Choice of Entity

The owners of a closely held business will confront many difficult decisions during the life of the business. Among the earliest of these decisions – and one with which the business may have to contend for many years to come[i] – is the so-called “choice of entity”: in what legal form should the business be organized, its assets held, and its activities conducted?

In the case of only one owner, the assets of the business may be held directly by the owner as a sole proprietor; or the business may be organized as single member LLC which, if disregarded for tax purposes,[ii] is treated as a sole proprietorship. Alternatively, it may be organized as a corporation under state law, which will be treated as a C corporation[iii] unless the shareholder elects to treat the corporation as an S corporation.[iv]

Where there are at least two owners, they may decide to own and operate the business as an unincorporated entity – a partnership[v] – or as a corporation.

The form of entity selected for a business may have far-reaching tax and economic consequences, both for the business and for its owners. For example, a decision to operate as a partnership will offer the owners the greatest flexibility in terms of how they share the profits of the business,[vi] but it may subject them to self-employment tax; a decision to operate as an S corporation may require the payment of reasonable compensation to those owners who work in the business,[vii] and will require that the corporation issue only one class of stock and have only individuals as shareholders,[viii] which may limit its ability to raise capital.

In both of these cases, the entity itself is generally not subject to income tax; rather, its annual profits and gains pass through, and are taxed directly, to the entity’s owners whether or not distributed to them – in other words, the owners do not enjoy any tax deferral with respect to the entity.[ix]

By contrast, the profits and gains of a C corporation are taxed to the corporation; in general, they are not taxed to the corporation’s owners until they are distributed to the owners as a dividend. At that point, the corporation’s after-tax profits will be subject to a second level of federal tax; in the case of an individual owner, the dividends will be taxed at the same 20 percent rate generally applicable to capital gains,[x] plus an additional net investment income surtax of 3.8 percent.[xi]

Enter the TCJA

If the choice of entity decision was not already daunting enough for the owners of a business in its infancy, the Tax Cuts and Jobs Act[xii] has added another layer of factors to consider, thus making the decision even more challenging.

For example, the Act reduced the corporate income tax rate by 40 percent – from a maximum graduated rate of 35 percent to a flat rate of 21 percent[xiii] – while also providing the non-corporate owners (basically, individuals) of a pass-through entity (partnerships and S corporations) with a special deduction of up to 20 percent of their share of the entity’s “qualified business income.”[xiv]

In light of this development, the owners of many partnerships, LLCs and S corporations may be considering whether to incorporate,[xv] or to revoke their “S” election,[xvi] in order to take advantage of the much lower corporate tax rate.

Such a change may be especially attractive to a business that is planning to reinvest its profits (for example, in order fund expansion plans) rather than distribute them to the owners.[xvii]

On the other hand, if the partners or S corporation shareholders are planning to sell the business in the next few years, it may not be good idea to convert into a C corporation.[xviii]

Choices, choices, choices. Right, wrong, indifferent?

Regretting the Choice

While taxpayers are free to organize their business in whatever form they choose, once having done so, they must accept the tax consequences of that choice, whether contemplated or not.[xix]

A recent decision by a federal district court considered the strained arguments advanced by one taxpayer in a futile effort to escape the tax consequences of their choice of entity.[xx]

Taxpayer operated his business as a sole proprietorship for several years before incorporating it (the “Corporation”). As the sole shareholder of the corporation, Taxpayer then elected to treat it as an S corporation for federal income tax purposes.

For the next several years, Taxpayer caused Corporation to file a Form 1120S, U.S. Income Tax Return for an S Corporation (“Form 1120S”), to report the income earned and the expenses incurred by the business.

During Tax Year, a second shareholder was admitted to Corporation. Taxpayer and the new shareholder entered into a shareholders’ agreement (the “Agreement”) pursuant to which they agreed that any income earned by Corporation prior to the admission of the second shareholder (“Pre-Existing Business”) would belong to Taxpayer and not to Corporation.[xxi]

On his individual income tax return for Tax Year, Taxpayer attached a Schedule C, Profit and Loss from Business (Sole Proprietorship), to his personal income tax return (Form 1040), on which he claimed deductions for expenses paid or incurred with respect to Pre-Existing Business. These deductions included amounts paid out of Corporation’s bank account. In addition, Taxpayer claimed a deduction for amounts that he paid, out of his personal bank account, to certain employees of Corporation for work they performed with respect to Pre-Existing Business.

After examining Taxpayer’s return for Tax Year, the IRS disallowed each of these deductions, and assessed an income tax deficiency against Taxpayer.

Taxpayer paid the tax liability and then filed a claim for refund, which the IRS denied. Taxpayer then brought a proceeding in a federal district court in which he sought relief from the IRS’s denial of his refund claim.[xxii]

The IRS moved for summary judgment.[xxiii]

“Live With It”

The Court explained that, in a refund action, the complaining taxpayer bears the burden of proving that the challenged IRS tax assessment was erroneous. Specifically, the taxpayer has the burden of proving: his right to a deduction; the amount of the deduction; and, as the nonmoving party, definite and competent evidence to survive summary judgment.

Taxpayer argued that he was entitled to the deductions claimed because the payments on the Pre-Existing Business were not related to Corporation but, instead, were from a separate business operation that he classified as a sole proprietorship. In so arguing, Taxpayer identified the steps he took to separate this Pre-Existing Business from Corporation. He stated that, although there was no formal dissolution of Corporation prior to the admission of the second shareholder, there was a withdrawal of corporate funds, an insertion of new funds, the issuance of new stock to an additional stockholder, and the appointment of an additional officer to the corporation.

The Court pointed out, however, that although Taxpayer claimed that the fees belonged to him personally, and not to Corporation, he also admitted that the funds were deposited into, and paid from, Corporation’s account. Further, Taxpayer admitted that the clients compromising the Pre-Existing Business had not formally retained him individually; rather, they had contracted with Corporation.

The Court observed that Taxpayer’s argument was essentially that he “intended” to form a new business. The Court stated that, notwithstanding Taxpayer’s intentions, a corporation exists for tax purposes if it is formed for a business purpose or if it carries on a business after incorporation. The choice of incorporating to do business, the Court continued, required the acceptance of the tax advantages and disadvantages.

Taxpayer chose to incorporate his business and elected to treat it as an “S” corporation for tax purposes. The Court explained that “S” corporations are corporations that elect to pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes. When the shareholders of a corporation make an S election, they switch from a two-level taxation system to a flow-through taxation system under which income is subjected to only one level of taxation.

The corporation’s profits and losses pass through directly to its shareholders on a pro rata basis and are reported on the shareholders’ individual tax returns, allowing an “S” corporation and its shareholders to avoid double taxation on its corporate income.

The Court stated that, since its formation, Corporation properly filed a Form 1120S to report its income and deductions. When a new a shareholder was added during Tax Year, Corporation amended its name, but it retained its employer identification number and continued to file tax returns using that number.

Taxpayer, however, filed a Schedule C claiming deductions from the Pre-Existing Business. In doing so, he attempted to report income and deductions stemming from a business operated as a sole proprietorship. A sole proprietor, however, is someone who owns an unincorporated business by themselves.

The Court found that Taxpayer could not establish that he operated as a sole proprietor entitling him to take deductions on a Schedule C. Corporation was not dissolved; rather, it continued to operate as an S corporation. Thus, Taxpayer should not have filed Schedule C, and the IRS properly disallowed the deductions on that form.

Though Taxpayer contended, with respect to the Pre-Existing Business, that he operated a separate business apart from Corporation. Notwithstanding that he paid the fees therefor out of Corporation’s account, he argued that he, individually, paid them because the Pre-Existing Business was not associated with Corporation.[xxiv]

The Court rejected Taxpayer’s argument, stating that he failed to establish that he operated any business other than through Corporation. As such, his payments of Corporation’s expenses constituted either a loan or a capital contribution, and were deductible, if at all, not by Taxpayer, but by Corporation.

Therefore, Taxpayer was not personally entitled to take deductions.

Additionally, Taxpayer contended that he was entitled to a deduction for the amount that he paid as bonuses to certain employees of Corporation because the payment was made for work separate and apart from that of Corporation. Taxpayer asserted that he personally, not Corporation, paid these employees and filed Forms 1099 on their behalf.

However, the clients of the Pre-Existing Business had contracted with Corporation, and the payments made in respect thereof were deposited into Corporation’s account. Taxpayer subsequently paid himself from that account. According to the Court, the fact that he did so, and personally made bonus payments to the employees for work associated with the Pre-Existing Business, was immaterial. Again, Taxpayer did not operate as a sole proprietor and, therefore, could not take deductions on a Schedule C. The payments, whether properly made or not, stemmed from Corporation’s business, that never ceased to exist, and “[b ]ecause the expenditures in issue were made on behalf of [Corporation’s] business, we conclude that [Taxpayer] may not claim these expenses as business expense deductions.”

Finally, Taxpayer argued that he entered the Agreement that carved out the Pre-Existing Business from the benefit and the liability of the newly formed corporation. As such, he argued that the work for this Pre-Existing Business was conducted as a separate business from Corporation, and he conducted that business as a sole proprietor entitling him to claim those fees as deductions on a Schedule C.

However, the Court responded, “[a] shareholder cannot convert a business expense of his corporation into a business expense of his own simply by agreeing to bear such an expense.”

“Agreements entered into between individuals may not prevail as against the provisions of the revenue laws in conflict,” the Court stated. Parties are free to contract and, when they agree to a transaction, federal law then governs the tax consequences of their agreement, whether those consequences were contemplated or not.

The Court found that Taxpayer could not establish that he was entitled to the disallowed deductions on his Schedule C – there was no clear evidence that he operated a business separate from that of Corporation.

Accordingly, the Court granted the IRS’s motion for summary judgment.

What to Do?

Taxes play a significant part in a business owner’s choice of entity decision. The selection made will result in tax consequences of which a business owner should be aware before making that decision; thus, the decision should be made only after consulting with one’s tax advisers.

It is also important that the decision be made with an understanding of the economics of the business. Among the items to be considered are the following: who will invest in the business, will the business have to borrow funds, is it expected to generate losses, will it be reinvesting its profits or distributing them?

Of course, the responses to these questions may depend upon the stage in the life of the business at which they are being considered. Likewise, the owners of the business may decide to change the form of their business entity when it makes sense to do so. In other words, the choice of entity decision should not be treated as a “make-it-and-forget-it” decision; rather, it should be viewed as one that evolves over the life of the business.[xxv]

For example, a simple evolution of a business’s form of entity may go something like this: it may start out as a sole proprietorship or partnership in order to pass through losses, it may convert to a C corporation as it becomes profitable and starts to retain earnings to fund the growth of the business,[xxvi] and it may elect S corporation status when it is ready to distribute profits or when its owners begin to consider the sale of the business.[xxvii]

What’s more, the choice of one form of entity does not necessarily preclude the concurrent use of another form for a specific purpose. Thus, for example, an S corporation that operates two lines of business may form an LLC (treated as a partnership) to serve as an investment vehicle to which it and a corporate or foreign investor[xxviii] may contribute the assets of one line of business and funds, respectively.[xxix]

However, whatever the form of entity chosen, it is imperative that the business owners respect their chosen form, lest they invite an audit. For one thing, it is certain that the IRS and the courts will hold them to their form (as the Taxpayer learned in the case described above); moreover, an audit will often entail other unexpected goodies for the IRS.

That being said, in the event the chosen form generates unexpected and adverse tax consequences, the business and its owners, in consultation with their tax advisers, may be able to mitigate them, provided they act quickly.


[i] No pressure.

[ii] Its default status in the absence of an election to be treated as an association taxable as a corporation. Reg. Sec. 301.7701-3.

[iii] Reg. Sec. 301.7701-2.

[iv] IRC Sec. 1361 and 1362.

[v] Reg. Sec. 301-7701-3; IRC Sec. 761. This includes an LLC that does not elect to be treated as an association.

[vi] For example, some owners may be issued preferred interests, or they may have special allocations of income and loss.

[vii] There is no comparable tax rule for partners.

[viii] Plus their estates and certain trusts created by these shareholders. IRC Sec. 1361(c).

[ix] The maximum federal income tax rate applicable to individuals is now set at 37 percent. If the individual partner or shareholder does not materially participate in the entity’s business, the 3.8 percent surtax on net investment income will also apply.

[x] IRC Sec. 1(h).

[xi] IRC Sec. 1411. Of course, I am assuming that the shareholder’s modified adjusted gross income exceeds the threshold amount.

[xii] P.L. 115-97 (the “Act”).

[xiii] IRC Sec. 11.

[xiv] IRC Sec. 199A.

[xv] IRC Sec. 351. Beware IRC Sec. 357(c). See Rev. Rul. 84-111.

[xvi] IRC Sec. 1362. Once the S election is revoked, the shareholders may not re-elect “S” status for five years.

It should also be noted that the conversion from “S” to “C” may require that the corporation change its accounting method from cash to accrual. This change may cause the immediate recognition of significant amounts of income. Thankfully, the Act provides for a 6-year period over which this income may be recognized by the C corporation, provided certain conditions are met. IRC Sec. 481(d).

[xvii] Although it is conceivable that a corporation may consider converting into a partnership or a disregarded entity, such a conversion, however effected, will be treated as a liquidation of the corporation, which will be taxable to both the corporation and its shareholders. Reg. Sec. 301.7701-3(g).

[xviii] Of course, I am referring to the two levels of tax attendant on the sale of C corporation. In most cases, the buyer of a closely held business will choose to structure the purchase as an acquisition of assets; not only does this allow the buyer to cherry pick the target assets to be acquired and the liabilities to be assumed, it also gives the buyer a stepped-up basis in these assets which the buyer may then expense, amortize or depreciate (depending on the asset), which enables the buyer to recover its investment faster than if it had just acquired the stock of the target corporation. Unfortunately for the target shareholders, the asset sale is taxable to the corporation and, when the remaining sale proceeds are distributed to the shareholders, those proceeds are taxable to the shareholders.

[xix] https://www.taxlawforchb.com/tag/danielson-rule/ . Call it a corollary of the “Danielson rule.”

[xx] Morowitz v. United States, No 1:17-CV-00291 (D.R.I. Mar. 7, 2019).

[xxi] Interestingly, neither the IRS nor the Court raised the issue of a prohibited second class of stock. IRC Sec. 1361(b); Reg. Sec. 1.1361-1(l). If the entity had been formed as a partnership with the admission of the new owner, the Taxpayer’s initial capital account would have reflected the value operational results of the business prior to the creation of the partnership; if the entity had already been a partnership, Taxpayer’s capital account would have been similarly adjusted prior to the admission of the new partner. Reg. Sec. 1.704(b)-1(b)(2)(iv).

[xxii] IRC Sec. 7422. It is unclear why the Taxpayer chose to pay the tax and then apply for a refund, rather than file a petition with the Tax Court. The Tax Court’s jurisdiction is not dependent on the tax having been paid.

[xxiii] Summary judgment is appropriate where the pleadings, depositions, etc., show that there is no genuine issue as to any material fact and that the moving party is entitled to judgment as a matter of law. The substantive law identifies the facts that are material; only disputes over facts that might affect the outcome of the suit under the governing law will preclude the entry of summary judgment.

[xxiv] This comes under the category of “you can’t make this shit up.”

[xxv] Complete non sequitur: life insurance also falls into this category – it should be reviewed periodically.

[xxvi] The current 21 percent flat corporate rate is key.

[xxvii] Of course, a sale structured as an actual or deemed sale of assets must consider the built-in gains tax. IRC Sec. 1374.

[xxviii] Neither of which may own shares of stock in an S corporation. IRC Sec. 1361(b).

[xxix] See the partnership anti-abuse rules in Reg. Sec. 1.701-2, in which the IRS accepted an S corporation’s bona fide business use of a partnership.

“You Know What I Meant”

In order to determine the income tax consequences of a given transaction, a court must sometimes ascertain the intention of the taxpayers who were parties to the transaction. In making its determination, the court will consider all of the relevant facts and circumstances, including the terms of any written agreement between the parties, the tax returns filed by the parties, the parties’ testimony and actions, and other indicia of intent.

In prior posts, we have discussed situations in which a court had to evaluate whether a transaction constituted a loan or a contribution to capital, a gift or an arm’s-length transfer, compensation or a loan, a sale or a lease, an option or a sale, etc. We have considered the capacity in which one or more parties to a transaction were acting; for example, as a shareholder or as a representative of a corporation, as an employee or as an individual, as a corporate officer or as a parent.

Depending upon the characterization of the transaction, and the identity of the parties, a taxpayer may have to recognize ordinary income or capital gain, or they may have no immediate taxable event at all.

Too often, however, and especially in the context of dealings involving a closely held business, the parties to the transaction – which may include the settlement of a dispute – will fail to set forth their agreement in sufficient detail, including its intended tax treatment.[i]

An unscrupulous party may seek to exploit any ambiguity for its own benefit by taking a position that is inconsistent with the parties’ implicit agreement or understanding, whether from a tax perspective or otherwise.

Alternatively, a taxing authority may rely upon an ambiguity to interpret an agreement and its tax consequences in a way that is inconsistent with a party’s tax return position.

Either way, at least one of the parties risks an economic loss.

A Recent Illustration

https://www.ustaxcourt.gov/ustcinop/opinionviewer.aspx?ID=11871

Employer provided business-to-business lead generation services for its clients.

Under Taxpayer’s initial employment contract, Employer paid Taxpayer both a salary and a commission. Under the terms of the contract, Taxpayer’s salary was reduced over time, the expectation being that his commissions would represent a greater portion of his pay as he settled into his position. At the same time, Taxpayer’s commission rate also decreased over time, thus creating an incentive for Taxpayer to sign new clients. Taxpayer and Employer later modified his compensation structure, forgoing any salary in favor of straight commission payments.

The IP

After being hired, Taxpayer began to design a method by which a business could allocate leads and target marketing efforts more effectively (the “IP”). Taxpayer filed a provisional patent application for the IP; after Employer waived any rights it had in the IP, Taxpayer filed a regular patent application.

Taxpayer used the IP to secure several important accounts for Employer. He was not involved in managing the accounts after he secured them.

A couple of years into their relationship, Taxpayer and Employer signed a broker agreement under which Taxpayer was no longer an employee of Employer but, instead, a broker acting on Employer’s behalf through Taxpayer’s wholly-owned S corporation (“Corp”). Under this agreement, Taxpayer continued to receive a commission from new account billings, but only for three years from the date on which Employer’s work on an account originated.

PC Wants the IP

At some point, Employer’s parent company (“PC”) began to consider a sale of Employer. In preparation for the sale of Employer, PC sought to obtain, and approached Taxpayer about acquiring, the rights to the IP.

As it turned out, Taxpayer needed cash to support another venture, so he was amenable to a transfer. He proposed two options: (1) he would license the IP to PC and receive royalties, which would increase once the patent was awarded; or (2) he would assign all rights in the IP to PC, in exchange for an extension of his commissions[ii] from certain accounts (the “Accounts”).

The Agreement

Taxpayer executed an assignment of the IP to PC. At the same time, Taxpayer and PC executed a written addendum to his commission structure (the “addendum”) that extended the period during which Taxpayer would receive commissions from the Accounts.

The addendum also provided that, in the event PC terminated its relationship with Taxpayer, PC would “pay the equivalent of one month’s commission (based on the average of the most recent 12 months of commissions) for each year of service provided.” Neither party consulted a lawyer in connection with the transfer of the IP or the addendum.

Tax Reporting

During the taxable year in issue, Taxpayer received commissions from the Accounts, and Employer issued a Form 1099-MISC, Miscellaneous Income, to Corp reporting a payment of nonemployee compensation.

One year later, PC terminated its broker relationship with Corp as it prepared to file for bankruptcy. Taxpayer filed a proof of claim in PC’s bankruptcy case for severance pay.

Taxpayer reported only $400 of long-term capital gain[iii] on his Form 1040, U.S. Individual Income Tax Return for the year in issue. Corp reported over $1.3 million of total income[iv] on its Form 1120S, U.S. Income Tax Return for an S Corporation.

Later, however, Taxpayer and Corp amended their respective returns: Taxpayer reported over $800,000 of long-term capital gains and attributed them to the transfer of the IP; Corp reduced its reported total income by the same amount, on its Form 1120S, which resulted in a loss for the tax year.

The IRS questioned whether the payments to Taxpayer, attributable to the above-referenced addendum, were made in consideration for the transfer of the IP; it asserted that the payments actually represented commissions that were taxable as ordinary income. The IRS issued a notice of deficiency, and Taxpayer petitioned the U.S. Tax Court.

Classification of Income

The question before the Court was whether any of the payments under the addendum were in exchange for Taxpayer’s assignment of the IP, or were owed to Corp under its broker agreement.

Section 1235

The Court began its analysis by reviewing Section 1235 of the Code https://www.law.cornell.edu/uscode/text/26/1235 , which provides that the “transfer * * * of property consisting of all substantial rights to a patent * * * by any holder[v] shall be considered the sale or exchange of a capital asset held for more than 1 year.”[vi] This treatment, the Court observed, applies regardless of whether payments in consideration of the transfer are payable periodically or are contingent on the productivity, use, or disposition of the property. Moreover, the patent need not be in existence at the time of transfer if the requirements of Section 1235 are otherwise met.[vii]

According to the Court, the term “all substantial rights to a patent” means “all rights * * * which are of value at the time the rights to the patent * * * are transferred.”

In determining whether all substantial rights in the IP were transferred, the Court stated that it would consider “[t]he circumstances of the whole transaction, rather than the particular terminology used in the instrument of transfer.”

The Court noted that the IRS did not dispute that the IP was transferred, or that the transfer of the IP met the requirements of Section 1235. However, the IRS disputed that the payments attributable to the addendum were made in consideration for that transfer; without that direct nexus, the payments would not be treated as long-term capital gain under Section 1235.

Contract Interpretation

Turning to the addendum, the Court stated that “[t]he cardinal rule in the interpretation of contracts is to ascertain the mutual intention of the parties.”

It then added that, under applicable State law, the Court would limit the scope of its search to the four corners of the document if its terms were “clear and unambiguous.” Where the terms of the document were unclear or ambiguous, the Court “may consider extrinsic evidence as well as the parties’ interpretation of the contract to explain or clarify the ambiguous language.” The parties’ construction of ambiguous terms in a contract, the Court added, “is entitled to great weight in determining its meaning.”

The Court found that the text of the addendum was susceptible of more than one interpretation.

The IRS’s Position

The IRS contended that the payments under the addendum were not consideration for the IP but, rather, for some other purpose, and that Taxpayer was compensated for the IP – which the IRS argued had little to no value – in some other way. First, the IRS pointed out that there was no reference in the addendum to the transfer, Taxpayer did not retain a security interest in the IP, and the addendum included several provisions that were standard in a commission agreement. Second, the IRS argued that the circumstances surrounding the addendum did not support Taxpayer’s claim; specifically, the IRS asserted that the addendum was executed before Taxpayer’s discussion with PC about transferring the IP. And third, the IRS argued that the form of the transaction did not support Taxpayer’s claim because both PC (on a Form 1099-MISC) and Taxpayer (on his tax return) initially reported the payments as nonemployee compensation to Corp, rather than as consideration for the IP; according to the IRS, Taxpayer should escape the tax consequences of his chosen form.[viii]

The Court Disagrees

The Court acknowledged that there was no explicit reference to the transfer of the IP in the addendum, and the date on the addendum seemed to support the IRS’s contention that the addendum was signed before and, therefore, was independent of the Taxpayer’s discussions about the transfer of the IP.

However, the Court believed that PC’s representative credibly testified that she approached Taxpayer about the transfer of the IP in the year immediately preceding the year in which the addendum was executed. She and Taxpayer also credibly testified that they understood the addendum to be consideration for the rights to the IP. The Court believed it was significant that the parties to the addendum conceived of it in the same way.

The Court turned next to the date the addendum was signed, commenting that it was possible that the addendum was signed in contemplation of some sort of transfer. In any event, in the context of the other evidence, in particular the credible testimony of key participants in the transaction, the Court stated that it could not decide that the date on the addendum foreclosed a conclusion that PC agreed to pay the additional amounts under the addendum in exchange for the IP.

The IRS also argued that the addendum was some kind of “makeshift noncompete agreement,” rather than consideration for the rights to the IP, and that PC compensated Taxpayer for those rights in some other way.

However, Taxpayer had no involvement with the Accounts after securing them for Employer, and the Court found no evidence that Taxpayer had the desire or the capacity to manage the Accounts himself. Furthermore, the record showed that PC assigned some value to the IP – it sought to acquire the IP from Taxpayer, not a noncompete agreement. For this reason, the Court also rejected the IRS’s theory that the IP had only nominal value to PC. The Court was also convinced that PC wanted something in return for the additional payments under the modified addendum, and the only valuable consideration remaining was the IP.

Therefore, the Court found that the addendum provided for additional payments in exchange for Taxpayer’s transfer of all his rights in the IP to PC (notwithstanding that the amount of such payments was determined by reference to a formula that had been used to calculate the Taxpayer’s commission for services rendered).

The Court also found that Taxpayer’s failure to retain a security interest was a reflection of the parties’ circumstances as they were discussing the transfer rather than evidence that the addendum constituted an ordinary commission or noncompete agreement. Both Taxpayer and PC were focused on transferring the IP as soon as possible – Taxpayer wanted cash to invest in a new venture, and PC wanted to obtain the rights before PC was sold.[ix]

Thus, the Court concluded that Taxpayer’s transfer of the IP to PC met the requirements for long-term capital gain treatment under Section 1235 of the Code. Because the payments on the Accounts attributable to the addendum were consideration for the rights to the IP, those payments were properly classified as long-term capital gains.

“That’s Not What You Said”

Taxpayer had a close call. The addendum did not refer to the transfer of the IP. It did refer to the commission payments on the Accounts, which had previously been treated as ordinary income to Taxpayer. Employer issued a 1099-MISC to Corp, reporting non-employee compensation, and Taxpayer and Corp initially filed their respective income tax returns consistently therewith. Neither party to the addendum sought an appraisal of the IP. Finally, it should be noted that, by the time of the Tax Court proceeding, the patent application had been abandoned, presumably by PC, which may have been an indication of its value.

It appears that Taxpayer’s success in the face of the foregoing rested, in large part, upon the “credible testimony” of Taxpayer and of the PC representative who negotiated the terms of the addendum. Not the ideal game plan, especially where the taxpayer bears the burden of proof; after all, memories become stale, people disappear, and relationships deteriorate.

Taxpayer would have been better served if he and PC had retained counsel to ensure that the addendum – within its four corners – accurately reflected their understanding regarding the transfer of the IP and the payments made in exchange therefor.[x]

Of course, there are situations in which the parties to an agreement “genuinely” disagree on the tax treatment of a specific payment made pursuant to its terms, usually as a result of someone’s not having focused on it. For example, the payment made by a partnership to a departing partner in liquidation of their interest where the agreement fails to properly characterize the payment for tax purposes. The partnership may seek to treat such a payment as a guaranteed payment (deductible by the partnership, and includible as ordinary income by the former partner, for tax purposes), whereas the former partner will treat it as a payment made in exchange for their interest in the partnership’s assets, including goodwill (treated as a return of capital, and then as capital gain, except to the extent of any “hot assets”).[xi]

Then there are those situations where a “not-so-good” actor will do as they please insofar as reporting the tax consequences of a transaction is concerned.[xii]

In most cases, it will behoove the conscientious taxpayer and their advisors to ensure, as best they can, that the four-corners of the agreement either express the tax treatment intended by the parties, or include such terms that inexorably manifest such intent. If a taxpayer is unable to secure the foregoing, then they should be on alert as to the intentions of the other party, and act accordingly.

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[i] Too many times have I heard a fellow adviser say that some ambiguity on a key term of a transaction document or settlement agreement may be a good thing; yeah, if you enjoy litigation and the associated costs and anxiety.

One of my high school physics teachers had a sign above his blackboard that read, “Eschew Obfuscation.” Thank you, Mr. Gordon.

[ii] Normally treated as ordinary income by Taxpayer, and deductible by Employer under Sec. 162 as an ordinary and necessary business expense.

[iii] Seemingly unrelated to the IP.

[iv] Based on the 1099-MISC.

[v] The “holder,” for purposes of Section 1235, includes “any individual whose efforts created such property.”

[vi] And taxed as long-term capital gain.

[vii] Sec. 1.1235-2(a). https://www.law.cornell.edu/cfr/text/26/1.1235-2

[viii] The “Danielson rule.” In brief: although a taxpayer is free to organize their affairs as they choose, once having done so, they must accept the tax consequences of such choice, whether contemplated or not, and may not enjoy the benefit of some other route they might have chosen to follow but did not. A taxpayer who falls within the scope of this rule is generally stuck with the form of their business transaction, and can make an argument that substance should prevail over that form only if a limited class of exceptions applies.

[ix] Finally, the Court was not convinced that PC’s reporting of the payments indicated that the addendum did not relate to the IP. Because those payments mirrored Taxpayer’s commissions, it was reasonable for both PC and Taxpayer to continue reporting commission payments as they always had in the absence of any tax or legal advice. The Court would not bind Taxpayer to the reporting by PC in the face of other contrary evidence.

[x] Query, however, whether an appraisal of the IP would have defeated capital gain treatment for the transfer of the IP. What if its fair market value was insignificant?

What if PC or Employer had deducted the payments on their tax return(s)?

[xi] IRC Sec. 736.

[xii] Form 8082 may come in handy at that point. https://www.irs.gov/forms-pubs/about-form-8082

Form v. Substance

It is a basic precept of the tax law that the substance of a transaction, rather than its form, should determine its tax consequences when the form of the transaction does not coincide with its economic reality. This substance-over-form argument is a powerful tool in the hands of a taxing authority.

According to another basic precept of the tax law, a taxpayer will generally be bound, for purposes of determining the tax consequences of a transaction, by the form of the transaction that he has used to achieve a particular business goal; the taxpayer may not freely re-characterize a transaction.

That being said, a taxpayer may assert a substance-over-form argument under certain circumstances. In those situations, however, the taxpayer faces a higher than usual burden of proof; indeed, the taxpayer must adduce “strong proof” to establish his entitlement to a position that is at variance with the form of the transaction reported on the taxpayer’s return.

The case discussed below addressed the classic tax issue of form versus substance as the Third Circuit considered a taxpayer’s attempt at re-characterizing a transaction.[1]

The Ingredients

Taxpayer, a U.S. person, was the majority shareholder of a U.S. corporation (“Target”) that owned and operated two Russian LLCs that, in turn, owned and operated most of Russia’s Pizza Huts and KFCs. Another U.S. corporation (“Minority”) held the remaining Target shares.

In order to sell the company, Taxpayer planned to buy out Minority’s Target shares, and then transfer all the Target shares – including those just purchased – to the buyer, a European corporation (“Buyer”) that owned KFCs, Pizza Huts, and other fast-food restaurants throughout Europe.

In May of the year in question, Taxpayer agreed to “purchase”, for his “own account”, Minority’s stake in Target. At closing, Minority was to transfer its Target shares to Taxpayer and then, in the following month, Taxpayer would make a “deferred” payment of the purchase price to Minority.

“You better cut the pizza in four pieces because I’m not hungry enough to eat six.” – Yogi Berra

Taxpayer also entered into a Merger Agreement with Target and Buyer. Under the terms of this Agreement: (1) Taxpayer would ensure, at the closing, that he was the “record” owner of 100% of the Target stock, “free and clear of any restrictions”; (2) Taxpayer would transfer 100% of Target’s shares to Buyer; and (3) Buyer would transfer cash and Buyer stock to Taxpayer as consideration. The transaction was intended to qualify as a partially “tax-free” reorganization within the meaning of the Code.[2] [IRC Sec. 368, 367]

The two transactions went through as planned. In June of the year in question, Minority transferred its Target stock to Taxpayer. On July 2, the Target-Buyer merger closed, and Taxpayer transferred all the Target stock to Buyer. On July 3, Buyer paid Taxpayer over $23 million in cash and transferred over $30 million worth of Buyer stock, a total of nearly $54 million for all Target’s shares. Then on July 5, Taxpayer paid Minority $14 million for its stake in Target.

In two tax filings for the year in question, Taxpayer took two different approaches to the transaction. In his original return, Taxpayer reported tax liability of almost $3.8 million, and paid that amount to the IRS. Taxpayer subsequently amended his return, reported a lower tax liability, and requested a refund.

“Finger Lickin’ Good” – Not for the Taxpayer

The IRS audited Taxpayer, found that the originally-filed return was correct, and denied Taxpayer’s request for a refund. Taxpayer then petitioned the U.S. Tax Court for a redetermination. The Tax Court held for the IRS, and Taxpayer then appealed to the Third Circuit Court of Appeals.

Taxpayer Never Owned It?

Taxpayer challenged the IRS’s determination that he had to pay tax on the $14 million that he received from Buyer and immediately remitted to Minority. The question was whether the form of the transaction made Taxpayer liable for the gain on the Target stock that had been held by Minority.

The Court began by describing the so-called “Danielson rule”:

[W]hile a taxpayer is free to organize his affairs as he chooses, . . . once having done so, he must accept the tax consequences of his choice, whether contemplated or not, and may not enjoy the benefit of some other route he might have chosen to follow but did not.

A taxpayer who falls within the scope of this rule, the Court stated, is generally stuck with the form of his business transaction, and can make an argument that substance should prevail over that form only if a limited class of exceptions applies.

Taxpayer argued that he was never the substantive owner of the Minority block of stock and, therefore, should not be taxed on the $14 million portion of Buyer’s payment that Taxpayer passed to Minority.

However, according to the Court, none of the Danielson exceptions applied – Taxpayer was not defrauded into the transaction, for example – and the contracts signed by the parties explicitly stated that Taxpayer acquired ownership of Minority’s stock: he purchase it for his “own account” prior to selling it to Buyer; and even though the shares were in his hands for only a brief period of time, he was the “record” owner, “free and clear of any restrictions.”

Thus, under Danielson, Taxpayer had to bear the tax liability for owning all the Target shares. He could have hypothetically structured the deal so that he never acquired formal ownership of Minority’s shares, but he did not, and could not benefit from an alternative route now.

“Danielson” Policy Wasn’t Implicated?

Taxpayer argued that the Danielson rule should not apply because its policies were not implicated. According to Taxpayer, the purpose of the Danielson rule was “to prevent a taxpayer from having her cake and eating it too.” Taxpayer claimed that he realized no benefit from serving as Minority’s and Buyer’s go-between.

The Court countered that Taxpayer likely did benefit: by structuring the transaction so that he purchased Minority’s stock for his own account prior to the sale to Buyer, Taxpayer made the overall transaction simpler by ensuring that Buyer would deal with only one party, which likely reduced the deal’s transaction costs and litigation risk, increased the likelihood of the deal actually closing, and perhaps caused Buyer to pay a higher price than it otherwise may have.

In any case, the Court stated, the point of a bright-line rule like Danielson’s requires that judges enforce it without wading into policy analysis, ensuring that the rule’s application will be easy and predictable.

Agency?

Taxpayer claimed that he was nothing more than Minority’s agent in selling Minority’s block of stock, and agents are not liable for the tax burden of their principals.

In responding to this claim, the Court explained that an agency relationship is created through “manifestation by the principal to the agent that the agent may act on his account” and the agent’s “consent” to the undertaking. The problem with this argument, the Court noted, is that the written agreement between Minority and Taxpayer stated in straightforward terms that Taxpayer purchased Minority’s shares for his own account; it did not mention an agency relationship, and none of the terms suggested that Taxpayer ever had an obligation to sell his newly-acquired shares to Buyer or anyone else; Taxpayer could have kept the stock for as long as he wanted, as long as he paid Minority its $14 million. That Taxpayer did encumber himself with an obligation to sell the Minority shares to Buyer arose out of the separate Merger Agreement to which Minority was not a party.

The food in Europe is pretty disappointing. I like fried chicken. But other than that Europe is great.” – Donnie Wahlberg

“Make it Great” – Not for the Taxpayer

The Court concluded that Taxpayer owned 100% of Target’s stock when he transferred Target to Buyer for a total consideration of $54 million, comprised of Buyer stock and cash, and he had to bear the tax burden for the entire payment, even the portion associated with the $14 million he remitted to Minority.

Taxpayer argued that if he must be taxed on the full $54 million from Buyer, he should be permitted to subtract from the gain on his original shares the amount that he “lost” on the sale of the Minority shares.

The Code provides that no gain or loss shall be recognized by a shareholder of a corporation if the shareholder’s stock in the corporation is exchanged, pursuant to a “plan of reorganization,” solely for stock in another corporation that is a party to the reorganization. [IRC Sec. 354]

Thus, a target corporation shareholder who receives only shares of stock in the buyer corporation in exchange for his shares of the target corporation stock, as part of a stock-for-stock merger transaction, does not recognize any of the gain or loss realized in the exchange.

This general rule has an exception for instances when a corporate reorganization involves a transfer of target stock in exchange for both stock of the acquiring corporation and other property or money (“boot”). In those transactions, gain must be recognized by the target shareholder to the extent of the boot received, but any losses realized by the target shareholder still fall within the scope of the general rule – they may not be recognized notwithstanding the receipt of boot by the target’s shareholder. [IRC Sec. 356]

Blocks of Target Stock

The Court explained that, in order to give content to the above recognition / nonrecognition rules, the IRS and the courts historically have analyzed multifaceted transactions according to their “separate units” of stock, so as to prevent a taxpayer from making an end-run around the non-recognition-of-loss rule by tucking his unit’s statutorily unrecognizable loss under the transaction’s broader recognizable gain; thus when an exchange transaction pursuant to a reorganization involves “separate units” of stock, each unit must be analyzed separately.

Taxpayer asked the Court to treat the two blocks of target stock – his block and Minority’s – as one unit, sold in one exchange. By doing so, Taxpayer hoped to subtract the loss realized on the Minority shares from the gain on his original shares (as he could have done if the transaction had not been structured as a partially tax-free reorganization). The Court rejected this request, finding that Taxpayer’s Target stock holdings were composed of two units: Taxpayer acquired one block of Target stock years before acquiring the second block, and he had a vastly different cost basis in the two blocks. Given that the blocks were separate, the Code’s reorganization provisions prohibited recognition of any loss realized by taxpayer in the Minority block.

Plop, Plop, Fizz, Fizz

Fried chicken and pizza aren’t the only things that can give a taxpayer heartburn. Unexpected tax liabilities are just as, if not more, likely to do so. Moreover, tax liabilities cannot be relieved by a simple antacid.

This part of almost every post on this blog must sound like the proverbial broken record. I apologize, but it cannot be said often enough. Before a taxpayer enters into a transaction, he has to be as certain as reasonably possible under the circumstances – risk can never be eliminated – that the transaction will accomplish the taxpayer’s desired business goal. Assuming that is the case, the taxpayer next has to analyze and quantify the tax cost associated with the transaction. This cost has to be added to the other deal costs, and weighed against the expected economic benefits. Depending upon the results of this analysis, the taxpayer may want to reconsider some of the proposed deal terms.

“Eschew obfuscation,” one of my high school physics teachers used to say. I have my own ironic saying: “avoid surprises.” Business owners should consult their tax advisers well before executing a letter of intent for a transaction – the foregoing analysis should not to be deferred until late in the game, because doing so could prove to be an expensive mistake.

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[1] I have to confess that when I came across this decision, I had already started writing a post on why some LLCs make S-corporation elections. For those of you who know me, as soon as I saw the references to Pizza Hut and KFC, I completely forgot about the LLC.

[2] As we shall see, this reorganization treatment was at the crux of the Taxpayer’s position (see infra).