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.

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[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.

This is the third in a series of posts reviewing the recently proposed regulations (“PR”) under Sec. 199A of the Code. https://www.federalregister.gov/documents/2018/08/16/2018-17276/qualified-business-income-deduction

So far, we’ve considered the elements of a “qualified trade or business” under Section 199A https://www.taxlawforchb.com/2018/09/the-proposed-sec-199a-regs-are-here-part-one/, and the related issue of what constitutes a “specified service trade or business,” the owners of which may be denied the benefit of Section 199A. https://www.taxlawforchb.com/2018/09/the-proposed-sec-199a-regs-are-here-part-two/ Today we’ll turn to the meaning of “qualified business income.”

Qualified Business Income – In General

In general, under Section 199A of the Code, a non-corporate taxpayer is allowed a deduction (the “Section 199A deduction”) for a taxable year equal to 20% of the taxpayer’s qualified business income (“QBI”) with respect to a qualified trade or business (“QTB”) for such year.

The term “QBI” means, for any taxable year, the net amount of “qualified items of income, gain, deduction, and loss” attributable to any QTB of the taxpayer, which in turn means those items of income, gain, deduction, and loss to the extent they are (i) “effectively connected with” the conduct of a trade or business within the U.S., and (ii) included or allowed in determining taxable income for the taxable year.

QBI items must be determined for each QTB by the individual or pass-through entity (“PTE”) that directly conducts the trade or business before applying the aggregation rules. https://www.taxlawforchb.com/2018/09/the-proposed-sec-199a-regs-are-here-part-one/

Exclusion from QBI for Certain Items

The PR provide a list of items that are not taken into account as qualified items of income, gain, deduction, and loss, including capital gain or loss, dividends, interest income other than interest income properly allocable to a trade or business, and certain other items; similarly, items of deduction or loss attributable to these items of income or gain are also not taken into account in determining a taxpayer’s QBI.

Compensation for Services

In general, S corporations must pay their shareholder-employees “reasonable compensation” for services rendered before making “dividend” distributions with respect to shareholder-employees’ stock in the S corporation.

The PR provide that QBI does not include the amount of reasonable compensation paid to the shareholder-employee of an S corporation that operates a QTB for services rendered by the shareholder-employee with respect to such trade or business.

However, the S corporation’s deduction for such reasonable compensation reduces QBI if such deduction is properly allocable to the trade or business and is otherwise deductible.

Guaranteed Payments

Similarly, the PR provide that QBI does not include any guaranteed payment – one determined without regard to the income of the partnership – made by a partnership to a partner for services rendered with respect to the partnership’s trade or business.

However, the partnership’s related expense deduction for making the guaranteed payment may constitute an item of QBI. [i]

The PR clarify that QBI does not include any guaranteed payment paid to a partner for services rendered, regardless of whether the partner is an individual or a PTE. Therefore, a guaranteed payment paid by a lower-tier partnership to an upper-tier partnership retains its character as a guaranteed payment and is not included in QBI of a partner of the upper-tier partnership regardless of whether it is guaranteed to the ultimate recipient.

Other Payments to “Partners”

QBI does not include any payment to a partner, regardless of whether the partner is an individual or a PTE, for services rendered with respect to the partnership’s trade or business where the partner engages with the partnership other than in their capacity as a partner. Thus, it is treated similarly to guaranteed payments, reasonable compensation, and wages, none of which is includable in QBI.

Guaranteed Payments for the Use of Capital

Because guaranteed payments for the use of capital are determined without regard to the income of the partnership, the PR provide that such payments are not considered attributable to a trade or business, and thus do not constitute QBI.

However, the partnership’s related expense for making the guaranteed payments may constitute an item of QBI.

Interest Income

QBI does not include any interest income other than interest income that is properly allocable to a trade or business.

According to the PR, interest income received on working capital, reserves, and similar accounts is income from assets held for investment and is not properly allocable to a trade or business.

In contrast, interest income received on accounts or notes receivable for services or goods provided by the trade or business is not income from assets held for investment, but income received on assets acquired in the ordinary course of the trade or business.

QBI – Special Rules

In addition to the foregoing exclusions, the PR clarify the treatment of certain items that may be of interest to taxpayers that are disposing of their interest in a trade or business.

“Hot Asset” Gain

Under the partnership rules, the gain realized by a partner on the exchange of all or part of their interest in a partnership is treated as ordinary income to the extent it is attributable to the unrealized receivables or inventory items (“hot assets”) of the partnership. These are items that eventually would have been recognized by the partnership and allocated to the partner in the ordinary course; the exchange by the partner of their partnership interest merely accelerates this recognition and allocation.

Similarly, a distribution of property by a partnership to a partner in exchange for the partner’s interest in the “hot assets” of the partnership may be treated as sale or exchange of such hot assets between the partner and the partnership, thereby generating ordinary income.

According to the PR, any gain that is attributable to the hot assets of a partnership – thereby giving rise to ordinary income in the circumstances described above – is considered attributable to the trade or business conducted by the partnership, and therefore, may constitute QBI to the partner.

Of course, the term “unrealized receivables” is defined to include not only receivables, but other items as well; for example, depreciation recapture. This may be significant in the sale of a business by a PTE where the gain arising from the sale would otherwise be excluded from QBI.

Change in Accounting Adjustments

If a taxpayer changes their method of accounting, the Code requires that certain adjustments be made in computing the taxpayer’s taxable income in order to prevent amounts of income or deduction from being duplicated or omitted. In general, these adjustments are taken into account by the taxpayer over a three-year period.

The PR provide that when such adjustments (whether positive or negative) are attributable to a QTB, and arise in a taxable year ending after December 31, 2017, they will be treated as attributable to that trade or business. Accordingly, such adjustments may constitute QBI.

Previously Suspended Losses

Several sections of the Code provide for the disallowance of losses and deductions to a taxpayer in certain cases; for example, the “at risk” rules and the “passive activity loss” rules. Generally, the disallowed amounts are suspended and carried forward to the following year, at which point they are re-tested and may become allowable; of course, when the taxpayer disposes of their interest in the business to an unrelated party in a fully taxable transaction, the loss will cease to be suspended.

Likewise, losses may be suspended because an individual shareholder of an S corporation does not have sufficient stock or debt basis to utilize them; however, the actual or deemed sale of the assets of the S corporation’s business may generate enough gain to increase such basis and enable the shareholder to use the suspended losses.

The PR provide that, to the extent that any previously disallowed losses or deductions, attributable to a QTB, are allowed in the taxable year, they are treated as items attributable to the trade or business. Thus, losses that cease to be suspended under one of the above “disposition rules” may be treated as QBI. However, losses or deductions that were disallowed for taxable years beginning before January 1, 2018 are not taken into account for purposes of computing QBI in a later taxable year.

Net Operating Losses

Generally, items giving rise to a net operating loss (“NOL”) are allowed in computing taxable income in the year incurred. Because those items would have been taken into account in computing QBI in the year incurred, the NOL should not be treated as QBI in subsequent years.

However, to the extent the NOL is comprised of amounts attributable to a QTB that were disallowed under the new “excess business loss” rule – which are not allowed in computing taxable income for the taxable year but which are, instead, carried forward and treated as part of the taxpayer’s net operating loss carryforward in subsequent taxable years – the NOL is considered attributable to that trade or business, and may constitute QBI. https://www.taxlawforchb.com/2018/01/the-real-property-business-and-the-tax-cuts-jobs-act/

Property Used in the Trade or Business

QBI does not include any item of short-term capital gain, short-term capital loss, long-term capital gain, or long-term capital loss.

The Code provides rules under which gains and losses from the sale or exchange of certain property used in a trade or business are either treated as long-term capital gains or long-term capital losses, or are not treated as gains and losses from sales or exchanges of capital assets.[ii]

The PR clarify that QBI excludes short-term and long-term capital gains or losses, regardless of whether those items arise from the sale or exchange of a capital asset, including any item treated as one of such items taken into account in determining net long-term capital gain or net long-term capital loss.

Conversely, if the gains or losses are not treated as gains and losses from sales or exchanges of capital assets, the gains or losses may be included in QBI.

Effectively Connected With a U.S. Trade or Business

Section 199A applies to all non-corporate taxpayers, whether such taxpayers are domestic or foreign. Accordingly, Section 199A applies to both U.S. citizens and resident aliens, as well as nonresident aliens (“NRA”) that have QBI.

QBI includes items of income, gain, deduction, and loss to the extent such items are (i) included or allowed in determining the U.S. person’s or NRA’s taxable income for the taxable year, and (ii) effectively connected with the conduct of a trade or business within the U.S.

Determining Effectively Connected Income

In general, whether a QTB is engaged in a trade or business within the U.S., partially within the U.S., or solely outside the U.S., is based upon all the facts and circumstances.[iii]

If a trade or business is not engaged in a U.S. trade or business, items of income, gain, deduction, or loss from that trade or business will not be included in QBI because such items would not be effectively connected with the conduct of a U.S. trade or business.

Thus, a shareholder of an S corporation, or a U.S. partner of a partnership, that is engaged in a trade or business in both the U.S. and overseas would only take into account the items of income, deduction, gain, and loss that would be effectively connected with the business conducted by the S corporation, or partnership, in the U.S.

In determining whether income or gain from U.S. sources is effectively connected with the conduct of a trade or business within the U.S., a number of factors have to be considered, including whether the income, gain or loss is derived from assets used in or held for use in the conduct of such trade or business, or the activities of such trade or business were a material factor in the realization of the income, gain or loss.

If an NRA’s QTB is determined to be conducted in the U.S., the Code generally treats all non-investment income of the NRA from sources within the U.S. as effectively connected with the conduct of a U.S. trade or business.[iv]

Income from sources without the U.S. is generally not treated as effectively connected with the NRA’s conduct of a U.S. trade or business. Thus, a trade or business’s foreign source income, gain, or loss, (and any deductions effectively connected with such foreign source income, gain, or loss) would generally not be included in QBI.[v]

However, this rule does not mean that any item of income or deduction that is treated as effectively connected with an NRA’s conduct of a trade or business with the U.S. is necessarily QBI. Indeed, certain provisions of the Code allow items to be treated as effectively connected, even though they are not “items” with respect to a trade or business. For example, the Code allows an NRA to elect to treat income from rental real property in the U.S. that would not otherwise be treated as effectively connected with the conduct of a trade or business within the U.S. as effectively connected. However, if items are not attributable to a QTB, they do not constitute QBI.

Allocation of QBI Items

The PR provides that, if an individual or a PTE directly conducts multiple trades or businesses, and has items of QBI that are properly attributable to more than one trade or business, the taxpayer or entity must allocate those items among the several trades or businesses to which they are attributable using a reasonable method that is consistent with the purposes of Section 199A.

The chosen reasonable method for each item must be consistently applied from one taxable year to another, and must clearly reflect the income of each trade or business.

There are several different ways to allocate expenses, such as direct tracing, allocating based on gross income, or some other method, but whether these are reasonable depends on the facts and circumstances of each trade or business.

Next week, we’ll bring together the basic elements of Section 199A, which we covered in the last three posts, to see how the “20% deduction” is determined.

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[i] The PR provides that QBI does not include reasonable compensation paid by an S corporation but does not extend this rule to partnerships. Because the trade or business of performing services as an employee is not a QTB, wage income received by an employee is never QBI.

The rule for reasonable compensation is merely a clarification that, even if an S corporation fails to pay a reasonable wage to its shareholder-employees, the shareholder-employees are nonetheless prevented from including an amount equal to reasonable compensation in QBI.

[ii] IRC Sec. 1231.

[iii] Because an NRA cannot be a shareholder on an S corporation, the NRA’s effectively connected income must arise from the NRA’s direct conduct of a trade or business in the U.S. (including through a disregarded entity; if the NRA is a resident of a treaty country, the NRA’s business profits will not be subject to U.S. tax unless the NRA operates the business through a permanent establishment in the U.S.); in addition, an NRA is considered engaged in a trade or business within the U.S. if the partnership of which such individual is a member is so engaged.

[iv] However, any “FDAP” income or “portfolio interest” income from sources within the U.S., and any gain or loss from the sale of capital assets, may be effectively connected only if the income meets certain requirements.

[v] There are exceptions.

One Day . . .
It is the dream of so many New York business owners: build a successful business, get your kids involved in the business, transition the operation, management and – eventually – the ownership of the business to the kids, move to Florida (or another warm, tax-friendly venue), successfully fend off New York’s inevitable challenge to your claimed change of domicile, stay involved in the business, pay no New York income tax on any income derived from the business, and pass away – yes, that is a morbid thing to say, but “death and taxes” – happy in the knowledge that your estate will not be subject to New York’s estate tax. Not much to ask for, right?

Earlier posts have described the factors that New York considers in determining an individual’s domicile or residence. See, e.g., “New York Business, the Federal Tax Return, and New York Domicile.”

Escape from NY . . .
The resolution of a taxpayer’s resident status vis-à-vis New York is of paramount importance to the taxpayer.

A New York State resident taxpayer is responsible for reporting and paying New York State personal income tax on income from all sources regardless of where the income is generated, or the nature of the income.

A nonresident taxpayer, however, is given the opportunity to allocate income, reporting to New York State only that income actually generated in New York. In addition, the nonresident need only report to New York income from intangibles which are attributable to a business, trade or profession carried on in the State.

Thus, significant benefits may be derived from filing as a nonresident.

. . . Not Entirely
Because a taxpayer’s New York source income will remain subject to New York’s tax jurisdiction even where the taxpayer has successfully established his or her status as a non-resident, it behooves the taxpayer to become familiar with New York’s sourcing rules. A nonresident taxpayer’s New York income will include the taxpayer’s income from:
• real or tangible personal property located in New York State, (including certain gains from the sale or exchange of an interest in an entity that owns real property in New York;
• services performed in New York;
• a business, trade, profession, or occupation carried on in New York;
• his or her distributive share of New York partnership income or gain;
• his or her share of New York estate or trust income or gain;
• any income he or she received related to a business, trade, profession, or occupation previously carried on in New York State, including but not limited to covenants not to compete and termination agreements; and
• a New York S corporation in which he or she is a shareholder.
Some of these source rules are more easily applied than others. In those cases where the facts are disputed, the taxpayer can count on New York to assert the requisite nexus.

In a recent decision, an Administrative Law Judge (“ALJ”) rejected New York’s somewhat creative attempt to tax a Florida resident’s consulting fees. [Carmelo and Marianna Giuffre, DTA NO. 826168)

Unfortunately, the ruling is light on facts and, so, leaves several questions unanswered.

Father Knows Best?
The Taxpayer resided and was domiciled in Florida during the year at issue. He was employed by Consulting LLC (Consulting). Consulting was a Florida limited liability company with its principal place of business located in Florida. Taxpayer was its sole member.

Prior to his employment by Consulting, Taxpayer was the president Family Corp., located in New York City. Family Corp. was a family-owned company that operated Business in New York and New Jersey. During the year at issue, Taxpayer’s sons and nephew owned and operated Business.

Consulting provided “management consulting” services for Business. Taxpayer rendered these services as an employee of Consulting, from its offices in Florida.

By agreement between Consulting and Family Corp., Consulting agreed to perform consulting work for Family Corp. The agreement explicitly provided that the consulting services “shall be provided via telephone or electronically” and that it is not anticipated that the consulting services would require any Consulting employee to travel to New York City or any of Business’s other locations.

Under the agreement, Consulting acted in an advisory role, and neither it nor Taxpayer was involved in the day-to-day management or decision-making process of Family Corp. The consulting services were performed, and the business of Consulting was conducted, from its Florida office. Taxpayer was paid an annual salary for his services by Consulting.

Taxpayer visited New York during the year at issue. The primary purpose of his visits were personal in nature. He visited family members who resided in the New York metropolitan area. Although he also visited the Business locations owned by Family Corp., these visits also were personal in nature. Taxpayer did not maintain a desk or office in any of the locations. He was not involved in any daily operations of Business during the year at issue.

New York’s Unsuccessful Play
New York asserted that Taxpayer had New York source income for the year at issue, based upon an allocation formula that used the number of Business locations in New York, divided by the total number of Business locations, to arrive at an allocation of 10/17, or approximately 59%. The State then multiplied that percentage by the amount of Taxpayer’s salary from Consulting for that year to arrive at a net allocation of almost $800,000 as New York income.

The only issue before the ALJ was whether Taxpayer had income that was derived from, or connected to, New York sources; in other words, whether Taxpayer had rendered consulting services in New York during the year at issue. According to the ALJ, he did not.

The ALJ explained that New York imposes personal income tax on the income of nonresident individuals to the extent that their income is derived from or connected to New York sources (Tax Law Sec. 601[e][1] http://codes.findlaw.com/ny/tax-law/tax-sect-601.html ). A nonresident individual’s New York source income includes the net amount of items of income, gain, loss and deduction entering into the individual’s federal adjusted gross income derived from or connected with New York sources, including income attributable to a business, trade, profession or occupation carried on in New York (Tax Law Sec. 631[a][1]; [b][1][B]).

The ALJ also observed that, under New York’s tax regulations, a business, trade, profession or occupation is carried on in New York by a nonresident when:
“such nonresident occupies, has, maintains or operates desk space, an office, a shop, a store, a warehouse, a factory, an agency or other place where such nonresident’s affairs are systematically and regularly carried on, notwithstanding the occasional consummation of isolated transactions without New York. (This definition is not exclusive.) Business is carried on within New York if activities within New York in connection with the business are conducted in New York with a fair measure of permanency and continuity” (20 NYCRR 132.4[a][2]).

The ALJ found that Taxpayer was employed by Consulting, the offices of which were located in Florida. There was no evidence that Taxpayer or Consulting maintained any office or place of business within New York.

In fact, as noted above, the consulting agreement specifically stated that the services provided by Taxpayer would be rendered via telephone or electronically. The agreement did not mention any work space located in New York nor did it contemplate Taxpayer providing any services within New York.

The State relied on case law that involved nonresident individuals who were employed by a New York employer, yet for convenience worked both within and without the State. According to this precedent, a nonresident who performs services in New York, or has an office in New York, is allowed to avoid New York tax liability for services performed outside the State only if they are performed of necessity in the service of the employer. Where the out-of-State services are performed for the employee’s convenience, they generate New York tax liability.

The ALJ rejected the State’s reasoning, finding this case law distinguishable from the Taxpayer’s situation. Taxpayer was a nonresident who worked for a Florida company, not a New York employer. Moreover, Taxpayer did not render services in New York and he did not have an office in New York. As such, the “convenience of the employer” analogy was inapplicable to the Taxpayer.

Any Takeaways?
Although the ALJ’s opinion does not state that Taxpayer was previously a New York resident, it is safe to assume that he was domiciled in New York before moving to Florida.

However, query over what period of time, and how (gifts, sales, GRATs, etc.), Taxpayer transitioned the management of Business, and transferred the ownership of Family Corp., to his sons? This would have been an important consideration in establishing that Taxpayer was no longer domiciled in New York.

According to the opinion, Taxpayer was not involved in the day-to-day management or decision-making process of Family Corp., and his “management consulting” services were to be rendered “via telephone or electronically.” The ALJ based its opinion on these “facts.”

That being said, Family Corp. nevertheless must have determined that Taxpayer’s ongoing services were important to its continued well-being. After all, New York sought to tax $800,000 (or 59%) of Taxpayer’s salary from Consulting for just one tax year. What, then, was the nature of the advice given? (I should tell you, Business operated car dealerships.)

Query also why the ALJ does not seem to have asked whether the fee payable to Consulting (and thereby to Taxpayer) represented reasonable compensation for the services rendered? What if the fee was excessive? To what would the excess amount be attributed? A form of continuing equity participation in Business? Additional, deferred, purchase price for Taxpayer’s equity in Family Corp.? Payment for Taxpayer’s promise not to compete against Family Corp.? Deferred compensation for services rendered by Taxpayer to Family Corp. when he was still a New York resident?

I don’t believe that I would be going out on a limb to suggest that at least one of these elements was at play. In any case, each of these re-characterizations would have generated New York income.

Or was the Family Corp.’s payment made simply to accede to Taxpayer’s demand for some cash flow from “his” business (not an uncommon occurrence) and to thereby remain in Taxpayer’s good graces? After all, a “last” will and testament (or revocable trust) may be changed at any time before the testator’s (or grantor’s) death. (Back to death again.)

As always, it is best for related parties to treat with one another on an arm’s-length basis. Taxpayer undoubtedly gave up ownership and control of Family Corp. and Business in order to support his claim that he had abandoned his New York domicile, and to achieve certain income and estate tax savings.

Yet Taxpayer appears to have required significant cash flow from Business – he could not afford to part with all the economic benefits associated with Family Corp. Granted, that reality is difficult to reconcile with the ends desired (e.g., no New York tax), but “you can’t always get what you want,” but with a little planning, . . . (you know how it goes).