I had a call a couple of weeks ago from the owner of a business. His brother, who owned half of the business, owed some money to someone in connection with a venture that was unrelated to the business. The brother didn’t have the wherewithal to satisfy the debt and, to make matters worse, the person to whom the money was owed was a long-time customer of the business. The customer qua creditor had proposed and, under the circumstances, the brothers had agreed, that the business would satisfy the debt by significantly discounting its services to the customer over a period of time. The brothers wanted to know how they should paper this arrangement and that the resulting tax consequences would be.

We talked about bona fide loans, constructive distributions, disguised compensation, and indirect gifts. “What?” the one brother asked incredulously, “how can all that be implicated by this simple arrangement?” After I explained, he thanked me. “We’ll get back to you,” he said.

Last week, I came across this Tax Court decision.

A Bad Deal

Taxpayer and Spouse owned Corp 1, an S corporation. Taxpayer also owned Corp 2, a C corporation.

Things were going well for a while. Then Taxpayer bid and won a contract for a project overseas. Taxpayer formed LLC to engage in this project, and was its sole member. Unfortunately, the project required a bank guaranty. Taxpayer was unable to obtain such a guaranty, but he was able to obtain a line of credit, which required cash collateralization that he was only able to provide by causing each of his business entities to take out a series of small loans from other lenders.

The project did not go well, and was eventually shut down, leaving LLC with a lot of outstanding liabilities and not much money with which to pay them.

“Intercompany Transfers”

In order to avoid a default on the loans, Taxpayer tapped the assets of the other companies that he controlled. However, because Corp 1, Corp 2, and LLC were “related” to one another, he “didn’t see the merit” in creating any formal notes or other documentation when he began moving money among them.

Taxpayer caused Corp 2 to pay some of Corp 1’s and LLC’s debts. On its ledgers, Corp 2 listed these amounts as being owed to it, but on its tax returns, Corp 2 claimed them as costs of goods sold (COGS); because Corp 2 was profitable, there was enough income to make these claimed COGS valuable. That same year, Corp 2 issued Taxpayer a W-2 that was subsequently amended to reflect a much smaller amount.

In the following year, Corp 2 paid Taxpayer a large sum, which he used to pay a portion of LLC’s debts. Corp 2’s ledgers characterized these payments as “distributions”. Corp 2 also directly paid a significant portion of Corp 1’s and LLC’s expenses, which its ledger simply described as “[Affiliate] Payments.”

That same year, Corp 2 elected to be treated as an S corporation and filed its tax return accordingly, reporting substantial gross receipts and ordinary business income, which flowed through to Taxpayer. At the same time, Taxpayer and Spouse claimed a large flow-through loss from Corp 1 – a loss that was principally derived from Corp 1’s claimed deduction for “Loss on LLC Expenses Paid” and its claimed deduction for “Loss on LLC Bad Debt.” Taxpayer’s W-2 from Corp 2, however, reported a relatively small amount in wages.

The IRS Disagrees

The IRS issued notices of deficiency to: (i) Corp 2 for income taxes for the first year at issue (its last year as a C corporation), (ii) Taxpayer for income taxes for both years at issue, and (iii) Corp 2 for employment taxes for the second year at issue in respect of the amounts it “distributed” to Taxpayer and the amounts it used to pay Corp 1’s and LLC’s expenses. Taxpayer petitioned the Tax Court.

The Court considered whether:

  • Corp 2’s payment to creditors of Corp 1 and LLC were a loan between Corp 2 and those companies, or a capital contribution that was also a constructive dividend to Taxpayer;
  • Corp 1 was entitled to a bad-debt deduction for payments it made to LLC’s creditors prior to the years at issue, or for the payments Corp 2 made; and
  • Corp 2’s payments to Taxpayer and to creditors of Corp 1 and LLC should be taxed as wages to Taxpayer and, thus, also subject to employment taxes.

Loans or Constructive Dividends?

Corp 2 claimed a COGS adjustment for expenses of Corp 1 and LLC that it had paid. However, it changed its position before the Court, arguing that the payment was a loan.

The IRS countered that the payment was only “disguised” as a loan; it was not a bona fide debt. Rather, it was really a contribution of capital by Corp 2 to each of Corp 1 and LLC. According to the IRS, this made the payment a constructive dividend to Taxpayer, for which Corp 2 could not claim a deduction, thereby increasing its income.

A bona fide debt, the Court explained, “arises from a debtor-creditor relationship based upon a valid and enforceable obligation to pay a fixed or determinable sum of money.”

Whether a transfer creates a bona fide debt or, instead, makes an equity investment is a question of fact. To answer this question, the Court stated, one must ascertain whether there was “a genuine intention to create a debt, with a reasonable expectation of repayment, and did that intention comport with the economic reality of creating a debtor-creditor relationship?”

According to the Court, there are a number of factors to consider in the “debt vs equity” analysis, including the following:

  • names given to the certificates evidencing the indebtedness
  • presence or absence of a fixed maturity date
  • source of payments
  • right to enforce payments
  • participation in management as a result of the advances
  • status of the advances in relation to regular corporate creditors
  • intent of the parties
  • identity of interest between creditor and stockholder
  • “thinness” of capital structure in relation to debt
  • ability to obtain credit from outside sources
  • use to which the advances were put
  • failure of the debtor to repay
  • risk involved in making the advances.

Corp 2’s book entries showed a write-off for payments made to Corp 1 described as “Due from Related Parties” which made it seem as though Corp 2 intended the payments to be loans. But Corp 2 deducted the payments as “purchases,” thus belying the label used on its books. And when Corp 2 made the payments, it didn’t execute a note, set an interest rate, ask for security, or set a maturity date.

The lack of these basic indicia of debt and Corp 2’s inconsistent labeling weighed in favor of finding that Corp 2 intended the payments to be capital contributions, not loans.

The fact that Corp 1 and LLC were broke when Corp 2 made the payments also undermined Taxpayer’s position that the payments were loans. Taxpayer testified that LLC “had no funds” or “wasn’t capitalized,” and its only contract (for which it hadn’t been paid) had been canceled. Corp 1’s situation was similar; it had virtually no book of business, its liabilities exceeded its assets, and it was losing money.

So, Corp 2’s payments went to entities that were undercapitalized, had no earnings, and could not have obtained loans from outside lenders – all factors suggesting that the payments were capital contributions.

The Court observed that Taxpayer treated legally separate entities as one big wallet. “Taking money from one corporation and routing it to another will almost always trigger bad tax consequences unless done thoughtfully.” The Court stated that “Taxpayer did not approach LLC’s problems with any indication that he thought through these consequences or sought the advice of someone who could help him do so.”

The Court found that Corp 2’s payments were not loans to LLC and Corp 1, but were capital contributions; the entities didn’t intend to form a debtor-creditor relationship.

Constructive Dividend

The Court then considered whether Corp 2’s payments were constructive dividends to Taxpayer. A constructive dividend, the Court explained, occurs when “a corporation confers an economic benefit on a shareholder without the expectation of repayment.”

A transfer between related corporations, the Court continued, can be a constructive dividend to common shareholders even if those shareholders don’t personally receive the funds. That type of transfer is a constructive dividend if the common shareholder has direct or indirect control over the transferred property, and the transfer wasn’t made for a legitimate business purpose but, instead, primarily benefited the shareholder.

Taxpayer had complete control over the transferred funds – he was the sole shareholder of Corp 2, the sole member of LLC, and he owned 49% of Corp 1. Moreover, there was no discernible business reason for Corp 2 to make the transfers because there was no hope of repayment or contemplation of interest. The transfer was bad for Corp 2, but it was good for Taxpayer because it reduced his other entities’ liabilities.

Corp 2’s payment of LLC’s and Corp 1’s expenses, therefore, was a constructive dividend to Taxpayer.

Bad-Debt Deduction

On their tax return, Taxpayer and Spouse claimed a large flow-through loss derived from a bad-debt deduction that Corp 1 took for earlier payments it made on behalf of LLC, and a deduction that it took for “Loss on LLC Expenses Paid.” The IRS denied all of these deductions, increasing the Taxpayer’s flow-through income from Corp 1.

Before there can be a bad-debt deduction, there had to be a bona fide debt. Even when there was such a debt, the Court continued, a bad-debt deduction was available only for the year that the debt became worthless.

The Court recognized that “transactions between closely held corporations and their shareholders are often conducted in an informal manner.” However, given the significant amount of the purported debt, the Court noted that the absence of the standard indicia of debt – formal loan documentation, set maturity date, and interest payments – weighed against a finding of debt.

The only documents Taxpayer produced about the purported loans were its books.

The amount that Corp 2 paid and that Corp 1 deducted that same year as “Loss on LLC’s Expenses Paid” appeared as entries on those books. But, the Court stated, it is not enough to look at the label a corporation sticks on a transaction; one has to look for proof of its substance, which the Court found was lacking.

Based upon the “debt vs equity” factors described above, the absence of any formal signs that a debt existed, and the underlying economics of the situation, the Court found that Taxpayer was “once again just using one of his companies’ funds to pay another of the companies’ debts.” Therefore, Corp 1’s advances to LLC did not create bona fide debt for which a bad debt deduction could be claimed.

Compensation

Taxpayer argued that the payments he received from Corp 2, and that he immediately used to pay other corporate debts, was either a distribution or a loan. He also claimed that Corp 2’s payments to Corp 1’s and LLC creditors were loans.

The IRS contended that these payments were wages to Taxpayer, and argued that Corp 2 “just called them something else” to avoid employment taxes.

The Court pointed out that these payments lacked formal loan documentation, had no set interest rate or maturity date, were made to companies with no capital, and could be repaid only if the companies generated earnings. For those reasons, the payments couldn’t have been loans.

But were the payments wages, as the IRS insisted?

Wages are payments for services performed. Whether payments to an employee-shareholder are wages paid for services performed or something else – such as dividends – is a question of fact. Again, the Court emphasized that all the evidence had to be considered; one had to look to the substance of the situation, not the name the parties gave a payment.

According to the Court, a significant part of this analysis was determining what “reasonable compensation” for the employee’s services would be. Among the factors to consider in making this determination were the following:

  • employee’s qualifications
  • nature, extent and scope of the employee’s work
  • size and complexities of the business
  • comparison of salaries paid with the gross income and the net income
  • prevailing general economic conditions
  • comparison of salaries with distributions to stockholders
  • prevailing rates of compensation for comparable positions in comparable concerns
  • salary policy of the employer as to all employees
  • in the case of small corporations with a limited number of officers, the amount of compensation paid to the particular employee in previous years.

The IRS estimated the salary for the CEO of a company comparable to Corp 2, and pointed out that while Taxpayer’s W-2 fell short of this salary, the amount paid to Taxpayer came fairly close to the IRS’s estimate when combined with the contested payments. There was no reason, the Court stated, “for us to think that the IRS’s estimate was unreasonable given Taxpayer’s decades” of business experience and the fact that he singlehandedly ran three companies, one of which was very profitable.

Be Aware

The overlapping, but not necessarily identical, ownership of closely held business entities, especially those that are controlled by the members of a single family, can breed all sorts of tax issues for the entities and for their owners.

Intercompany transactions, whether in the ordinary course of business or otherwise, have to be examined to ensure that they are being undertaken for valid business reasons. That is not to say that there cannot be other motivating factors, but it is imperative that the parties treat with one another as closely as possible on an arm’s-length basis.

To paraphrase the Court, above, related companies and their owners may avoid the sometimes surprising and bad tax consequences of dealing with one another – including the IRS’s re-characterization of their transactions – if they act thoughtfully, think through the tax consequences, and seek the advice of someone who can help them.

Relief? Not So Fast

You may recall that the President directed the Treasury Department to identify “significant tax regulations” issued during 2016 that, among other things, add undue complexity to the tax laws. An interim report to the President in June identified the proposed rules on the valuation of family-controlled business entities as “unworkable,” and recommended that they be withdrawn.

Although many taxpayers are pleased to see the demise of the proposed valuation rules, which many had heralded as the end of valuation discounts for estate and gift tax purposes, there remain a number of traps against which taxpayers and their advisers must be vigilant – but of which many are unaware – lest they inadvertently stumble onto a taxable gift.

One such trap involves the maintenance of capital accounts where the family-controlled business entity is treated as a partnership for tax purposes.

Family Partnership

Family members often combine their “disposable” investment assets in a tax-efficient family-held investment vehicle, such as an LLC that is taxable as a partnership. By pooling their resources, they may be able to better diversify their investments and gain access to larger, more sophisticated, investments that may not have been available to any single family member.

Moreover, as younger family members mature and amass their own wealth, they may decide to participate in the family investment vehicle by making a capital contribution in exchange for a partnership interest.

Capital Account Rules

An earlier post reviewed the capital account and allocation rules applicable to partnerships; in particular, the requirement that the tax consequences to each partner arising from the partnership’s operations – specifically, from such partner’s allocable share of the partnership’s items of income, gain, loss, deduction, or credit – must accurately reflect the partners’ economic agreement.

According to these regulations, an allocation set forth in a partnership agreement shall be respected by the IRS if the allocation has substantial economic effect or, if taking into account all of the facts and circumstances, the allocation is in accordance with the partners’ interests in the partnership.

Economic Effect

In order for an allocation to have economic effect, it must be consistent with the underlying economic arrangement of the partners. This means that in the event there is an economic benefit or economic burden that corresponds to the allocation, the partner to whom an allocation is made must receive such economic benefit or bear such economic burden. Stated differently, tax must follow economics.

In general, an allocation will have economic effect if the partnership agreement provides for the determination and maintenance of the partners’ capital accounts in accordance with the rules set forth in the regulations and, upon the liquidation of the partnership (or of a partner’s interest in the partnership), liquidating distributions are made in accordance with the positive capital account balances of the partners, as determined after taking into account all capital account adjustments. In other words, a partner’s capital account will generally reflect the partner’s equity in the partnership.

Basically, the capital account rules require that a partner’s capital account be increased by (1) the amount of money contributed by him to the partnership, (2) the fair market value (“FMV”) of property contributed by him to the partnership (net of liabilities that the partnership is considered to assume or take subject to), and (3) allocations to him of partnership income and gain; and is decreased by (4) the amount of money distributed to him by the partnership, and (5) the FMV of property distributed to him by the partnership (net of liabilities that such partner is considered to assume or take subject to), and (6) allocations to him of partnership loss and deduction.

Revaluation of Property

It should be noted that the capital account rules generally do not require that the partners’ capital accounts be adjusted on an ongoing basis to reflect changes in the FMV of the partnership’s assets.

However, the rules do require that the capital accounts be adjusted to reflect a revaluation of partnership property on the partnership’s books upon the happening of certain enumerated events. In general, these adjustments are based upon the FMV of partnership property on the date of the adjustment.

These adjustments reflect the manner in which the unrealized gain inherent in such property (that has not been reflected in the capital accounts previously) would be allocated among the partners if there were a taxable disposition of such property for its FMV on the date of a “revaluation event.”

In general, a revaluation event is one that marks a change in the economic arrangement among the partners. Among these events is the contribution of money or other property (other than a de minimis amount) to the partnership by a new or existing partner as consideration for an interest in the partnership. The adjustments are made among the capital accounts of the existing partners in accordance with their existing economic agreement, just prior to the above-referenced change.

In this way, the capital accounts will reflect the amount to which each existing partner would have been entitled had the partnership been liquidated immediately prior to the admission of the new partner and the change in the partners’ economic agreement.

Grandson:      Hold it, hold it! What is this? Are you tryin’ to trick me?

   Where’s the [estate tax]? Is this a [partnership tax post?]

Grandfather:  Wait, just wait.

Grandson:     Well when does it get good?

– from “The Princess Bride” (mostly)

Book-Tax Difference

When partnership property is revalued under these rules, and the partners’ capital accounts are adjusted accordingly, the gain computed for book purposes with respect to such property will differ from the gain computed for tax purposes for such property; in other words, the book value of the property reflected in the now-adjusted capital accounts will differ from the tax basis of such property (which was not adjusted in connection with the revaluation).

Consequently, the partners’ shares of the corresponding tax items – such as the gain on the sale of the property – are not reflected by further adjustments to the capital accounts, which have already been adjusted as though a sale had occurred.

Rather, these tax items must be shared among the partners in a manner that takes account of the variations between the adjusted tax basis of the property and its book value. Otherwise, the allocation may not be respected by the IRS.

Illustration

Perhaps the best way to convey the import of the foregoing rules is with an example.

Facts

Assume dad Abe and son Ben form an equal partnership to which each contributes $10,000 cash (which is credited to their respective capital account; each has a capital account of $10,000). This $20,000 is invested in securities (the book value and the tax basis of the securities are both $20,000). Assume that the partnership breaks even on an operational basis (no profit, no loss; no change to capital accounts), and that the securities appreciate in value to $50,000.

At that point, grandson Cal joins the partnership, making a $25,000 cash contribution in exchange for a one-third interest (an amount equal to one-third of the FMV of the partnership ($75,000) immediately after his capital contribution). Assume that the cash is held in held in a bank account.

Revaluation; Account for Book-Tax Difference

Upon Cal’s admission to the partnership – a revaluation event – the capital accounts of Abe and Ben are adjusted upward (from $10,000 to $25,000, each: $50,000 FMV of securities minus book value of $20,000 = $30,000 gain, or $15,000 each) to reflect their shares of the unrealized appreciation in the securities that occurred before Cal was admitted to the partnership.

Immediately after Cal’s admission, the securities are sold for $50,000, resulting in taxable gain of $30,000 ($50,000 less tax basis of $20,000), and no book gain (because the capital accounts had already been adjusted to FMV to reflect the appreciation; $50,000 less $50,000 = zero). Because there is no gain for book purposes, the allocation of the taxable gain cannot have economic effect (tax is unable to follow book in that situation).

Unless the partnership agreement provides that the tax gain will be allocated so as to account for the variations between the adjusted tax basis of the securities and their book value – by allocating the $30,000 of tax gain to Abe and Ben ($15,000 each), to whom the economic benefit of the appreciation “accrued” prior to Cal’s admission (tax to follow economics, as reflected in the adjusted capital accounts) – the IRS may not accept the allocation.

No Revaluation, but Special Allocation

Alternatively, assume that the capital accounts of Abe and Ben are not adjusted upon Cal’s admission to reflect the $30,000 of appreciation in the partnership securities that occurred before Cal was admitted.

Rather, the partnership agreement is amended to provide that the first $30,000 of taxable gain upon the sale of the securities is allocated equally between Abe and Ben, and that all other gain (appreciation occurring after Cal’s admission) will be allocated equally among all three partners, including Cal.

These allocations of taxable gain have economic effect; tax will follow book. Moreover, the capital accounts of Abe and Ben will in effect be adjusted upon the sale (by $15,000 each, to $25,000 each) to reflect the appreciation inherent in the securities immediately prior to Cal’s admission.

No Revaluation, no Special Allocation – Gift?

If the capital accounts of Abe and Ben are not adjusted upon Cal’s admission, and the partnership agreement provides for all taxable gain (including the $30,000 attributable to the appreciation in the securities that occurred prior to Cal’s admission to the partnership) to be allocated equally among Abe, Ben and Cal ($10,000 each), the allocation will have economic effect (tax will follow book). In that case, Abe and Ben will each have a capital account of $20,000 (instead of $25,000 as above), while Cal will have a capital account of $35,000 (instead of $25,000 as above).

However, the partners will have to consider whether, and to what extent, a gift may have been made to Cal in that his capital account is allocated one-third of the appreciation ($10,000 of the $30,000) that occurred prior to his admission.

As always, query whether this same result would have followed if Cal had not been related to Abe and Ben. After all, why would someone allow value that accrued on their investment, to inure to the benefit of another?

Let’s Be Careful Out There (from “Hillstreet Blues”)

The foregoing may not be easy to digest, but anyone who purports to provide estate and gift tax advice to the members of a family-owned business or investment vehicle that is formed as a tax partnership must realize that there is nothing simple about the taxation of such an entity.

Whether we are talking about the disguised sale rules, the shifting of liabilities, hot assets, the mixing bowl rules or, as in this post, the capital account revaluation rules, there are many pitfalls. The provisions of a partnership agreement, including the revaluation rule, that are so often described as “boilerplate” are anything but, and the partnership’s advisers must be familiar with their purpose and application.

It is imperative that the partnership agreement be reviewed periodically, especially in connection with the admission or withdrawal of a partner. In this way, the tax and economic consequences of such an event may be anticipated and, if possible, any adverse results may be addressed or avoided.

Some lessons need to be repeated until learned. It’s a basic rule of life. Don’t tug on Superman’s cape; don’t spit into the wind; don’t pull the mask off that old Lone Ranger; and if you are going to make a loan, give it the indicia of a loan and treat it as a loan.

The last of these lessons appears to be an especially difficult one for many owners of closely held businesses, at least based upon the steady flow of Tax Court cases in which the principal issue for decision is whether an owner’s transfer of funds to his business is a loan or a capital contribution.

The resolution of this question can have significant tax and economic consequences, as was illustrated by a recent decision.

Throwing Good after Bad

Corp had an unusual capital structure. It had about 70 common shareholders, including key employees and some of Taxpayer’s family members, but common stock formed a very small portion of its capital structure. Indeed, although Taxpayer was Corp’s driving force, he owned no common stock. Corp’s primary funding came in the form of cash advances from Taxpayer.

Over several years, Taxpayer made 39 separate cash advances to Corp totaling millions of dollars. For each advance, Corp executed a convertible promissory note, bearing market-rate interest that Corp paid when due.

Taxpayer subsequently advanced a few more millions, of which only a small portion was covered by promissory notes, Corp recorded all these advances as loans on its books, and it continued to accrue interest, though no interest was paid on any of this purported indebtedness.

After a few years, the entirety of this purported indebtedness was converted to preferred stock (the “Conversion”), representing 78% of Corp’s capital structure.

Taxpayer then made additional cash advances to Corp which were Corp’s sole source of funding during this period. Taxpayer generally made these advances monthly or semi-monthly in amounts sufficient to cover Corp’s budgeted operating expenses for the ensuing period.

Corp executed no promissory notes for these advances and furnished no collateral. As before, it recorded these advances on its books as loans and accrued interest, but it never paid interest on any of this purported indebtedness. These advances, coupled with Taxpayer’s preferred stock, constituted roughly 92% of Corp’s capital structure.

Corp incurred substantial losses during most years of its existence. This fact, coupled with Corp’s inability to attract other investors or joint venture suitors, caused Taxpayer to question the collectability of his advances. He obtained an independent evaluation of Corp’s financial condition, and was informed that Corp’s condition was precarious: Its revenue was 98% below target, and it had massive NOLs. Without Taxpayer’s continued cash infusions, he was told, the company would have to fold.

Taxpayer discussed with his accountant the possibility of claiming a bad debt loss deduction for some or all of his advances. Taxpayer took the position that all of his advances were debt and that the advances should be written off individually under a “first-in, first-out” approach.

Taxpayer’s attorney prepared a promissory note to consolidate the still-outstanding advances that Taxpayer did not plan to write off. While these documents were being prepared, Taxpayer made additional monthly advances to Corp. Taxpayer and Corp executed a debt restructuring agreement, a consolidated promissory note, and a certificate of debt forgiveness, all of which were backdated to a date after the Conversion.

Corp continued to operate with Taxpayer continuing to advance millions which, again, were not evidenced by promissory notes.

Taxpayer filed his Federal income tax return on which he reported a business bad debt loss reflecting the write-down of his advances to Corp. According to Taxpayer, this loss corresponded to advances he had made after the Conversion. Taxpayer claimed this loss as a deduction against ordinary income.

Business Bad Debt

The IRS disallowed the business bad debt deduction, and issued a notice of deficiency. Taxpayer petitioned the Tax Court.

The Code allows as an ordinary loss deduction for any “bona fide” business debt that became worthless within the taxable year. A business debt is “a debt created or acquired in connection with a trade or business of the taxpayer” or “a debt the loss from the worthlessness of which is incurred in the taxpayer’s trade or business.” To be eligible to deduct a business bad debt, an individual taxpayer must show that he was engaged in a trade or business, and that the debt was proximately related to that trade or business.

A bona fide debt is one that arises from “a debtor-creditor relationship based upon a valid and enforceable obligation to pay a fixed or determinable sum of money.” Whether a purported loan is a bona fide debt for tax purposes is determined from the facts and circumstances of each case, including the purported creditor’s reasonable expectation that the amount will be repaid.

Advances made by an investor to a closely held or controlled corporation may properly be characterized, not as a bona fide loan, but as a capital contribution. In general, advances made to an insolvent debtor are not debts for tax purposes, but are characterized as capital contributions.

The principal issue for decision was whether Taxpayer’s advances to Corp constituted debt or equity.

Bona Fide Debt

Taxpayer asserted that all of his advances to Corp constituted bona fide debt, whereas the IRS contended that Taxpayer made capital investments in his capacity as an investor. In determining whether an advance of funds constitutes bona fide debt, the Court stated, “economic reality provides the touchstone.”

The Court began by noting that, if an outside lender would not have lent funds to the corporation on the same terms as did the insider, an inference arises that the advance was a not a bona fide loan, even if “all the formal indicia of an obligation were meticulously made to appear.”

In general, the focus of the debt-vs.-equity inquiry is whether the taxpayer intended to create a debt with a reasonable expectation of repayment and, if so, whether that intent comports with creating a debtor-creditor relationship. The key to this determination is generally the taxpayer’s actual intent.

The Court identified the following nonexclusive factors to examine in determining whether an advance of funds gives rise to bona fide debt as opposed to an equity investment:

Labels on the Documents

If a corporation issues a debt instrument, such as a promissory note, that labeling supports the debt characterization.

Corp issued promissory notes for some of the cash advances Taxpayer made before the Conversion, those notes were converted to preferred stock and were not before the Court. The amount that was before the Court was advanced after the Conversion, and Corp did not issue a single promissory note to cover any of those advances. Rather, Taxpayer advanced cash on open account.

It was only in connection with the write-down that Corp issued a promissory note to Taxpayer to consolidate the portion of his advances that he chose not to write off, backdated to an earlier time. The Court found that this document was a self-serving document created in connection with Taxpayer’s year-end tax planning.

Fixed Maturity Date

A fixed maturity date is indicative of an obligation to repay, which supports characterizing an advance of funds as debt. Conversely, the absence of a fixed maturity date indicates that repayment depends on the borrower’s success, which in turn supports characterization as equity.

Because Corp issued no promissory notes for any of the advances at issue, there was of necessity no fixed maturity date.

Source of Payments

Where repayments depend on future corporate success, an equity investment may be indicated. And where prospects for repayment are questionable because of persistent corporate losses, an equity investment may be indicated.

Corp had substantial losses, its expenses vastly exceeded its revenue for all relevant years, and no payments of principal or interest had been made on Taxpayer’s still-outstanding advances. Corp was kept afloat only because Taxpayer continued to provide regular cash infusions keyed to Corp’s expected cash needs for the ensuing period. Thus, the most likely source of repayment of Taxpayer’s advances would be further cash infusions from Taxpayer himself.

Taxpayer testified that he hoped to secure ultimate repayment upon sale of Corp to a third party or a third-party investment in Corp. But this, the Court countered, is the hope entertained by the most speculative types of equity investors. Taxpayer was a “classic capital investor hoping to make a profit, not a creditor expecting to be repaid regardless of the company’s success or failure.”

Right to Enforce Payment of Principal and Interest

A definite obligation to repay, backed by the lender’s rights to enforce payment, supports a debt characterization. A lack of security for repayment may support equity characterization.

Although Taxpayer’s advances were shown as loans on Corp’s books, there was no written evidence of indebtedness fixing Corp’s obligation to repay at any particular time. None of Taxpayer’s advances was secured by any collateral. And even if Taxpayer were thought to have a “right to enforce repayment,” that right was nugatory because his continued cash infusions were the only thing keeping Corp afloat. Had he enforced repayment, he would simply have had to make a larger capital infusion the following month.

Participation in Management

Increased management rights, in the form of greater voting rights or a larger share of the company’s equity, support equity characterization.

Although Taxpayer had de facto control, he literally owned no common stock. But through his cash advances and preferred stock he held about 92% of Corp’s capital. Taxpayer contended that none of his advances gave him increased voting rights or a larger equity share. This was literally true, but it meant little because he already had complete control of the company by virtue of his status as its sole funder.

Status Relative to Regular Creditors

If Taxpayer had subordinated his right to repayment to that of other creditors, that would have supported an equity characterization.

However, Taxpayer was the only supplier of cash to Corp, which borrowed no money from banks and had no “regular creditors.” Taxpayer had, in absolute terms, none of the rights that a “regular creditor” would have; there was no promissory note, no maturity date, no collateral, no protective covenant, no personal guaranty, and no payment of interest. No “regular creditor” would have lent funds to a loss-ridden company like Corp on such terms.

Parties’ Intent

The Court examined whether Taxpayer and Corp intended the advance to be debt or equity. The aim is to determine whether the taxpayer intended to create a “definite obligation, repayable in any event.”

Taxpayer’s actions suggested that he intended the advances to be equity. He did not execute promissory notes for any of the advances at issue. He received no interest on his advances and made no effort to collect interest or enforce repayment of principal. Although Corp recorded the advances as loans and accrued interest on them, Taxpayer’s control over the company gave him ultimate discretion to decide whether and how repayment would be made. In fact, he expected to be repaid, as a venture capitalist typically expects to be repaid, upon sale of Corp to a third party or a third-party investment in Corp.

Inadequate Capitalization

A company’s capitalization is relevant to determining the level of risk associated with repayment. Advances to a business may be characterized as equity if the business is so thinly capitalized as to make repayment unlikely.

Taxpayer urged that, after the Conversion, the bulk of Corp’s capital structure consisted of preferred stock. He accordingly insisted that Corp was adequately capitalized at the time he made later advances.

The Court disagreed with Taxpayer’s assessment of the situation, observing that he made dozens of cash advances totaling many millions of dollars, and did not receive promissory notes until he decided to write off a portion of the purported debt.

Moreover, the Court continued, while Corp’s capitalization may have been adequate, that fact was not compelling. Normally, a large “equity cushion” is important to creditors because it affords them protection if the company encounters financial stress: The creditors will not be at risk unless the common and preferred shareholders are first wiped out. But because Taxpayer himself supplied almost 100% of Corp’s “equity cushion,” he would not derive much comfort from the latter prospect.

Identity of Interest between Creditor and Sole Shareholder

Taxpayer was not Corp’s sole shareholder, but he controlled the company and during the relevant period owned between most of Corp’s capital structure. There was thus a considerable identity of interest between Taxpayer in his capacities as owner and alleged lender. Under these circumstances, there was not a “disproportionate ratio between * * * [the] stockholder’s ownership percentage and the corporation’s debt to that stockholder.”

Payment of Interest

If no interest is paid, that fact supports equity characterization. Corp made no interest payments on any of the advances that Taxpayer made after the Conversion.

Ability to Obtain Loans From Outside Lending Institutions

Evidence that the business could not have obtained similar funding from outside sources supports characterization of an insider’s advances as equity. Although lenders in related-party contexts may offer more flexible terms than could be obtained from a bank, the primary inquiry is whether the terms of the purported debt were a “patent distortion of what would normally have been available” to the debtor in an arm’s-length transaction.

The evidence was clear that no third party operating at arm’s length would have lent millions to Corp without insisting (at a minimum) on promissory notes, regular interest payments, collateral to secure the advances, and a personal guaranty from Taxpayer. Especially is that so where the purported debtor was losing millions a year and could not fund its operations without Taxpayer’s monthly cash infusions.

Corp’s financial condition was extremely precarious in every year since its inception. The IRS determined that Corp had an extremely high risk of bankruptcy and that, without Taxpayer’s continued advances, it would surely have ceased operations. Under these circumstances, no third-party lender would have lent to Corp on the terms Taxpayer did.

In addition, Taxpayer continued to advance funds to Corp even after he concluded that its financial condition was dire enough to justify writing off some of his advances. An unrelated lender would not have acted in this manner.

After evaluating these factors as a whole, the Court found that Taxpayer’s advances were equity investments and not debt. Thus, it disallowed the Taxpayer’s business bad debt deduction.

Lesson

The proper characterization of a transfer of funds is more than a metaphysical exercise enjoyed by tax professionals. It has real economic consequences. In the Taxpayer’s case, it meant the loss of a deduction against ordinary income. Whether out of ignorance, laziness, or negligence, many business owners continue to act somewhat cavalierly toward the characterization and tax treatment of fund transfers to their business.

This behavior begs the question: “Why?” Why, indeed, when the owner can dictate the result by following a simple lesson: a promissory note, consistent bookkeeping, accrual and regular payment of interest at the AFR. C’mon guys.

Silly Question?

“Which do you prefer: a taxable or a non-taxable transaction?”

Most taxpayers would probably respond that they prefer a non-taxable transaction. After all, who wants to pay tax if they don’t have to?

 

Closer analysis, however, may reveal that given a particular taxpayer’s situation, a taxable transaction may yield a better result. For example, the taxpayer may have loss carry-forwards that a taxable transaction would enable the taxpayer to utilize, or the taxpayer may want to recognize the loss inherent in the property.

 

In most cases, a taxpayer that desires a taxable transaction should not have much difficulty in effecting that result. However, there have been a number of instances in which such a taxpayer has inadvertently stumbled into a non-taxable exchange.

Tax-Free By Mistake

How, one might ask, can a taxpayer “inadvertently” qualify for non-taxable treatment? tax free label

 

Easy: by satisfying the requirements for such treatment. For example, The Code provides that “no gain shall be recognized if property is transferred to a corporation” solely in exchange for stock in such corporation,” and “immediately after the exchange,” the transferor is in control of the corporation.

 

This provision is not elective – it is mandatory. It applies regardless of the taxpayer’s intent, so long as its requirements are satisfied. One taxpayer realized too late that this was the case.

 

Sale or Contribution?

A recent decision examined whether the Taxpayer’s transfer of assets to Corp was a sale or a capital contribution.  Taxpayer operated a real estate business (selling foreclosed properties on behalf of lenders) as a sole proprietorship for many years. In 2008, Taxpayer created Corp and, shortly thereafter, Corp’s board of directors authorized Corp to purchase Taxpayer’s sole proprietorship.

 

Corp and Taxpayer entered into a purchase agreement pursuant to which Taxpayer agreed to sell to Corp “[a]ll the work in process, customer lists, contracts, licenses, franchise rights, trade names, goodwill, and other tangible and intangible assets of” the sole proprietorship.

 

When the purchase agreement was signed, Corp had no capital, no assets, and no shareholders. Weeks after the purchase agreement was signed, Corp’s board of directors resolved to issue shares to Taxpayer in exchange for $X.

 

No appraisal was performed, so there was no way to establish the reasonableness of the $X. The purchase price was determined exclusively by the Taxpayer. The Taxpayer allocated a portion of  the purchase price to a franchise license agreement to which Taxpayer was a party and the balance of the purchase price was allocated to contracts between Taxpayer and various lenders.

 

The purchase agreement stated that the purchase price was payable in monthly installments and that the unpaid principal amount was subject to 10% interest each year. Corp did not provide any security for the purchase price, and a promissory note was not executed. The purchase price was eventually paid in full, but Corp did not make all payments timely.

 

Tax Return and the IRS

On his returns for the years at issue, the Taxpayer reported long-term capital gain from the transaction using the installment method. The Taxpayer also reported interest income. Corp reported substantially the same amounts as deductible interest payments on its returns for the years at issue. Corp also amortized the purchase price.

 

The IRS issued notices of deficiency for the years at issue to both Taxpayer and Corp, arguing that the transfer of the sole proprietorship’s assets to Corp was a capital contribution subject to section 351, not a sale. The IRS also argued that the payments made to Taxpayer were, in fact, taxable dividends and that the assets transferred to Corp may not be amortized.

 

The issue to be decided, the Court said, was whether the transfer was a capital contribution or a sale creating a debtor-creditor relationship.

 

Court’s Analysis

The Court began its analysis by stating that the substance of a transaction, not its form, is controlling for tax purposes. Transfers between related parties, such as Taxpayer and Corp, are subject to close scrutiny but do not necessarily lack economic substance.

 

According to the Court, when an overall plan is accomplished through a series of steps, it is the overall plan that must be evaluated for tax purposes, not each step.

“Where a series of closely related steps are taken pursuant to a plan to achieve an intended result, the transaction must be viewed as an integrated whole for tax purposes.” The sole purpose of Corp’s organization was to incorporate Taxpayer’s sole proprietorship. The inseparable relationship between Corp’s organization and the transfer of the sole proprietorship’s assets weighed in favor of finding that the transfer was a capital contribution, particularly in the light of the lack of evidence of a business reason for dividing the transaction.

 

Factors to Consider

The Court then applied a multi-factor test to determine whether Taxpayer’s transfer to Corp was a sale or a capital contribution. No single factor was controlling, it said, and the facts and circumstances of each case must be taken into consideration. The primary purpose of the factors is to help the Court determine the parties’ intent “through their objective and subjective expressions.”

The following factors were considered:

The issuance of a note evidences debt, and the issuance of stock indicates an equity contribution;

  • The lack of a fixed maturity date indicates that payment is linked to the success of the business and is evidence of an equity interest;
  • Payments that depend on earnings or come from a restricted source indicate an equity interest;
  • The right to enforce payment of principal and interest (as through a secured interest) is evidence of a debt;
  • An increase in a shareholder’s interest in a corporation as the result of a transaction indicates an equity interest;
  • Subordinating the right to repayment to rights of the corporation’s other creditors generally indicates an equity interest;
  • Thin capitalization tends to indicate that a transaction is a capital contribution;
  • Advances made by shareholders in proportion to their stock ownership indicate a capital contribution; and
  • The corporation’s ability to borrow funds from a third party indicates a debt.

The Court found that some of these factors were neutral, that others weighed in favor of finding that the transaction created a debtor-creditor relationship, and that others favored finding that it created an equity interest. Considering all of the factors together, the Court concluded that they weighed in favor of finding that the transaction was in substance a capital contribution.

Contribution and Dividends

Section 351(a) provides: “No gain or loss shall be recognized if property is transferred to a corporation by one or more persons solely in exchange for stock in such corporation and immediately after the exchange such person or persons are in control * * * of the corporation.” Person(s) have control if they own stock possessing at least 80% of: (1) the total combined voting power of all of the corporation’s voting stock and (2) the total number of shares of all of the corporation’s other classes of stock. The application of section 351 is mandatory when all of the requirements are met.

In substance, in order to incorporate Taxpayer’s existing business, the Taxpayer transferred a nominal amount of cash and all of the sole proprietorship’s assets to Corp solely in exchange for Corp’s stock. Taxpayer was in control of Corp immediately after the transfer of cash because taxpayer became Corp’s sole shareholder. Thus, section 351 governed the tax consequences of the transaction.

The Court then turned to the payments made by Corp to the Taxpayer pursuant to the “exchange agreement.” Money distributed to a shareholder out of a corporation’s E&P is considered a dividend and shall be included in gross income. To the extent that a corporation has E&P, they are generally considered the source of corporate distributions.

Since the Court determined that the Taxpayer’s transfer of the sole proprietorship’s assets to Corp was a capital contribution, Corp’s payments to the Taxpayer in the years at issue must be treated as distributions, not installment payments. Because Corp’s E&P in each of these years exceeded the amount distributed to the Taxpayer, the distributions should have been treated as dividends for tax purposes.

Lessons

Generally speaking, it will usually be more advantageous for a transaction to be treated as a non-taxable event. However, if the taxpayer’s overall tax consequences will be more favorable if the transaction were taxable, then the taxpayer must plan carefully—especially where the transaction involves a transfer to a closely-held business entity.

If a sale is to be respected as such, the taxpayer must be mindful of the factors set forth above to avoid recharacterization of the sale as a capital contribution and dividends. (Of course, even a “successful” sale must be careful to avoid the related party sale rules.)  Alternatively, a taxpayer may consider failing the “control” requirement referred to above though this may be unattractive from a business perspective.

The bottom line, as always, is: plan in advance. It is often the case that the business goals sought may be accomplished and reconciled, at least in part, with the desired tax consequences.