A lot has been written about the tax benefits of investing in a Qualified Opportunity Fund. Some have suggested that the gain from the sale of a closely held business may be invested in such a fund in order to defer the recognition of this gain and to shelter some of the appreciation thereon.

In order to better understand and evaluate the potential tax benefits of such an investment, especially from the perspective a business owner who may be contemplating a sale, one must appreciate the underlying tax policy.[i]

Economic Risk

Almost every aspect of a business, from the mundane to the extraordinary, involves some allocation of economic risk. In the broadest sense, “deals” get done when the parties to a transaction agree to terms that allocate an acceptable level of risk between them.[ii]

In the case of a closely held business, the owners will face a significant amount of risk throughout the life of the business. On a visceral level, their risk may seem greatest at the inception of the venture; however, this is also the point at which the owners will have less economic capital at risk, in both an absolute and a relative sense, than perhaps at any other stage of the business.[iii]

Fast forward. Let’s assume the business has survived and has grown. The owners’ investment in the business has paid off, but only after many years of concentrating their economic risk[iv] in the business. The owners may now be ready to monetize their illiquid investment,[v] and reduce their economic risk.

Sale of the Business

They will seek out buyers.[vi] Some of these buyers will pay: (1) all cash for the business at closing; (2) mostly cash plus a promissory note; (3) mostly cash plus an earn-out;[vii] (4) a relatively small amount of cash plus a promissory note; (5) mostly cash, but will also insist that the owners roll over some of their equity in the business[viii] into the buyer; or (6) equity in the buyer and, maybe (depending upon the structure of the transaction) some cash.

Each of these purchase-and-sale transactions presents a different level of risk for the owners of the business being sold, with an all-cash deal providing the lowest degree of risk, and an all-equity deal the greatest. What’s more, the equity deal will place the owner into a non-controlling position within the buyer. Generally speaking, few owners are willing to give up control of their business (and the benefits flowing therefrom) and yet remain at significant economic risk.

Gain Recognition and Economic Risk

In general, the timing of a taxpayer’s recognition of the gain realized on their sale of a property is related to the level of economic risk borne by the taxpayer.

Specifically, in the case of an all-cash, low risk deal,[ix] all of the gain realized on the sale of the business will be recognized in the year of the sale; where part of the consideration consists of a promissory note – such that the seller bears some credit risk vis-à-vis the buyer – that portion of the gain realized on the sale that is attributed to the note will be recognized only as and when principal payments are made.

Continuing Investment and Deferral

Where the buyer issues equity in exchange for the business, the gain realized on the exchange by the seller and its owners may be deferred until such equity is sold, provided certain requirements are satisfied. If the deal is structured in a way that allows the owners to receive some cash along with the equity, then gain will be recognized to some extent.[x]

The Code generally provides for the deferral of gain recognition in recognition of the fact that the selling owners’ investment remains at risk where they exchange their business for equity in the buyer; they have not liquidated their interest in the business or exchanged it for cash; rather, they are continuing their investment, albeit in a somewhat different form.[xi]

Public Policy and Deferral

There are other situations, however, in which the above-stated theoretical underpinning for the deferral of gain is not applicable – because the owners have converted their interest in the business into cash – but for which the Code nevertheless provides that the seller’s gain does not have to be recognized in the year of the sale.

In these situations, the Code is seeking to promote another economic or societal goal that Congress has determined is worthy of its support.

Consider, for example, the deferral of gain realized on the sale of “qualified small business stock,” which seeks to encourage investment in certain types of “small” business;”[xii] another is the deferral of gain from the sale of stock to an ESOP, which seeks to encourage employee-retirement plan ownership of the employer-C corporation.[xiii]

Enter the Qualified Opportunity Zone

The latest addition to the family of provisions, that seeks to encourage certain investment behavior through the deferral of otherwise taxable gain, entered the Code as part of the Tax Cuts and Jobs Act[xiv] in late 2017; regulations were proposed thereunder in October of 2018.[xv]

New Section 1400Z-2 of the Code,[xvi] in conjunction with new section 1400Z-1,[xvii] seeks to encourage economic growth and investment in designated distressed communities (“qualified opportunity zones” or “QOZ”) by providing federal income tax benefits to taxpayers who invest in businesses located within these zones.

The Tax Benefits

Section 1400Z-2 provides three tax incentives to encourage investment in a QOZ:

  • the temporary deferral of inclusion in gross income of certain capital gains to the extent they are reinvested in a qualified opportunity fund (“QOF”);[xviii]
  • the partial exclusion of such capital gains from gross income to the extent they remain invested in the QOF for a certain length of time; and
  • the permanent exclusion of post-acquisition capital gains (appreciation) from the sale or exchange of an interest in a QOF held for at least 10 years.

In brief, a QOF is an investment entity that must be classified as a corporation or as a partnership for federal income tax purposes, that is organized for the purpose of investing in QOZ property, and that holds at least 90 percent of its assets in such property.[xix]

Eligible Gain

Gain is eligible for deferral under the QOZ rules only if it is capital gain – ordinary income does not qualify. For example, the depreciation recapture[xx] that is recognized as ordinary income on the sale of equipment would not qualify; nor would the sale of inventory or receivables; but the capital gain from the sale of real property, shares of stock, or the goodwill of a business, would qualify.[xxi]

That being said, the gain may be either short-term or long-term capital gain. Thus, the gain recognized on the sale of a capital asset will qualify whether or not it has been held for more than one year.[xxii]

The capital gain may result from the actual or deemed sale or exchange of property. Thus, the gain recognized by a shareholder, on the distribution by an S corporation to the shareholder of cash in an amount in excess of the shareholder’s adjusted basis for its stock, would qualify for deferral.[xxiii]

In addition, the gain must not arise from the sale or exchange of property with a related person.[xxiv] In other words, the gain must arise from a sale to, or an exchange with, an unrelated person.

The gain to be deferred must be gain that would be recognized (but for the elective deferral) not later than December 31, 2026.[xxv]

Eligible Taxpayer

Any taxpayer that would otherwise recognize capital gain as a result of a sale or exchange is eligible to elect deferral under the QOZ rules; this includes individuals, C corporations, partnerships, S corporations, estates and trusts.

Where a partnership would otherwise recognize capital gain, it may elect to defer its gain and, to the extent that the partnership does not elect deferral, a partner may elect to do so.[xxvi]

If the election is made to defer all or part of a partnership’s capital gain – to the extent that it makes an equity investment in a QOF – no part of the deferred gain is required to be included in the distributive shares of the partners.

To the extent that a partnership does not elect to defer capital gain, the capital gain is included in the distributive shares of the partners.

If all or any portion of a partner’s distributive share satisfies all of the rules for eligibility under the QOZ rules – including the requirement that the gain did not arise from a sale or exchange with a person that is related either to the partnership or to the partner – then the partner generally may elect its own deferral with respect to the partner’s distributive share. The partner’s deferral is potentially available to the extent that the partner makes an eligible investment in a QOF.[xxvii]

Temporary Deferral

A taxpayer may elect to temporarily defer, and perhaps even partially exclude, capital gains from their gross income to the extent that the taxpayer invests the amount of those gains in a QOF.

The maximum amount of the deferred gain is equal to the amount invested in a QOF by the taxpayer during the 180-day period[xxviii] beginning on the date of the actual sale that produced the gain to be deferred. Where the capital gain results from a deemed or constructive sale of property, as provided under the Code, the 180-day investment period begins on the date on which the gain would be recognized (without regard to the deferral).[xxix]

Capital gains in excess of the amount deferred (i.e., that are not reinvested in a QOF) must be recognized and included in gross income in accordance with the applicable tax rules.

In the case of any investment in a QOF, only a portion of which consists of the investment of gain with respect to which an election is made (the “deferred-gain investment”), such investment is treated as two separate investments, consisting of one investment that includes only amounts to which the election applies, and a separate investment consisting of other amounts.

The temporary deferral and permanent exclusion provisions of the QOZ rules do not apply to the separate investment. For example, if a taxpayer sells stock (held for investment) at a gain and invests the entire sales proceeds (capital gain and return of basis) in a QOF, an election may be made only with respect to the capital gain amount. No election may be made with respect to amounts attributable to a return of basis, and no special tax benefits apply to such amounts.

Eligible Investment

In order to qualify for gain deferral, the capital gain from the taxpayer’s sale must be invested in an equity interest in the QOF; in addition to “common” equity interests, this may include preferred stock (in the case of a corporate QOF), or a partnership interest with special allocations (in the case of a partnership QOF).

The eligible investment cannot be a debt instrument.

Provided that the taxpayer is the owner of the equity interest in the QOF for federal income tax purposes, its status as an eligible interest will not be impaired by the taxpayer’s use of the interest as collateral for a loan, whether a purchase-money borrowing or otherwise.

This is an important point because it is possible that a taxpayer’s gain from a sale or exchange of property will exceed the amount of cash received by the taxpayer in such sale or exchange. Thus, a taxpayer may have to borrow money in order to make the necessary reinvestment and thereby defer the gain.

Partial Exclusion

The taxpayer’s basis for a deferred-gain investment in a QOF immediately after its acquisition is deemed to be zero, notwithstanding that they may have invested a significant amount of cash.[xxx]

If the deferred-gain investment in the QOF is held by the taxpayer for at least five years from the date of the original investment in the QOF, the basis in the deferred-gain investment (the taxpayer’s equity interest in the QOF) is increased by 10 percent of the original deferred gain.

If the QOF investment is held by the taxpayer for at least seven years,[xxxi] the basis in the deferred gain investment is increased by an additional five percent of the original deferred gain.[xxxii]

Gain Recognition

Some or all of the gain deferred by virtue of the investment in a QOF will be recognized on the earlier of: (1) the date on which the QOF investment is disposed of, or (2) December 31, 2026.

In other words, the gain that was deferred on the original sale or exchange must be recognized no later than the taxpayer’s taxable year that includes December 31, 2026, notwithstanding that the taxpayer may not yet have disposed of its equity interest in the QOF.

This point is significant insofar as a taxpayer’s ability to utilize the basis adjustment rule is concerned. In order for the taxpayer to receive the “10 percent of gain” and the additional “5 percent of gain” basis increases, described above, the taxpayer must have held the investment in the QOF for five years and seven years, respectively.

Because the taxpayer’s deferred gain from the original sale will be recognized no later than 2026, the taxpayer will have to sell or exchange “capital gain property,” and roll over the capital gain therefrom into an equity interest in a QOF, no later than December 31, 2019 in order to take advantage of the full “15 percent of gain basis increase.”[xxxiii]

The amount of gain recognized in 2026 will be equal to (1) the lesser of the amount deferred and the current fair market value of the investment,[xxxiv] over (2) the taxpayer’s basis in their QOF investment, taking into account any increases in such basis at the end of five or seven years.

As to the nature of the capital gain – i.e., long-term or short-term – the deferred gain’s tax attribute will be preserved through the deferral period, and will be taken into account when the gain is recognized. Thus, if the deferred gain was short-term capital gain, the same treatment will apply when that gain is included in the taxpayer’s gross income in 2026.

At that time, the taxpayer’s basis in the QOF interest will be increased by the amount of gain recognized.

No election to defer gain recognition under the QOZ rules may be made after December 31, 2026.[xxxv]

Death of the Electing Taxpayer

If an electing individual taxpayer should pass away before the deferred gain has been recognized,[xxxvi] then the deferred gain shall be treated as income in respect of a decedent, and shall be included in income in accordance with the applicable rules.[xxxvii]

In other words, the beneficiaries of the decedent’s estate will not enjoy a basis step-up for the deferred-gain investment in the QOF at the decedent’s death that would eliminate the deferred gain.

Exclusion of Appreciation

The post-acquisition capital gain on a deferred-gain investment in a QOF that is held for at least 10 years will be excluded from gross income.

Specifically, in the case of the sale or exchange of equity in a QOF held for at least 10 years from the date of the original investment in the QOF, a further election is allowed by the taxpayer to modify the basis of such deferred-gain investment in the hands of the taxpayer to be the “fair market value” of the deferred-gain investment at the date of such sale or exchange.[xxxviii]

However, under Sec. 1400Z-1, the designations of all QOZ in existence will expire on December 31, 2028. The IRS acknowledges that the loss of QOZ designation raises numerous issues regarding gain deferral elections that are still in effect when the designation expires. Among these is whether, after the relevant QOZ loses its designation, investors may still make basis step-up elections under Sec. 1400Z-2 for QOF investments from 2019 and later.[xxxix]

Investor Beware[xl]

A taxpayer who invests their gains in a QOF may continue to realize and recognize losses associated with their investment in the QOF. After all, the QOF is a “business” like any other, notwithstanding its genesis in Congress.

Moreover, its purpose is to invest in certain distressed communities (QOZs); that’s why the income tax incentives are being offered – to encourage investment in businesses located within QOZs.

In the case of a fund organized as a pass-through entity, a taxpayer-investor may recognize gains and losses associated with both the deferred-gain and non-deferred gain investments in the fund, under the tax rules generally applicable to pass-through entities.

Thus, for example, an investor-partner in a fund organized as a partnership would recognize their distributive share of the fund’s income or deductions, gains or losses, and the resulting increase or decrease in their “outside basis” for their interest in the partnership.[xli]

Aside from the ordinary business risk, an investor should also be aware that if a QOF fails to satisfy the requirement that the QOF hold at least 90 percent of its assets in QOZ property, the fund will have to pay a monthly penalty;[xlii] if the fund is a partnership, the penalty will be taken into account proportionately as part of the distributive share of each partner.

Example

The following example illustrates the basic operation of the above rules.

Assume a taxpayer sells stock for a gain of $1,000 on January 1, 2019, and elects to invest $1,000 in the stock of a QOF (thereby deferring this gain). Assume also that the taxpayer holds the investment for 10 years, and then sells the investment for $1,500.

The taxpayer’s initial basis in the deferred-gain investment is deemed to be zero.

After five years, the basis is increased to $100 (i.e., 10 percent of the $1,000 of deferred gain).

After seven years, the basis is increased to $150 (i.e., $100 plus an additional 5 percent of the deferred gain).

At the end of 2026, assume that the fair market value of the deferred-gain investment is at least $1,000, and thus the taxpayer has to recognize $850 of the deferred capital gain ($1,000 less $150 of basis).

At that point, the basis in the deferred gain investment is $1,000 ($150 + $850, the latter being the amount of gain recognized in 2026).

If the taxpayer holds the deferred-gain investment for 10 years and makes the election to increase the basis, the $500 of post-acquisition capital gain on the sale after 10 years is excluded from gross income.

What Does It All Mean?

QOFs are just now being organized. The IRS’s guidance on QOFs and their tax benefits is still in proposed form. The clock on the deadline for recognizing any gain that is deferred pursuant to these rules will stop ticking at the end of 2026 – that’s when the deferred gain must be recognized; generally speaking, the shorter the deferral period, the less beneficial it is to the taxpayer. In order to enjoy the full benefit of the gain reduction provided by the 15 percent of basis adjustment rule, a taxpayer will have to generate eligible gain and invest the amount thereof in a QOF prior to December 31, 2019.[xliii] Finally, in order to exclude the post-investment appreciation in a QOF interest, a taxpayer must hold that interest for at least ten years – that’s a long time.

Let’s start with the premise that, unless a taxpayer has a good business reason for selling an investment, including, for example, their business, they should not do so just to take advantage of the QOZ rules.

Assuming the taxpayer has decided that it makes sense to sell, aside from the hoped-for tax benefits, they have to consider the “tax rule of thumb” described at the beginning of this post:[xliv] economic certainty and tax deferral share an inverse relationship – there is generally an economic risk associated with long-term deferral.

With that, it will behoove the taxpayer to consult with their accountant and financial adviser, not to mention their attorney, prior to jumping into a QOF. Although questions remain, the QOZ rules provide some attractive tax benefits. Provided the taxpayer takes a balanced approach, there may be a place for a QOF investment in their portfolio.[xlv]

Note: Lou Vlahos was recently quoted in a Long Island Business News article on opportunity zones. Please click here to read the article. 

————————————————————————————

[i] I am neither a proponent nor an opponent of such investments. I am not qualified, nor do I purport, to give financial advice – I leave that to the financial planners. My goal is to give you something to think about.

[ii] Think Goldilocks. “Just right.”

[iii] Compare the passive investor who is willing to fund the new venture, provided they receive a preferred return for placing their money at risk, or the lender who is willing to extend credit to the business, but only at a higher rate, and maybe with the ability to convert into equity.

[iv] Not to mention their time and labor. Opportunity costs.

[v] After all, there is no market on which they may readily “trade” their equity.

[vi] Hopefully with the assistance of professionals who know the market, who can educate them in the process, who will “run interference” for them with potential buyers, and who can crunch the numbers in a meaningful way to compare offers.

[vii] Which may require the owners’ continued involvement if they hope to attain the earn-out targets.

[viii] As in the typical private equity deal.

This may be done on a pre- or post-tax basis; in the former, the owners will contribute their equity interest or assets to the buyer in exchange for equity in the buyer – the recognition of the gain inherent in the contributed property is thereby deferred; in the latter, they will take a portion of the cash paid to them (which is taxable) and invest it in the buyer.

[ix] Of course, I am ignoring the level of risk associated with the reps, warranties, and covenants given by the owners and the target business under the purchase-and-sale agreement, the breach of which may require that the now-former owners of the business indemnify the buyer for any losses incurred attributable to such breach – basically, an adjustment of the purchase price and a re-allocation of risk.

[x] For example, a forward corporate merger will allow some cash “boot” to be paid along with stock of the acquiring corporation; gain will be recognized to the extent of the cash received. In the case of a contribution to a partnership in exchange for an interest therein plus some cash, the so-called disguised sale rules will apply to determine the tax consequences.

[xi] To paraphrase Reg. Sec. 1.1001-1(a), the gain realized from the conversion of property into cash, or from the exchange of property for other property differing materially in kind, is treated as income sustained. In the context of the corporate reorganization provisions, we refer to there being a “continuity of business enterprise” and a “continuity of interest.” IRC Sec. 368; Reg. Sec. 1.368-1(d) and (e).

This recalls the like kind exchange rules under IRC Sec. 1031, the benefits of which are now limited to exchanges of real property. See Sec. 1031, as amended by the Act. https://www.law.cornell.edu/uscode/text/26/1031.

[xii] IRC Sec. 1202. Under this provision, non-corporate taxpayers may be able to exclude all of the gain from the sale of “qualified small business stock” held for more than five years. In order to qualify as qualified small business stock, several requirements must be satisfied, including the following: C corporation, original issue, qualified trade or business, gross assets not in excess of $50 million, at least 80% of the value of the assets must be used in the active conduct of the qualified trade or business. Query whether the reduction in the corporate tax rate, to a flat 21%, will spur interest in this provision and investment in qualifying corporations and businesses.

[xiii] IRC Sec. 1042. This provision affords the individual shareholder of the employer corporation the opportunity to sell stock to the ESOP (the ESOP must own at least 30%) and to defer the recognition of the gain realized on such sale by reinvesting the proceeds therefrom (within a 15-month period that begins three months prior to the sale) in the securities of other domestic corporations. This allows the owner to take some risk off the table, and to diversify their equity by investing in publicly traded corporations. In the meanwhile, the owner may continue to operate their business.

[xiv] P.L. 115-97 (the “Act”). I know, you’re tired of seeing this cite. I’m tired of . . . citing it. It is what it is.

[xv] https://www.irs.gov/pub/irs-drop/reg-115420-18.pdf .

[xvi] IRC Sec. 1400Z-2. https://www.law.cornell.edu/uscode/text/26/1400Z-2 . “Z” is so ominous. Anyone read the novel “Z” by Vassilikos?

[xvii] Which sets forth the requirements for a Qualified Opportunity Zone. We will not be discussing these requirements in this post. https://www.law.cornell.edu/uscode/text/26/1400Z-1 . See also https://www.irs.gov/pub/irs-drop/rr-18-29.pdf

[xviii] We will not be discussing the requirements for QOF status in any detail.

[xix] QOZ property, in turn, is defined to include QOZ stock, QOZ partnership interest, and QOZ business property. Although these terms are defined is some detail by the Code, one might say that the common denominator is that there be a qualified business that is conducted primarily within the QOZ. A penalty may be imposed for failing to satisfy this requirement. See EN xxxvii and the related text.

[xx] IRC Sec. 1245.

[xxi] IRC Sec. 1221, 1231.

[xxii] IRC Sec. 1222. This “attribute” of the gain is preserved for purposes of characterizing the gain when it is finally recognized.

Section 1231 property must be held for more than one year, by definition.

[xxiii] IRC Sec. 1368. This is often the case when an S corporation liquidates (or is deemed to liquidate) after the sale (or the deemed sale, under IRC Sec. 338(h)(10)) of its assets.

[xxiv] See IRC Sec. 267(b) https://www.law.cornell.edu/uscode/text/26/267 and Sec. 707(b)(1) https://www.law.cornell.edu/uscode/text/26/707 ; substitute “20 percent” in place of “50 percent” each place it appears.

[xxv] A taxpayer with gain, the recognition of which would be deferred beyond this time under the Sec. 453 installment method, would probably not elect to defer such gain under the QOZ rules. After all, why accelerate the recognition event? However, query whether there are circumstances in which it would make sense to elect out of installment reporting so as to utilize Sec. 1400Z-2? IRC Sec. 453(d). Perhaps to take advantage of the exclusion of gain after satisfying the ten-year holding period?

[xxvi] These proposed regulations clarify the circumstances under which the partnership or the partner can elect, and also clarify when the applicable 180-day period begins.

[xxvii] The proposed regulations state that rules analogous to the rules provided for partnerships and partners apply to other pass-through entities (including S corporations, decedents’ estates, and trusts) and to their shareholders and beneficiaries.

[xxviii] This investment period should be familiar to those of you who are experienced with like kind exchanges.

[xxix] A partner’s 180-day reinvestment period generally begins on the last day of the partnership’s taxable year, because that is the day on which the partner would be required to recognize the gain if the gain is not deferred. Query, however, whether the partnership will distribute the proceeds from the sale to its partners to enable them to make the roll-over investment – individual partners may have to use other funds (or borrow) in order to achieve the desired deferral.

[xxx] That being said, if the QOF is a partnership that has borrowed funds, the investor may be allocated a portion of such indebtedness, which amount would be added to their basis for their partnership interest. See IRC Sec. 752.

[xxxi] I.e., two more years.

[xxxii] Yielding basis equal to 15 percent of the original deferred gain.

[xxxiii] 2019 plus 7 equals 2026.

[xxxiv] Ah, the risk of an investment in equity.

[xxxv] Thus, the gain from a sale in 2025 may be deferred for one year. The gain from a sale during or after 2026 is not deferred under these rules.

[xxxvi] For example, before 2026.

[xxxvii] IRC Sec. 691.

[xxxviii] Query if this is the correct formulation; for example, what if the QOF is a partnership that generates losses which flow through to its members, thereby reducing their basis – does the statute intend for the members to wipe out this basis reduction and never recapture the benefit thereof on a subsequent sale? See the Example, below.

[xxxix] The proposed regulations would permit taxpayers to make the basis step-up election after the QOZ designation expires.

[xl] See EN 1. The IRS says as much in the preamble to the proposed regulations.

[xli] See EN xxxiii and the related text.

[xlii] Unless the failure is due to reasonable cause.

[xliii] An investment by December 31, 2021 may enjoy the 10 percent basis adjustment, which follows a five-year holding period.

[xliv] I know, you can’t remember that far back. I apologize. Lots to say this week.

[xlv] The saying “meden agan” was inscribed on the temple of Apollo at Delphi. It means “nothing in excess.”

 

We Want You

One of the most challenging problems facing a business is how to attract, and then retain, qualified employees.[i] The competition among businesses can be fierce and, in order to succeed, businesses have, over the years, developed a number of compensation alternatives. Some of these have become “standard” options,[ii] thereby forcing businesses to devise more tailored arrangements for certain prospective employees. In almost all cases, however, both parties have recognized the impact of taxes – in terms of the amount of compensation and the timing of its recognition – on the net economic benefit of a particular compensation package.

Transition Loan/Compensation

In the financial services industry, it has long been the practice for a firm to loan a new key employee a significant sum of money (so-called “transition compensation”) in order to entice them to join the firm. In exchange, the employee executes a promissory note to evidence the amount they owe to the firm, along with an employment agreement pursuant to which the firm “pays” the employee a monthly amount, which is then immediately applied toward the amount owing to the firm for that month under the note. This arrangement allows the employee to receive the full amount of their transition compensation upfront, while recognizing income only as each monthly payment comes due. No moneys change hands with respect to each monthly “repayment” of the loan.

If the loan is consistently treated as such by the parties, it will likely withstand IRS scrutiny and be respected as a loan.[iii] Consequently, the monthly payments will be included in the employee’s gross income and will be deductible by the firm, provided the total compensation paid by the firm to the employee is reasonable for the services to be rendered.[iv]

Of course, circumstances may arise that cause the key employee and the firm to go their separate ways. In that case, depending upon the particular facts, the amount of the “transition compensation loan” that remains outstanding may become due immediately.[v]

The U.S. Tax Court recently considered a complicated version of this situation. https://www.ustaxcourt.gov/USTCInOP/OpinionViewer.aspx?ID=11848.

Welcome

Taxpayer was a very successful financial adviser and certified financial planner. He was employed by Firm A, where he developed a large book of business. To service those clients, he worked with a five-person team of brokers and assistants who, though they were employed by Firm A, worked exclusively for Taxpayer.

Taxpayer and his team subsequently joined Firm B. Upon his agreeing to work for Firm B, the firm lent him approximately $3.6 million. To evidence the loan, Taxpayer signed a promissory note. He also signed an employment agreement, which, among other things, provided for a “monthly transition compensation payment” in an amount equal to the amount due and payable each month by Taxpayer pursuant to the terms of the note. In order to facilitate the repayment of the loan, this amount – which was taxable to Taxpayer as compensation – was deducted from Taxpayer’s compensation from Firm B.[vi]

The employment agreement provided that Taxpayer would cease to be entitled to transition compensation upon the termination of his employment with Firm B for any reason. However, if his termination was other than for “cause,”[vii] Firm B would pay Taxpayer a lump sum equal to the remaining transition compensation payments through a specified date, less any outstanding debts Taxpayer owed Firm B. In the event Taxpayer resigned or his employment was terminated by Firm B for cause, Taxpayer would not receive these payments.

The loan became immediately repayable if Taxpayer’s employment with Firm B was terminated for any reason.

Taxpayer was offered this high level of compensation in anticipation of his clients’ moving with him and his team to Firm B. His efforts to contact his clients and persuade them to leave Firm A and join him at Firm B were governed by an protocol entered into by participating financial services firms, to which Firms A and B were parties, and which set forth the specific types of information which a financial adviser, such as Taxpayer, could take with them when they left one financial services firm to join another.

Seeking to bring his clients to Firm B, Taxpayer consulted with Firm B’s attorneys to interpret the protocol, and then relied on their interpretation of the protocol when he brought his client information with him to Firm B and used it to contact the clients, inform them of the move, and invite them to change financial services firms.[viii]

Taxpayer brought his entire team to Firm B. As part of the transition, Taxpayer also brought various spreadsheets and documents with client information used by his group at Firm A, which he had developed over his years of work. These documents and spreadsheets were treated as Taxpayer’s personal property at Firm A.

Sorry It Didn’t Work Out

Less than a year after Taxpayer joined Firm B, their relationship soured. Firm B launched an investigation with respect to how Taxpayer brought his clients from Firm A to Firm B and whether he violated the protocol and/or his employment agreement.

At that point, Taxpayer voluntarily resigned and began seeking employment at another financial services firm. He was stymied, however, because Firm B did not immediately submit the requisite form to FINRA[ix] with details regarding the termination of his employment, without which no reputable would hire him. Consequently, for a time after he left Firm B, Taxpayer could not service his clients.

In the meantime, Firm B actively solicited Taxpayer’s clients. It had Taxpayer’s former team members[x] contact each client in an attempt to persuade them to abandon Taxpayer and remain with Firm B. It also retained Taxpayer’s documents and spreadsheets, which the team members continued to use to service clients.

About a month after Taxpayer’s resignation, Firm B made the requisite filing, but under the form included an explanation that Taxpayer was permitted to resign on account of “conduct resulting in loss of management’s confidence, including conduct relating to the handling of customer information and lack of cooperation in the firm’s review of the matter.”

Firm B then brought a proceeding against Taxpayer before a FINRA panel in which it sought repayment of the outstanding balance of Taxpayer’s loan, asserting that the terms of the promissory note called for such repayment upon termination of Taxpayer’s employment.[xi]

In response, Taxpayer requested that the panel award him (i.e., forgive) the “unpaid” transition compensation (approximately $3.2 million) “loaned” to him when he joined Firm B. He also requested that Firm B release to his documents and spreadsheets.

The Panel’s Decision

Taxpayer stated that the panel should reject Firm B’s demand that he repay the outstanding balance of the upfront forgivable loan because if Firm B were allowed to collect the amount allegedly remaining due under such loan,[xii] after having induced Taxpayer to transfer his entire book of business to Firm B and then effectively forcing his resignation less than one year later, the firm would have been permitted to freeze Taxpayer out of the financial services industry, thus receiving the entire benefit of his substantial book of business, including the revenues generated from such book of business, all without having to provide any compensation to Taxpayer for that book of business.[xiii]

According to Taxpayer, these same facts supported his contention that Firm B had essentially converted his book of business and misappropriated his trade secrets (in the form of the client-documents and spreadsheets) via a plan whereby it: (1) lured Taxpayer to join the firm with a large compensation package (i.e., the amount of the monthly transition compensation and the upfront forgivable loan that was based on the value of his book of business); (2) forced his resignation just before his first year bonus was due to be paid; (3) demanded he repay the upfront forgivable loan; and (4) filed “a false and defamatory Form U5”, which “virtually assured that [Taxpayer] * * * [would] not be able to find comparable employment in the financial services industry, thereby allowing [Firm B] to continue to service [Taxpayer’s] clients almost entirely free from competition.”

Taxpayer stressed the fact that, unlike the scenario wherein a hypothetical financial planner leaves one firm to work at another with an outstanding balance remaining on a forgivable loan, when Taxpayer resigned from Firm B, he did not join a competitor. Instead, having effectively sidelined Taxpayer, Firm B was able to solicit his entire book of business free from competition, while in the several months since his resignation, Taxpayer had only managed to acquire a handful of clients.

The panel declined to order Taxpayer to pay the remaining balance of the upfront forgivable loan owing to Firm B under the promissory note, and ruled that Taxpayer was entitled to retain such balance.

The panel also ordered Firm B to deliver to Taxpayer the templates for his documents and spreadsheets, but expressly stated that the templates were to be delivered to him without any data. Upon delivery, Firm B was ordered to certify that it had removed these materials from its own computer systems. However, the order did not prevent Firm B from retaining the substantive client information.

Taxpayer’s Federal Income Tax Return

Firm B issued Taxpayer an IRS Form 1099-C, Cancellation of Debt, reporting debt cancellation income of approximately $3.2 million.[xiv]

Taxpayer timely filed his Federal income tax return, wherein he reported an overall loss and claimed a refund. He reported the 1099-C cancellation of indebtedness income as “deferred compensation.”[xv] He offset this amount with certain ordinary loss items, including a “Firm A Deferred Compensation Loss” of $2.5 million.

The IRS examined Taxpayer’s tax return and determined that the Firm A deferred compensation loss was actually a capital loss from the sale of stock, and could not be used to offset ordinary income.

Taxpayer conceded this adjustment, and then amended his income tax return to recharacterize the extinguishment of the balance of the Firm B upfront forgivable loan from ordinary income to capital gain,[xvi] and again claimed a refund.

The IRS denied the refund claim, and Taxpayer petitioned the Court.

The issue before the Tax Court involved the character of the balance of the upfront forgivable loan which was extinguished as a result of the panel’s award determination. Specifically, the Court had to determine whether that award constituted capital gain resulting from Firm B’s taking of Taxpayer’s book of business, as Taxpayer maintained, or ordinary income resulting from the cancellation of indebtedness, as asserted by the IRS. To resolve the characterization of the award, the Court focused on Taxpayer’s arguments raised before the panel.

The Tax Court

It is axiomatic that a taxpayer’s gross income includes all income realized by the taxpayer, from whatever source it is derived, unless it is specifically excluded by statute. Thus, proceeds “received” pursuant to a judgment arising from a dispute – including the amount of the reduction or cancellation of a debtor’s obligation[xvii] – constitutes taxable income unless the taxpayer can establish that the proceeds come within the scope of a statutory exclusion.

Starting from this premise, the Court recognized that “[t]he taxability of the proceeds of a lawsuit, or of a sum received in settlement thereof, depends upon the nature of the claim and the actual basis of recovery.” The nature of the litigation, the Court continued, “is determined by reference to the origin and character of the claim which gave rise to the litigation.” Thus, to the extent that amounts received for injury or damage to capital assets exceed the basis of the property, such amounts are taxable as capital gain, whereas amounts received for lost profits are taxable as ordinary income.

In deciding the character of the upfront forgivable loan that was extinguished as a result of the panel’s award, the Court asked: “In lieu of what were the damages awarded?”

The IRS argued that Taxpayer was bound by his employment agreement and promissory note. The promissory note was made as part of Taxpayer’s compensation package with Firm B (i.e., the monthly transition compensation). The note made no mention of Taxpayer’s book of business.

Moreover, Taxpayer treated the monthly transition compensation he received during his tenure at Firm B as ordinary income, which is consistent with the terms of the employment agreement and promissory note.

The IRS also pointed out that Taxpayer did not assert that the income was capital gain income until the IRS determined that his Firm A stock loss was a capital (rather than ordinary) loss.

The Court observed that the panel did not explain the basis of its award; hence, the Court was left to infer the panel’s reasoning. It explained that, in similar cases, it has looked to the claims made in the pleadings to determine the nature of the taxpayers’ claims.

Taxpayer argued that his filings with the FINRA panel made it clear that the award was to compensate him for the taking of his book of business and hence should be taxed as a capital gain.

The gravamen of Taxpayer’s claim before the panel was that he was entitled to retain the unpaid portion of the loan proceeds because they represented fair compensation for Firm B’s having taken his book of business. In fact, that was the only argument he made with respect to his claim for retention of those proceeds.

The Court disagreed.

It conceded that the filings heavily emphasized Taxpayer’s argument that Firm B lured him in order to acquire his book of business and that thereafter it set out to ruin his professional reputation so as to keep him from working at a competing financial services firm.

But this argument was not the only one Taxpayer presented to the panel. For example, Taxpayer’s filings emphasized that Firm B breached the terms of the employment contract, causing Taxpayer to suffer damages. This argument, by itself, would have relieved Taxpayer of his obligation to pay the outstanding balance of the promissory note to Firm B.

Unfortunately for Taxpayer, the record before the Court did not reveal the specific argument that the panel found most persuasive when it extinguished the balance of the upfront forgivable loan.

Taxpayer had the burden of answering the question “in lieu of what were the damages awarded?” On the basis of its examination of the record, the Court concluded that Taxpayer did not meet his burden to establish that the amount at issue was solely for the acquisition of Taxpayer’s book of business.

Consequently, the Court sustained the IRS’s determination that the extinguishment of Taxpayer’s debt to Firm B constituted cancellation of debt income, and that the amount of the extinguishment was taxable as ordinary income.

Takeaways?

It’s an old question: how to distinguish between being given the opportunity to provide services for which one receives compensation taxable as ordinary income, on the one hand, and the transfer of an asset that produces ordinary income, on the other.

The Court did not expressly address the issue, nor did it have to. There were just too many indicia of ordinary income: the industry practice of the forgivable loan as a substitute for immediately taxable compensation, the fact that Taxpayer (as the purported “seller”) rather than Firm B (as the purported buyer) gave a promissory note, Taxpayer’s reporting of the transition payments as ordinary income, Taxpayer’s having negotiated the right in his employment agreement to solicit the customers he brought to Firm B in the event he left the firm, and the fact that he first reported the forgiven loan as ordinary before amending his tax return in response to the IRS’s adjustment of the Firm A stock loss.

That being said, there were also some factors that may have supported capital gain (i.e. sale) treatment under different circumstances. For example, Firm A treated Taxpayer’s spreadsheets and other documents as his personal property, his team remained with Firm B after Taxpayer’s departure, and Taxpayer was effectively precluded from taking his clients with him when he resigned from Firm B. If Taxpayer had not been an employee of Firm A prior to moving his team and clients to Firm B, an argument might have been made that the relationship among Taxpayer, his team, and his clients was indicative of a going concern and of personal goodwill, which together represented an asset, the sale of which generated capital gain.[xviii]

Of course, if the parties had intended something other than a compensatory arrangement, they could have memorialized their agreement differently, and they could have reported their payments and receipts under this arrangement, for tax purposes, other than as they did; in other words, their chosen form would presumably have been consistent with the intended tax treatment.

——————————————————————————–

[i] Last week we considered this issue from the perspective of a tax-exempt organization, in light of the Tax Cuts and Jobs Act. https://www.taxlawforchb.com/2019/01/its-a-business-no-its-a-charity-wait-its-a-charity-that-is-treated-like-a-business/ .

[ii] At least within an industry.

[iii] I.e., a receipt of value that is nontaxable because it has to be repaid; there has been no accretion in value by the recipient.

[iv] IRC Sec. 162(a).

[v] Indeed, these upfront forgivable loan arrangements are often contingent upon the continued employment of the employee with the employer-lender.

[vi] Query why the IRS did not argue that this circular flow of funds caused the entire amount of the “loan” to be treated as compensation in the taxable year the proceeds were transferred to Taxpayer?

[vii] “Cause” was defined to include, among other things:

  1. violation of any rules or regulations of any regulatory or self-regulatory organization;
  2. violation, as reasonably determined by Firm B, of its rules, regulations, policies, practices, directions, and/or procedures; or
  3. a suspension, bar, or limitation on Taxpayer’s activities for Firm B by any regulatory or self-regulatory

organization.

[viii] Taxpayer’s relationship with his clients was important to him. He negotiated special terms in his employment agreement which allowed him to solicit his longtime clients (i.e., those clients who came with him from Firm A) if he should ever leave Firm B. Specifically, for a period of one year following the termination of Taxpayer’s employment with Firm B for any reason, he agreed not to solicit, or initiate contact or communication with, either directly or indirectly, any account, customer, client, customer lead, prospect, or referral whom Taxpayer served or whose name became known to him during his employment at Firm B. However, this restriction did not apply to clients whom Taxpayer served at his prior employer (Firm A) or who became clients of Firm B within one year after he began employment with Firm B.

[ix] Form U5. FINRA is a private corporation that acts as a self-regulatory organization. It is the successor to the NASD, and ultimately reports to the SEC.

[x] Whom Firm B had convinced to stay with the firm through various incentives.

[xi] Interestingly, none of Taxpayer’s team, including his partner and the four sales assistants who transitioned with him, seem to have faced any repercussions for the actions in which they all engaged and which allegedly constituted violations of the protocol. The rest of the team remained at Firm B servicing Taxpayer’s entire book of business. “Who’s your daddy?”

[xii] Which amount was directly tied to the amount of revenue his book of business generated the year before he joined Firm B.

[xiii] Taxpayer relied on these facts to support his claims against Firm B of unjust enrichment, fraudulent inducement, breach of contract, and breach of the implied covenant of good faith.

[xiv] The remaining balance of the upfront forgivable loan.

[xv] Ordinary income.

[xvi] So as to offset the capital loss resulting from the IRS’s adjustment.

[xvii] IRC Sec. 108, 61(a)(12).

[xviii] Much as a non-compete is an important element in ensuring the transfer of a seller’s goodwill to a buyer, so the acts allegedly taken by Firm B effectively secured for its benefit the asset represented by Taxpayer’s client base.

 

Ode to a Dividend

It sounds relatively simple:

A distribution of property made by a regular “C” corporation to an individual shareholder with respect to the corporation’s stock[i] (a) will be treated as a dividend[ii] to the extent it does not exceed the corporation’s earnings and profits; (b) any remaining portion of the distribution will be applied against, and will reduce, the shareholder’s adjusted basis for the stock, to the extent thereof – i.e., a tax-free return of the shareholder’s investment in the stock; and (c) any remaining portion of the distribution will be treated as capital gain from the sale or exchange of the stock.[iii]

Unfortunately for many taxpayers, establishing the proper tax treatment for a “dividend” distribution may be anything but simple,[iv] which may lead to adverse economic consequences. In most cases, the difficulty stems from the shareholder’s inability to establish the following elements:

  • the amount distributed by the corporation where the distribution is made in-kind rather than in cash – in other words, determining the “fair market value” of the property distributed;[v]
  • the “earnings and profits” of the corporation – basically, a running account that the corporation must maintain from its inception through the present, which indicates the net earnings of the corporation that are available for distribution to its shareholders; and
  • the shareholder’s holding period and adjusted basis for their shares of stock in the distributing corporation.[vi]

Stock Basis

The final item identified above – the shareholder’s basis for their stock – is generally not an issue for the shareholders of a closely held C corporation. In most cases, an individual made a contribution of cash to the capital of the corporation in exchange for stock in the corporation; in some cases, the individual purchased shares of stock from another shareholder. Unless the shareholder subsequently makes an additional capital contribution to the corporation (for example, pursuant to a capital call under a shareholders’ agreement),[vii] or unless the shareholder receives a distribution from the corporation that exceeds the shareholder’s share of the corporation’s earnings and profits, or unless the corporation redeems a significant portion of the shareholder’s stock (such that the shareholder experiences a substantial reduction in their equity interest relative to the other shareholders),[viii] the shareholder’s stock basis will be equal to the amount paid by them to acquire the stock, and will remain constant during the period they own the stock.[ix]

However, what if the shareholder’s capital contribution was made in-kind; for example, a contribution of real property or equipment, or of a contract or other intangible right? The amount of such contribution would be equal to the fair market value of the property; however, unless the transfer of the property was a taxable event to the contributing shareholder,[x] the shareholder’s basis for their stock in the corporation would be equal to their adjusted basis – i.e., their unrecovered investment – in the contributed property immediately before such contribution.[xi]

Alternatively, what if the shareholder made a transfer of cash to the corporation that was recorded by the corporation as a loan? What if the corporation never issued a promissory note to the shareholder or otherwise memorialized the terms of the loan (maturity, interest rate, collateral)? What if it never paid or accrued interest on the loan? Can the shareholder argue against the form of their “loan,” treating it, instead, as a capital contribution that would increase their stock basis?[xii]

The Taxpayer’s Burden

The taxpayer has the responsibility to substantiate the entries, deductions, and statements made on their tax returns. Thus, in the case of a “dividend” distribution by a closely-held corporation to an individual shareholder, the latter has the burden of proving the elements of the distribution,[xiii] described above, including that portion of the distribution that represents a nontaxable return of capital; in other words, the shareholder must be able to establish their adjusted basis for the stock on which the distribution is made.

In order to carry this burden, it is imperative that the taxpayer maintain accurate records to track the amount of their equity investment in the corporation. Where the stock was issued by the corporation in exchange for a contribution of cash, it would be very helpful to have a canceled check plus an executed capital contribution agreement, or corporate minutes accepting the contribution and authorizing the issuance of the stock. If the stock was received in exchange for an in-kind contribution of property in a non-taxable transaction, evidence of the taxpayer’s adjusted basis in the property is required; for example, the original receipt evidencing the taxpayer’s acquisition of the property, plus records of any subsequent adjustments, which may depend upon the nature of the property.[xiv] If the stock was purchased from another shareholder, the executed purchase and sale agreement, along with canceled checks or proof of satisfaction of any promissory note issued to the seller would be helpful.

Where a shareholder is unable to establish their basis for the stock – i.e., where the shareholder has failed to carry their burden of proof – the IRS will treat the shareholder as having a zero basis in such stock; consequently, the entire amount of the dividend distribution to the shareholder will be taxable,[xv] as one Taxpayer – who was already having a pretty bad day[xvi] – found to his detriment.

“Return-of-Capital” Defense

The Court of Appeals for the Ninth Circuit determined that a federal district court did not abuse its discretion in precluding Taxpayer’s “return-of-capital” defense. https://cdn.ca9.uscourts.gov/datastore/memoranda/2018/09/24/17-50091.pdf.

The Taxpayer was charged with tax evasion. As part of his defense, he tried to establish that there was no tax deficiency because the money removed from his corporation represented a return of capital, or stock basis.

The Court ruled that the district court “may preclude a defense theory where ‘the evidence, as described in the defendant’s offer of proof, is insufficient as a matter of law to support the proffered defense.’”

To establish a factual foundation for a “return-of-capital” theory, the Court stated, a taxpayer must show: “(1) a corporate distribution with respect to a corporation’s stock, (2) the absence of corporate earnings or profits, and (3) stock basis in excess of the value of the distribution.”

Taxpayer, the Court continued, failed to establish that his stock basis exceeded the value of the distributions. Taxpayer presented checks that purported to demonstrate the amount he paid to purchase the stock of Corp. He also provided a declaration stating that he transferred a deed of valuable property to Corp; despite being given the opportunity to do so, however, Taxpayer provided no evidence of the property’s value aside from his own estimate.

The government presented the declaration of a CPA involved in Corp’s bankruptcy proceedings who stated that “according to escrow documents,” the property Taxpayer transferred was assigned a value below that claimed by Taxpayer. It also presented a declaration that Taxpayer submitted in his divorce proceedings, in which Corp’s CPA stated the amount for which Corp had redeemed stock from Taxpayer, thereby reducing his basis. The government submitted the bank records for such payment.

The Court explained that Taxpayer had the burden to establish factual support for a finding that his stock basis exceeded the value of the distributions. Taxpayer’s testimony was insufficient to carry his burden. He did not provide evidentiary support for his valuation, nor evidence to rebut the documents establishing how much Corp paid Taxpayer for the redemption of stock.

Because the evidence did not establish that Taxpayer had a stock basis in Corp in excess of the value of the distributions, the Court decided that the district court did not abuse its discretion in finding that Taxpayer failed to establish a factual basis for a return-of-capital defense.

It Pays to Be Prepared[xvii]

A corporation’s distribution of a large dividend, or a shareholder’s sale of their stock for a price they “couldn’t refuse,” should represent a moment of affirmation of the shareholder’s investment or business decision-making.

Of course, the imposition of income taxes, and perhaps surtaxes, with respect to the amount received by the shareholder will tend to dampen the shareholder’s celebratory mood, but every shareholder/taxpayer expects to share some of their economic gains with the government in the form of taxes. Those who are well-advised will have accounted for this tax liability in planning for the welcomed economic event.

That being said, no taxpayer would willingly remit to the government more than what was properly owed. It is the taxpayer’s burden, however, to establish this amount by, among other things, establishing their basis in the stock that was sold or on which a corporate distribution was made.

Imagine a shareholder’s having to pay tax on dollars that actually represent a return of their capital investment – which should have been returned to them free of tax – simply because the shareholder was not prepared and unable to substantiate their basis in the stock. Talk about low-hanging fruit.

——————————————————————————————————————

[i] In others words, it is made to the individual in their capacity as a shareholder.

[ii] Taxable at a federal rate of 20%, though the 3.8% surtax on net investment income may also apply.

[iii] Taxable at a federal rate of 23.8% if long-term capital gain. See EN ii.

[iv] In the case of a closely held corporation, shareholders must also be attuned to the risk of constructive dividends distributions.

[v] This is also key for the corporation, which will be treated as having sold the property distributed if the fair market value of the property exceeds its adjusted basis in the hands of the corporation.

[vi] Which will be important if the amount of the distribution exceeds the earnings and profits and the stock’s adjusted basis; will the resulting gain be long-term or short-term capital gain?

[vii] In the case of a closely held corporation, most “capital contributions” made after the initial funding of the corporation take the form of loans from the shareholders, especially when made disproportionately among the shareholders.

[viii] An “exchange” under IRC Sec. 302.

[ix] Compare to the stock basis of a shareholder of an S corporation; their basis is adjusted every year to reflect their allocable share of the corporation’s income, gain, deduction, and loss, as well as the amount of any distribution made to them. IRC Sec. 1367.

[x] IRC Sec. 1001. In which case, they would take the stock with a cost (i.e., fair market value) basis. IRC Sec. 1012.

[xi] IRC Sec 351 and Sec. 358. In this way, the shareholder’s deferred gain is preserved.

[xii] The short answer: No; which is not to say that taxpayers have not tried that argument.

[xiii] The corporation will have to issue a Form 1099-DIV but, in the case of a close corporation, the controlling shareholder may be hard-pressed to rely upon such information return without more.

[xiv]  For example, depreciation schedules.  If the stock was inherited, the fair market of the stock on the date of the decedent’s death will be necessary. Start with a copy of the estate tax return filed by the decedent’s estate, on IRS Form 706. The appraisal obtained in connection with the estate tax return, or a copy of the shareholders’ agreement that fixed the price for the buyout of the stock upon the death of a shareholder, would be helpful.

[xv] Albeit, presumably, at the rate applicable to capital gain.

[xvi] Crime shouldn’t pay.

[xvii] No, I am not thinking about the song from the “Lion King” movie made famous by Jeremy Irons in the role of Scar. I am thinking of the Boy Scout motto. Taxpayers and their advisers would do well to adopt this motto.

Last week’s post considered the risk assumed by a taxpayer that ignores the plain meaning of a Code provision (the definition of “capital asset”) in favor of a more “rational” – favorable? – interpretation of that provision.

capital assets

This week’s post considers the “plain meaning” of the same section of the Code: the definition of the term “capital asset;” in particular, how one well-advised taxpayer was able to establish, through contemporaneously prepared documents, that they had changed the nature of their relationship to the property at issue.

Why does it Matter?

The Code provides that the gain recognized by an individual from the sale of a “capital asset” held for more than one year shall be taxed as long-term capital gain, at a maximum federal income tax rate of 20%.

It also provides that the gain from the sale of real property used by an individual taxpayer in a “trade or business,” held for more than one year, and not “held primarily for sale in the ordinary course of the taxpayer’s trade or business,” shall be treated as long-term capital gain.

Thus, if real property does not represent a capital asset in hands of an individual taxpayer, and it is held primarily for sale to customers in the ordinary course of the taxpayer’s trade or business, the gain from the sale of the property shall be taxed to the taxpayer as ordinary income, at a maximum federal rate of 37%.

Poor Timing

LLC was formed in the late 1990’s to acquire several contiguous tracts of land (the “Property”), and to develop them into residential building lots and commercial tracts.

The Property was adjacent to other properties that were being developed by other business entities, related to LLC, and LLC’s original plan was to subdivide the Property into residential units for inclusion in the related entities’ development. To that end, LLC entered into a development agreement with City, which specified the rules that would apply to the Property should it be developed.

LLC sold or otherwise disposed of some relatively small portions of the Property, retaining three main parcels for development.

Change in Plans?

As a result of the subprime mortgage crisis, however, LLC’s managers decided that LLC would not attempt to subdivide or otherwise develop the Property. They believed that LLC would be unable to develop, subdivide, and sell residential and commercial lots from the Property because of the effects of the subprime mortgage crisis on the local housing market, and the unavailability of financing for such projects in the wake of the financial crisis.

Instead, they decided that LLC would hold the Property as an investment until the market recovered enough to sell it off. These decisions were memorialized, on a contemporaneous basis, in a written “unanimous consent” that was dated and executed by the managers, as well as in a written resolution that was adopted by the members of LLC to further clarify LLC’s policy.

Thus, between 2008 and 2012, LLC did not develop the three parcels in any way, nor did it list them with any brokers, or otherwise market the parcels.

The Sale

In 2011, an unrelated developer (“Developer”) approached LLC about buying the parcels. LLC sold one of the parcels to Developer in 2011 and the other two in 2012.

One of the sale contracts called for Developer to pay a lump sum to LLC in 2012 for two of the parcels. The contract also listed certain development obligations, almost all of which fell on Developer.

LLC’s Forms 1065, U.S. Return of Partnership Income, for 2012 – and, indeed, for all years – stated that its principal business activity was “Development” and that its principal product or service was “Real Estate”. On its 2012 Form 1065, LLC reported $11 million of capital gain from its sale of one parcel and a $1.6 million capital loss from its sale of the second parcel, and this tax treatment was reflected on the Schedules K-1 issued by LLC to its individual members.

IRS Disagrees

The IRS determined that the aggregate net income from these two sale transactions should have been taxed as ordinary income.

The issue presented to the Tax Court was whether LLC’s sales of the two parcels in 2012 should have been treated as giving rise to capital gains or ordinary income.

The Court began by reviewing the Code’s definition of capital asset: “property held by the taxpayer (whether or not connected with his trade or business),” but excluding “inventory” and “property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business.”

Factors to Consider

The Court stated that the three principal questions to be considered in deciding whether the gain is capital in character are:

a. Was taxpayer engaged in a trade or business, and, if so, what business?
b. Was taxpayer holding the property primarily for sale in that business?
c. Were the sales contemplated by taxpayer “ordinary” in the course of that business?

The Court also indicated that various factors may be relevant to these inquiries, including the:

i. Frequency and substantiality of sales of property (which the Court noted was the most important factor);
ii. Taxpayer’s purpose in acquiring the property and the duration of ownership;
iii. Purpose for which the property was subsequently held;
iv. Extent of developing and improving the property to increase the sales revenue;
v. Use of a business office for the sale of property;
vi. Extent to which the taxpayer used advertising, promotion, or other activities to increase sales; and
vii. Time and effort the taxpayer habitually devoted to the sales.

Original Intent

The parties agreed that LLC was formed to engage in real estate development; specifically, to acquire the Property and develop it into residential building lots and commercial tracts; LLC’s tax returns, City’s development agreement, LLC’s formation documents, and the testimony of its managers, all showed that LLC originally intended to be in the business of selling residential and commercial lots to customers.

Change in Purpose

But the evidence also clearly showed that, in 2008, LLC ceased to hold the Property primarily for sale in that business, and began to hold it only for investment. LLC’s members decided not to develop the parcels any further, and they decided not to sell lots from those parcels. This conclusion was supported by the testimony of its managers, by their 2008 unanimous consent, and by the members’ resolution. Moreover, from 2008 on, LLC in fact did not develop or sell lots from the Property until 2012.

More particularly, when the main parcels were sold, they were not sold in the ordinary course of LLC’s business:

a. LLC did not market the parcels by advertising or other promotional activities;
b. LLC did not solicit purchasers for the parcels, nor did its managers or members devote any time or effort to selling the property;
c. Developer approached LLC; and
d. Most importantly, the sale of the parcels was essentially a bulk sale of a single, large, and contiguous tract of land to a single seller – clearly not a frequent occurrence in LLC’s ordinary business.

Court Disagrees with the IRS

Because the parcels were held for investment and were not sold as part of the ordinary course of LLC’s business, the Court rejected the IRS’s arguments and held that the net gain from the sales was capital in character.

The IRS argued that the extent of development of the parcels showed that they were held primarily for sale in the ordinary course of LLC’s business. The Court conceded that, from 1998 to sometime before 2008, LLC developed the Property to a certain extent. But it was also clear that, in 2008, LLC’s managers decided not to develop or market the Property as they ordinarily would have.

The Court stated that a taxpayer is “entitled to show that its primary purpose changed” from held-for-sale to held-for-investment. The Court concluded that LLC made such a showing. Any development activity that occurred before the marked change in purpose in 2008 (including whatever was reported on LLC’s earlier returns) was largely irrelevant.

The IRS also argued that the frequency of sales, along with the nature and extent of LLC’s business, showed that gains from the sale of the parcels should be ordinary in character. But LLC’s sales were infrequent, the Court observed, and the extent of its business was extremely limited. After 2008, LLC disposed of the entire Property in just nine sales over eight years (most of which were small sales to related entities). Moreover, the main parcels, sold in 2012, had not been developed into a subdivision when they were sold, and little or no development activity occurred on those parcels for at least three years before the sale.

In sum, after 2008, LLC sold most of its undeveloped Property in a single transaction to a single buyer, Developer, and sold the remainder to related parties.

The IRS suggested that the Court should impute to LLC the development activity which was performed by the parties related to LLC on the other property contiguous to the Property. The IRS did not provide the Court with any legal authority or evidence in support of this position. But, the Court continued, even if one assumed that LLC engaged in substantial development activity on, or in active and continuous sales from, these parcels (by imputation or otherwise), nevertheless – in the absence of a connection between those other parcels and the parcels sold in 2012 – the Court was not persuaded that the bulk sale of the parcels to Developer would have been in the ordinary course of LLC’s alleged development business, considering that all development activity had been halted on these parcels at least three years before the sales at issue and that these parcels were never developed into a subdivision by LLC.

The Court noted, “if a taxpayer who engaged in a high volume subdivision business sold one clearly segregated tract in bulk, he might well prevail in his claim to capital gain treatment on the segregated tract.” That is precisely what happened here, the Court stated; the parcels sold were clearly segregated from the other parcels and were sold in bulk to a single buyer.

Still the IRS argued that the sale generated ordinary income because: the parcels were covered by the development agreement with the City; Developer agreed to develop the parcels; and LLC was to receive certain post-sale payments from Developer whenever certain conditions were met.

The Court found that these facts were either irrelevant or were consistent with investment intent. For example, there would have been no reason for LLC to undo or modify the development agreement with City after deciding not to develop the parcels. There seemed to be little doubt that the highest and best use of the Property was for development into residential and commercial lots. Any buyer would likely have been a developer of some kind. Therefore, the Court continued, maintenance of the development agreement was consistent with both development intent and investment intent.

Next, the IRS pointed out that, on its 2012 Form 1065, LLC listed its principal business activity as “Development” and its principal product or service as “Real Estate”. (Ugh!) Although this circumstance may count against taxpayers to some limited degree, the Court believed that these statements “are by no means conclusive of the issue.” Considering the record as a whole, the Court was inclined to believe that these “stock descriptions” were inadvertently carried over from earlier returns.

Finally, the IRS asserted a schedule of LLC’s capitalized expenses showed that LLC “continued to incur development expenses up until it sold” the land to Developer. But the Court accorded these little weight because the record as a whole clearly showed that the parcels were not developed between 2008 and the sale to Developer. Also, most of the post-2008 expenditures on the schedule of capitalized expenditures were consistent with investment intent.

Therefore, the Court concluded that LLC was not engaged in a development business after 2008 and that it held the two parcels as investments in 2012. Accordingly, LLC properly characterized the gains and losses from the sales of these properties as income from capital assets.

Lessons?

There is no doubt that, as in the case of LLC, a taxpayer’s purpose in holding certain property may change over time, thus affecting the nature of the gain recognized by the taxpayer on the sale of the property.

Of course, the taxpayer has the burden of establishing their purpose for holding the property at the time of the sale. A well-advised taxpayer will seek to substantiate such purpose well before the IRS challenges the taxpayer’s treatment of the gain recognized from the sale.

Indeed, if the taxpayer has, in fact, decided to change their relationship to the property, they should document such change contemporaneously with their decision – while the facts are still fresh and the decision-makers are still alive – including the reasoning behind it, whether as a result of a change in economic conditions, a change of business, or otherwise.

Moreover, they should reflect such change in their dealings with the property and throughout their subsequently filed tax returns. Why give the taxing authorities an easy opening on the basis of which to wrest an unnecessary concession?

What Does It Mean?

The Tax Cuts and Jobs Act[1] has now been in effect for fifty days. During this relatively brief period, many tax professionals have pored over the statutory language, as well as the Joint Explanatory Statement issued by Congress, and, in the process, have found provisions that are in need of clarification. “That doesn’t make sense” or “that could not have been intended” are among the phrases that often accompany discussions of these provisions.[2]

2018 Tax Cuts and Jobs Act

These observations are usually followed by calls for legislative “technical corrections,” or for regulatory and other guidance from the IRS. It is as yet uncertain when such legislation or guidance will be forthcoming.[3]

A recent Court of Appeals decision, however, should serve as a reminder that it could be dangerous to ignore the text of a statutory provision that yields a result that one may believe was “clearly” not intended by Congress.

Termination of Contract Rights

Taxpayer purchased commercial real property (“Property”). Although Taxpayer ultimately hoped to sell Property for a profit, it hired a third party to operate Property in the meantime.

About one year later, Taxpayer reached an agreement to sell Property to another company at a significant profit. Over the next two years – during which Taxpayer continued to operate Property – the parties amended the contract several times, eventually finalizing the purchase price, and including a 25% nonrefundable Deposit that was paid immediately to Taxpayer, and that would thereafter be credited toward the purchase price at closing.[4] Unfortunately, the buyer defaulted on the agreement and forfeited the Deposit.

On its tax return for the year of the default, Taxpayer reported the Deposit as long-term capital gain. The IRS, however, determined that Taxpayer should have reported the amount of the forfeited Deposit as ordinary income.

Taxpayer petitioned the U.S. Tax Court, asserting that the Code was meant to prescribe the same tax treatment for gains related to the disposition of “trade-or-business” property regardless of whether the property was successfully sold or the sale agreement was canceled.

The IRS responded that the plain text of the governing Code provision distinguished between consummated and terminated sales of trade-or-business property, providing capital-gain treatment only for the former.

The Tax Court agreed with the IRS, holding that under the Code’s unambiguous language Taxpayer couldn’t treat the forfeited Deposit as capital gain.

Taxpayer appealed to the Eleventh Circuit.

Thus Spoke the Court[5]

Both Taxpayer and the IRS agreed that if the sale of Property had gone through as planned, the Deposit – which, under the contract, would have been applied toward the purchase price – would have been taxed at the lower capital-gains rate. The Code provides that “any recognized gain on the sale or exchange of property used in the trade or business” shall “be treated as long-term capital gain.”[6] The Code goes on to specify that, for purposes of this provision, the “term ‘property used in the trade or business’ means property used in the [taxpayer’s] trade or business, of a character which is subject to the allowance for depreciation …, held for more than 1 year, and real property used in the trade or business, held for more than 1 year …”

The parties stipulated that Property was properly classified as real property used in Taxpayer’s trade or business. Accordingly, it was undisputed that if Taxpayer had sold Property, the resulting income, including the Deposit, would have been taxed as long-term capital gain.

But the deal fell through, and Taxpayer did not sell Property. Accordingly, the tax treatment of the Deposit was governed by a different section of the Code[7] which provides, in relevant part, as follows:

Gain or loss attributable to the cancellation, lapse, expiration, or other termination of … a right or obligation … with respect to property which is (or on acquisition would be) a capital asset in the hands of the taxpayer … shall be treated as gain or loss from the sale of a capital asset.

Thus, any gain or loss that results from the termination of an agreement to buy or sell property that is properly classified as a “capital asset” will, notwithstanding the termination, be treated as a gain or loss from a consummated sale. This rule ensures capital-gain treatment of income resulting from canceled property sales by relaxing the “sale or exchange” element of the Code’s general definition of “long-term capital gain” – i.e., “gain from the sale or exchange of a capital asset held for more than 1 year ….”[8]

According to the Court, this rule applies only to property that is classified as a “capital asset.” The Court’s analysis, therefore, turned on whether Property was a capital asset in Taxpayer’s hands during the relevant tax year.

“As a matter of plain textual analysis,” the Court began, “the answer to the question whether [Property] was a ‘capital asset’ couldn’t be clearer.” The Code defines the term “capital asset” in a way that “expressly excluded” Property from status as a capital asset; specifically, the Code states that “the term ‘capital asset’ means property held by the taxpayer (whether or not connected with his trade or business), but does not include, [among other things,] real property used in his trade or business.”[9]

This definition of “capital asset, the Court noted, reflects almost precisely the definition of the term “property used in the trade or business,” examined above.[10] “There is, however, a decisive difference,” the Court continued, “which cuts to the very heart of this case: Whereas Section 1231’s definition, which applies to consummated sales of trade or business property, expressly prescribes capital-gains treatment of the resulting income, Section 1221’s definition, which applies to terminated sales of such property, expressly proscribes capital-gains treatment.”

Because Taxpayer’s sale transaction fell through, the controlling question, the Court stated, was whether Property was real property used in Taxpayer’s trade or business.

Taxpayer and the IRS stipulated that, from the date that Taxpayer acquired Property through the year at issue, Property was used by Taxpayer in a trade or business. Accordingly, Taxpayer “conceded that [Property] . . . was not a capital asset.”

“That concession,” the Court observed, “was fatal,” because it leads to the conclusion that the rule which treats the income realized on the termination of a sale contract as capital gain did not apply to the Deposit.

Taxpayer to Court: “That’s Not Fair”

In response, Taxpayer asserted that the Court’s plain-text reading of the Code impermissibly yielded a result that was “absurd.”

First, Taxpayer noted that while all “agree that, had the sale of [Property] been completed, the [Deposit] would have been … applied toward the purchase price and, thus, treated as capital gain,”[11] it made no sense that the same Deposit “must be treated as ordinary income because the parties terminated the [c]ontract rather than completing it,”[12] especially given that it was not Taxpayer’s fault that the sale did not occur.

Second, Taxpayer complained that the exclusion of trade-or-business property from capital-gain treatment on the cancellation of a contract for the sale of such property “effectively penalize[d]” taxpayers “for operating a trade or business as opposed to being a passive investor in real property,” in which case (as with a consummated transaction) any resulting income would receive capital-gain treatment.

For both reasons, Taxpayer insisted that the only rational way to read the Code was “to give the termination of a contract the same tax treatment afforded a sale or exchange of the property underlying the contract in order to eliminate differing tax treatment of economically equivalent transactions.”

The Court disagreed. The supposed anomalies that Taxpayer posited – between completed and canceled transactions, and between active managers and passive investors – may seem a little odd, the Court stated, but they did not yield such an “absurd” result that the straightforward application of the statutory text should not be respected, particularly given that, when the sale fell through, Taxpayer got to keep not only the Deposit (albeit at an ordinary-income tax rate) but also Property.

Taxpayer also insisted that a plain-text reading of the Code’s interlocking provisions actually “ignore[d] the clear purpose behind the enactment” of the provision[13] that treated the cancellation of a sale contract as the economic equivalent of a sale, which Taxpayer said “was to ensure that taxpayers receive the same tax characterization of gain or loss whether the underlying property is sold or the contract to which the property is subject is terminated.”

The problem with Taxpayer’s argument, the Court pointed out, is that the Code’s plain language forecloses it. If an asset – like Property – is “real property used in a trade or business,” then by definition it is not a “capital asset” within the meaning of the “cancellation-of-contract” provision.  The definitions of “property used the trade or business” and “capital asset” are mutually exclusive; while one provision expressly prescribes capital-gains treatment of such income, the other expressly forbids capital gains treatment of the same property.

The Court stated that in a contest between clear statutory text and evidence of sub- or extra-textual “intent,” the former must prevail. As a formal matter, it is of course only the statutory text, the Court continued, that is “law” in the constitutional sense; and as a practical matter, “conscientious adherence to the statutory text best ensures that citizens have fair notice of the rules that govern their conduct, incentivizes Congress to write clear laws, and keeps courts within their proper lane.”[14]

Accordingly, Taxpayer was not entitled to treat the Deposit as capital gain.

Harsh Result?

I don’t think so, especially given that Taxpayer got to keep the Deposit and Property. Moreover, the Court’s reading was wholly consistent with the plain language of the Code.

The lesson, of course, as we await clarification, correction, and guidance from Congress and the IRS regarding many provisions of the Tax Cuts and Jobs Act, is to proceed with caution, to avoid assumptions that are more hopeful than grounded on objective fact, to voice our opinions and concerns as tax professionals, and to keep abreast of developments in Washington.


[1] Pub. L. 115-97.

[2] See, for example, the apparent denial of a plaintiff’s deduction for legal fees incurred in pursuing a sexual harassment claim, the settlement of which includes a non-disclosure provision. “What we do in haste, . . .”

[3] The IRS announced recently that proposed regulations would be issued by the end of 2018, and final regulations by mid-2019. The Ways and Means Committee are supposedly gathering, and filtering through, the feedback given by tax professionals, but there has been no indication of when any substantive and/or technical changes will be proposed, let alone made.

[4] Under an “open transaction” theory, the recognition and treatment of such a deposit await the consummation or failure of the sale.

[5] No, I’m not getting metaphysical on you.

[6] IRC Sec. 1231.

[7] IRC Sec. 1234A.

[8] Sale of a Contract: Capital Gain or Ordinary Income?

[9] IRC Sec. 1221(a)(2).

[10] See FN 6, FN 9, and accompanying texts.

[11] Under IRC Sec. 1231. See FN 6.

[12] Under a plain-text reading of IRC Sections 1221 and 1234A.

[13] IRC Sec. 1234A.

[14] The Court observed, that even if Congress really did mean for Section 1234A to reach beyond “capital assets” as defined in Section 1221 to include Section-1231 property, “it’s not our place or prerogative to bandage the resulting wound. If Congress thinks that we’ve misapprehended its true intent – or, more accurately, that the language that it enacted in I.R.C. §§ 1221 and 1234A inaccurately reflects its true intent – then it can and should say so by amending the Code.”

Perhaps the single most important day in the life of any closely held business is the day on which it is sold. The occasion will often mark the culmination of years of effort on the part of its owners.

The business may have succeeded to the point that its competitors seek to acquire it in furtherance of their own expansion plans; alternatively, private equity investors may view it as a positive addition to their portfolio of growth companies.

On the flip side, the owners of the business may not have adequately planned for their own succession; consequently, they may view the business as a “wasting asset” that has to be monetized sooner rather than later.

Worse still, the business may be failing and the owners want to recover as much of their investment as possible.

In any of the foregoing scenarios, the tax consequences arising from the disposition of the business will greatly affect the net economic result for its owners.

The following outlines a number of provisions included in the recently enacted Tax Cuts and Jobs Act[1] that should be of interest to owners of a closely held business that are considering the sale of the business, as well as to the potential buyers of the business.

Corporate Tax Rate

In general, the individual owner of a C corporation, or of an S corporation that is subject to the built-in gains tax, would prefer to sell his stock to a buyer – and thereby incur only a single level of federal income tax, at the favorable 20% capital gain rate[2] – rather than cause the corporation to sell its assets.

An asset sale generally results in two levels of tax: (a) to the corporation based upon the gain recognized by the corporation on the disposition of its assets; and (b)(i) to the shareholder of a C corporation upon his receipt of the after-tax proceeds in liquidation of the corporation, or (ii) to the shareholder of an S corporation under the applicable flow-through rules.

Prior to the Act, the maximum federal corporate tax rate was set at 35%; thus, the combined effective maximum rate for the corporation and shareholder was just over 50% (assuming the sale generated only capital gain).

The Act reduced the federal corporate tax rate to a flat 21%; consequently, the combined maximum federal rate has been reduced to 39.8%.

From the tax perspective of a seller, the reduced corporate rate will make asset deals[3] less expensive. For the buyer that agrees to gross-up the seller for the additional tax arising out of an asset deal (as opposed to a stock deal), the immediate out-of-pocket cost of doing so is also reduced.

Individual Ordinary Income Rate

The Act reduced the rate at which the ordinary income recognized by an individual is taxed, from 39.6% to 37%.[4]

In the case of an S corporation shareholder, or of an individual member of an LLC taxable as a pass-through entity[5], any ordinary income generated on the sale of the corporate assets – for example, depreciation recapture[6] – will be taxed at the reduced rate.

Any interest that is paid by a buyer to a seller in respect of a deferred payment of purchase price – i.e., an installment sale – or that is imputed to the seller[7], as in the case of an earn-out, will be taxable at the reduced rate for ordinary income.

Similarly, if the seller or its owners continue to hold the real estate on which the business operates, the rental income paid by the buyer will be subject to tax at this reduced rate.

Finally, any compensation paid to the owners, either as consultants or employees, or in respect of a non-compete, will be taxable at the reduced rate.

Self-Created Intangibles

The Act amended the Code to exclude a patent, invention, model or design (whether or not patented), and a secret formula or process which is held either by the taxpayer who created the property, or a taxpayer with a substituted or transferred basis from the taxpayer who created the property (or for whom the property was created), from the definition of a “capital asset.”

Thus, gains or losses from the sale or exchange of any of the above intangibles will no longer receive capital gain treatment.

NOLs

Prior to the Act, the net operating losses (“NOLs”) for a taxable year could be carried back two years and forward 20 years. The Act eliminates the carryback and allows the NOLs to be carried forward indefinitely, though it also limits the carryover deduction for a taxable year to 80% of the taxpayer’s taxable income for such year.

The Act did not change the rule that limits a target corporation’s ability to utilize its NOLs after a significant change in the ownership of its stock.[8] However, the Act’s elimination of the “NOL-20-year-carryover-limit” reduces the impact of the “change-in-ownership-loss-limitation” rule on a buyer of the target’s stock; even though the annual limitation imposed by the rule will continue to apply, the NOL will not expire unused after twenty years – rather, it will continue to be carried over until it is exhausted.

At the same time, however, the Act’s limitation of the carryover deduction for a taxable year, to 80% of the corporation’s taxable income, may impair a target’s ability to offset some of the gain recognized on the sale of its assets.

Interest Deduction Limit

The Act generally limits the deduction for business interest incurred or paid by a business for any taxable year to 30% of the business’s adjusted taxable income for such year.[9] Any interest deduction disallowed under this rule is carried forward indefinitely.

In the case of a buyer that will incur indebtedness to purchase a target company – for example, by borrowing the funds, or by issuing a promissory note as part of the consideration for the acquisition – this limitation on its ability to deduct the interest charged or imputed in respect of such indebtedness could make the acquisition more expensive from an economic perspective.[10]

Immediate Expensing

Prior to the Act, an additional first-year depreciation deduction was allowed in an amount equal to 50% of the adjusted basis of qualified property acquired and placed in service before January 1, 2020. Property qualifying for the additional first-year depreciation deduction had to meet requirements; for example, it had to be tangible personal property, certain computer software, or qualified improvement property. Moreover, the “original use” of the property had to commence with the taxpayer.

The Act, extended and modified the additional first-year depreciation deduction for qualifying property through 2026. It also increased the 50% allowance to 100% for property placed in service after September 27, 2017, and before January 1, 2023.[11]

It also removed the requirement that the original use of the qualifying property had to commence with the taxpayer. Thus, the provision applies to purchases of used as well as new items; in other words, the additional first-year depreciation deduction is now allowed for newly acquired used property.

The additional first-year depreciation deduction applies only to property that was not used by the taxpayer prior to the acquisition, and that was purchased in an arm’s-length transaction. It does not apply to property acquired in a nontaxable exchange such as a reorganization, or to property acquired from certain related persons, including a related entity (for example, from a person who controls, is controlled by, or is under common control with, the taxpayer).

Thus, a buyer will be permitted to immediately deduct the cost of acquiring “used” qualifying property[12] from a target business, thereby recovering what may be a not insignificant portion of its purchase price, and reducing the overall cost of the acquisition.

Pass-Throughs?

Query whether the owners of an S corporation (or of another target that is treated as a pass-through entity for tax purposes) will be allowed to claim the 20% deduction based on qualified business income in determining their tax liability from the sale of the assets of the business. Stated differently, and assuming that the owner’s income for the taxable year is derived entirely from the operation and sale of a single business, will the gain from the sale be included in determining the amount of the deduction?

It appears not. The definition of “qualified business income” excludes items of gain even where they are effectively connected with the conduct of a qualified trade or business; this would cover any capital gain arising from the sale of assets used in the trade or business. Moreover, it appears that the presence of such gain in an amount in excess of the taxable income of the business for the year of the sale (exclusive of the gain) would disallow any such deduction to the taxpayer.[13]

What Does It All Mean?

It remains to be seen whether these changes will influence the structure of M&A transactions. After all, most buyers would prefer to cherry-pick the target assets to be acquired and to assume only certain liabilities; they will consider a stock deal only if necessary. The reduction in the corporate tax rate will likely reinforce that fundamental principle, and may cause certain corporate sellers and their shareholders to be more amenable to an asset deal.

However, the pricing of an M&A transaction will likely be affected by the reduced corporate tax rate, by the limitation on a buyer’s deduction of acquisition interest, and by a buyer’s ability to immediately expense a portion of the purchase price. Each of these factors should be considered by a buyer in evaluating its acquisition of a target, the amount the buyer can offer in consideration, and its ability to finance the acquisition.

Only time and experience will tell.

As was mentioned in an earlier post, the Act was introduced on November 2, 2017, was enacted on December 22, 2017 – without the benefit of meaningful hearings and of input from tax professionals – and became effective on January 1, 2018 (just three weeks ago). The Congress is already discussing technical corrections, and the tax bar is asking for guidance from the IRS. Much remains to be discovered.

Stay tuned.


[1] Pub. L. 115-97 (the “Act”).

[2] The shareholder of a C corp, or of an S corp in which he does not materially participate, will also incur the additional 3.8% surtax on net investment income.

[3] Including sales of stock that are treated as asset sales for tax purposes under Sec. 338(h)(10) or Sec. 336(e) of the Code.

[4] The rate may be greater if the 3.8% surtax also applies to the item of income in question; for example, interest income.

[5] For example, a partnership.

[6] Sec. 1245 of the Code.

[7] Sec. 1274 of the Code.

[8] Code Sec. 382.

[9] In general, before 2022, the limitation is tied to EBITDA; thereafter, it is tied to EBIT.

[10] In general, the limitation does not apply to a corporation if its average annual gross receipts for the three-taxable-year period ending with the prior taxable year does not exceed $25 million.

[11] The allowance is thereafter reduced, and phased out, through 2026.

[12] This should cover both actual and deemed acquisitions of assets (as under a Sec. 338(h)(10) election).

[13] Although the underlying basis for the result is not discussed in the Congressional committee reports, it is likely attributable to favorable capital gain rate that applies to the individual owners of a pass-through entity.

Maximize Capital Gain

In the sale of a business, it is the goal of every business owner and his tax adviser to minimize the amount of gain recognized and, to the extent gain is recognized, to maximize the amount that is treated as capital gain.

Property Used in Trade or Business

The gain realized on the sale or exchange of property used in a taxpayer’s trade or business is treated as capital gain. In general, the Code defines “property used in a trade or business” to include amortizable or depreciable property (subject to the so-called “recapture” rules), as well as real property, that has been used in a trade or business and has been held for more than one year.

If a property is not so described, the gain realized on its sale will generally be treated as ordinary income. Indeed, certain properties that are used in a business are explicitly excluded from capital gain treatment, including inventory and property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business (“inventory”).

Capital Asset

Capital gain treatment may also result from the sale of a “capital asset.” This is generally defined to include property held by the taxpayer, whether or not it is connected with his trade or business, but not including “inventory,” “property used in a trade or business,” or accounts or notes receivable acquired in the ordinary course of a trade or business for services rendered or from the sale of “inventory.”

Contracts as Capital Asset?

Over the years, questions have arisen concerning the proper tax treatment of the gain realized by a business on the sale of certain contracts to which it is a party.

The courts have stated that not everything that can be called “property” under local law, and that is outside the statutory exclusions described above, qualifies as a capital asset; rather, according to the courts, the term “capital asset” should be construed narrowly in accordance with the purpose of Congress to afford capital gain treatment only in situations typically involving the realization of appreciation in value accrued over a substantial period of time.

Beyond these general, cautionary principles, it appears that the courts have not been able to clearly or consistently delineate between contracts that are capital assets and those that represent a right to income.

Thus, the courts have stated, at various times and in various contexts, that:

  • a capital asset requires something more than an opportunity, afforded by a contract, to obtain periodic receipts of income;
  • a taxpayer does not bring himself within capital gain treatment merely by showing that a contract constitutes “property,” that he held the contract for more than one year, and that the contract does not fall within any of the exclusions from the definition of capital asset;
  • the consideration received for the transfer of a contract right to receive income for the performance of personal services is taxable as ordinary income;
  • a lump-sum payment that is essentially a substitute for what would otherwise be received at a future time as ordinary income is consideration for the right to receive future income, not for an increase in the value of the income-producing property;
  • simply because the property transferred will produce ordinary income, and such income is a major factor in determining the value of the property, does not necessarily mean that the amount received in exchange for the property is essentially a lump-sum substitute for ordinary income;
  • contract rights may be a capital asset where they provide the possessor significant long-term benefits;
  • it is important to distinguish between proceeds from the present sale of the future right to earn income (capital gain) and the present sale of the future right to earned income (ordinary income).

Congress Provides Some Certainty

In many cases, taxpayers will have to consider the inconsistently applied criteria that have been developed by the courts in determining how the sale of a contract will be treated for tax purposes.

Thankfully, Congress has occasionally stepped in to clarify, at least somewhat, the tax treatment of the disposition of certain contract rights.

Sale of a Franchise

Taxpayer was formed in 1997 to bid on a request for proposal from County to take care of its waste/recycling needs. Taxpayer won a package of contracts that gave it the exclusive right to collect and dispose of County’s waste. The collection contracts started running in the summer of 1998 and ran through 2007, but could be extended by mutual agreement.

In 2002, a consultant for the waste industry asked Taxpayer if it would be willing to sell its business. It was, and that summer Taxpayer signed an agreement with the consultant, who put together a package that estimated potential sale prices. Things moved quickly and, by that fall, Taxpayer had signed a letter of intent to negotiate with the highest bidder.

In the fall of 2003, Taxpayer sold its assets, including its contracts with County, in an all-cash deal for $X million; there were no contingent payments. Taxpayer did not keep any interest in the contracts. The asset-purchase agreement allocated the purchase price among a covenant not to compete, tangible assets, buildings, land, intangibles, going concern value and goodwill.

Tax Return and Audit

On the Form 8594, Asset Acquisition Statement under Section 1060, filed with its 2003 tax return, Taxpayer reported the values of the assets sold the same way the parties allocated them in the asset-purchase agreement. The bulk of the purchase price was allocated to what Taxpayer reported as intangible assets (including the contracts) and going concern value/goodwill, to be taxed at as capital gain.

The IRS audited Taxpayer’s returns, and proposed an adjustment by re- characterizing as ordinary income the gain realized from the sale of Taxpayer’s contractual rights to provide waste-collection services to County. Taxpayer disagreed with the IRS, and filed a timely petition with the U.S. Tax Court.

Tax Court

Specifically, Taxpayer claimed that the contracts were franchises, and that their sale was covered by a statutory rule that taxed their sale at capital gain rates.

The IRS disagreed, stating that the Code provision relied upon by the Taxpayer did not apply, and urging the Court to apply the “substitute-for-ordinary-income” doctrine instead.

The Court began its discussion by analyzing the provision at issue. According to that provision, the sale of a franchise may not be treated as a sale or exchange of a capital asset if the transferor retains any significant power, right, or continuing interest in the franchise transferred.

The first question to be addressed, the Court stated, was whether the contracts sold were “franchises” within the meaning of that provision. A “franchise” for the purposes of that provision, it continued, includes an agreement that gives one of the parties to the agreement the right to distribute, sell, or provide goods, services, or facilities, within a specified area. The Court found that Taxpayer’s contracts were agreements to provide services within the County. Thus, they satisfied these requirements and came under the provision.

However, holding that the contracts were “franchises,” the Court noted, did not end the matter. The Court also had to determine whether Taxpayer kept any “significant power, right, or continuing interest” in the franchises; if it did, then its income from the sales would be ordinary (as if it had arisen under a license).

The Court found that Taxpayer did not retain any interest in the franchises/contracts, and that it did not receive any contingent payments; in fact, it received a single lump-sum payment.

Because the contracts qualified as franchises, and the Taxpayer neither kept any interests in the franchises nor received any contingent payments, the Court concluded that the sale transaction was not ineligible for capital gain treatment.

Taxpayer argued that this determination alone – not being ineligible for capital gain treatment – automatically entitled it to capital-gain treatment.

The Court pointed out, however, that the provision sets forth what does not get capital gain treatment; it does not specifically state that the sale of a franchise with respect to which the seller did not retain an interest automatically receives capital gain treatment.

According to the IRS, this meant that the provision was inapplicable by its own terms, covering only sales in which an interest in the franchise was retained by the seller. Thus, the IRS argued, the transactions were taxable as ordinary income.

The Court disagreed with the IRS. The provision, it stated, refers to capital accounts; specifically, any amount paid or incurred on account of a sale of a franchise, that is not deductible as an ordinary and necessary business expense by the acquiring-payor because it is not contingent upon the productivity or use of the franchise, is treated as an amount chargeable to capital account.

According to the Court, this implied that the sale of a franchise leads to capital gain treatment so long as the seller does not retain any significant interest in the franchise and the franchise was a capital asset.

Because Taxpayer kept no significant interest in the contracts sold, it was entitled to capital gain treatment on the gain realized from the sales.

Guidance?

I wish there was something beyond general principles on which to confidently rely in determining the tax treatment of the gain realized on the sale of a contract.

Some situations will obviously warrant capital gain treatment while others will obviously warrant ordinary income treatment. In between, there can be considerable uncertainty.

That being said, if the seller does not retain any interest in the contract (query how an earn-out will affect this), if the contract provides significant long-term benefits, if the contract involved a capital investment by the seller, and if the contract has some potential to appreciate in value over time, then the chance of capital gain treatment on the sale of the contract will be improved.

Of course, this analysis only goes to the nature of the gain. It does not necessarily influence the “structure”/terms of the contract, nor should it. The contract is a business arrangement, negotiated and entered into between two parties, each of which expects to profit from it currently, in the ordinary course of its trade or business, and not necessarily upon the disposition of the contract. Indeed, many contracts are not assignable, or are assignable only with the consent of the other party, in which case new contracts may just as likely be “re”-negotiated by the buyer.

It will nevertheless behoove the seller to understand and quantify the tax/economic cost of the sale of a contract, and to account for it in negotiating the price for the sale of the business. After all, it’s how much the seller keeps after taxes that matters.

“We Could Have Had it All”

ABC has been looking for someone special for a long time. Suitors have come and gone. Some have been better than others. Some were non-starters. Then ABC meets a person that may be “the one.” As it turns out, that person has also been looking for someone.

After getting to know each other a bit, ABC decides that it may be time to open up to one another, with the implicit understanding, of course, that neither of them would ever hurt the other by sharing this information with anybody else.Breakup Fee

In a few months’ time, that special someone indicates that they are interested in a long-term relationship, and ABC promises that it will not entertain “overtures” from others. Then, one day, the moment ABC has been waiting for finally comes. That special someone proposes a permanent relationship with ABC. They select a date to formalize their union and announce it to the world.

ABC couldn’t be happier, or so it thinks. Then someone new appears. ABC never expected to hear from anyone like this person, didn’t think they would ever be interested, but there they are. What’s more, they are offering ABC much more than any other suitor ever did.

Too good to turn down? You bet. The existing engagement has to be called off. But there’s a price to pay. ABC’s now-former suitor spent a lot of money in getting to the point where they agreed to unite with ABC. In the process, the former suitor (who has been burned before) also determined that there was a less-than remote possibility that ABC would walk away if another, “better” suitor came along. “I would never do that to you,” ABC said, and in that spirit, agreed not to hold itself out as being “available,” and also agreed to pay a break-up fee if it ever called off the engagement.

Deal Economics

Every deal, whether from the perspective of the seller or the buyer, is about economics. Few items will impact the economics of a deal more immediately than taxes. The deal involves the receipt and transfer of value, with each party striving to maximize its economic return on the deal. The more taxes that a party to the deal pays as a result of the deal structure, the lower is the party’s economic return. The more slowly that a party recovers its investment in the deal – for example, through tax deductions, such as amortization – the more expensive the deal becomes.

But what happens if the deal does not close? The buyer may have retained accountants, attorneys, financial advisers, and appraisers to assist it in investigating the deal and in putting it together. These professionals are expensive. (Sometimes, you even have to pay them what they are worth.)

Many buyers will seek to protect themselves from a target that may suffer from the jitters, or that may get a better offer, by requiring that the target agree to pay a termination fee. The target will recognize the logic in this, at least from the buyer’s perspective, and will have to take it into account – as an additional cost that it or its new suitor will have to bear – in determining whether to walk away from the deal.

Whether the amount of this fee will fully reimburse the buyer for its expenditures will depend, in no small part, upon how it will be treated for tax purposes.

Termination Fee

The IRS’s Office of Chief Counsel recently issued an advisory opinion in which it discussed how gain or loss would be determined by a buyer corporation (“Taxpayer”) that incurred expenses investigating the acquisition of a target corporation’s stock (“Target”). Taxpayer entered into an agreement (“Contract”) with Target that was designed to lead to Taxpayer’s acquisition of Target’s stock. The Contract also provided that Taxpayer would receive a fee in the event Target terminated the Contract.

The Contract required Taxpayer and Target to pursue a plan of merger to effectuate Taxpayer’s stock acquisition through a merger of a newly-formed, wholly-owned subsidiary of Taxpayer with and into Target, with Target as the surviving entity (a “reverse subsidiary merger” – often used where Target has many shareholders, some of whom may be less than cooperative).

Regarding Target’s obligations under the Contract, the Contract required Target to recommend to its shareholders that they approve the plan of merger subject, however, to the receipt of a superior offer. The Contract provided that Target may terminate the contract upon (i) entering into another agreement based on a superior offer, (ii) a rejection of Taxpayer’s offer by Target’s shareholders, or (iii) a failure to obtain approval of Target’s shareholders by a certain date. The Contract provided that in the event the Contract was terminated due to one of the foregoing, Target would have to pay a termination fee of $X to Taxpayer.

As it turned out, Target received a superior offer from another suitor and entered into an agreement with this other corporation. Target terminated the Contract and paid Taxpayer the $X termination fee. At the time the Contract was terminated, Taxpayer had incurred $Y of costs in the process of investigating and pursuing the transaction that Taxpayer capitalized as costs of facilitating the proposed transaction.

Capitalization Rules

Before discussing the IRS’s opinion, let’s review the applicable capitalization rules.

Amounts that are paid in the process of investigating or otherwise pursuing certain acquisitive transactions – including a taxable acquisition of assets that constitute a trade or business or a taxable acquisition of an ownership interest in a business entity if, immediately after the acquisition, the acquiring taxpayer owns more than 50% of the equity of the business entity – are capitalized as costs of “facilitating” the transaction.

An amount is paid to facilitate an acquisitive transaction if the amount is paid in the process of investigating or otherwise pursuing the transaction. Whether an amount is paid in the process of investigating or pursuing the transaction is determined based on all of the facts and circumstances. In determining whether an amount is paid to facilitate a transaction, the fact that the amount would not have been paid but for the transaction is relevant, but is not determinative. An amount paid to determine the value or price of a transaction is an amount paid in the process of investigating or otherwise pursuing the transaction. Employee compensation, overhead, and other costs are treated as amounts that do not facilitate a transaction.

In general, an amount paid by a taxpayer in the process of investigating or otherwise pursuing a covered transaction facilitates the transaction only if the amount relates to activities performed on or after the earlier of –

(i) The date on which a letter of intent, exclusivity agreement, or similar written communication (other than a confidentiality agreement) is executed by the acquirer and the target; or
(ii) The date on which the material terms of the transaction (as tentatively agreed to by the acquirer and the target) are authorized or approved by the taxpayer’s board of directors, or the date on which the acquirer and the target execute a binding written contract reflecting the terms of the transaction.
Notwithstanding the general rule, an amount paid in the process of investigating or otherwise pursuing a covered transaction facilitates that transaction if the amount is “inherently facilitative”, regardless of whether the amount is paid for activities performed prior to the date determined above. An amount is inherently facilitative if the amount is paid for –
(i) Securing an appraisal or formal written evaluation;
(ii) Structuring the transaction, including obtaining tax advice on the structure;
(iii) Preparing and reviewing the documents that effectuate the transaction;
(iv) Obtaining regulatory approval;
(v) Obtaining shareholder approval; or
(vi) Conveying property between the parties.

In the case of a taxable asset or stock acquisition, an amount required to be capitalized by the acquirer is added to the basis of the acquired assets (in the case of a transaction that is treated as an acquisition of the target’s assets for federal income tax purposes) or the acquired stock (in the case of a transaction that is treated as an acquisition of the target stock for federal income tax purposes).

The IRS’s Opinion: Capital Gain or Loss?

The IRS explained that capital gain or loss is gain or loss that is realized from the sale or exchange of a capital asset.

Gain or loss, it stated, that is attributable to the cancellation, lapse, expiration or other termination of a right or obligation with respect to property which is (or on acquisition would be) a capital asset in the hands of the taxpayer is treated as gain or loss from the sale of a capital asset.

The Code allows as a deduction any uncompensated loss sustained by a taxpayer during the taxable year. The IRS noted, however, that capital losses are subject to certain limitations.

Specifically, in the case of a corporation, losses from sales or exchanges of capital assets are limited to gains from the sale or exchange of such assets. The IRS noted, however, that capital losses in excess of such gains are carried forward.

In the advisory opinion, the IRS determined that Target’s stock would have been a capital asset in Taxpayer’s hands upon acquisition. The Contract provided Taxpayer with a bundle of rights vis-a-vis Target that related to Taxpayer’s proposed acquisition of Target stock. Although the Contract was between Taxpayer and Target, rather than between Taxpayer and Target’s shareholders, a contract between the acquiring corporation and the target corporation, the IRS stated, is a customary part of the process by which the stock of a target corporation may be acquired. The Contract imposed obligations on both parties with respect to Target’s stock. The Contract also provided Taxpayer with rights with respect to Target’s stock.

The IRS determined that the termination fee payable to Taxpayer under the Contract was in the nature of liquidated damages. Thus, any gain or loss realized by Taxpayer on the termination of the Contract, which provided rights and obligations with respect to Target’s stock (a capital asset), would be capital in nature.

Based on the foregoing, the IRS concluded that Taxpayer’s amount realized from the receipt of the termination fee of $X should be reduced by Taxpayer’s capitalized facilitative costs of $Y.

Where the termination fee exceeded these costs, Taxpayer would have realized a gain. Because this gain would have been attributable to the termination of Taxpayer’s right with respect to Target’s stock, property that would have been a capital asset in Taxpayer’s hands, the gain would have been treated as a gain from the sale of a capital asset. Accordingly, Taxpayer would have realized a capital gain.

Where the termination fee was less than Taxpayer’s capitalized facilitative costs, Taxpayer would have realized a loss and, because this loss was attributable to the termination of Taxpayer’s right with respect to Target’s stock, property that would have been a capital asset in Taxpayer’s hands, the loss would be treated as a loss from the sale of a capital asset. Accordingly, Taxpayer would have a capital loss that Taxpayer may deduct, subject to certain limitations on capital losses.

Take-Away

Yes, I sound like a broken record (or CD or phone or notebook or whatever), but it bears repeating.

Every transfer of value in an acquisitive transaction will have economic and tax consequences. In order to ensure the desired economic result (after taxes), a party to the transaction has to consult its tax advisers regarding the tax consequences and the manner in which the transfer should be structured and/or characterized so as to generate the desired result. Armed with this knowledge, the party can then determine whether the appropriate amount of value is being paid or received.