Maximize Capital Gain

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

Property Used in Trade or Business

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

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

Capital Asset

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

Contracts as Capital Asset?

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

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

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

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

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

Congress Provides Some Certainty

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

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

Sale of a Franchise

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

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

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

Tax Return and Audit

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

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

Tax Court

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

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

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

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

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

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

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

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

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

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

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

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

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

Guidance?

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

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

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

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

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

“Tax free” – two words that often bring great delight when they are spoken by a tax adviser to the owner of a business, whether he is considering the disposition of a single asset, or of substantially all of the assets, of his business. (It’s the feeling I have when the local McDonald’s offers two-for-one breakfast sandwiches.)

Yes, “tax free” can be a great result for a transfer of property out of one business and into another. However, such a transfer is not really free of tax in the sense of never being taxed; rather, it defers the recognition, and taxation, of the gain inherent in the asset being transferred.

It is important that the business owner recognize the distinction. Allow me to illustrate this concept.

Gain Recognition

When a taxpayer disposes of property, the amount of gain that he realizes is measured by the difference between the amount realized – the amount of cash plus the fair market value (FMV) of the property received by the taxpayer – over his adjusted basis for the property transferred.

Where the property received by the taxpayer is not of a kind that the Code views as a “continuation” of the taxpayer’s investment in the property disposed, the taxpayer must recognize and pay tax on the entire amount realized. This is what occurs, for example, when a taxpayer exchanges a property for other property that is not of like-kind (such as cash).

Continuing the Investment

So, what kind of property must a taxpayer receive in exchange in order to make the disposition of his property “tax free”?

Most business owners are familiar with the “like-kind exchange” transaction, especially one that involves the exchange of one real property for another, where both are held by the taxpayer for use in a trade or business or for investment.

Many owners are also familiar with the contribution of property by a taxpayer to a corporation in exchange for shares of stock in the corporation. In general, if the taxpayer does not receive any cash in the exchange and is “in control” of the corporation immediately after the exchange, the taxpayer’s disposition of the property will not be treated as a taxable event.

A similar rule applies in the case of a contribution of property to a partnership in exchange for a partnership interest. Generally speaking, such a property transfer will not be treated as a taxable event, even if the taxpayer receives a less-than controlling interest in the partnership.

Preserving the Gain

In each of the above examples of “tax free” dispositions, the taxpayer’s adjusted basis for the property or equity interest that he receives will be the same basis that he had in the property transferred.

Similarly, the business entity to which a contribution of property is made, in exchange for an equity interest therein, will take the contributed property with a basis equal to the basis that the contributing taxpayer had in the property at the time of the contribution.

Thus, the gain inherent in the property disposed of by the taxpayer is preserved in the property received by the taxpayer in the exchange, such as the shares of stock issued by a corporation.

Receipt of Cash

The foregoing discussion contemplates a situation in which a taxpayer does not receive any cash in connection with the transfer of his property. Often, however, a taxpayer will want to monetize some of his equity in connection with the transfer of what may otherwise be illiquid property. (It may also be the case that the acquiring entity wants to increase its depreciable/amortizable basis in the property by paying some cash for it, or the existing owners of the entity may not appreciate the dilution of their holdings that an issuance of only equity would cause.)

In that case, because the taxpayer is partially “discontinuing” his investment in the transferred property (by receiving cash), he is required to recognize some taxable gain.

Contribution to Corp/ Like-Kind Exchange

In the case of a like-kind exchange, or in the case of a contribution to a corporation in exchange for stock therein, the taxpayer must recognize an amount equal to the lesser of the amount of cash received or the gain realized in the exchange.

Thus, if the amount of cash received is less than the gain realized on the transfer of the property, the taxpayer will recognize, and be taxed on, a portion of the gain realized, up to the amount of cash received.

Where the amount of cash received is equal to or greater than the gain realized on the transfer of the property, then the entire gain realized must be recognized by, and taxed to, the taxpayer.

The import of this result should not be underestimated, as will be shown below.

Contribution to a Partnership

The analysis is somewhat different in the case of a partnership. The Code’s partnership tax provisions do not have a rule equivalent to the “recognition of gain to the extent of cash received” rule applicable to corporations.

Instead, the contribution of property to a partnership in exchange for a partnership interest plus cash is treated as two transactions: a partial sale/contribution in which property with a FMV equal to the amount of cash paid by the partnership is treated as having been sold (under the so-called “disguised sale” rules), and a contribution of the remaining FMV of the property.

The gain to be recognized by the taxpayer is determined by allocating the taxpayer’s basis in the property between the sale and the contribution transactions, based upon the percentage of the total consideration that is represented by the cash.

Some Examples

Assume that Property has a FMV of $100, and an adjusted basis in the hands of Taxpayer of $40.

If Property were sold in exchange for $100 of cash, Taxpayer would realize and recognize $60 of gain ($100 minus $40).

Same facts, except Taxpayer contributes Property to a corporation in exchange for $100 worth of stock therein in a transaction that satisfies the criteria for “tax free” treatment. Taxpayer realizes $60 of gain ($100 of stock over $40 basis), but because Taxpayer receives only stock of the transferee corporation (no cash), none of the gain is recognized. Taxpayer takes the stock with a basis of $40 (preserving the $60 of unrecognized gain).

Same facts, except Taxpayer receives $70 of stock and $30 of cash. Taxpayer must recognize an amount equal to the lesser of the amount of cash received ($30) or the gain realized ($60). Thus, Taxpayer must recognize $30 of gain. He takes the stock with a basis equal to his basis in Property ($40), less the amount of cash received ($30) plus the amount of gain recognized ($30), or $40. Thus, $30 of the unrecognized gain inherent in Property ($30) is deferred ($70 FMV stock over $40 basis.)

Same facts, except Taxpayer receives $20 of stock and $80 of cash. Taxpayer must recognize an amount equal to the lesser of the amount of cash received ($80) or the gain realized ($60). Thus, Taxpayer must recognize the entire $60 of gain realized. He takes the stock with a basis equal to his basis in Property ($40), less the amount of cash received ($80) plus the amount of gain recognized ($60), or $20 (there is no gain to defer).

Same facts, except Taxpayer contributes Property to Partnership in exchange solely for a partnership interest therein. Taxpayer takes his partnership interest with a basis of $40 (his basis in Property), and Partnership takes Property with a basis of $40.

Same facts, except Taxpayer receives a $70 equity interest in Partnership, plus $30 of cash. Taxpayer is treated as having sold a $30 portion of Property, and as having contributed a $40 portion. The gain to be recognized on the sale and the gain to be deferred on the contribution are determined by allocating Taxpayer’s basis in Property between the sale and contribution transactions. Because the cash represents 30% of the total consideration received, 30% of Taxpayer’s basis is allocated to the sale, or $12 ($40 x 0.30). Thus, Taxpayer recognizes gain of $30 minus $12 = $18. The remaining 70% of the basis, or $28, is allocated to the contribution transaction; thus, Taxpayer takes his partnership interest with a basis of $28 (preserving the $42 of gain not recognized on the transfer of Property).

Is the “Deferral” Worthwhile?

The taxpayer who finds himself in one of the foregoing situations usually transfers a business asset over which he has full control. He may give up this control in order to attain other benefits, including, for example, diversification, the funding and assistance necessary to further grow the business (and to share in the growth as an equity owner, albeit one with a minority stake), and the deferral of tax on any gain that he may realize on the transfer.

The loss of control may present many difficulties for the taxpayer. Some are obvious; others are less so – for example, if he contributes appreciated property to a partnership in exchange for a partnership interest, the partnership is required to allocate its income, deductions, gains, and losses in such a way so as to cause the gain inherent in the property at the time of its contribution to be allocated entirely to the taxpayer. He will be taxed on such gain, but he may not receive a distribution of cash from the partnership to enable him to satisfy his tax liability.

Moreover, the like-kind property or the equity interest that the taxpayer receives in exchange for his property may be just as illiquid, at least initially, as the property he has exchanged for it. There may not be a market for the entity’s equity, and its shareholders’ agreement or operating agreement will likely restrict the transfer of the taxpayer’s interest.

But at least he deferred the tax on the transfer of his property.

But What If?

Query, then, what happens if a taxpayer gives up control of a property in exchange for an illiquid minority interest in the business entity to which he contributed such property, yet does not enjoy any tax deferral?

If the deferral was not a principal reason for the transfer, which otherwise made good business sense, then the taxpayer should be fine with the outcome: although he has suffered an immediate net loss of economic value (in the form of taxes paid), hopefully he has determined that the long-term prospects of exchanging his property for the acquirer’s equity are worth the short-term cost.

If, on the other hand, deferral was an important consideration, then the taxpayer should rethink his deal.

Perhaps he can ask to be grossed up for the tax hit, though this may be too expensive a proposition for the acquiring entity. Or, he may ask for more equity, and less cash, so as to reduce the tax hit, provided he recognizes that there will be more investment risk associated with holding more equity. Of course, the other investors may not want to be diluted further, and they may resist losing the benefit of any depreciation/amortization basis step-up for the property acquired.

The matter will ultimately be determined by the parties’ relative bargaining leverage: how badly does one want to dispose of the property, and how badly does the other want to acquire it?

Roll-Over: Tax Issue

Picking up on yesterday’s discussion, how can a PEF reconcile its preference to acquire a depreciable or amortizable basis for its target’s assets while, at the same time, affording the target’s owners the opportunity to roll-over a portion of their equity in the target into the PEF HC on a tax-favored basis? The answer is hardly simple, and it will depend upon a number factors.

inspecting taxesThe following discussion will consider some of these factors in the context of various scenarios. In each case, it is assumed that the acquisition will be structured to give the PEF a depreciable or amortizable basis for the acquired assets; that the target or its owners, as the case may be, will acquire an equity interest in the PEF’s HC (the roll-over that will allow them to participate in the growth of the PEF’s other portfolio companies); and that such equity interest shall not exceed 50% of the HC’s equity (thus ensuring capital gain treatment where otherwise available).

Target “C” Corporation
Where the target is a “C” corporation, the sale of its assets will be taxable to the corporation, and the corporation’s distribution of the after-tax proceeds to its shareholders will generate a second layer of tax (albeit as capital gain) to the shareholders (a combined tax rate of almost 50% at present). The shareholders may then invest some portion of their after-tax proceeds in the PEF HC in exchange for an equity interest therein.

In this case, the only way for the target’s owners to enjoy a tax-free, but indirect, roll-over of a portion of their equity into the PEF is by having the target contribute some of its assets to the PEF’s HC in exchange for an equity interest therein, while selling the balance of the assets for cash.

In general, provided the PEF’s HC will be treated as a tax partnership, the contribution of assets to the HC in exchange for a partnership interest therein will not be taxable to the target corporation. (An exception to this nonrecognition rule would apply if the HC assumes liabilities of the target’s business, or takes assets subject to such liabilities, and the contributing corporation’s allocable share of the HC’s liabilities after the contribution is less than the amount of the liabilities assumed or taken subject to) another exception to nonrecognition may apply where the liabilities were incurred in anticipation of the transaction.

However, if the PEF’s HC is a corporation, the target corporation’s contribution of assets to the HC’s capital in exchange for shares of stock therein will be treated as a taxable disposition of its assets unless the target corporation is treated as part of a so-called “control group.” This would be a group of persons (including the PEF) that, acting “in concert,” contributed assets to the HC in exchange for stock in the HC, and that was in “control” of the HC immediately afterwards.

Of course, not all of the target shareholders may want to participate in the roll-over to the PEF’s HC. In that case, the target corporation may have to redeem those shareholders, thus limiting the amount of cash that may be reinvested.

Moreover, some PEFs may insist that only individual shareholders, rather than the target corporation, hold equity in the HC. In that case, a contribution by the target corporation may not be permitted, or may have to be followed by a liquidating distribution to its shareholders. Such an in-kind distribution would be treated as taxable sale by the corporation, thus defeating the sought-after tax deferral benefit.

Target “S” Corporation
If the target corporation is an “S” corporation, it may sell its assets to the PEF HC without incurring a corporate-level income tax (provided the target is not subject to the built-in gains tax). Of course, the gain realized on the sale of the target’s assets will flow through and be taxable to its shareholders. Depending upon the nature of the assets sold, the gain may be taxed as ordinary income or as capital gain.

As in the case of a C corporation, the S corporation may distribute the net proceeds from the sale of its assets to its shareholders, who may then invest a portion of their after-tax proceeds in the PEF’s HC.

Alternatively, if the sale of the S corporation’s business is effected through an acquisition of at least 80% of its stock for cash, coupled with an election to treat the stock sale as a sale of assets for tax purposes, the target shareholders may contribute their remaining shares to the PEF’s HC as a capital contribution. Unfortunately, this capital contribution will not generate any tax deferral benefit for the shareholders because they will still have to recognize all of the gain inherent in the target’s assets by virtue of the deemed asset sale election.

If the only way in which the shareholders of the S corporation target may roll over a portion of their investment on a tax-free basis is for the S corporation itself to make a capital contribution to the HC, then regardless of whether the HC is a corporation or a LLC, then they will have to consider the same issues as described above for a C corporation.

Target Partnership
A sale of assets by a target partnership to a PEF HC in exchange for cash will be taxable to the target’s owners. As in the case of an S corporation, the nature of the gain taxed to the owners will depend upon the nature of the assets sold.

Alternatively, the owners of a target partnership may sell all of their partnership interests to the PEF, or to its acquisition subsidiary. A sale of 100% of the partnership interests will be treated, for tax purposes, as sale of the target’s assets, thus providing the PEF with a depreciable or amortizable basis in such assets.

In either case, if the target’s owners (the partners or members) are to acquire an equity interest in the PEF or subsidiary, they will have to do so with after-tax dollars.

In order to roll-over a portion of its equity into the HC on a tax-advantaged basis, the target partnership will have to contribute some of its assets to the HC, or the target owners will have to contribute some of their partnership interests to the HC. In other words, the transaction will have to be effected as a part-sale-for-cash/part-contribution-for-equity by either the target or its owners. The PEF will acquire a depreciable or amortizable basis for the assets acquired for cash. The same result may be achieved where interests in the target partnership are sold to the HC for cash while the remaining interests are contributed to the HC as capital. In that case, because the HC is treated as acquiring all of the interests in the target partnership, it will receive a depreciable or amortizable basis for the assets to the extent of the cash paid (though a protective election may also be made on the target partnership’s final tax return to adjust the basis for the assets in the hands of the HC).

If the PEF’s HC is a corporation, however, then the target partnership and its owners face the same issues with respect to their capital contributions to the HC as were described earlier in the case of a corporate target – they will need to be treated as part of a “control group.”

Before the LOI

The foregoing discussion should provide potential parties to a PEF acquisition transaction with some insight into their respective structural and tax preferences. It should also give them an understanding of the tax and economic consequences they will have to consider in negotiating such a transaction.

Armed with this information, they may consider how best to structure the target or the acquisition vehicle so as to minimize any negative tax consequences that may arise out of a roll-over (for example, making an “S” corporation election as early as possible for a potential target corporation, or substantiating the existence and value of personal goodwill).

Where a structural solution is not feasible, the parties should consider a “gross-up” to the purchase price for the depreciable or amortizable assets to be acquired, so as to leave the target’s owners in the same after-tax position in which they would have been had their roll-over been completed on a tax-free basis.

As always, it will behoove the parties to be aware of these considerations and to plan for them well before executing a letter of intent, let alone a purchase and sale agreement. Such preparation will facilitate negotiations and completion of the sale and acquisition of the business.

For many business owners, the final step of a successful career may be the sale of their business. At that point, the investment into which the owners have dedicated so much time, effort and money is liquidated, leaving them with what is hopefully a significant pool of funds with which to enjoy their retirement, diversify their assets, or pursue other goals.private equity

It used to be that the prospective buyer would almost always come from within the same industry (or one related to it) as the business being sold. It was often a competitor, or someone seeking to fill a void in their own business. In other words, the buyers were strategic and were looking for synergistic acquisitions – ones that would enable them to grow their own business and provide long-term benefits.

Over the last several years, however, a new type of buyer has emerged: the private equity fund (“PEF”). In general, PEFs are not engaged in any “conventional” business. Rather, they are well-funded investment vehicles that are engaged in the acquisition of conventional businesses (“portfolio companies”). A PEF will often create a holding company (“HC”) that, in turn, will use subsidiary companies to acquire target businesses. Almost by definition, a PEF is not necessarily looking to develop long-term synergistic relationships from an acquisition. Instead, it is looking to add to its portfolio of companies that it, in turn, hopes to sell to another buyer in the not-too-distant future, hopefully at a gain for the PEF’s investors.

Roll-Over: PEF’s Perspective

One facet of a PEF acquisition that tends to distinguish it from a strategic buyer acquisition is the PEF’s strong preference that the owners of a target business “roll over” (or reinvest) some portion of their equity investment in the target business into the PEF’s “corporate structure” in exchange for a minority interest therein. From the perspective of the PEF, such a roll-over yields several benefits. For one thing, it aligns the former owners of the target business with the interests of the PEF – their rolled-over investment is at risk similar to that of the PEF’s investors. Thus, the former owners are incentivized (the theory goes) to remain with the business, to cooperate fully in the transition of the business and its customers, and to work toward its continued growth and success. The roll-over also saves the PEF some money: issuing equity is less expensive than paying out funds that the PEF already has or that it has to borrow.

Roll-Over: Seller’s Perspective

From the perspective of the target’s owner, however, the roll-over may present a troublesome issue.

In many cases, an owner will want to take all of his cash off the table. He may not want to continue risking his capital, especially where the investment is to be controlled by another.

Of course, some owners will be attracted to the potential upside that a roll-over investment in a PEF may generate. After all, the owner may have the opportunity to benefit not only from the future growth of his former business (to which similar businesses may have been added by the PEF), but also that of the PEF’s other portfolio companies. In fact, a business owner may even insist upon being given the opportunity to participate in the growth of these other companies (which is generally consistent with most PEF’s desire that the owners invest at the same level of the corporate structure as the PEF has).

However, the owner may also insist that the roll-over be effected without any adverse tax consequences. The ability of the PEF to satisfy this request will depend, in no small part, upon the form of the acquisition of the target business.

Acquisition Mechanics

Like most other buyers, the PEF will prefer an acquisition of the target’s assets, in a transaction that is taxable to the target, over an acquisition of the equity interests of the target’s owners. A taxable sale of assets will provide the PEF (specifically, its HC) with a depreciable or amortizable basis in the acquired assets that may be written off by the PEF over the useful lives of the assets. The tax deductions so generated will offset the PEF’s income, thereby allowing the PEF to recover some of its investment in the target’s business and reducing the overall cost of the transaction to the PEF.

The target’s owners, on the other hand, will generally not prefer an asset sale because such a sale may result in both the recognition of ordinary income by the target’s owners as well as an entity-level tax, thus reducing the net economic benefit to the owners. Rather, they would choose to sell their equity interest in the target, at least in the case of a corporate target. The gain realized on such a sale will generally be treated as long-term capital gain. However, such a sale will not generate a depreciable or amortizable basis for the PEF.

Roll-Over: Mechanics

In general, a PEF will create a subsidiary corporation or LLC as the HC through which it will acquire a target. This HC will, at least initially, be wholly-owned by the PEF. Where the assets of a target are being purchased, each target acquisition may be completed through an acquisition vehicle (another corporation or LLC) that will be wholly-owned by the HC. In this way, the assets of one business may be protected from the liabilities of another.

The form of roll-over by the target’s owners will depend upon the form of the acquisition. Thus, where the HC is acquiring the equity interests of the target owners, the roll-over will come directly from the former owners. Where the HC is acquiring the target’s assets, the roll-over may, at least in theory, come from the target. However, if the PEF insists that it must come from the target’s owners, then the proceeds paid to the target will have to find their way into the hands of its owners to enable them to acquire equity in the HC.

The chosen forms of acquisition and roll-over will generate very different tax and economic results for both the PEF and the target’s owners. Thus, it is imperative that the target’s owners examine the nature of both the PEF’s acquisition vehicle and of the target (e.g., corporation or partnership/LLC), and the nature of the sale (a sale of equity interests in the target or a sale of the target’s assets). They must consider how their equity roll-over can be effectuated, and whether this transfer may be done tax-efficiently.

The owners of the target business have to recognize that if the roll-over cannot be accomplished on a tax-free (or, more accurately, tax-deferred) basis, they may be left with less liquidity than they would have preferred.

Check back tomorrow for a discussion of the specific effects of a roll-over depending on the types of entity involved and the approach taken in various scenarios.

This is a question that we encounter with some frequency in the context of family-owned corporations, and the backdrop against which the issue arises is not uncommon.

In the Beginning

The older generation may have acquired a building many years ago, either as an investment that would generate a stream of rental income from unrelated commercial and/or residential tenants, or as the site for the family’s operating business.

In some cases, the older generation acquired the property in its own name and subsequently contributed the property to a corporation; in others, a corporation was created, funded, and then used to acquire the property.

At that time– well before the introduction of LLCs– the older generation may have been advised that a corporation would afford it a measure of protection against the liabilities that may arise out of the ownership and operation of a building; that direct ownership, or through a general partnership, would expose the owners, and their other assets, to such liabilities.  Whatever the reasons may have been for using a corporation, the fact remains that the older generation and its descendants became shareholders of the corporation.

As time went on and the property appreciated (as real estate tends to do), the older generation may have purchased new properties in the same corporation (perhaps by leveraging the equity in the original property), or it may have sold the original property and, through a like-kind exchange, replaced it with several other properties as a way to diversify its holdings.

The Seeds of Discontent

As the years passed, eventually so did the older generation. Either through lifetime gifts or upon the death of its members, the older generation transferred its shares in the corporation to children, grandchildren, and trusts for their benefit.

Disagreements begin to arise among the members of the younger generation. Someone is unhappy with the way in which the properties are being managed. Someone else is disappointed that the corporation is not distributing larger or more frequent dividends. Others believe that the corporation should diversify geographically, or that its holdings should be more (or less) balanced between residential and commercial properties. Still others would like to see the corporation invest in non-real estate assets.

At some point, the friction among the shareholders may become an obstacle to the operation and management of the properties (and forget about Thanksgiving dinner).

Options for Splitting up?

Assuming the parties cannot be reconciled, there are several alternatives by which this friction may be addressed.

Buyout for Cash?

The disgruntled shareholders may be bought out, either by the corporation (through a redemption of shares) or by the other shareholders (a cross-purchase of shares). The price for these shares may have to be paid in some combination of cash and/or promissory notes. The remaining shareholders or the corporation may have to borrow the monies needed to fund the purchase.

In either case, the departing shareholders would experience a taxable event, and may owe taxes if the amount realized on the sale of their shares exceeds their adjusted basis in those shares. Perhaps worse still, in their minds, they would no longer own an interest in the family’s real properties. (To quote Gerald O’Hara, from Gone with the Wind: “Why, land is the only thing in the world worth workin’ for, worth fightin’ for, worth dyin’ for, because it’s the only thing that lasts.”)

In-Kind Distributions?

Instead of being bought out for cash, the disgruntled shareholders may insist that one or more of the corporation’s properties be distributed to them in liquidation of their interests in the corporation.

While such a distribution is certainly possible from a corporate and real estate perspective – assuming it doesn’t violate the terms of any mortgage or other agreement, and assuming the parties can actually agree on how to divide the properties among them – the distribution would be treated, for tax purposes, as though the corporation had sold the distributed properties for their fair market value. As a result, the corporation may realize a taxable gain, for which it will have to pay taxes.

The departing shareholders may also realize a taxable gain to the extent the fair market value of the property distributed exceeds their adjusted basis in the shares of the distributing corporation.

Moreover, if the corporation is an S corporation, its shareholders (both those remaining and the departing shareholders) will have to report and be taxed on that gain. Although the gain realized will usually be capital gain, it is possible that the deemed sale will generate ordinary income (for example, because of depreciation recapture or the application of a “related party sale” rule).

Is a Taxable Event Inevitable?

Even at the height of their disagreement,the family members will likely concur that the less tax paid, the better. They will thus be encouraged to hear that it may be possible for a corporation that owns real properties to contribute some of those properties to a subsidiary corporation, and to then distribute all of the shares of the subsidiary to some of its shareholders in liquidation of their interests in the parent corporation, without triggering a taxable event for either the corporation or its shareholders– provided certain requirements are satisfied.

Among these requirements, the one that is often the most difficult to satisfy in the case of a real estate business is the requirement that both the parent (distributing) corporation and the subsidiary (controlled) corporation are each engaged in the active conduct of a trade or business immediately after the distribution.

The Active Trade or Business

A corporation is treated as engaged in the active conduct of a trade or business if the assets and activities of the corporation satisfy certain requirements.

Specifically, a corporation shall be treated as engaged in a trade or business if the corporation carries on a specific group of activities for the purpose of earning income or profit, and the activities include every operation that forms a part of, or a step in, the process of earning income or profit. Such group of activities ordinarily must include the collection of income and the payment of expenses.

The determination of whether a trade or business is actively conducted will be made from all of the facts and circumstances. The corporation is required itself to perform active and substantial management and operational functions through its employees. Generally, activities performed by the corporation itself do not include activities performed by persons outside the corporation, including independent contractors. However, a corporation may satisfy the requirement through the activities that it performs itself (through its employees), even though some of its activities are performed by others (for example, skilled contractors).

A trade or business that is relied upon to meet these requirements must have been actively conducted throughout the five-year period ending on the date of the distribution.

Expansion or New Business?

The fact that a trade or business underwent change during the five-year period preceding the distribution is disregarded, provided that the changes are not of such a character as to constitute the acquisition of a new or different business. In particular, if a corporation that is engaged in the active conduct of one trade or business during that five-year period, purchased, created, or otherwise acquired another trade or business in the same line of business, then the acquisition of that other business is ordinarily treated as an expansion of the original business, all of which is treated as having been actively conducted during that five-year period.  (Query how a like kind exchange of real properties would be treated for this purpose.)

However, if that purchase, creation, or other acquisition effects a change of such a character as to constitute the acquisition of a new or different business, and that trade or business is to be relied upon to meet the above requirements, then the acquisition must not have occurred during the five-year period ending on the date of the distribution unless the new business was acquired in a transaction in which no gain or loss was recognized.

Stay tuned for Part II, tomorrow.

Don’t miss Part I, here!

“I appreciate your eagerness,” said the adviser. “You can just imagine how I feel every morning when I read through the latest tax news. It takes a Herculean effort to contain myself.”

“OMG,” he’s crazy, “what was my dad thinking when he retained this guy?!”

“I see the look in your eyes. Rest assured, your patience is about to be rewarded.

The “Independent Investor Test”

“I’m sure you are familiar with the basic economic principle that the owners of an enterprise with significant capital are entitled to a return on their investment. Thus, a corporation’s consistent payment of salaries to its shareholder-employees in amounts that leave insufficient funds available to provide an adequate return to the shareholders on their invested capital indicates that a portion of the amounts paid as salaries is actually a distribution of earnings.

“The ‘independent investor test,’ the Court noted, recognizes that shareholder-employees may be economically indifferent to whether payments they receive from their corporation are labeled as compensation or as dividends.

“From a tax standpoint, however, only compensation is deductible to the corporation; dividends are not. Therefore, the shareholder-employees and their corporations generally have a bias toward labeling payments as compensation rather than dividends, without the arm’s-length check that would be in place if nonemployees owned significant interests in the corporation.

“Thus, the courts consider whether ostensible salary payments to shareholder-employees meet the standards for deductibility by taking the perspective of a hypothetical ‘independent investor’ who is not also an employee.

“Ostensible compensation payments made to shareholder-employees by a corporation with significant capital that ‘zero out’ the corporation’s income, and leave no return on the shareholders’ investments, fail the independent investor test. An independent (non-employee) shareholder would probably not approve of a compensation arrangement pursuant to which the bulk of the corporation’s earnings are being paid out in the form of compensation, so that the corporate profits, after payment of the compensation, do not represent a reasonable return on the shareholder’s equity in the corporation.

“The record established that Taxpayer had substantial capital even without regard to any intangible assets, although Taxpayer’s expert witness admitted, at trial, that a firm’s reputation and customer list could be valuable entity-level assets.

“Invested capital of the magnitude described in the decision, the Court said, could not be disregarded in determining whether ostensible compensation paid to shareholder-employees was really a distribution of earnings. The Court did not believe that Taxpayer’s shareholder-attorneys, were they not also employees, would have forgone any return on this invested capital. Thus, Taxpayer’s practice of paying out year-end bonuses to its shareholder-attorneys that eliminated its book income failed the independent investor test.

Exemption From the Independent Investor Test?

“Taxpayer observed that its shareholder-attorneys held their stock in the corporation in connection with their employment, they acquired their stock at a price equal to its cash book value, and they had to sell their stock back to Taxpayer at a price determined under the same formula upon terminating their employment. Taxpayer suggested that, as a result of this arrangement, its shareholder-attorneys lacked the normal rights of equity owners.

“Contrary to Taxpayer’s argument, the Court noted, the use of book value as a proxy for market value for the issuance and redemption of shares in a closely-held corporation to avoid the practical difficulties of more precise valuation hardly meant that the shareholder-attorneys did not really own the corporation and were not entitled to a return on their invested capital. Any shareholders who were not also employees would generally demand such a return.

“More generally, Taxpayer’s argument that its shareholder-attorneys had no real equity interests in the corporation that would have justified a return on invested capital proved too much. If Taxpayer’s shareholder-attorneys were not its owners, who was? If the shareholder-attorneys did not bear the risk of loss from declines in the value of its assets, who did? The use of book value as a proxy for fair market value deprived the shareholder-attorneys of the right to share in unrealized appreciation upon selling their stock—although they were correspondingly not required to pay for unrealized appreciation upon buying the stock.

“But acceptance of these concessions to avoid difficult valuation issues did not compel the shareholder-attorneys to forgo, in addition, any current return on their investments based on the corporation’s profitable use of its assets in conducting its business.

“Taxpayer’s arrangement effectively provided its shareholder-attorneys with a return on their capital through amounts designated as compensation. The Court believed that, were this not the case, the shareholder-attorneys would not have been willing to forgo any return on their investment.

Court’s Conclusion

“The Court concluded that the independent investor test weighed strongly against the claimed deductions. The independent investor who had provided the capital demonstrated by the cash book value of petitioner’s shares—even leaving aside the possibility of valuable firm-owned intangible assets—would have demanded a return on that capital and would not have tolerated Taxpayer’s consistent practice of paying compensation that zeroed out its income.

“The classification of a law practice as a business in which capital is not a material income-producing factor, the Court said, did not mean that all of an attorney’s income from his or her practice was treated as earned income and that any return on invested capital was ignored.

“The Court did not doubt the critical value of the services provided by employees of a professional services firm. Indeed, the employees’ services may be far more important, as a factor of production, than the capital contributed by the firm’s owners. Recognition of these basic economic realities might justify the payment of compensation that constitutes the vast majority of the firm’s profits, after payment of other expenses—as long as the remaining net income still provides an adequate return on invested capital.

“But Taxpayer, the Court said, did not have substantial authority for the deduction of amounts paid as compensation that completely eliminated its income and left its shareholder-attorneys with no return on their invested capital.

“Because Taxpayer did not have substantial authority for its treatment of the year-end bonuses it paid during the years in issue, the disallowance of a portion of the deductions Taxpayer claimed for those payments represented a ‘substantial understatement’ for each year.”

Post Script

The tax adviser turned back from the window and looked at the client. The client’s head was resting against the back of the chair. Was that drool trickling from the side of her mouth?

He cleared his throat. Nothing. He cleared it again, this time more forcefully. Her head was now upright. He looked meaningfully into her eyes. “They were lifeless eyes,” he thought, “like a doll’s eyes.” He realized he was channeling Captain Quinn from “Jaws.”

Then she blinked, or tried to – she winced in pain, moved her hands to her face, seemed to fiddle with something, rubbed her eyes, then focused on the adviser. amazing-monkey-face

“You’ve always told me that clients, like me,” she said, base hiring decisions on the reputation of the individual lawyer rather than upon that of the firm at which the lawyer practices. If I heard you correctly just now, “ and she doubted anything she might have heard by that point, “the goodwill of a law firm may be an asset of the firm, rather than of its individual partners, is that right?”

“In the right circumstances, that’s correct. That’s one of many reasons why most firms operate as a pass-through entity, like a partnership, for tax purposes.” He went to the shelf behind his desk, and as he began to remove a volume on “choice of entity” issues, the door slammed. He turned, but the client was gone.

Who can blame her for wanting to avoid another long-winded lecture, but she should have stuck around a while longer. The message of the decision described above is not limited to the personal service business, though it is chock-full of guidance for such a business.

Taxpayers have long sought structures by which they could reduce the double tax hit that attends both the ordinary operation of a C corporation and the sale of its assets.

Many of you have come across the concept of “personal goodwill,” probably in the context of a sale by a corporation.  Some shareholders have argued that they own personal goodwill, as a business asset that is separate from the goodwill of their corporation.  They have then attempted to sell this “personal” asset to a buyer, hoping to realize capital gain in the process, and – more to the point of this post – also hoping to avoid corporate level tax on a sale of corporate goodwill.

Of course, the burden is on the taxpayer to substantiate the existence of this personal goodwill and its value, not only in the context of the sale of the corporate business, but also in the sale of his or her services to the corporate business.  The best chance of supporting its existence is in the circumstances of  a business where personal relationships are paramount, or where the shareholder has a reputation in the relevant industry or possesses a unique set of skills.

The right circumstances may support a significant compensation package for a particular shareholder-employee, either on an annual basis or in the context of an asset sale by his or her corporation.  In each case, a separate, corporate-level tax would not be imposed in respect of the portion of the payments made to the shareholder-employee.

However, before a taxpayer, hell-bent on avoiding corporate-level tax, causes his or her corporation to pay compensation in an amount that wipes out any corporate-level tax, he or she needs to be certain that the existence and value of the personal goodwill – the reasonableness of the compensation for the service rendered – can be substantiated.  The taxpayer needs to plan well in advance.

The employee-owner of a corporate business will sometimes ask his or her tax adviser, “How much can I pay myself out of my corporation?”

The astute tax adviser may respond, “First of all, you are not paying yourself. The corporation is a separate entity from you, its shareholder. That being said, the corporation can pay you as much as it can reasonably afford in light of its business needs and other relevant facts and circumstances, and subject to state corporate law requirements, depending on the nature of the payment. For example, . . .”

The client will then typically interrupt, “C’mon wise guy. You know what I mean.”

The offended tax adviser will then say, “From a tax perspective, the corporation can pay you – and deduct against its income – a reasonable amount of compensation for the personal services you have actually rendered to the corporation. Anything in excess of that amount will be treated as a dividend distribution, to the extent of the corporation’s earnings and profits. Of course, . . .”

“I know, I know,” says the client, “and a dividend is not deductible by the corporation in calculating its own taxes. Give me some credit here.”

“OK. Except in the case of a start-up, or any other situation in which the corporation cannot ‘afford’ to pay its shareholder-employees, the corporate employer will – in fact, should – pay an amount of compensation that is reasonable for the services rendered – an exchange of value-for-value, or cash for services. In the case of an S corporation –”

Another interruption.

“Does the amount depend on the nature of the business?” asks the client.

“In general, yes. In a capital-intensive business, it may be more difficult to justify a certain level of compensation than in a business that involves only personal services.

“But,” continues the adviser, let me tell you about a recent decision involving a professional corporation . . .”

And as the adviser began, the client sunk deeper into the chair, recognizing the didactic look on the adviser’s face (the one that would broach no further interruptions), wishing that she had never raised the subject, willing for her phone to ring with some emergency, to extract her from her predicament.

Oblivious to his client’s plight, the tax adviser went on, encouraged by the thought that this client really cared about what he had to share.

Once Upon A Time, . . .

“Taxpayer was a law firm organized as a corporation. During the years at issue, it employed about 150 attorneys, of whom about 65 were shareholders. It also employed a non-attorney staff of about 270. storybook

“Taxpayer’s shareholders held their shares in the corporation in connection with their employment by the corporation as attorneys. Each shareholder-attorney acquired her shares at a price equal to their book value and was required to sell her shares back to Taxpayer at a price determined under the same formula upon terminating her employment.

“Taxpayer’s shareholder attorneys were entitled to dividends as and when declared by the board. For at least 10 years before and including the years in issue, however, Taxpayer had not paid a dividend. Upon a liquidation of Taxpayer, its shareholder-attorneys would share in the proceeds.

“For the years in issue, the board met to set compensation and ownership-percentages in late November or early December of the year preceding the compensation year. Before those meetings, the board settled on a budget for the compensation year. On the basis of that budget, the board determined the amount available for all shareholder-attorney compensation for that year. With that amount in mind, it set each shareholder-attorney’s expected compensation using a number of criteria, then determined the adjustments in their ownership-percentages necessary to reflect changes in proportionate compensation. Adjustments in actual share ownership were made by share redemptions and reissuances.

“The board intended the sum of the shareholder-attorneys’ year-end bonuses to exhaust Taxpayer’s book income. Shareholder-attorneys shared in the bonus pool in proportion to their ownership-percentages. Specifically, Taxpayer calculated the year-end bonus pool to equal its book income for the year after subtracting all expenses other than the bonuses. Thus, Taxpayer’s book income was zero for each year: its income statements showed revenues exactly equal to expenses.”

The client carefully placed the second toothpick at the corner of her right eye. “Great,” she exhaled, “that should do it. Sure hope he’s near-sighted.”

At that point, the adviser glanced over at the client, who seemed to be listening intently, her eyes wide open. Pleased with himself, he continued.

Compensation, Or Something Else?

“Taxpayer treated as employee compensation the amounts it paid to its shareholder-attorneys, including the year-end bonuses.  In each of its tax returns for the years at issue, Taxpayer included the year-end bonuses it paid to its shareholder-attorneys in the amount it claimed as a deduction for officer compensation.

“Taxpayer’s returns reflected a relatively small amount of taxable income. Because Taxpayer’s book income was zero for each year, the taxable income Taxpayer reported was attributable entirely to items that were treated differently for book and tax purposes.”

The IRS Disagrees

“Now comes the good part,” said the adviser, his voice rising slightly.

The client hadn’t moved, yet her eyes were fixed on him, like some Byzantine icon.

“When the IRS examined Taxpayer’s returns, it disallowed the deductions for the year-end bonuses paid to Taxpayer’s shareholder-attorneys. After negotiations, the parties entered into a closing agreement that disallowed portions of Taxpayer’s officer compensation deductions for the years in issue, which portions it re-characterized as non-deductible dividends.”

The client bent forward slightly, then rocked back, as though nodding in agreement.

Encouraged by this sign of assent, the adviser continued.

“The sole issue remaining for the court was whether Taxpayer was liable for accuracy-related penalties on the underpayments of tax relating to its deduction of those portions of the year-end bonuses that it agreed were nondeductible dividends.

“The court began by stating the general rule that the Code allows a deduction for ordinary and necessary business expenses. However, in order for amounts paid as salary to be deductible, they must be paid for services actually rendered, and they must be reasonable. Ostensible salary payments to shareholder-employees that are actually dividends are thus nondeductible.

The Parties’ Arguments

“In support of its deduction of year-end bonuses paid to its shareholder-attorneys that eliminated its book income for the years in issue, Taxpayer cited a number of authorities that purportedly established that capital was not a material income-producing factor in a professional services business.

“The IRS claimed that amounts paid to shareholder-employees of a corporation did not qualify as deductible compensation to the extent that the payments were funded by earnings attributable to the services of non-shareholder-employees or to the use of the corporation’s intangible assets or other capital. The IRS said that amounts paid to shareholder-employees that are attributable to those sources must be nondeductible dividends.

“Taxpayer responded that any ‘profit’ made from the services of non-shareholder-attorneys could justifiably be paid to its shareholder-attorneys in consideration of their business generation and other non-billable services.”

The adviser turned toward the window. “I hope he jumps,” was the first thought that occurred to the client. No such luck – he only opened it a crack.

“It’s a bit stuffy in here,” he said, as if to himself, clearly not expecting a response.

“You have no idea,” she whispered under her breath.

“What’s that?”

“I said I have no idea where this is going.”

Stay tuned for Part II, tomorrow, to find out!

It Was the Worst of Times, Except . . .

It happens in most closely-held businesses: so long as the business is profitable and cash keeps flowing into the hands of the owners, everyone is happy. When the spigot slows, or is just plain turned off, however, the investor-owners (as distinguished from the management-owners) will have questions that they want answered, and quickly. When responses are not forthcoming, or are viewed as evasive, a lawsuit may not be far behind. iStock_000000181896XSmall11

In any litigation, there are few real winners. A lawsuit arises in the first place because someone was wronged, or believes to have been wronged, and there has certainly been an economic loss. Enter the attorneys, the accountants, perhaps, the “experts,” and rapidly-mounting costs.  Years may pass, and who knows what becomes of the business in the interim.

Sounds awful, right? But what if someone told you that, under the right circumstances, the costs may be cut by at least forty percent? You may say, “Tauric defecation.” (Any readers from Bronx Science out there?) “No,” I would reply, “it’s called tax savings.”

The Facts of a Recent PLR

Taxpayer was a shareholder in several closely-held corporations that owned and operated Business for many years. Taxpayer personally or jointly managed the finances of all the closely-held corporations that operated Business.

Taxpayer, E and F formed a closely-held corporation (“Corp.”), an S corporation, to operate Business in a new location. The shareholders agreed that Taxpayer was to manage Corp. and receive a management fee. The distribution of the remaining net profits was allocated among the shareholders based on their ownership percentages. For several years, E consistently received monthly distribution checks from Taxpayer. However, at some point the checks became less regular. After not receiving checks for several months, E made several inquiries of Taxpayer. There were several meetings and many letters and e-mails in which E asked Taxpayer for Corp.’s financial records. E eventually received some of the records, but they did not explain why Corp. was losing money. E filed a lawsuit against Taxpayer asserting causes of action that included fraud, breach of fiduciary duty, and breach of contract.

The jury found Taxpayer liable for breach of fiduciary duty and fraud. It also awarded E punitive damages. The court awarded costs to E. The final judgment against Taxpayer consisted of compensatory and punitive damages, prejudgment interest, costs, and post-judgment interest.

Taxpayer paid E the amounts ordered by the judgment of the trial court. In addition, Taxpayer paid legal fees to his accounting consultants and expert at trial, as well as to the attorneys he retained to defend him in the lawsuit at the trial court.

The Law

Section 162 of the Code provides a deduction for all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business. The regulations promulgated under Sec. 162 provide that deductible expenses include the ordinary and necessary expenditures directly connected with or pertaining to the taxpayer’s trade or business. The regulations under Section 263 of the Code provide that a taxpayer must capitalize an amount paid to another party to acquire any intangible from that party in a purchase or similar transaction. To qualify as a deduction  allowable under Sec. 162, an expenditure must satisfy a five part test: it must

(1) be paid or incurred during the taxable year,

(2) be for carrying on a trade or business,

(3) be an expense,

(4) be necessary, and

(5) be ordinary.

Thus, personal expenditures incurred outside of a taxpayer’s trade or business are not deductible under Sec. 162. In addition, capital expenditures under Sec. 263 are not deductible.

Once In A Lifetime

Even though a particular taxpayer may incur an expense only once in the lifetime of its business, the expense may qualify as ordinary and necessary if it is appropriate and helpful in carrying on that business, is commonly and frequently incurred in the type of business conducted by the taxpayer, and is not a capital expenditure. “Ordinary” in this context does not mean that the payments must be habitual or normal in the sense that the same taxpayer will have to make them often. A lawsuit affecting the “safety” of a business may happen only once in a lifetime. Nonetheless, the expense is an ordinary one because we know from experience that payments for such a purpose, whether the amount is large or small, are the common and accepted means of defense against attack. The term “necessary,” under Sec. 162, imposes the requirement that the expense be appropriate and helpful for the taxpayer’s business. However, if litigation arises from a capital transaction (e.g., the sale of property) then the costs and legal fees associated with the litigation are characterized as acquisition costs and must be capitalized under Sec. 263.

The Origin of the Claim

A payment will be deductible under Sec. 162 as a trade or business expense only if it is not a personal expenditure or a capital expenditure. The controlling test to distinguish business expenses from personal or capital expenditures is the “origin of the claim.” Under this test, the origin and character of the claim with respect to which an expense was incurred – rather than its potential consequences upon the fortunes of the taxpayer – is the controlling test of whether the expense was “business” or “personal” and, hence, whether it is deductible or not. Similarly, the origin and character of the claim with respect to which a settlement is made, rather than its potential consequences on the business operation of the taxpayer, is the controlling test of whether a settlement payment constitutes a deductible expense or  a nondeductible capital outlay. It should be noted that the “origin-of-the-claim” test does not contemplate a mechanical search for the first in the chain of events that led to the litigation but, rather, requires an examination of all the facts. The inquiry is directed to ascertaining the “kind of transaction” out of which the litigation arose. One must consider the issues involved, the nature and objectives of the litigation, the defenses asserted, the purpose for which the claimed deductions were expended, and all the facts pertaining to the controversy. Generally, amounts paid in settlement of lawsuits are currently deductible if the acts that gave rise to the litigation were performed in the ordinary conduct of a taxpayer’s business.

Similarly, amounts paid for legal expenses in connection with litigation are allowed as business expenses where such litigation is directly connected to, or proximately results from, the conduct of a taxpayer’s business.

The IRS Rules

The IRS determined that Taxpayer’s payments to satisfy the judgment awarded against him were ordinary and necessary expenditures. Under the origin of the claim test, E’s claims against Taxpayer had their origin in the conduct of Taxpayer’s trade or business – the management of Corp. Taxpayer’s activities that gave rise to the lawsuit did not result in the acquisition of a capital asset, did not perfect or defend title to an existing asset, and did not create a separate and distinct asset. Taxpayer did not receive a long-term benefit from the payments. An examination of all the facts indicated that the litigation payments were business expenses, and not personal or capital expenditures. Thus, the IRS concluded that the expenditures that Taxpayer paid, that resulted from the lawsuit by E against Taxpayer as the managing shareholder of Corp., were deductible under Sec. 162, provided that Taxpayer was not reimbursed for any of the payments by insurance or similar compensation.

Be Aware

In some cases, the deductibility of litigation-related expenses may not be relevant, as where the taxpayer’s costs are reimbursed by insurance.

In many other cases, however, the taxpayer and his or her attorneys ought to be aware of the opportunity for tax savings.

Although there is little that can be done about the facts when litigation has begun, a taxpayer should determine the kind of transaction out of which the litigation arose. He or she must consider the background of the litigation, its nature and its objectives. In turn, the defenses asserted may be framed in order to support the treatment of the litigation and settlement expenditures, as ordinary and necessary expenditures incurred in the conduct of the taxpayer‘s trade or business.

The goal in defending any litigation is damage-control, which includes the reduction of the economic cost of conducting and settling the litigation. The ability to reduce such cost through tax deductions can go a long way in making the economics of a deal easier to swallow.

There is nothing like an old proverb to remind you of the obvious. Unfortunately, too many taxpayers need to be reminded all too often. It’s one thing when the reminder comes from the taxpayer’s own advisers – at that point, the taxpayer may still have an opportunity to “correct” his or her actions. It is a very different thing, however, when the reminder comes from the IRS or from a court.

Imagine being the taxpayer to whom the Tax Court directed the following statement:

There is no doubt [a taxpayer] is entitled to benefit from his hard work. However, there is also no doubt that it was [the taxpayer’s] choice to structure the payments in a certain manner. He now must face the tax consequences of his choice, whether contemplated or not.

Corp. was a closely-held C corporation, the issued and outstanding shares of which were owned 85% by Dad (together with Corp., the “Taxpayers”) and 5% each by Mom (together with Dad, the “Shareholders”) and their two daughters, all of whom sat on Corp.’s board of directors and served as corporate officers.

Dad was employed full time as the president and CEO of Corp. In that capacity he had final decision-making and supervisory power over all business matters, including compensation and tax return preparation and approval. As it often happens in small-to-medium size businesses, Dad had to be a jack of all trades and ended up performing the work of three to four individuals.

“It Was A Very Good Year”

Corp. never declared a dividend. The Taxpayers explained that, historically, they kept any excess cash in the business in order to fund its expansion, instead of paying it out as compensation or dividends.

During the tax years at issue, Corp’s business was more profitable than usual. As a result, Dad received not only his base salary, but Corp. also paid him a significant bonus. In fact, his total reported compensation for those years was more than three times his reported salary in prior years. These were also the first years that Corp. had paid bonuses.

 Also during these tax years, Corp. paid for materials and labor in connection with the construction of several structures on land owned by the Shareholders, including a new personal residence for the Shareholders and a barn (the “Barn”). amex corp

The Barn housed Dad’s office, which he used for both business and personal purposes. In addition, the Shareholders used a part of the building to store their personal vehicles and some Corp. vehicles. There was no lease or other written agreement for the use of the Barn between the Shareholders and Corp.

In addition, during the same tax years, Corp. paid and reported on its books as cost of goods sold personal credit card charges on the Shareholders’ behalf. Corp. never recorded these amounts as compensation for Dad and Mom on its books.

Finally, Corp. paid for the purchase of a sports car (“Car”) to which Dad took title in his individual capacity, explaining that this was because Corp.’s business insurance would not permit it to insure the Car. Corp. claimed depreciation deductions for the Car. The Taxpayers, however, did not produce any records or other evidence associated with the alleged business use of the Car. Corp. did not report the amount paid for the car as compensation to Dad.

IRS vs. Taxpayer

According to the IRS, the construction costs of the Shareholders’ house and the Barn, the personal credit card bills, and the purchase of the Car were personal expenses paid by Corp. The IRS argued that these amounts should be treated as a constructive dividend to the Shareholders and, thus, nondeductible to Corp. The IRS also argued that Corp. could not deduct depreciation for the car because it was Dad’s personal property.

The Taxpayers disagreed and petitioned the Tax Court for relief.

The Taxpayers admitted that they “mistakenly” reported the house construction expenses as cost of goods sold, and they conceded that the Corp.’s credit card payments were for personal expenses of the Shareholders.

They argued, however, that the Barn and the Car were capital assets owned by Corp. The Taxpayers contended that the Barn was a storage facility that belonged to Corp., and that any expenses related to that facility should be treated as business-related. They claimed that they used the facility to store Corp.’s vehicles.

However, the IRS pointed out that the Shareholders also used it to store their personal vehicles. Dad had one of his offices in the Barn, and he admitted to using it for both business and personal purposes. The title to the land on which the Barn was constructed belonged to the Shareholders, and the Taxpayers did not introduce any documents containing an agreement between the Shareholders and Corp. as to the use of the land or the ownership of any structures on that land. The only testimony Taxpayers introduced on the subject of the Barn’s ownership was Dad’s, and he did not shed any light on the title to the property or other arrangements with Corp. that would allow the Court to conclude that the Barn was used for legitimate business purposes. Thus, the Taxpayers failed to meet their burden of proof, and the Court concluded that the expenses paid by Corp. to construct the Barn were personal expenses of the Shareholders.

Next, the Taxpayers argued that the Car was an asset that belonged to Corp. and that was used for business purposes, namely, as a means of transportation for Dad between various Corp.   worksites. The IRS argued that because the title to the vehicle was in Dad’s name alone and Taxpayers did not introduce any evidence of the business use of the vehicle such as travel logs detailing date, mileage, and business purpose for the use of the Car, it must be a personal expense of the Shareholders. As a result, the Taxpayers failed to meet the burden of proof to show that Corp. purchased the Car for business purposes.

The Court’s Analysis

Gross income includes all income from whatever source derived unless otherwise specifically excluded. The definition of gross income broadly includes any instance of undeniable accession to wealth, clearly realized, and over which the taxpayer has complete dominion and control.

The IRS argued that the income the Shareholders received in the form of a “distribution” of corporate property was a constructive dividend. The Taxpayers, in turn, argued that the payments should be treated as compensation to Dad for the prior years of service when he was underpaid. Under both theories, the Shareholders would have been required to include the amounts received as ordinary income for the tax years at issue.

It should be noted, however, that if the Taxpayers prevailed, Corp. may have been able to deduct the amounts paid as an ordinary and necessary business expense, provided the amounts represented reasonable compensation. The Shareholders, however, could potentially have benefited from the lower tax rate on qualified dividend income.  Moreover, dividend treatment would have avoided the imposition of employment taxes.

Compensation?

The Code allows a taxpayer to deduct payments for reasonable compensation for services when incurred as ordinary or necessary business expenses during the taxable year.  Whether amounts are paid as compensation turns on the factual determination of whether the payor intends at the time that the payment is made to compensate the recipient for the services performed. Only if payment is made with the intent to compensate is it deductible as compensation. The relevant time for determining the intent is when the purported compensation payment is made, not when the IRS later challenges the payment’s characterization. The taxpayer bears the burden of proof as to intent to compensate.

According to the Court, the record did not support the Taxpayer’s assertion that Corp. intended the payments for the construction of the house, the Barn, credit card bills, and the Car to be compensation. The only evidence the Taxpayers introduced to prove compensatory intent was Dad’s “self-serving testimony,” as Corp.’s CEO and majority shareholder, that he always intended the payments as compensation for his services in prior years. The Taxpayers did not introduce into evidence any board resolutions that addressed the payment of compensation to Dad. Absent such evidence, the Court could not conclude that Corp. “intended an action not reflected in its corporate documents.”

The Court stated that it did not question Dad’s business decision to keep the money in the business instead of paying himself a higher salary. Because of his efforts, Corp’s business grew substantially—as did his compensation. However, on the record, the Court was convinced that the payments in question were not intended as compensation for services at the time they were made. Dad tacitly approved running the personal expenses at issue through the corporate accounts and recording them as cost of goods sold. Corp. did not report these expenses as compensation either on its books or on its tax return for the years at issue. Nor did Corp.  pay payroll taxes on these amounts. The Shareholders did not report these amounts on their tax return at all, and did not inform their tax preparer that they considered these payments compensation.

It seemed clear, the Court stated, that the Taxpayers played “tax audit roulette” by trying to hide the expense payments and pay as little tax as possible.

Under the circumstances, the Court concluded that Corp. did not intend to compensate Dad for his services at the time it paid the expenses in question. Thus, these amounts were not compensation for prior services that could be deducted by Corp. In addition, Corp. was not entitled to a depreciation deduction for the car because it was Dad’s personal property and the Taxpayers did not introduce any evidence of the business use of the car.

Dividend?

The Court then considered whether the payment by Corp. of the Shareholders’ personal expenses was a constructive dividend. If a distributing corporation has sufficient earnings and profits, the Court stated, the distribution is a dividend, and a shareholder must include it in gross income. [IRC Sec. 301 and 316]. A constructive dividend is a payment or economic benefit conferred by a corporation on one of its shareholders. A constructive dividend may arise through a diversion or conversion of corporate earnings and profits, or through corporate payments to third parties at the direction of shareholders. Whether corporate expenditures constitute a constructive dividend is a question of fact. The amount of the constructive dividend is equal to the fair market value of the benefits received.

In the years at issue, Corp. had sufficient earnings and profits to declare a dividend to its shareholders. Because Dad, as Corp.’s CEO and majority shareholder, had the ultimate control over Corp.’s dealings, he was able to divert corporate funds to pay his personal expenses. Moreover, he approved the payment of those expenses out of the corporate funds. These facts fit squarely into the definition of a constructive dividend.

When Will They Ever Learn?

Every tax adviser has encountered a situation like the one described above. That is because almost every business owner, to some degree, diverts business profits to the payment of a personal, non-business expense. Businesses sometimes pay for personal credit card expenses, residential property taxes, club dues, personal cars, trips, etc. They provide no-show, paying jobs for family members. They over- or under-pay related businesses for services or property.

It is also a fact that many business owners believe that their gambits will never be discovered, especially during a period that has seen Congress basically eviscerate the IRS’s enforcement budget.

Yet, as many tax advisers see every day, taxpayers do get “caught,” whether as a result of traditional IRS audit activity, the analysis of information collected through data mining using new technologies, increased state tax enforcement activity, whistleblowers, or other means.

The guiding principle, as always, should be the following: how would you conduct business with an unrelated third party? Would you charge a reasonable fee and expect to be paid only a reasonable fee? What would you do to determine the reasonableness of a payment? Would you insist that the arrangement between you be properly authorized and memorialized?

Within these parameters, there are many legitimate business and personal goals that a business owner can accomplish without necessarily weakening his or her position vis-à-vis the IRS. One need only ask how.

 

In General

In earlier posts, we described how a closely-held business may use a nonqualified deferred compensation (“NQDC”) plan to retain the services of, and to incentivize, a key executive employee. We also discussed the various requirements that such a plan must satisfy in order to successfully defer the inclusion in the employee’s income of the compensation provided under the plan and the imposition of the associated tax liability.

Because a substantial amount of compensation may be deferred under a NQDC plan, the IRS has an interest in ensuring that the plan is structured and operated in a way that complies with the applicable rules and, thereby, warrants such deferral.

Toward that end, the IRS recently updated its Nonqualified Deferred Compensation Audit Techniques Guide (the “Guide”).  The Guide offers some insight into how the IRS will apply these rules. Thus, any employer that has a NQDC plan in place should become familiar with the Guide and plan accordingly.

What is a NQDC Plan?

A NQDC plan is an elective or non-elective plan or agreement between an employer and an employee to pay the employee compensation in the future. Retirement-201x300

Under a NQDC plan, employers generally only deduct expenses when income is recognized by the employee.

NQDC plans typically fall into four categories:

  1. Salary Reduction Arrangements defer the receipt of otherwise currently includible compensation by allowing the participant to defer receipt of a portion of his or her salary.
  2. Bonus Deferral Plans resemble salary reduction arrangements, except they enable participants to defer receipt of bonuses.
  3. Supplemental Executive Retirement Plans, or SERPs, are plans maintained for a select group of management or highly compensated employees.
  4. Excess Benefit Plans are plans that provide benefits solely to employees whose benefits under the employer’s qualified plan are statutorily limited.

Within these general categories are particular kinds of NQDC plans, including those that are based upon the value of the employer’s stock, such as stock options, stock appreciation rights, and phantom stock.

Unfunded Plans

Most NQDC plans are unfunded because of the tax advantages they afford participants.

An unfunded arrangement is one where the employee has only the employer’s “mere promise to pay” the deferred compensation in the future, and the promise is not secured in any way. The employer may simply keep track of the benefit in a bookkeeping account, or it may voluntarily choose to transfer amounts to a “rabbi trust” that remains a part of the employer’s general assets, subject to the claims of the employer’s creditors if the employer becomes insolvent, in order to help keep its promise to the employee.

If amounts are segregated or set aside from the employer’s creditors for the exclusive benefit of the employee – they are identified as a source to which a participant can look for the payment of his or her benefits (a “funded” arrangement) – the employee may have currently includible compensation.

NQDC plans must be in writing. While many plans are set forth in extensive detail, some are referenced by nothing more than a few provisions contained in an employment contract. In either event, the form (in terms of plan language) of a NQDC arrangement is just as important as the way the plan is carried out.

Audit Potential

According to the Guide, a NQDC plan examination should focus on when the deferred amounts are includible in the employee’s gross income and when those amounts are deductible by the employer. Two principle issues stemming from deferred compensation arrangements include the doctrines of constructive receipt and economic benefit. The Guide also states that the examiner should address if deferred amounts were properly taken into account for employment tax purposes, given that the timing rules for income tax and for FICA/FUTA taxes are different.

When are deferred amounts includible?  

According to the Guide, employees must include compensation in gross income for the taxable year in which it is actually or constructively received. Under the constructive receipt doctrine, income, although not actually in the taxpayer’s possession, is constructively received by an employee in the taxable year during which it is credited to the employee’s account, set apart for the employee, or otherwise made available so that the employee may draw upon it at any time. However, income is not constructively received if the taxpayer’s control of its receipt is subject to substantial limitations or restrictions.

Establishing constructive receipt requires a determination that the recipient had control of the receipt of the deferred amounts and that such control was not subject to substantial limitations or restrictions. According to the Guide, it is important to scrutinize all plan provisions relating to each type of distribution or access option. It also is imperative, the Guide states, to consider how the plan has been operating regardless of the existence of provisions relating to the types of distributions or other access options.  The Guide identifies certain devices, such as credit cards, debit cards, and check books, that may be used to grant employees unrestricted control of the receipt of the deferred amounts. Similarly, permitting employees to borrow against their deferred amounts may achieve the same result.

Under the economic benefit doctrine, if an individual receives any economic or financial benefit as compensation for services, the value of the benefit is currently includible in the individual’s gross income if the employee has a non-forfeitable interest in the benefit.

If property is transferred to employee as compensation for services, the employee will be taxed at the time of receipt of the property if the property is either transferable or not subject to a substantial risk of forfeiture. If the property is not transferable and subject to a substantial risk of forfeiture, no income tax is incurred until the property is not subject to a substantial risk of forfeiture or the property becomes transferable.

Property is subject to a substantial risk of forfeiture if the individual’s right to the property is conditional on the future performance of substantial services, or if rights in the transferred property are conditioned upon the occurrence of a condition related to a purpose of the transfer.

In general, property is considered transferable if a person can transfer his or her interest in the property to anyone other than the transferor (usually the employer) from whom the property was received.

General Audit Steps

The Guide explains that issues involving constructive receipt and economic benefit generally will present themselves in the administration of the plan, in actual plan documents, employment agreements, deferral election forms, or other communications (written or oral, formal or informal) between the employer and the employee.

The Guide directs examiners to ask the following questions and to request documentary substantiation where appropriate:

  • Does the employer maintain any qualified retirement plans?
  • Does the employer have any plans, agreements, or arrangements for employees that supplement or replace lost or restricted qualified retirement benefits?
  • Does the employer maintain any NQDC arrangements, or any trusts, or separate accounts for any employees? If yes, the examiner should obtain complete copies of each plan including all attachments, amendments, restatements, etc.
  • Do employees have individual employment agreements?
  • Do employees have any salary or bonus deferral agreements?
  • Does the employer have an insurance policy or an annuity plan designed to provide retirement or severance benefits for executives?
  • Are there any board of directors’ minutes or compensation committee resolutions involving executive compensation?
  • Is there any other written communication between the employer and the employees that sets forth “benefits,” “perks,” “savings,” “severance plans,” or “retirement arrangements”?

When reviewing the answers and documents received in response to these questions, examiners are instructed to look for indications that –

A. the employee has control over the receipt of the deferred amounts without being subject to substantial limitations or restrictions. If the employee has such control, the amounts are taxable under the constructive receipt doctrine. For example, the employee may borrow, transfer, or use the amounts as collateral, or there may be some other signs of ownership exercisable by the employee, which should result in current taxation for the employee; or

B. amounts have been set aside for the exclusive benefit of the employee. Amounts are set aside if they are not available to the employer’s general creditors if the employer becomes bankrupt or insolvent. Examiners are also asked to confirm that no preferences have been provided to employees over the employer’s other creditors in the event of the employer’s bankruptcy or insolvency. If amounts have been set aside for the exclusive benefit of the employee, or if the employee receives preferences over the employer’s general creditors, the employee has received a taxable economic benefit. Examiners are told to verify whether the arrangements result in the employee receiving something that is the equivalent of cash.

Audit Techniques

In addition to providing the “general audit steps” described above, the Guide advises examiners to interview the employer-company personnel that are most knowledgeable on executive compensation practices, such as the director of human resources or a plan administrator.

Examiners, the Guide says, should determine who is responsible for the day-to-day administration of the plans within the company. For example, who processes the deferral election forms and maintains the account balances?

Examiners are also instructed to review the deferral election forms and to determine if changes were requested and approved. They are told to review the notes to the company’s financial statements, as well as any materials that are disclosed to shareholders if they are asked to vote on a compensation plan.

Examiners are asked to determine whether the company paid a benefits consulting firm for the executive’s wealth management and, if so, to review a copy of the contract between the consulting firm and the corporation. They must determine who is administering the plan, what documents were created by the administrator, and who is maintaining the documents.

In addition, examiners are directed to review the ledger accounts/account statements for each plan participant, noting current year deferrals, distributions, and loans. They are told to compare the distributions to amounts reported on the employee’s Form W-2 for deferred compensation distributions, and to determine the reason for each distribution. They are instructed to check account statements for any unexplained reduction in account balances, and to review any distributions other than those for death, disability, or termination of employment.

IRC § 409A

Finally, the Guide reminds examiners that, under Section 409A, all amounts deferred under a NQDC plan for all taxable years are currently includible in gross income (to the extent not subject to a substantial risk of forfeiture and not previously included in gross income), unless certain requirements are satisfied.

The Guide states that all plans must be in compliance with the final Section 409A regulations, both in form and operation.

Forewarned is Forearmed

It may sound trite, but it is preached every week in this blog.

If a closely held-business knows what the IRS is looking for when it examines a NQDC plan, then it knows what provisions to include in the plan, what pitfalls to avoid, and what documentation to prepare and maintain. In this way, it can proceed with confidence that the plan it has implemented will withstand IRS examination and will deliver the anticipated benefits to its key employee.