The withdrawal of a partner from a partnership is one of the most common business transactions. In some cases, the partner leaves amicably; in other cases, the departure may occur after many disagreements and, perhaps, litigation.  Regardless of the cause of the partner’s withdrawal, it is often the case that neither the partner nor the continuing partnership has thoroughly considered the income tax consequences of the withdrawal.  As a result, the economic cost of the separation may be greater than need be.

Liquidation:  Timing

As a matter of state law, the withdrawal or “retirement” of a partner from a partnership occurs when the partnership redeems the retiring partner’s interest and the latter ceases to be a partner.  The tax inquiry, however, is more involved, and the “retirement agreement” should seek to address as many tax issues as possible.

According to IRS regulations, the term “liquidation of a partner’s interest” means the termination of a partner’s entire interest in a partnership by means of a distribution, or a series of distributions, to the partner by the partnership.  The series of distribution may be made in more than one tax year, in which case the partnership interest will not be considered as liquidated, for tax purposes, until the final distribution has been made.  This is so notwithstanding that the partner ceased to be a partner as a matter of state law.  Thus, in the recent Brennan decision, T.C. Memo 2012-209, a retiring partner, who left the partnership in 2002 (but was still owed liquidating payments), was required to report his share of the gain from the partnership’s sale of certain assets in 2003 and 2004, even though no distributions had been made to him in respect of the sale.

It is imperative, therefore, for the partnership, and the partner whose interest is being liquidated, to address the allocation of partnership income and gain both for the year in which he ceases to be a partner as a matter of state law, and for any subsequent years in which “liquidation payments” are being made.

The Final Year

In the case of the year in which the partner withdraws from the partnership, the partner must include his allocable share of the partnership’s income for the portion of the year preceding his withdrawal.  Where the partner’s interest is completely liquidated in the year of withdrawal, the partnership’s tax year will close as to the departing partner; the partnership’s income will usually be allocated to the partner on the basis of an interim closing of the books.  Where the partner’s interest is not immediately liquidated for tax purposes, the partnership’s allocation provisions should be amended to ensure that the partner is not allocated any income subsequent to the date of withdrawal, other than that which is “allocated” to him in liquidation of his interest.

The partnership and the withdrawing partner will also have to consider whether a “tax distribution” should be made to the partner in respect of his share of partnership income for the final year, in addition to his liquidating distribution(s).

They must also be mindful of prior-year partnership tax returns, and particularly the consequences arising out of the examination thereof by the taxing authorities; for example, who controls the examination, and if an adjustment is made that results in more taxable income to the persons who were partners during the earlier year, will a “tax distribution” be forthcoming to the departed partner?

Payment for Assets – 736(b)

In order to adequately address the allocation of partnership income to a retiring partner, the partnership needs to understand what the payments being made to him represent, since they may represent several items.  Before one can characterize the liquidating payments to be made to a retiring partner, the payments must be allocated between the value of the partner’s interest in partnership assets and other payments.  The value of the partner’s share of the partnership’s assets (which will be reflected in an adjusted capital account) must first be determined.  These include all tangible and intangible assets of the partnership.  The valuation placed by the partners upon a partner’s interest in partnership property, in an arm’s-length agreement, will typically be regarded as correct.  In general, the remaining partners are allowed no deduction for these payments, though it may be possible to amortize or depreciate them (subject to anti-churning rules) if the partnership has a Sec. 754 election in effect.

Where money is paid by the partnership to the partner for his interest in partnership assets, the payment is treated as a distribution by the partnership, and the partner recognizes gain to the extent that the amount distributed exceeds the adjusted basis of the partner’s interest in the partnership immediately before the distribution.  The gain is treated as being realized from the sale or exchange of a capital asset.  For these purposes, the partner’s “relief” from his share of partnership liabilities, which is generally deemed to occur in the year he withdraws from the partnership under local law, is treated as a distribution of money.

However, there are exceptions to this capital sale treatment.  For example, to the extent the money received by the partner in exchange for his partnership interest is attributable to his share of the partnership’s substantially appreciated inventory, he will be treated as having sold or exchanged such inventory and will realize ordinary income.  To the extent the payments are made for the partner’s share of unrealized receivables, where the partnership’s business is capital intensive, once again the partner will realize ordinary income.  The partnership itself should not realize any income on the subsequent sale of such inventory or collection of such receivables.

Other Payments – 736(a)

Certain other assets receive special treatment, depending on the nature of the partnership’s business and of the retiring partner’s involvement therein.  Thus, in the case of a service partnership, a payment for partnership assets will not include the partner’s share of partnership goodwill unless the liquidation agreement specifically provides for a reasonable payment for goodwill and the retiring partner was the equivalent of a general partner.  If these criteria are not satisfied, then any payment that would otherwise cover partnership goodwill would, instead, be treated as a guaranteed payment, producing ordinary income to the retiring partner and a deduction to the partnership.

The portion of the payments made to a retiring partner for his share of unrealized receivables (where the business is not capital intensive) or goodwill (with certain exceptions), or otherwise not in exchange for his interest in other partnership assets, will be considered either a distributive share of partnership income if the amount is determined with regard to the income of the partnership, or a so-called “guaranteed payment” if the amount is determined without regard to partnership income.  In either case, the retiring partner realizes ordinary income.  To the extent they are considered as a distributive share of partnership income, the payments reduce the distributive shares of the remaining partners.  To the extent the payments are considered guaranteed payments, they are deductible by the partnership.

Where liquidating payments are made to a partner during the taxable year, the partner must segregate that portion of each such payment which is determined to be in exchange for the partner’s interest in partnership property from that portion that is treated as a distributive share or guaranteed payment, as described above.  Where the payments are to be made over two or more years, IRS regulations provide rules for making the allocation, though the partners may agree to a different method.

Plan for Taxes

Many of the foregoing tax issues may be addressed in the partnership agreement, well before the departure of any partner.  A well-drafted agreement can facilitate the subsequent liquidation of a partner’s interest.  Alternatively, they may be covered in a liquidation agreement between the retiring partner and the partnership ,or in a settlement agreement in resolution of litigation between the retiring partner and the partnership.

Regardless of where they are addressed, it is important that they be addressed, preferably from the outset.  If the partnership fails to recognize the issues in the first place, it may leave itself open to significant tax cost by failing to generate a deduction, or its equivalent, for the remaining partners.

If the partner and the partnership fail to consider the tax issues, the IRS and the courts may do it for them, with unexpected tax and economic consequences for both parties.

Earlier this year, the IRS issued Rev. Proc. 2013-30 to provide relief to corporations that have ceased to qualify as S corporations where the terminating event was not reasonably within the control of the corporation. In particular, the Rev. Proc. addresses late QSST and ESBT elections.

 The issuance of the Rev. Proc., which consolidates various relief provisions previously adopted by the IRS, points to the continuing difficulty that some taxpayers have in determining whether trusts to which shares of S corporation stock are transferred are permitted S corporation shareholders. This state of affairs may lead to some serious tax and economic consequences to taxpayers who are engaged in gift and estate planning with respect to their shares of S corporation stock.

 The Internal Revenue Code limits the permitted shareholders of an S corporation to domestic individuals, estates, certain trusts, and certain exempt organizations.  What follows is a brief description of the basic rules applicable to the ownership of S corporation stock by trusts.

 Trusts that May Hold S Corp. Stock

 Grantor Trusts

 A grantor trust is a trust, all of which is treated, for tax purposes, as owned by an individual (typically the grantor) who is a citizen or resident of the United States.

Upon the death of the deemed owner of the grantor trust, if the trust was a grantor trust immediately before the death, and it continues in existence after the death, the trust may continue to hold S corporation stock, but only for the 2-year period beginning on the day of the deemed owner’s death. In general, a trust is considered to continue in existence if the trust continues to hold the stock pursuant to the terms of the decedent’s will or of the trust agreement.

Testamentary Trusts

A trust to which S corporation stock is transferred pursuant to the terms of a decedent’s will, may hold S corporation stock, but only for the 2-year period beginning on the day the stock is transferred to the trust.

 QSSTs

A QSST is a permitted S corporation shareholder if the beneficiary of the QSST makes an election under the Code. A QSST is defined as a trust that

  1. distributes or is required to distribute  all of its income to a citizen or resident of the United States,
  2. has certain trust terms, including the requirement that there be only one income beneficiary,
  3. does not distribute any portion of the trust corpus to anyone other than the current income beneficiary during the income beneficiary’s lifetime, including the time at which the trust terminates, and
  4. the income interest of the current income beneficiary ceases on the earlier of such beneficiary’s death or the termination of the trust.

In the case of a QSST with respect to which a beneficiary makes an election, the beneficiary of the trust is treated, for purposes of the grantor trust rules, as the owner of that portion of the trust that consists of stock in an S corporation with respect to which the election is made.

A QSST election is made by signing and filing an election statement with the applicable IRS Service Center. The QSST election must be made within the 16-day-and-2-month period beginning on the day that the S corporation stock is transferred to the trust.

ESBTs

An ESBT is a permitted S corporation shareholder. It is defined as any trust where:

  1. the trust does not have as a beneficiary any person other than an individual, an estate, or certain charitable organizations;
  2. no interest in the trust was acquired by purchase; and
  3. an election has been made with respect to the trust.

 To qualify as an ESBT, the trustee of the trust must make an ESBT election by signing and filing an election statement with the applicable IRS Service Center. The ESBT election must be filed within the same time requirements prescribed for filing a QSST election.

 Who is Treated as the Shareholder for Various Tax Purposes

 For purposes of

  1. qualification as a small business (“S”) corporation and, in general, for purposes of
  2. (i) the pass-through of items of S corporation income, loss, deduction, or credit, (ii) the adjustments to basis of shareholder’s stock, and (iii) the treatment of distributions by an S corporation, the shareholder of S corporation stock held by a trust that is a permitted shareholder, is determined as follows:

 (A) If stock is held by a grantor trust, the deemed owner of the trust is treated as the shareholder.

(B) If stock is held by a trust that was a grantor trust immediately before the death of the deemed owner, and the trust continues in existence after the death of the deemed owner, the estate of the deemed owner is generally treated as the shareholder as of the day of the deemed owner’s death.

 The estate ordinarily will cease to be treated as the shareholder upon the earlier of the transfer of the stock by the trust or the expiration of the 2-year period beginning on the day of the deemed owner’s death.

 If the trust qualifies and becomes an electing QSST, the beneficiary and not the estate is treated as the shareholder as of the effective date of the QSST election. If the trust qualifies and becomes an ESBT, the shareholders are determined under paragraph (E), below, as of the effective date of the ESBT election.

 However, solely for purposes of applying the pass-through, basis and distribution rules, the trust is treated as the shareholder of S corporation stock held by the former grantor trust. If the trust continues to own the stock after the expiration of the 2-year period, the corporation’s S election will terminate unless the trust is otherwise a permitted shareholder.

(C) If stock is held by an electing QSST, the income beneficiary who makes the QSST election, and is treated (for purposes of the grantor trust rules) as the owner of that portion of the trust that consists of the S corporation stock, is treated as the shareholder for purposes of the qualification, pass-through, basis and distribution rules; however, the beneficiary will not be treated as the owner of the S corporation stock in determining and attributing the income tax consequences of a disposition of the stock by the QSST.
If, upon the death of an income beneficiary, the trust continues in existence, continues to hold S corporation stock but no longer satisfies the QSST requirements, is not a grantor trust, and does not qualify as an ESBT, then, solely for purposes of the qualification rule, as of the date of the income beneficiary’s death, the estate of that income beneficiary is treated as the shareholder of the S corporation with respect to which the income beneficiary made the QSST election.

 The estate ordinarily will cease to be treated as the shareholder for purposes of the S corporation qualification rule upon the earlier of the transfer of that stock by the trust or the expiration of the 2-year period beginning on the day of the income beneficiary’s death.

 During the period that the estate is treated as the shareholder for purposes of the qualification rule, the trust is nevertheless treated as the shareholder for purposes of the pass-through, basis and distribution rules.

 If, after the 2-year period, the trust continues to hold S corporation stock and does not otherwise qualify as a permitted shareholder, the corporation’s S election terminates.

(D) If stock is transferred or deemed distributed to a testamentary, the estate of the testator is treated as the shareholder until the earlier of the transfer of that stock by the trust or the expiration of the 2-year period beginning on the day that the stock is transferred or deemed distributed to the trust.

 However, solely for purposes of applying the pass-through, basis and distribution rules, in the case of a testamentary trust, the trust is treated as the shareholder of the S corporation stock held by the trust. If the trust continues to own the stock after the expiration of the 2-year period, the corporation’s S election will terminate unless the trust otherwise qualifies as a permitted shareholder.

 If the trust qualifies and becomes an electing QSST, the beneficiary and not the estate is treated as the shareholder as of the effective date of the QSST election. If the trust qualifies and becomes an ESBT, the shareholders are determined under paragraph (E), below, as of the effective date of the ESBT election.

(E) If S corporation stock is held by an ESBT, each potential current beneficiary is treated as a shareholder.  The trust itself, however, is treated as a separate taxpayer for purposes of the pass-through rules – the income does not flow-through to the beneficiaries; in addition, any gain from the disposition of the S corporation stock is taxable to the trust; the ESBT is not entitled to a deduction for distributions to its beneficiaries.

 A trust cannot make a conditional ESBT election that would be effective only in the event the trust fails to meet the requirements for an otherwise eligible. If a trust attempts to make such a conditional ESBT election and it fails to otherwise qualify as an eligible S corporation shareholder, the S corporation election will terminate because the corporation will have an ineligible shareholder.

Estate – Or Is It A Trust?

An estate is an eligible S corporation shareholder. Upon the death of an S corporation shareholder, if the decedent’s stock in the corporation is held by the executor of his estate for purposes of administration, the estate will become a shareholder as of the date of the decedent’s death. This is true notwithstanding the fact that state law may provide that the legal title to the stock passes directly to the decedent’s legatees or heirs.

However, an estate cannot remain in existence indefinitely. Indeed, under IRS regulations, an estate will be considered terminated if the period of administration is unduly prolonged. The period of administration of an estate is the period actually required by the executor to perform the ordinary duties of administration, such as the collection of assets and the payment of debts, taxes, legacies, and bequests.

The IRS may contend that a corporation has ceased to qualify as an S corporation where one of its shareholders is, in effect, a testamentary trust, rather than an estate, where the executors have long since completed their duties as executors yet have continued to hold the stock (i.e., the estate has converted into a trust).

 Conclusion

The forgoing discussion highlights the complexity of the rules governing the ownership and taxation of trusts that hold shares of stock in an S corporation. In light thereof, it is easy to appreciate how an S corporation may inadvertently lose its status by virtue of a trust’s ceasing to qualify as a permitted shareholder. Thankfully, the IRS has provided some relief from such terminations, as in the form of Rev. Proc. 2013-30.

However, it also underlines the importance of having a well-drafted shareholders agreement, one that restricts the transfer of stock so as to preserve the corporation’s S election and that ensures the cooperation of all the shareholders in preserving or reinstating the election. 

Historically, the gift and estate tax laws have limited the ability of wealthy individuals to transfer their interests in family businesses to their children without suffering potentially severe tax consequences.  However,  many wealthy taxpayers are interested in shifting the appreciation in their business out of their estate and into the hands of their children.

Transfers by Gift

Usually, a gift of property to a family member will remove the property, and any subsequent appreciation in its value, from the donor’s estate.  If the taxpayer does not transfer the property during his life, the full value of that property as of his date of death is included in his estate and is subject to transfer tax.  In general, a gift transfer occurs if the consideration received by the donor is less than the value of the property transferred. In that case, the amount of the gift is equal to the excess of the value of the property transferred over the amount of the consideration received.

To the extent that adequate consideration has been received, the transferor has made a sale that is subject to the income tax.

For some, though, an outright gift may not be the most attractive option because the business represents their main source of revenue. Such a taxpayer may want to consider a form of transfer which provides a stream of payments in exchange for the interest.  (It should be noted that, by their nature, interests in closely-held entities are difficult to value. Even if the taxpayer relies upon a well-reasoned appraisal, the IRS will often challenge the reported value. )

Transfers by Sale

 One way to transfer property to beneficiaries, while receiving a stream of income therefrom, is through a sale of the property, often to an irrevocable, grantor trust (funded with a not insignificant “seed gift”), in exchange for a trust-buyer’s installment note.  The sale to the trust is not subject to income tax (because the taxpayer is dealing with himself), and the issuance of the note prevents any gift tax (because there is adequate consideration). The value of the business interest sold is frozen in the seller’s hands at the amount of the note. The future appreciation of, and the cash-flow from, the interest should cover the loan service.

In order to avoid gift characterization for the sale-transfer, the taxpayer must establish:

  1. the value of the property sold, and
  2. the value of the note received in exchange.

The installment note must bear a minimum rate of interest. The installment obligation should be memorialized in writing and, preferably, it should be secured. The term of the note should not exceed the seller’s life expectancy, and payments should be made as required by the terms of the sale and note agreements.

If the taxpayer-seller should die before the note is satisfied, the value of the note (presumably the outstanding principal amount as of the date of death) will be included in the seller’s estate for estate tax purposes.

SCINs to the Rescue!

The inclusion of the note in the seller’s estate in the event of his premature death presents an issue which taxpayers have sought to address through a sale of the property to a trust in exchange for a self-cancelling installment note (“SCIN”). Under the terms of a SCIN, if the taxpayer-seller dies before the end of the note term, the remaining principal on the note is cancelled.  This, of course, benefits the buyer, and it also avoids inclusion of the note in the seller’s estate.  In general, this technique works best where the seller is not expected to survive his actuarial life expectancy, but is not terminally ill.

In order to avoid a bargain sale and gift when using a SCIN, the seller must be compensated for the self-cancellation feature, either through an interest rate premium or through a purchase price premium. In general, during the term of the note, both principal and interest should be payable currently.

An Example

While the forgoing may sound fairly straightforward, a recent advisory issued by the Office of the Chief Counsel of the IRS illustrates how things can go wrong in structuring a SCIN transaction. The taxpayer in IRS CCA 201330033 participated in two transactions involving SCINs.

In both transactions, the taxpayer transferred shares of to a grantor trust of which he was the deemed owner. In exchange, the trusts issued promissory notes with a term based upon his actuarial life expectancy as derived from IRS tables used in the valuation of annuities, term and remainder interests. The notes bore interest that was payable annually. No principal was payable until the end of the note’s stated term. The notes included a self-cancellation feature.

The shares were appraised at $X. In the case of the first trust, the face amount of the notes was almost double the appraised value, supposedly to compensate the taxpayer for the cancelation feature. As to the second trust, the interest rate was above-market in order to account for the cancelation feature. The ruling makes no mention of the taxpayer’s health as of the time of the transactions. In a typical SCIN transaction, the taxpayer will have contemporaneously obtained a relatively clean bill of health from a physician.

The taxpayer died less than six months later. The taxpayer received neither any interest payments nor the principal due on the notes. The SCINs were not included on the decedent’s estate tax return, nor were they reported as gifts on his gift tax return.

The advisory indicated that a transaction where property is exchanged for promissory notes will generally not be treated as a gift if the value of the property transferred is substantially equal to the value of the notes. The face value and term of the notes must be reasonable in light of the circumstances.

The IRS noted that a SCIN transaction between family members is presumed to be a gift, and not a bona fide transaction, though the presumption may be rebutted by an affirmative showing that there existed at the time of the transaction a real expectation of repayment and an intent to enforce the collection of the indebtedness; for example, if the taxpayer was not willing to gift the stock to his family because he required a steady stream of income, he would transfer the stock in exchange for a note that provided for both installment payments of principal plus interest which, had he lived, he would have throughout the term of the note.  In other words, there must be a real expectation of repayment, and the intention to enforce the collection of indebtedness.

In contrast, the IRS pointed out, the decedent in the advisory structured the notes such that the payments during the term consisted of interest only, with a balloon payment at the end of the note’s term. A steady stream of income was not contemplated. Moreover, the decedent had substantial other assets and did not require the income from the notes to cover his living expenses. Thus, the arrangement in this case was nothing more than a device to transfer the stock to family members at a lower value than the fair market value of the stock.

In addition, the IRS stated that the notes lacked the indicia of genuine debt because there was no reasonable expectation that the debt would be repaid. The estate must demonstrate that the trusts that issued the notes had the ability to repay the amount of the note. According to the IRS, it failed to do so.

Finally, the IRS stated that it was inappropriate to value the notes using the actuarial tables described above. Rather, the notes should have been valued based on a method that takes into account the so-called “willing-buyer willing-seller” standard. In this regard, the decedent’s life expectancy, taking into consideration the decedent’s medical history on the date of the gift, should have been taken into account. (The IRS made the same argument in its recently filed answer to the taxpayer’s petition in Est. of Davidson v. Commissioner, T.C., No. 013748-13, where the decedent died shortly after the SCIN transaction.)

The IRS concluded that, because of the decedent’s health, it was unlikely that the full amount of the note would ever be paid. Thus, the notes were worth significantly less than their stated amounts, and the difference between the fair market value of the notes and the value of the shares sold to the trusts (as reflected in the notes’ stated amounts) constituted a taxable gift at the time of the transfer to the trusts.

Conclusion

The foregoing highlights some of the issues and pitfalls that need to be considered before embarking on a sale of an interest in a closely-held business in exchange for a SCIN. While a sale to a trust in exchange for a SCIN can be a useful estate planning tool, it is not appropriate in all circumstances. As with all estate planning in the context of a closely-held business, the taxpayer has to consider a number of consequences that may arise out of any  transfer decision.

 

Many of us encounter family-owned corporations in which the founder’s children are engaged in the business to varying degrees.  They may even own shares in the corporation.  These situations present difficult estate and succession planning considerations for the family and the business.

Scenarios

It may be that two siblings actively participate in the business.  They are capable and each aspires to lead the corporation.  Eventually, their competing goals, personalities, or divergent management styles may generate enough friction between them, and within the business, so as to jeopardize the continued well-being of the business.

Alternatively, the siblings are interested in different parts of the corporation’s business.  Each sibling may be responsible for a different line of business; for example, a different product, service, or geographic region.  Their differing interests may lead to disagreements as to the allocation of resources.

In other situations, the founder and his children may not see eye-to-eye.  For example, the parent wants to emphasize the corporation’s traditional line of business, while his children seek to develop an offshoot of that business.

The Problem

It may be difficult, using traditional estate planning techniques, to accommodate the varying interests of family members involved in a single corporation.  For example, assume that Corp. is owned 80% by Parent, 10% by Daughter and 10% by Son; it operates two lines of business; one line is managed by Son and the other by Daughter; neither has any interest in the other’s line of business; how should Parent transfer his shares of Corp.?

Equal gifts or bequests to each child would leave them as equal shareholders, with the potential for disagreement.  Moreover, to the extent Daughter’s efforts increase the value of her business while Son’s business remains unchanged will Son be unfairly benefitted?  Alternatively, what if an older line of business is operated by Parent, while a newer line is operated by Son and Daughter?  There is little growth potential for the older line, but the newer line is poised to take off.  What estate planning can Parent implement to shift the future appreciation of the new business line to the children and out of his estate?

A solution may be found in a transaction that is associated with corporate tax planning, but which may yield estate planning benefits:  the tax-free corporate separation.

 

Tax-Free Separations

When a corporation distributes appreciated property to its shareholders  as a dividend or liquidating distribution, the corporation is treated as having sold that property for an amount equal to the property’s fair market value, and it is taxed accordingly. The shareholders are taxed on their receipt of the property, either as a dividend or as payment in exchange for their shares.

There is an exception to this recognition rule, however, for certain distributions.  In general, no gain will be recognized by either the distributing corporation (“Distributing”) or its shareholders if the following requirements are satisfied:

(i) Distributing distributes to some or all of its shareholders all of the stock of a subsidiary corporation controlled by Distributing (“Controlled”);

(ii) the distribution is not used principally as a device to distribute the earnings and profits of either corporation;

(iii) each of Distributing and Controlled is engaged, immediately after the distribution, in the active conduct of a trade or business which has been actively conducted (by Distributing or Controlled) throughout the five-year period ending on the date of the distribution;

(iv) there is a real and substantial business purpose for the distribution that cannot be accomplished by another nontaxable alternative which is neither impractical, or unduly expensive;

(v) the distributee shareholders did not acquire their shares in Distributing by purchase during the five-year period ending on the date of distribution;

(vi) neither active trade or business was acquired in a taxable transaction during that period; and

(vii) the distribution is not made pursuant to a plan by which at least 50% of Distributing or Controlled is acquired by third parties.

A Closer Look

The determination of whether a trade or business is actively conducted is based on all the facts and circumstances.  Generally, the corporation is required itself to perform active and substantial management and operational functions, though some of its activities may be performed by others.  The holding of property for investment does not constitute the active conduct of a trade business; generally, neither does the ownership and operation of real estate.

Historically, the IRS has accepted a number of valid business purposes, including the following:

  1. To provide equity in a business of Distributing or Controlled to a key employee;
  2. To enhance the success of a line of Distributing’s business by enabling the corporation to resolve management and other problems that arise in (or are exacerbated by) Distributing’s operation of different businesses within a single corporation; and
  3. To resolve shareholder disputes in the management of a business.

These business purposes may be accomplished by contributing business assets to a new subsidiary (Controlled).  These assets may represent a fraction of the assets used by Distributing in a single business; or they may represent a distinct business, separate from that retained by Distributing.  After this asset transfer, Distributing distributes Controlled to some of Distributing’s shareholders, in respect of or in exchange for some or all of their Distributing stock.

A Solution?

Assuming these requirements are satisfied, the three scenarios described above may be addressed as follows:

  • Distributing creates  Controlled, to which it contributes one-half of the business conducted by Distributing; Distributing then distributes Controlled to Parent and Son, in exchange for all of Son’s shares in Distributing; this  leaves Parent and Son as the owners of Controlled, while Parent and Daughter own Distributing; Parent may now transfer shares in separate corporations to each child.
  • Distributing contributes one business to Controlled and then distributes Controlled  to Parent and Son, as above.  Parent and Daughter continue to own Distributing and to operate the other business.
  • Distributing contributes the “children’s business” to Controlled and then distributes Controlled to Son and Daughter in exchange for all of their Distributing stock.

Conclusion

In each instance, the parties and their respective businesses may be separated without incurring income tax.  This enables the children to pursue their own interests and retain the benefits of their own efforts.  It allows Parent to maintain some level of involvement, while also enabling Parent to better tailor his gift and estate planning.  In light of these benefits, a taxpayer should, in the appropriate circumstances, consider the application of a corporate separation to a family-owned business.

This article appeared in the October 2013 issue of The Suffolk Lawyer.

The IRS recently announced its annual inflation adjustments for 2014, which will cover more than 40 tax provisions.  Notably, the following adjustments will be made for 2014:

 

  • The maximum tax rate of 39.6% will affect singles whose income exceeds $406,750 ($457,600 for married taxpayers filing a joint return), up from $400,000 and $450,000, respectively.

 

  •  The standard deduction rises to $6,200 for singles and married persons filing separate returns and $12,400 for married couples filing jointly, up from $6,100 and $12,200, respectively, for tax year 2013. The standard deduction for heads of household rises to $9,100, up from $8,950.

 

  •  Estates of decedents who die during 2014 have a basic exclusion amount of $5,340,000, up from a total of $5,250,000 for estates of decedents who died in 2013.

 

  •  The limitation for itemized deductions claimed on tax year 2014 returns of individuals begins with incomes of $254,200 or more ($305,050 for married couples filing jointly).

 

Alternatively, certain provisions will not be subject to any annual inflation adjustments, including the annual exclusion for gifts, which remains at $14,000 for 2014, and the annual dollar limit on employee contributions to employer-sponsored healthcare flexible spending arrangements (FSA), which remains unchanged at $2,500.

The grant of an equity interest by a partnership to one of its key employees should be approached with great caution because it may result in unintended tax consequences, both for the partnership and the partner.1

Many corporate employers use equity-based compensation in the form of stock or stock options to motivate their employees.  Individuals who are employed by partnerships may expect compensation in the form of partnership interests.  A partnership is flexible enough to accommodate equity-based compensation, but the arrangements may have different tax consequences than in similar corporate plans.  There are three common forms in which a partnership may transfer an interest to an employee:

  • a full partnership (capital/profits) interest;
  • a profits interest only; and
  • an option to acquire an interest.

 Transfer of a Full Partnership Interest

Surprisingly, there is no consensus as to the tax consequences for a partnership if a transfer of a full or capital interest takes place when the partnership has unrealized appreciation in its assets.  The preferred analysis is to treat the partnership as transferring to the employee a proportional interest in all its assets.  This would trigger recognition to the partners of the unrealized appreciation in the partnership assets at the time of the transfer under Code Section 1001.

Under Code Section 83, if property (including a partnership interest) is issued to an employee in exchange for services, the excess of the fair market value of the property at the lapse of any substantial risk of forfeiture over any amount paid for the property will be taxable compensation at the time of the lapse, and the excess may be deductible by the partnership at that time.

In sum, the value to the partnership of any deduction can be diminished by gains recognized on the transfer of partnership interests for services.  A corporate employer, on the other hand, is allowed a deduction for the full amount of the compensation, but does not recognize any gain on issuance of its own shares (under Code Section 1032).

Transfer of a Profits Interest

In contrast to a capital interest, there is no current compensation to the partnership employee who receives a profits interest, because of the speculative value of such an interest.  If the profits interest is subject to a substantial risk of forfeiture, it would seem advisable for the employee to make a protective Code Section 83(b) election to ensure that any capital that may accumulate with respect to the interest before the restriction lapses is not then taxable to the partner.

Consistent with the foregoing, the IRS has held that the receipt of a vested profits interest, and the vesting of a unvested profits interest, generally will not result in a taxable event for either the partnership or the employee provided two requirements are satisfied:

  1. Both the partnership and the employee must treat the employee as the owner of the partnership interest from the date that the profits interest is granted and the employee must take into account the distributive share of partnership income, gain, loss, deduction and credit associated with that interest in computing the employee’s income tax liability; and
  2. Upon the grant of the interest, or when it becomes substantially vested, neither the partnership nor any of the partners may deduct any amounts for the fair market value of the interest.

It should be noted that under rules proposed by the IRS in 2005, there would be no distinction in the treatment of capital and profits interests.  If a partnership interest were transferred in connection with the performance of services, the employee-recipient would not be treated as a partner until the interest became substantially vested or a Section 83(b) election was made. In addition, taxpayers could treat the “liquidation value” of a compensatory partnership interests as the interest’s fair market value.  Until these regulations are finalized, however, taxpayers may rely upon the IRS’s earlier holdings.

In addition, until additional guidance is issued, for purposes of Section 409A, taxpayers may treat the issuance of a partnership interest granted in connection with the performance of services under the same principles that govern the issuance of stock. For example, taxpayers may treat an issuance of a profits interest that is properly treated under applicable guidance as not resulting in inclusion of income by the employee at the time of issuance, as also not resulting in the deferral of compensation.

Transfer of an Option to Acquire an Interest

In lieu of a partnership interest, a partnership can issue nonqualified options to purchase partnership units.  In general, the grant of an option to purchase partnership units to an employee in exchange for services does not have a taxable consequence for the partnership. Presumably, any such option would not be freely transferable, but might be subject to a substantial risk of forfeiture to ensure that the holder of the option satisfactorily performs services under the option agreement. Under the regulations proposed in 2005, no gain or loss would be recognized by a partnership upon a transfer of a partnership interest from the exercise of a compensatory option.

This means that Code Section 83 would come into play as in the normal context of the employer-employee relationship, and income would result to the option holder at the time of exercise, equal to the excess of the fair market value of the partnership interest at that time over the exercise price.

 he value of the partnership interest relative to the option’s strike price also needs to be closely examined because it may implicate Section 409A. An option to purchase an interest in the employer-partnership does not provide for a deferral of compensation if the exercise price may never be less than the fair market value of the underlying interest on the date the option is granted.

 Conclusion

Partnerships that want to incentivize key employees by compensating them with partnership interests face some unique challenges. With proper planning and structuring, they should be able to do so without triggering significant, or unexpected, tax costs for the partners or for the employees.

 

FN 1. Most LLCs that have at least two members are treated as partnerships for income tax purposes.

 

For many executives, the 2013 tax year began with an increase in the marginal federal income tax rate applicable to their compensation, from 35% to 39.6%.  It also saw the expiration of the temporary payroll reduction for the employee’s share of OASDI, which consequently increased from 4.2% to 6.2%, plus an additional 0.9% increase in the Medicare tax rate for compensation above a threshold amount.

Along with these increased rates, 2013 saw the reinstatement of the limitations on itemized deductions and the phase-out of the personal exemption for high-income taxpayers.  These changes further increased the effective tax rate for many executives.

While many executives may be troubled by these developments, they are not helpless to deal with them. Indeed, in the case of the closely-held business, there are some compensation-planning techniques that may be used by employers, in cooperation with their executives, to address the increased tax burden.  One such technique is a nonqualified deferred compensation arrangement.

 

Nonqualified Deferred Compensation

In general, a nonqualified deferred compensation plan allows an executive to defer the receipt of a portion of his compensation.  This defers the imposition of tax on such compensation, thereby reducing the impact of the increased rates.  The amount deferred may even be significant enough to move the executive into a lower tax bracket currently.  If the employee’s deferred compensation is also credited by the employer with any investment earnings thereon, the tax on these earnings is also deferred.  Of course, when the deferred compensation, and the earnings thereon, are ultimately paid out to the executive, they will then be subject to income tax as compensation.  However, that pay-out period may extend over several years, during which time the executive’s effective tax rate may also be lower.

Deferred compensation occurs when the payment of compensation is deferred to a tax period after the period in which the compensation is earned (i.e., the time when the services giving rise to the compensation are performed).  Payment is generally deferred until some specified event, such as the individual’s retirement, death, disability, or other termination of services, or until a specified time in the future (e.g., ten years).

There are a number of valid business reasons for deferring compensation.  One of the most common reasons employers use deferred compensation arrangements is to induce or reward certain behavior; e.g., to retain the services of an employee, or to encourage the employee to attain certain performance goals.

Structure

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

A nonqualified arrangement may provide for deferral of base compensation (salary), incentive compensation (bonuses), or supplemental compensation (above qualified plan limits),  or it may permit the employee to elect whether to defer compensation or to receive it currently.  It may be measured by reference to the value of the employer’s equity (as in the case of phantom stock or stock appreciation rights). It may provide for compensation that is only payable on the occurrence of future events (e.g., upon attainment of performance goals, or a change-in-control).  It may be structured as an account for the employee, to which amounts—including “investment income”—are credited, with benefits payable based on the amount “in the account.”  It also may provide for specified benefits to be paid to the employee.

Tax Principles

The determination of when amounts deferred under a nonqualified deferred compensation arrangement are includible in the gross income of the executive earning the compensation depends on the facts and circumstances of the arrangement.  A variety of tax principles and Internal Revenue Code (IRC) provisions may be relevant in making this determination, including the doctrine of constructive receipt, the economic benefit doctrine, the provisions of IRC Section 83 (relating to transfers of property in connection with the performance of services), and the provisions of IRC Section 409A.

In general, the time for inclusion of nonqualified deferred compensation depends on whether the arrangement is unfunded or funded.  Most nonqualified deferred compensation arrangements are unfunded; i.e., the compensation is payable from the employer’s general corporate funds that are subject to the claims of its general creditors. Such an arrangement represents an unsecured promise to pay money in the future. (Contributions to a so-called “rabbi trust” will not cause the plan to be funded for tax purposes.) The compensation is generally includable in income when it is actually or constructively received by the employee  (as when it is made available so that he could draw upon it at any time, without substantial limitations), when the employee realizes the economic benefit of the compensation (as when he can pledge it to secure a loan), or when the deferral plan fails to satisfy the requirements of Section 409A.

Section 409A

Under IRC Section 409A, all amounts deferred under a nonqualified plan are currently includible in gross income to the extent they are not subject to a “substantial risk of forfeiture” (i.e., the person’s rights to the compensation are conditioned upon the performance of substantial services or the occurrence of a condition related to a purpose of the compensation, such as the attainment of a prescribed level of earnings), unless certain requirements are satisfied.  Specifically, the deferred compensation may not be distributed earlier than the employee’s “separation from service”, disability, death, or at a specified time (or pursuant to a fixed schedule) specified under the plan, or upon a “change-in-control.”  In addition, the plan may not generally permit the acceleration of the time or schedule of any payment.

Planning Considerations

An executive and his employer may utilize the forgoing rules to structure a deferred compensation plan that may satisfy the closely-held employer’s goals to incentivize and reward a key employee, while also deferring the imposition of income tax on a significant portion of the executive’s compensation. These rules are complex, however, and the terms of the plan must be approached with care; otherwise, the executive may be faced with current income tax liability with respect to amounts which, contractually, he cannot yet access.  Such a situation will likely prove costly for the closely-held business as well as the executive.

 

The owners of a business must consider many tax issues in connection with its sale.  These include the structure of the transaction as a sale of assets or stock, the amount of gain arising from each structure, the character of the gain as ordinary or capital, and the resulting tax liability.  From the foregoing, the owners may determine the net economic benefit inuring to them as a result of the sale.  Owners will sometimes use this information in negotiating an increased purchase price, or some other form of “gross-up”, to arrive at the after-tax figure for which they would be willing to sell the business.

New Surtax

After 2012, the tax cost of selling a business increased for higher-income taxpayers.  In the case of individuals, the top rate for ordinary income increased to 39.6%, while the top long-term capital gain rate increased to 20%.

In addition, a new 3.8% surtax is imposed on an individual’s net investment income (“NII”) for the year.  This tax presents another cost which must be considered in determining the net economic result of a sale.

 

The Deal

The impact of the surtax is best appreciated by reviewing a typical deal structure.

The sale of a business includes several components.  First, is the sale of either equity or assets by the owners of the “target.” In the case of an asset sale, the selling entity may then be liquidated.  In either case, the consideration received usually includes money and/or notes.  Owners who were active in the target may receive consulting/non-compete agreements from the buyer.  Sometimes, these individuals own the property on which the business was conducted; as part of the transaction, they may lease or sell the property to the buyer.

NII:  What Does It Include?

As it relates to the sale of a business, NII includes the net gain attributable to the disposition of property, other than property held in a trade or business which is not a passive activity as to the taxpayer.  It also includes income from interest and rents, unless such income is derived in the ordinary course of a trade or business which is not a passive activity as to the taxpayer.

Do C Corps Escape the Surtax?

Since the tax only applies to the NII of individual taxpayers, the sale of assets by a C corporation does not trigger the tax.  However, the distribution of the sale proceeds in liquidation of a shareholder’s stock will trigger the tax.

In addition, the gain recognized on the sale of C corporation stock by an individual will also be subject to the tax.

Pass-Through Entities and “Material Participation”

Gain realized by an S corporation or partnership on a sale of assets is passed through and taxed to its owners.  An owner’s NII includes the gain attributable to the entity’s sale of property held in a trade or business that is a passive activity as to the owner.  The determination of whether the property sold was held in a trade or business that is a passive activity is made at the level of the individual owner, not at the entity level.

Thus, the determination of whether the surtax applies to a shareholder’s allocable share of the gain from an S corporation’s sale of assets depends upon whether the corporation held the assets for use in its business and whether that business was a passive activity as to the shareholder; i.e., whether the shareholder “materially participated” in the business.

A taxpayer is treated as materially participating in a business activity if the taxpayer is involved in the operations of the activity on “regular, continuous and substantial” basis.

If the business activity was passive as to the shareholder, then the shareholder’s allocable share of the gain from the asset sale shall be subject to the surtax.  However, if the business was not passive as to the shareholder, the gain is not subject to the tax, except to the extent it is derived from the sale of assets not used in the business.  This may result in a situation where a passive shareholder is liable for the surtax on his share of the gain from an asset sale, while an active shareholder is not.

In the case of an equity sale, a sale of an ownership interest in a pass-through entity may result in NII subject to the surtax if the entity is engaged in a trade or business that is a passive activity with respect to the seller.  In general, however, if the seller  materially participated in the business, the gain recognized by him shall be subject to the surtax only to the extent of the gain which would have been treated as NII if the entity had sold all of its assets (including goodwill) for fair market value immediately before the sale of the interest.

Other NII 

An owner’s NII from the sale of a business will also include his share of  interest income arising from the sale, including interest on an installment note or interest imputed on other deferred payments of purchase price, as well any gain recognized under the installment method on the receipt of the deferred payment.

Additionally, if the seller retains ownership of the real property on which the business operated, and  leases that property to the buyer, the rental income will likely be subject to the surtax since the rental of real property is generally treated as a passive activity.  This is especially true for property that requires little activity.

As for payments to be made to the owner under any consulting agreement, these will be subject to the 2.9% Medicare tax on self-employment income, and not the tax on NII.  However, if this consulting income exceeds a certain threshold, the excess will be subject to an additional 0.9% Medicare tax.

Conclusion: Plan Ahead

The best time to plan for the sale of a business is well before the sale.   This advice applies to the tax on NII. The surtax rules are complex, but the tax may be addressed, at least partially, in a number of ways; the owner’s level of activity may be adjusted, the owner’s equity may be shifted to lower-income family members, the owner’s other investments may be used to offset NII. While some of the planning alternatives may carry an economic cost, it behooves the taxpayer to consider them since some combination thereof  may help reduce the surtax.

When a C corporation sells its assets, it recognizes gain equal to the excess of the amount realized on the sale (generally, the purchase price plus any liabilities assumed or taken subject to) over the adjusted basis of the assets being sold.  This gain is subject to a corporate-level Federal income tax at a maximum rate of 35%.  When the C corporation later distributes the remaining sale proceeds (after corporate tax) to its individual shareholders, in liquidation of the corporation, the shareholders also realize capital gain to the extent the amount distributed exceeds the adjusted basis for their shares of stock.  Assuming the gain is long-term gain, it is subject to a shareholder-level Federal tax at a maximum rate of 20%, plus a potential 3.8% net investment income surtax, depending on the shareholder’s income level (both effective January 1, 2013).

Reducing the Double Tax

Taxpayers have long sought legitimate transaction structures by which they could reduce this double tax hit.  In a recent decision, H&M Inc., T.C. Memo 2012-290, the taxpayer was successful in fending off an IRS challenge to one such structure.  The taxpayer shareholder caused his C corporation to sell its biggest asset, an insurance-brokerage business, including the related customer lists and goodwill.  (He kept the corporation alive to exploit certain patents.)  The purchase agreement was contingent on the parties’ execution of an employment agreement.  Under the terms of his employment agreement (which had a six-year term), the taxpayer received (i) a base wage, (ii) annual variable compensation based upon a percentage of net income, and (iii) deferred compensation.

Applying a substance over form analysis, the IRS asserted that the wages paid to the taxpayer under the employment agreement were actually payments to the C corporation for the sale of the insurance business, which should have been treated as capital gain and imputed interest income to the corporation.  This reallocation, the IRS maintained, would account for the corporation’s goodwill and, so, would more accurately reflect the fair market value of the insurance assets at the time of sale.  In support of this position, the IRS pointed to the fact that the taxpayer’s estate would still receive certain compensation payments if he died, the parties lacked documentation supporting their allocation, and the parties did not have adverse interests in the transaction because there were tax advantages for both of them in allocating more of the overall price to compensation.

The court disagreed with the IRS.  It noted that “there will be no saleable goodwill  . . . where the business of a corporation depends on the personal relationships of a key individual, . . . unless he transfers his goodwill to the corporation by entering into a covenant not to compete or other agreement so that his relationships become property of the corporation.”

The court went on to explain that the insurance business is “extremely personal” and the development of the corporation’s business before the sale was due to the taxpayer’s ability to form relationships with customers and with insurance companies.  The court found that when customers come to the agency, “they come to buy from [the taxpayer] – it was his name and his reputation that brought them there.”  The court also found that the taxpayer was required to perform extensive duties under the employment agreement.

The court concluded that the taxpayer and the buyer were genuinely interested in creating an employment relationship, and were not “just the massaging the paperwork” to achieve favorable tax consequences.

Planning for Personal Goodwill

So, what does this decision mean with respect to planning for future sales of assets by C corporations?  Undoubtedly, many of you have come across the concept of “personal goodwill,” probably in the context of a sale by a corporation.  As was mentioned above, taxpayers have sought to reduce the double taxation that follows an asset sale by a C corporation.  Some shareholders have argued that they own personal goodwill, as a business asset that is separate from the goodwill of the corporation.  They have then attempted to sell this “personal” asset to a buyer, hoping to realize capital gain in the process and also hoping to avoid corporate level tax on a sale of corporate goodwill (as the IRS suspected in the case above).  

Of course, the burden is on the taxpayer to substantiate the existence of this personal goodwill and its value.  The best chance of supporting its existence is in circumstances similar to those described above:  a business where personal relationships are paramount, and where the shareholder is not a party to an employment agreement or a non-compete with the corporation the business assets of which are being sold.  The fact that the shareholder has a unique set of skills, or that he developed a reputation and business relationships before forming the corporation is helpful.  A specific reference to personal goodwill in a separate purchase and sale agreement is vital.  The execution of a non-compete or consulting agreement between the shareholder and the buyer would further support the existence of the personal goodwill.  Finally, a reasonable allocation of value between the personal goodwill, on the one hand, and the employment agreement, on the other, would likely help the arrangement withstand scrutiny by taxing authorities.

In summary, the existence of personal goodwill may, in the right circumstances, support a significant compensation package for a shareholder in the context of an asset sale by his corporation.  It may also justify the sale of the goodwill itself as a separate, non-corporate asset.  In each case, a separate, corporate-level tax would not be imposed in respect of this portion of the payments made to the shareholder.  The circumstances in which either of these transaction structures may be employed, however, are fairly limited.  Before a taxpayer jumps into them hell-bent on avoiding corporate-level tax, he needs to be certain that the existence and value of the personal goodwill can be substantiated.  The taxpayer needs to plan well in advance.