, but is treated as being the income of, and taxable to, the deemed owner.  The same rule applies for purposes of the surtax.  Accordingly, material participation should be determined based on whether the grantor materially participates in the activity.

If a grantor of a grantor trust is materially participating in the business of the S corporation in which the grantor trust is a shareholder, the income from such activity will not be subject to the 3.8% surtax.

Many business owners use grantor trusts in their gift planning so as to leverage their gifts and further reduce their estates; if the grantor is materially participating in the business, the ability to avoid the surtax provides yet another reason for using a grantor trust.

QSST

For a QSST, the beneficiary of the trust is treated as the owner of that portion of the trust that consists of S corporation stock, at least for purposes of the flow-through of S corporation income and gain.  Consequently, material participation for such a trust should be determined by reference to the beneficiary’s participation in the activity.  If the beneficiary is active in the business, the trust’s income will be “active” for purposes of the surtax. (The same analysis will apply in the event the trust has a successor beneficiary.)

 ESBT and Other Trusts

For an ESBT, the character of the income is determined and taxed at the trust level.  Accordingly, material participation should be determined at the trust level.

Similarly, in the case of a former grantor trust or a testamentary trust, material participation and the character of the income should be determined (and may be taxed) at the trust level.

The same seems to apply as to a QSST for purposes of determining the gain from the trust’s sale of S corporation stock.

Under the Code and general trust principles, if a simple or complex trust that has NII makes a distribution to its beneficiary, the trust income allocated to the beneficiary has the same character in the hands of the beneficiary as in the hands of the trust.  The nature of the activity as passive or active, at the trust level, should also be carried out to the beneficiary upon distribution of the trust’s income.  Thus, if a simple or complex trust determines that an activity is passive at the trust level, and the trust distributes all of its NII to a beneficiary, then the activity would be considered passive at the beneficiary level, regardless of the beneficiary’s participation in the activity.

In the event an ESBT is subject to the surtax, it should be noted that it will not be able to use distributions to its beneficiaries to reduce its NII tax liability because ESBTs are denied distribution deductions.

 Limited Application

It should be noted that a former grantor trust (including a former QSST whose income beneficiary has died) and a testamentary trust may be S corporation shareholders for a period of only two years, at which time they must elect either QSST or ESBT status (if they qualify). Thus, the nature of their material participation may change over time, depending upon the election made.

The more difficult “material participation issue” arises in the case of an ESBT or other type of permitted S corporation trust.  How is the material participation test to be applied with respect to one of these trusts? This will be the subject of our next post.

While the S corporation has a number of shortcomings, it historically has offered the best means for avoiding corporate level tax on the sale of business assets, provided the sale occurs beyond the corporation’s built-in gain recognition period.  A recent development provides yet another advantage for an S corporation over a C corporation: an opportunity for shareholders to avoid the imposition of a surtax on net investment income (“NII”).   Specifically, if the S corporation’s income is derived from a trade or business in which the shareholder-taxpayer materially participates, such income will not be subject to the surtax.

The Surtax

After 2012, the tax cost of operating an S corporation or of selling its business increased for higher-income taxpayers.  In addition to increased income and capital gain tax rates, a new 3.8% surtax is now imposed on the NII of an individual or trust.  In the case of an individual, the tax is imposed on the lesser of (a) the taxpayer’s NII for the year, or (b) the excess of the taxpayer’s modified AGI for the year over the “threshold amount” ($200,000 in the case of a single taxpayer).

But, what if the shareholder is a trust? This is not an uncommon occurrence; after all, the family-owned business is often the family’s most valuable asset, and it is often transferred to the next generation in trust (either by way of a gift, sale or bequest), so as to keep it within the family, or to protect it from spendthrifts, creditors, spouses, etc.

In the case of a trust, the tax is imposed on the lesser of (a) its undistributed NII for the year, or (b) the excess of (i) the trust’s AGI for the year over (ii) the dollar amount at which the highest trust tax bracket begins for such year.  For 2014, this dollar amount is only $12,150.

Thus, a trustee may be incentivized to make distributions of trust income to its beneficiaries so as to reduce the trust’s NII surtax. Alternatively, the trustee may consider invading the trust and distributing the income-producing corpus to a beneficiary whose AGI is under the threshold for the application of the surtax to individuals, or who is active in the business.

Of course, these options must be considered in light of the grantor’s purpose for the trust.  Any distribution has to make family and business sense first.  In any case, as we shall see, the distribution option will have limited application to most S corporation trusts, except during the 2‑year periods for which former grantor trusts and testamentary trusts may be S corporation shareholders.

Material Participation

Returning to the S corporation shareholder,  in general, a shareholder that is involved in the corporation’s business on a regular, continuous and substantial basis will not be subject to the 3.8% tax on the shareholder’s distributive share of S corporation business income, or on the gain from the S corporation’s sale of assets used in such trade or business, or on the gain recognized by the shareholder on the sale of the S corporation’s stock.  By contrast, in the case of a C corporation, an individual or trustee shareholder will be subject to the 3.8% surtax on any dividends received from the corporation and on any gain recognized on the sale of its stock, regardless of the shareholder’s level of participation.

The determination of whether an individual shareholder has materially participated in a business is fairly straightforward; in general, one of several alternative tests may be applied, including the annual participation requirement of 500 hours in the operations of the business.

Thus, the characterization of passive or non‑passive as to a particular activity may vary from one shareholder to another, with a “passive” shareholder being liable for the surtax on his or her share of the income or gain, while an “active” shareholder is not.

This potential difference in treatment among the shareholders of an S corporation should be considered in context. In many family businesses, only those members who are actually active in the business receive any economic benefit therefrom, usually in the form of salary or bonus. The passive members are dependent upon distributions from the corporation. It is often the case that the active members also control the corporation’s board and are its officers; among other things, they determine its distribution policy. Query whether the surtax will prove to be another source of friction between the “insider” and the “investor” shareholders?

In our next post, we will take a closer look at the application of the material participation test with respect to S corporation trusts.

In two earlier posts, we discussed how the division of a closely held, corporate-owned business may be effected on a tax-free basis. The IRS recently issued a ruling  that illustrates the variety of circumstances in which such a division may be appropriate and feasible.

Distributing was an LLC that was treated as an S corporation for federal income tax purposes (possibly because the owners preferred the governance provisions of the state’s LLC law to those of its corporate law; see the check-the-box regulations). Shareholder A and Shareholder B, who were related to one another, each directly owned X% of the equity of Distributing (the “Distributing Interests”). The remaining Y% of the Distributing Interests were held by a Trust (see our post here), the beneficial ownership of which was held equally by Shareholder A and Shareholder B.

Additionally, Shareholder A (together with trusts for the benefit of Shareholder A’s spouse and descendants) owned RelatedCo1, and Shareholder B owned RelatedCo2, each a corporation engaged in the same line of business as Distributing: Business A.

Distributing and RelatedCo1 were each engaged in Business A for many years. Distributing did not have any employees on its payroll. Rather, Shareholder A managed Distributing and the Operational Employees, who were formally employed by RelatedCo1 and performed Distributing’s operational activities. Since Distributing’s formation, Distributing and RelatedCo1 had an unwritten employee-sharing arrangement in place (the “Employment Arrangement”) under which the Operational Employees performed operational activities and some management services for both Distributing and RelatedCo1, RelatedCo1 compensated the Operational Employees for all of their work and provided them with benefits, and Distributing reimbursed RelatedCo1 for a portion of the Operational Employees’ compensation and benefits. Specifically, Distributing periodically made payments to RelatedCo1 for Z% of RelatedCo1’s costs for the Operational Employees’ salaries, benefits, workers’ compensation insurance, health insurance, and other employment-related expenses (apparently without an element of profit for RelatedCo1). The Z% was intended to approximate the portion of the Operational Employees’ work hours spent working on behalf of Distributing. When performing services on behalf of Distributing, the Operational Employees held themselves out to third parties as employees of Distributing.

Eventually, Shareholder A and Shareholder B stopped getting along.  As a result, they proposed to separate their interests in Distributing in order to avoid further disharmony in the management and operations of Business A, as well as to avoid litigation.

Specifically, the following transaction (the “Proposed Transaction”) was proposed:
(i) Distributing would form Controlled as a new corporation;
(ii) in exchange for the issuance of all of the Controlled stock, Distributing would transfer to Controlled the Contributed Assets (a portion of its Business A assets), as well as the financial accounts and the liabilities associated with these business assets (the “Contribution”);
(iii) the Trust would distribute one-half of its Distributing Interests to Shareholder A and the other one-half of its Distributing Interests to Shareholder B (the “Trust Distribution”);
(iv) Distributing would distribute all of the outstanding Controlled stock to Shareholder B in exchange for all of Shareholder B’s Distributing Interests (the “Distribution”), leaving Shareholder A as the sole owner of Distributing;

(v) after the Distribution, Controlled would elect to be an S corporation effective as of the date of formation, with Shareholder B as its sole owner; and

(vi) following the Proposed Transaction, Distributing and Controlled would each continue, independently and with its separate employees (or with operational employees of Related Co 1 or Related Co 2, respectively), the active conduct of its share of all of the integrated activities of Business A conducted by Distributing prior to consummation of the Proposed Transaction.

The IRS determined that the Contribution, followed by the Distribution, would qualify as a tax-free reorganization: (1) no gain or loss would be recognized by Distributing on its transfer of the Contributed Assets to Controlled in exchange for the assumption of liabilities and the issuance of the Controlled stock in the Contribution; (2) no gain or loss would be recognized by Controlled on its receipt of the Contributed Assets from Distributing in exchange for its assumption of liabilities and the issuance of its stock in the Contribution; (3) no gain or loss would be recognized by Distributing on the distribution of the Controlled stock to Shareholder B in the Distribution; and (4) no gain or loss would be recognized by Shareholder B upon the receipt of Controlled stock in exchange for the Distributing Interests in the Distribution.

In accordance with its ruling policies, the IRS did not determine whether the Distribution satisfied the business purpose requirement or whether Business A was an active trade or business.

It also did not rule on the income tax treatment of the Trust and the Trust Distribution, although a distribution of corpus is generally not a taxable event, either to the trust or to its beneficiaries.

This ruling is factually noteworthy for a couple of reasons. It involved an LLC (Distributing) that elected to be taxed as an S corporation. Distributing did not have its own employees but, rather, conducted its business through an employee-sharing agreement with a corporation that was owned by only one of Distributing’s owners. Shareholder A and Shareholder B were already separately engaged in the same line of business as Distributing through their own, separate corporations (and with their own workforces), possibly competing against one another; in other words, they may have already started the separation process.

It also illustrates one of the many scenarios in which the spin-off provisions of the Code may be utilized to separate shareholders on some rational basis – including a division of customers, workforce, geographic area, lines of business, etc., and possibly an equalizing payment – and without the emotional and economic costs of litigation.  Advisers to closely held businesses should be mindful of these provisions in any scenario that has the potential to turn into a litigated matter among shareholders.