Yesterday’s post examined various changes to the taxation of S corporations, partnerships, and their owners.

Today, we will focus on a number of partnership-specific issues that were addressed by the Act.

Profits Interests2017 Tax Act

A partnership may issue a profits (or “carried”) interest in the partnership to a service or management partner in exchange for their performance of services.[1] The right of the profits interest partner to receive a share of the partnership’s future profits and appreciation does not include any right to receive money or other property upon the liquidation of the partnership immediately after the issuance of the profits interest. The right may be subject to various vesting limitations.[2]

In general, the IRS has not treated the receipt of a partnership profits interest for services as a taxable event for the partnership or the partner. However, this favorable tax treatment did not apply if: (1) the profits interest related to a substantially certain and predictable stream of income from partnership assets (i.e., one that could be readily valued); or (2) within two years of receipt, the partner disposed of the profits interest. More recent guidance clarified that this treatment would apply with respect to a substantially unvested profits interest, provided the service partner took into income his share of partnership income (i.e., the service provider is treated as the owner of the interest from the date of its grant), and the partnership did not deduct any amount of the FMV of the interest as compensation, either on grant or on vesting of the profits interest.[3]

By contrast, a partnership capital interest received for services has been includable in the partner’s income if the interest was transferable or was not subject to a substantial risk of forfeiture.[4] A capital interest for this purpose is an interest that would entitle the receiving partner to a share of the proceeds if the partnership’s assets were sold at fair market value (“FMV”) immediately after the issuance of the interest and the proceeds were distributed in liquidation.

Under general partnership tax principles, notwithstanding that a partner’s holding period for his profits interest may not exceed one year, the character of any long-term capital gain recognized by the partnership on the sale or exchange of its assets has been treated as long-term capital gain in the hands of the profits partner to whom such gain was allocated and, thus, eligible for the lower applicable tax rate.

The Act

In order to make it more difficult for some profits interest partners to enjoy capital gain treatment for their share of partnership income, for taxable years beginning after December 31, 2017, the Act provides for a new three-year holding period for certain net long-term capital gain allocated to an applicable partnership interest.

Specifically, the partnership assets sold must have been held by the partnership for at least three years[5] in order for a profits interest partner’s share of such gain to enjoy the lower tax rate applicable to long-term capital gains.

If the assets sold had not been held by the partnership for at least three years, the entire amount of any capital gain allocated to the profits interest would be treated as short-term capital gain, and would be taxed up to a maximum rate of 37% as ordinary income.[6]

An “applicable partnership interest” is any interest in a partnership that is transferred to a partner in connection with the performance of “substantial” services in any applicable trade or business.[7]

In general, an “applicable trade or business” means any activity conducted on a regular, continuous, and substantial basis that consists in whole or in part of: (1) raising or returning capital, and (2) investing in, or disposing of, or developing specified assets.

“Developing” specified assets takes place, for example, if it is represented to investors or lenders that the value, price, or yield of a portfolio business may be enhanced or increased in connection with choices or actions of a service provider or of others acting in concert with the service provider.

“Specified assets” means securities, commodities, real estate held for rental or investment, as well as other enumerated assets.

If a profits interest is not an applicable partnership interest, then its tax treatment should continue to be governed by the guidance previously issued by the IRS.[8]

Adjusting Inside Basis

In general, a partnership does not adjust the basis of partnership property following the transfer of a partnership interest unless the partnership has made an election under Code Sec. 754 to make such basis adjustments, or the partnership has a substantial built-in loss[9] immediately after the transfer.

If an election is in effect, or if the partnership has a substantial built-in loss immediately after the transfer, inside basis adjustments are made only with respect to the transferee partner. These adjustments account for the difference between the transferee partner’s proportionate share of the adjusted basis of the partnership property and the transferee’s basis in its partnership interest. The adjustments are intended to adjust the basis of partnership property to approximate the result of a direct purchase of the property by the transferee partner, and to thereby eliminate any unwarranted advantage (in the case of a downward adjustment) or disadvantage (in the case of an upward adjustment) for the transferee.

For example, without a mandatory reduction in a transferee partner’s share of a partnership’s inside basis for an asset, the transferee may be allocated a tax loss from the partnership without suffering a corresponding economic loss. Under such circumstances, if a Sec. 754 election were not in effect, it is unlikely that the partnership would make the election so as to wipe out the advantage enjoyed by the transferee partner.

The Act

In order to further reduce the potential for abuse, the Act expands the definition of a “substantial built-in loss” such that, in addition to the present-law definition, for transfers of partnership interests made after December 31, 2017, a substantial built-in loss also exists if the transferee would be allocated a loss in excess of $250,000 upon a hypothetical disposition by the partnership of all of its assets in a fully taxable transaction for cash equal to the assets’ FMV, immediately after the transfer of the partnership interest.

Limiting a Partner’s Share of Loss

A partner’s distributive share of partnership loss is allowed only to the extent of the adjusted basis (before reduction by current year’s losses) of the partner’s interest in the partnership at the end of the partnership taxable year in which the loss occurred.

Any disallowed loss is allowable as a deduction at the end of succeeding partnership taxable years, to the extent that the partner’s adjusted basis for its partnership interest at the end of any such year exceeds zero (before reduction by the loss for the year).

In general, a partner’s basis in its partnership interest is decreased (but not below zero) by distributions by the partnership and the partner’s distributive share of partnership losses and expenditures. In the case of a charitable contribution, a partner’s basis is reduced by the partner’s distributive share of the adjusted basis of the contributed property.

In computing its taxable income, no deductions for foreign taxes and charitable contributions are allowed to the partnership – instead, a partner takes into account his distributive share of the foreign taxes paid, and the charitable contributions made, by the partnership for the taxable year.

However, in applying the basis limitation on partner losses, the IRS has not taken into account the partner’s share of partnership charitable contributions and foreign taxes.

By contrast, under the S corporation basis limitation rules (see above), the shareholder’s pro rata share of charitable contributions and foreign taxes are taken into account.

The Act

In order to remedy this inconsistency in treatment between S corporations and partnerships, the Act modifies the basis limitation on partner losses to provide that the limitation takes into account a partner’s distributive share of partnership charitable contributions (to the extent of the partnership’s basis for the contributed property)[10] and foreign taxes. Thus, effective for partnership taxable years beginning after December 31, 2017, the amount of the basis limitation on partner losses is decreased to reflect these items.

What’s Next?

This marks the end of our three-post review of the more significant changes in the taxation of pass-through entities resulting from the Act.

In general, these changes appear to be favorable for the closely held business and its owners, though they do not deliver the promised-for simplification.

Indeed, the new statutory provisions raise a number of questions for which taxpayers and their advisers must await guidance from the IRS and, perhaps, from the Joint Committee (in the form of a “Blue Book”).

However, in light of the administration’s bias against the issuance of new regulations, and given its reduction of the resources available to the IRS, query when such guidance will be forthcoming, and in what form.

Until then, it will behoove practitioners to act cautiously, to keep options open, and to focus on the Act’s legislative history (including the examples contained therein) in ascertaining the intent of certain provisions and in determining an appropriate course of action for clients.

As they used to say on Hill Street Blues, “Let’s be careful out there.”

[Next week, we’ll take a look at the Act’s changes to the estate and gift tax, and how it may impact the owners of a closely held business, as well as the changes to the taxation of C corporations.]


[1]It may be issued in lieu of a management fee that would be taxed as ordinary income.

[2]See Sec. 83 of the Code.

[3]Rev. Proc. 93-27, Rev. Proc. 2001-43.

[4]In general, property is subject to a substantial risk of forfeiture if the recipient’s right to the property is conditioned on the future performance of substantial services, or if the right is subject to a condition other than the performance of services, provided that the condition relates to a purpose of the transfer and there is a substantial possibility that the property will be forfeited if the condition does not occur.

[5]Notwithstanding Code Sec. 83 or any election made by the profits interest holder under Sec. 83(b); for example, even if the interest was vested when issued, or the service provider elected under Sec. 83(b) of the Code to include the FMV of the interest in his gross income upon receipt, thus beginning a holding period for the interest.

[6]Query whether this will have any impact on profits interests that are issued in the context of a PE firm or a real estate venture, where the time frame for a sale of the underlying asset will likely exceed three years.The Act also provides a special rule for transfers by a taxpayer to related persons

[7]A partnership interest will not fail to be treated as transferred in connection with the performance of services merely because the taxpayer also made a capital contribution to the partnership. An applicable partnership interest does not include an interest in a partnership held by a corporation.

[8]Rev. Proc. 93-27, Rev. Proc. 2001-43, Prop. Reg. REG-105346-03.

[9]Prior to the Act, a “substantial built-in loss” existed only if the partnership’s adjusted basis in its property exceeded by more than $250,000 the FMV of the partnership property.

[10]The basis limitation does not apply to the excess of the contributed property’s FMV over its adjusted basis.

A post earlier this year considered the basis-limitation that restricts the ability of S corporation shareholders to deduct their pro rata share of the corporation’s losses. It was observed that, over the years, shareholders have employed many different approaches and arguments to increase the basis for their shares of stock or for the corporation’s indebtedness, in order to support their ability to claim their share of S corporation losses.

Many of these arguments have been made in situations in which the shareholder did not make an economic outlay, either as a capital contribution or as a loan to the S corporation.

In a recent decision, however, the Tax Court considered a shareholder who did, in fact, make a significant economic outlay, but who also utilized a form of transaction – albeit for a bona fide business purpose – that the IRS found troublesome. In defending its right to claim a loss deduction, the shareholder proffered a number of interesting arguments.

The Transaction

Taxpayer owned Parent, which was taxed as an S corporation.

Parent acquired 100% of the issued and outstanding stock of Target from Seller through a reverse triangular merger: Parent formed a new subsidiary corporation (“Merger-Sub”), which was then merged with and into Target, with Target surviving. As a result of the merger, Target became a wholly-owned subsidiary of Parent, and the Seller received cash plus a Merger-Sub promissory note; Target became the obligor on the note after the merger.

Immediately after the merger, Target made an election to be treated as a qualified subchapter S subsidiary (“QSub”).

The cash portion of the merger consideration was funded in part by a loan (the “Loan”) from Lender, which was senior to the promissory note held by Seller.

After the merger, Taxpayer decided to acquire the Loan from Lender. However, Taxpayer believed that (i) if he loaned funds directly to QSub to acquire the Loan, or (ii) if he contributed funds to Parent, intending that they be loaned to QSub to repay the Loan in full, his loan would not be senior to the QSub note held by Seller without obtaining Seller’s consent.

In order to make QSub’s repayment of the Loan to Newco senior to QSub’s repayment of the note to Seller, Taxpayer organized another S corporation, Newco, to acquire the Loan from Lender. Taxpayer transferred funds to Newco, which Newco used to purchase the Loan, following which Newco became the holder of the Loan.

Thus, the indebtedness of QSub was held, not directly by Taxpayer, but indirectly through Newco.

During the Tax Year, Parent had ordinary business losses that were passed through to Taxpayer.

The Tax Return

In preparing his return for Tax Year, Taxpayer used his adjusted basis in the Parent stock, and also claimed adjusted basis in what he believed was QSub’s indebtedness to Taxpayer, to claim deductions for the losses passed through to Taxpayer from Parent for the Tax Year.

The IRS reduced the losses Taxpayer could take into account for the Tax Year, thereby increasing Taxpayer’s taxable income by that amount. Taxpayer petitioned the Tax Court.

Taxpayer argued that Newco should be disregarded for tax purposes, and that the Loan should be deemed an indebtedness of Parent (through its disregarded QSub) to Taxpayer. This would allow Taxpayer to count Newco’s adjusted basis in the Loan in calculating the amount of Parent’s flow-through losses that he could deduct for the Tax Year.

The IRS urged the Court to respect Newco’s separate corporate existence, and not to treat the Loan as indebtedness of Parent to Taxpayer.

S Corp. Losses

The Code generally provides that an S corporation’s shareholder takes into account, for his taxable year in which the corporation’s taxable year ends, his pro rata share of the corporation’s items of income, loss, deduction, or credit.

However, the aggregate amount of losses and deductions taken into account by the shareholder is limited: It may not exceed the sum of the adjusted basis of the shareholder’s stock in the S corporation plus the shareholder’s adjusted basis of any indebtedness of the S corporation to the shareholder (the “loss-limitation rule”).

The Code does not define the term “indebtedness of the S corporation to the shareholder” as used in the loss-limitation rule.

QSub

A QSub is a domestic corporation which is wholly-owned by an S corporation, and that elects to be treated as a QSub. In general, a QSub is not treated as a separate corporation, and all of its assets, liabilities, and items of income, deduction, and credit are treated those of the S corporation. Thus, for purposes of the loss-limitation rule, a QSub’s indebtedness to its parent S corporation’s shareholder is treated as the parent’s indebtedness for purposes of determining the amount of loss that may flow through to the parent’s shareholder.

Acquisition of Basis in Indebtedness of Parent

The IRS argued that a shareholder can acquire basis in an S corporation either by contributing capital, or by directly lending funds, to the corporation. The loan must be direct, the IRS maintained; no basis is created where funds are loaned by a separate entity that is related to the shareholder.

The IRS emphasized that the Loan ran to QSub from Newco, not from Taxpayer; thus, the Loan could not be considered in computing the basis of any indebtedness of Parent to Taxpayer.

Taxpayer conceded that the courts have interpreted the loss-limitation rule generally to require that the indebtedness of an S corporation be owed directly to its shareholder. However, the Taxpayer asserted, “form is but one-half of the inquiry, and the transaction’s substance also needs to be considered.”

The IRS asserted that Taxpayer ought to be bound by the form of the transaction chosen, and should not, “in hindsight, recast the transaction as one that they might have made in order to obtain tax advantages.”

Moreover, the IRS pointed out, where the entities involved in transactions are wholly-owned by a taxpayer, the taxpayer bears “a heavy burden of demonstrating that the substance of the transactions differs from their form.”

Taxpayer posited that an intermediary, such as Newco, could be disregarded for tax purposes where it (1) acted as a taxpayer’s incorporated pocketbook, (2) was a mere conduit or agent of the taxpayer, or (3) failed to make an actual economic outlay to the loss S corporation that made the intermediary poorer in a material sense as a result of the loan.

Incorporated Pocketbook

Taxpayer urged the Court to find that Newco acted as the Taxpayer’s incorporated pocketbook in purchasing the Loan from the Lender and holding it thereafter.

Taxpayer emphasized that Newco had no business activities other than holding the Loan and acting as a conduit for payments made by QSub.

The Court observed that the term “incorporated pocketbook” refers to a taxpayer’s habitual practice of having his wholly-owned corporation pay money to third parties on his behalf.

The Court, however, stated that the “incorporated pocketbook” rationale was limited to cases where taxpayers sought to regularly direct funds from one of their entities through themselves, and then on to an S corporation. Here, the Court found, Taxpayer did not use Newco to habitually to pay QSub’s, or his own personal, expenses. “Frequent and habitual payments,” the Court stated, are “key to a finding that a corporation served as an incorporated pocketbook.” Newco did not make frequent and habitual payments on behalf of Taxpayer.

Conduit or Agent

Taxpayer also argued that Newco served as Taxpayer’s agent in purchasing the Loan from Lender and, as such, could be ignored for tax purposes.

Taxpayer pointed out that the Court had previously suggested that, in a true conduit situation, a loan running through a corporate intermediary could instead be considered to run directly from the shareholder for purposes of the loss-limitation rule.

Taxpayer emphasized that Newco had no business activity besides the Loan acquisition, and no assets besides the Loan; all the funds necessary to purchase the Loan came from Taxpayer; thus, Newco served effectively as a conduit for payments from Parent and QSub.

The IRS reminded the Court that, in other cases, it had been reluctant to apply the agency exception to the rule that indebtedness must run directly from the S corporation to its shareholder.

Moreover, the IRS argued, Parent, QSub, Newco and Taxpayer were sophisticated parties who consulted with their advisers before purchasing the Loan from Lender. They consciously chose the form of the transaction to maintain the Loan’s seniority with respect to QSub’s obligations under the notes.

The IRS also asserted that the record was devoid of any indication of an agency relationship.

The Court agreed with the IRS that Newco did not act as Taxpayer’s agent. It set forth several factors that are considered when evaluating whether a corporation is another’s agent, including:

  • whether it operates in the name, and for the account, of the principal,
  • whether its receipt of income is attributable to the services of the principal or to assets belonging to the principal,
  • whether its relations with the principal depend upon the principal’s ownership of it,
  • whether there was an agreement setting forth that the corporation was acting as agent for its shareholder with respect to a particular asset,
  • whether it functioned as agent, and not principal, with respect to the asset for all purposes, and
  • whether it was held out as agent, and not principal, in all dealings with third parties relating to the asset.

The Court reviewed each of these indicia, and concluded that no agency relationship existed between Newco and Taxpayer.

 Actual Economic Outlay

Taxpayer argued that: (i) Newco made no economic outlay to purchase the Loan, (ii) it was he who provided the funds used by Newco to purchase the Loan, (iii) he owned and controlled Newco, (iv) Newco was a shell corporation with no business or other activity besides holding the Loan, and (v) Newco’s net worth both before and after the Loan’s acquisition was the amount of Taxpayer’s capital contribution.

The IRS noted that the amounts contributed by Taxpayer to Newco were first classified by Newco’s bookkeeper as shareholder loans and then as paid-in capital, which increased Taxpayer’s basis in the Newco stock; accordingly, Taxpayer’s capital contributions to Newco, which increased his stock basis in that corporation, could not be used to increase his debt basis in Parent.

The IRS also disputed Taxpayer’s characterization of Newco as a shell corporation, arguing that Taxpayer had a significant business purpose in structuring the transaction as he did: the maintenance of the Loan’s seniority to Seller’s promissory note.

The Court agreed that Taxpayer did make actual economic outlays, and that these outlays were to Newco, a corporation with its own separate existence. It was not simply a shell corporation, but a distinct entity with at least one substantial asset, the Loan, and a significant business purpose. Taxpayer’s capital contributions, combined with Newco’s other indicia of actual corporate existence, were compelling evidence of economic outlay.

The Court also noted that taxpayers generally are bound to the form of the transaction they have chosen. Taxpayer failed to establish that he should not be held to the form of the transaction he deliberately chose. Therefore, any economic outlays by Taxpayer were fairly considered to have been made to Newco, a distinct corporate entity, which in turn made its own economic outlay.

Step Transaction Doctrine (?)

Finally, Taxpayer argued that the Court should apply the step transaction doctrine (really “substance over form”) to hold that Taxpayer, and not Newco, became the holders of the Loan after its purchase from Lender.

The IRS disputed Taxpayer’s application of the step transaction doctrine, arguing that Taxpayer intentionally chose the form of the transaction and should not be able to argue against his own form to achieve a more favorable tax result. The IRS added that because Newco was not an agent of or a mere conduit for Taxpayer, the form and the substance of the Loan acquisition were the same, and the step transaction doctrine should not apply.

Again, the Court agreed with the IRS, stating that Taxpayer’s “step transaction” argument was just another permutation of his other theories, which were also rejected by the Court.

Taxpayers, the Court continued, are bound by the form of their transaction and may not argue that the substance triggers different tax consequences. It explained that they have “the benefit of forethought and strategic planning in structuring their transactions, whereas the Government can only retrospectively enforce its revenue laws.”

Accordingly, the Court found that Taxpayer did not become the holder of the Loan after its acquisition from Lender.

Conclusion

Thus, the Court held that Taxpayer did not carried his burden of establishing that his basis in Parent’s (i.e., QSub’s) indebtedness to Taxpayer was other than as determined by the IRS.

Was it Equitable?

I suspect that some of you may believe that the Court’s reasoning was too formulaic. I disagree.

Both taxpayers and the IRS need some certainty in the application of the Code, so as to assure taxpayers of the consequences of transactions, to avoid abuses of discretion, and to facilitate administration of the tax system, among other reasons.

Of course equitable principles play an important role in the application and interpretation of the Code, but as to the Taxpayer, well, he was fully aware of the applicable loss-limitation rule, chose to secure a business advantage instead (a senior loan position) by not complying with the rule, which in turn caused him to resort to some very creative justifications for his “entitlement” to the losses claimed.

So, was the Court’s decision equitable? Yep.