Committed to a Zone

Last week’s post[i] considered how the newly-enacted qualified opportunity zone (“QOZ”) rules seek to encourage investment and stimulate economic growth in certain distressed communities by providing various federal income tax benefits to taxpayers who invest in businesses that operate within these zones.[ii] After describing these tax incentives, the post cautioned taxpayers who may have already recognized capital gain,[iii] or who are planning to sell or exchange property in a transaction that will generate taxable capital gain, that the tax incentives, although attractive, may be indicative of some not insignificant economic risk that is associated with the targeted investment.[iv]

This week, we continue our discussion of the QOZ rules,[v] beginning with the premise that the taxpayer already owns a business in a QOZ,[vi] or is already committed to investing in a QOZ.[vii] In other words, the taxpayer has already considered the risks of expanding within, or of moving into, such an area, and they have decided that it makes sense to do so from a long-term economic or business perspective. As to this taxpayer, the new tax incentives coincide with their long-term investment horizon, and also offer the opportunity[viii] to increase the taxpayer’s after-tax return on their investment.[ix]

However, in order to enjoy these tax benefits, the taxpayer[x] has to invest its “eligible gains”[xi] in a “qualified opportunity fund” (“QOF”).

What’s a Fund?

The use of the word “fund” may be misleading to some, who may interpret it strictly as a vehicle by which several investors can pool their resources for purposes of acquiring interests in one or more qualifying businesses.

The regulations proposed by the IRS provide that a QOF must be an entity that is classified as a partnership or as a corporation for federal income tax purposes. The reference to a “partnership” necessarily requires that there be at least two members that are respected as separate from one another for tax purposes.[xii]

The fact that a number of asset and wealth management businesses seem to have formed QOFs, and have begun to solicit investments therein from the “general public,” has reinforced the impression that a QOF must be some kind of pooled investment vehicle.[xiii]

Although such a vehicle generally offers single investors the opportunity[xiv] to combine their money to increase their “buying power,” decrease their individual risk, attain a level of diversification, and gain other advantages, such as professional management, there is nothing in the Code or in the regulations proposed thereunder that requires a QOF to be a multi-member investment vehicle.[xv]

In other words, so long as the subject entity is formed as a partnership, it can have as few as two investor-members and may still qualify as a QOF; in the case of a corporation, it can have only as few as one shareholder. Thus, a closely held business entity may be QOF.

That being said, there are a number of other requirements that the partnership or corporation must satisfy in order to be treated as a QOF, and that may prevent a closely held business from qualifying.

Requirements for QOF Status

Corporation or Partnership. The fund must be created or organized as a partnership or as a corporation in one of the 50 States, the District of Columbia, or a U.S. possession;[xvi] it must be organized for the purpose of investing in “QOZ property,” but not in another QOF.

A corporation may be a C corporation, or its shareholders may elect to treat it as an S corporation.[xvii] Alternatively, the fund may be formed as an LLC but elect to be treated as a corporation for tax purposes.[xviii]

New or Pre-existing. Moreover, the partnership or corporation may be a pre-existing entity and still qualify as a QOF,[xix] provided that the pre-existing entity satisfies the requirements for QOF status, including the requirement that QOZ property be acquired after December 31, 2017.[xx]

90 Percent of Asset Test. In addition, the fund must hold at least 90 percent of its assets[xxi] in “QOZ property,” determined by the average of the percentage of QOZ property held in the fund as measured (A) on the last day of the first 6-month period of the taxable year of the fund,[xxii] and (B) on the last day of the taxable year of the fund.[xxiii]

QOZ Property; QOZ Business Property

The following three kinds of property are treated as QOZ property that is counted toward the 90 percent test:

  • QOZ stock,
      • which is stock in a corporation that is acquired by the fund after December 31, 2017,
      • at its original issue,[xxiv] from the corporation,
      • solely in exchange for cash,
      • as of the time the stock was issued, the corporation was a “QOZ business” (or the corporation was being organized for purposes of being such a business), and
      • during “substantially all” of the fund’s holding period for the stock, the corporation qualified as a QOZ business;
  • QOZ partnership interest,
      • which is any capital or profits interest in a partnership,
      • that is acquired by a fund after December 31, 2017,
      • from the partnership,
      • solely in exchange for cash,
      • as of the time the partnership interest was acquired, the partnership was a “QOZ business” (or the partnership was being organized for purposes of being a QOZ business), and
      • (c) during “substantially all” of the fund’s holding period for the partnership interest, the partnership qualified as a QOZ business; and
  • QOZ business property,
      • which is tangible property used in a trade or business of the fund,
      • that was purchased by the fund after December 31, 2017,
      • from an “unrelated” person,[xxv]
      • for which the fund has a cost basis,
      • (i) the “original use”[xxvi] of which within the QOZ commences with the fund, or (ii) which the fund “substantially improves;” and
      • during “substantially all of the fund’s holding period” for the tangible property, “substantially all of the use” of the tangible property was in the QOZ.[xxvii]

N.B. Consequently, if a QOF operates a trade or business directly, and does not hold any equity in a QOZ business formed as a corporation or partnership, at least 90 percent of the QOF’s assets must be QOZ business property; i.e., it must be tangible property – no more than 10 percent of its property can be intangible property, such as goodwill.[xxviii]

Substantially Improved. The definition of QOZ business property basically requires the property to be used in a QOZ, and also requires that new capital be employed in a QOZ.

Specifically, tangible property is treated as “substantially improved” by a QOF (for purposes of applying the definition of QOZ business property) only if, during any 30-month period beginning after the date of acquisition of the property, additions to the basis of the property in the hands of the QOF exceed an amount equal to the adjusted basis of the property at the beginning of the 30-month period in the hands of the QOF; in other words, the fund must at least double the adjusted basis of the property during such 30-month period. For example, if property is acquired in February of 2019, it must be substantially improved by August 2021.

Significantly, if a QOF purchases a building located on land wholly within a QOZ, a substantial improvement to the purchased tangible property is measured by the QOF’s additions to the adjusted basis of the building only; the QOF is not required to separately “substantially improve” the land upon which the building is located.[xxix]

QOZ Business

In order for a share of stock in a corporation, or for a partnership interest, to be treated as QOZ property in the hands of a fund, the issuing entity must be a QOZ business, which is any trade or business:

      • In which “substantially all” of the tangible property owned or leased by the trade or business is QOZ business property;[xxx]
      • At least 50 percent of the total gross income of which is derived from the “active conduct of business”[xxxi] in the QOZ;
      • A “substantial portion” of the business’s intangible property is used in the active conduct of business[xxxii] in the QOZ; and
      • Less than 5 percent of the average of the aggregate adjusted bases of the property of the business is attributable to “nonqualified financial property;”[xxxiii]
          • nonqualified financial property does not include “reasonable amounts” of working capital held in cash, cash equivalents, or debt instruments with a term of no more than 18 months;
          • nor does it include accounts or notes receivable acquired in the ordinary course of a trade or business for services rendered or from the sale of inventory property;
      • The trade or business is not a golf course, country club, massage parlor, hot tub or suntan facility, racetrack or other facility used for gambling, or store whose principal business is the sale of alcoholic beverages for consumption off premises.[xxxiv]

Substantially All. A corporation’s or partnership’s trade or business is treated as satisfying the “substantially all” requirement (for purposes of applying the definition of QOZ business) if at least 70 percent of the tangible property owned or leased by the trade or business is QOZ business property.[xxxv] (This is to be compared to the requirement that 90 percent of the fund’s assets must be QOZ business property where the fund directly owns only a trade or business.)

Working Capital. For purposes of applying the limit on nonqualified financial property, working capital assets will be treated as reasonable in amount if all of the following requirements are satisfied:

  • The amounts are designated in writing for the acquisition, construction, and/or substantial improvement of tangible property in a QOZ.
  • There is a written schedule consistent with the ordinary start-up of a trade or business for the expenditure of the working capital assets.
  • Under the schedule, the working capital assets must be spent within 31 months of the receipt by the business of the assets.[xxxvi]
  • The working capital assets are actually used in a manner that is “substantially consistent” with the foregoing.[xxxvii]

Similarly, a safe harbor is provided for purposes of applying the 50-percent test for gross income derived from the active conduct of business. Specifically, if any gross income is derived from property that is treated as a reasonable amount of working capital, then that gross income is counted toward satisfaction of the 50-percent test.[xxxviii]

Substantial Portion. The requirement that a “substantial portion” of the business’s “intangible property” be used in the active conduct of business will be treated as being satisfied during any period in which the business is proceeding in a manner that is substantially consistent with the use of the working capital described above.

Although these “safe harbors” are helpful, the absence of guidance on other requirements is troubling, including those related to the fund’s “active conduct of business;” for example, will rental real estate be treated as an active trade or business for this purpose?

N.B. It is noteworthy that the proposed safe harbor for working capital applies only in determining whether a partnership or corporation in which a QOF owns an interest (a lower-tier entity) qualifies as a QOZ business. It does not apply to a trade or business that is owned directly by a fund, thereby making the 90 percent test more restrictive.

The 90 Percent of Assets Test

As indicated above, a QOF must undergo semi-annual tests to determine whether its assets consist, on average, of at least 90 percent QOZ property. For purposes of these semi-annual tests, a tangible asset can be treated as QOZ business property by a find that has self-certified as a QOF (or an operating subsidiary corporation or partnership) only if it acquired the asset after 2017 by purchase.

For purposes of the calculation of the “90 percent of assets test” by the QOF, the QOF is required to use the asset values that are reported on the QOF’s applicable financial statement for the taxable year.[xxxix]

Failing the 90 Percent. In general, if a fund fails to satisfy the 90 percent test, a monthly penalty will be imposed on the fund in an amount equal to the product of:

(A) the excess of (1) the amount equal to 90 percent of the fund’s aggregate assets, over (2) the aggregate amount of QOZ property held by the fund, multiplied by (B) the underpayment rate. This penalty will not apply before the first month in which the entity qualifies as a QOF.

Working Capital Safe Harbor. Query whether cash be an appropriate QOF property for purposes of the 90 percent test if the cash is held with the intent of investing in QOZ property? Specifically, because developing a new business or the construction or rehabilitation of real estate may take longer than six months (i.e., the period between testing dates), QOFs should be given longer than six months to invest in qualifying assets.[xl]

The proposed regulations provide a working capital safe harbor for QOF investments in QOZ businesses (i.e., partnerships and corporations) that acquire, construct, or rehabilitate tangible business property, which includes both real property and other tangible property used in a business operating in an opportunity zone.

The safe harbor allows qualified opportunity zone businesses a period of up to 31 months, if there is a written plan that identifies the financial property as property held for the acquisition, construction, or substantial improvement of tangible property in the opportunity zone, there is written schedule consistent with the ordinary business operations of the business that the property will be used within 31 months, and the business substantially complies with the schedule. Taxpayers would be required to retain any written plan in their records.[xli]

If a corporation or partnership qualifies as a QOZ business, the value of the QOF’s entire interest in the entity counts toward the QOF’s satisfaction of the 90 percent test. Thus, if a QOF operates a trade or business (or multiple trades or businesses) through one or more partnerships or corporations, then the QOF can satisfy the 90 percent test if each of the entities qualifies as a QOZ business;[xlii] among other things, “substantially all” of the tangible property owned or leased by the entity must be QOZ business property.

A business will be treated as satisfying the substantially all requirement for this purpose if at least 70 percent of the tangible property owned or leased by a trade or business is QOZ business property.[xliii]

N.B. Again, it is noteworthy that the proposed 70 percent test for purposes of satisfying the substantially all requirement applies only in determining whether a partnership or corporation in which a QOF owns an interest (a lower-tier entity) qualifies as a QOZ business. It does not apply to a trade or business that is owned directly by a fund; it appears that no more than 10 percent of the assets of such a business can be cash or intangibles (like goodwill).

Certification as a QOF

In order to facilitate the investment process, and minimize the information collection burden placed on taxpayers, a corporation or partnership that is eligible to be a QOF is allowed to self-certify that it is organized as a QOF.

The self-certification must identify the first taxable year that the fund wants to be a QOF; it may also identify the first month (in that initial taxable year) in which it wants to be a QOF.[xliv]

If a taxpayer who has recognized gain invests in a fund prior to the fund’s first month as a QOF, any election to defer such gain with that investment is invalid.

Return. It is expected that a fund will use IRS Form 8996, Qualified Opportunity Fund,[xlv] both for its initial self-certification and for its annual reporting of compliance with the 90-percent test. It is also expected that the Form 8996 would be attached to the fund’s federal income tax return for the relevant tax years.[xlvi]

The proposed regulations allow a QOF both to identify the taxable year in which the entity becomes a QOF and to choose the first month in that year to be treated as a QOF. If an eligible entity fails to specify the first month it is a QOF, then the first month of its initial taxable year as a QOF is treated as the first month that the eligible entity is a QOF.[xlvii]

Thoughts?

The QOZ rules were enacted in December of 2017. Regulations were proposed in October of 2018. The IRS has indicated that a second round of proposed regulations will be released relatively soon. The period for recognizing capital gains that will be eligible for reinvesting in QOFs and enjoying the resulting tax benefits expires in 2026.[xlviii] Many questions remain unanswered.

Although a closely held business entity (a fund) that chooses to own a business directly, and to operate such a business in a QOZ, may qualify as a QOF into which its taxpayer-owner may invest their post-2017 capital gains, it appears that the IRS has placed some obstacles in its path to doing so. Whether these were intentional or not remains to be seen. In the meantime, the clock continues to run.

What is a business owner (the “Taxpayer”) to do if they are planning a liquidity event, such as a sale of the business to an unrelated person, in the near future and want to defer their gain by taking advantage of the QOZ tax benefits, but without giving up control over their investment? They can create and capitalize their own fund (within the prescribed investment period), that will try to start a QOZ business that satisfies the tests described above, including the requirement that they timely purchase QOZ business property, and such property shall represent at least 90 percent of the fund’s assets. Good luck.

Alternatively, they can create their own fund, identify one or more existing QOZ businesses (C corporations or partnerships) that are ready to expand and, over the next six months, try to negotiate a cash investment in such a business in exchange for equity therein (including a preferred interest) that also provides the Taxpayer with a significant voice in the management of the business as to major decisions (“sacred rights”), including any decisions that may affect the business’s qualification as a QOZ business or the qualification of the Taxpayer’s investment vehicle as a QOF. The QOZ business would have 31 months in which to use the Taxpayer’s infusion of working capital to acquire QOZ business property.[xlix]

Failing these options, the Taxpayer may invest timely in an “institutional” fund, but with the understanding that they will have little-to-no voice therein. It may not be ideal, but it is much easier to accomplish than the alternatives described above.[l]


[i] Any “quoted” terms that are not defined herein were either defined in last week’s post or have not yet been defined by the IRS.

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

[iii] And whose 180-day period for reinvesting the gain(s) from such sale(s) has not yet expired. As an aside, any taxpayer planning to take advantage of the QOZ rules should start investigating reinvestment options well before their capital gain event.

[iv] For example, the investment is being made in an economically-challenged area, the deferral ends in 2026, at which point the taxpayer who invests their gain in a QOF may not have the liquidity to pay the tax; in order for a taxpayer to enjoy the full 15 percent reduction in the deferred gain, they must acquire an interest in a QOF before the end of 2019 and then hold the interest for at least seven years; and the exclusion from income of any appreciation above the deferred gain requires that the taxpayer hold their investment in the QOF for at least ten years.

[v] I.e., IRC Sec. 1400Z-1 and 1400Z-2, and the regulations proposed thereunder; the regulations generally are proposed to be effective on or after the date they are published as final in the Federal Register. However, a QOF may rely on the proposed rules with respect to taxable years that begin before the final regulations’ date of applicability, but only if the QOF applies the rules in their entirety and in a consistent manner.

[vi] A complete list of designated qualified opportunity zones is found in Notice 2018-48, 2018-28 I.R.B. 9.

[vii] Consider, for instance, the number of businesses that had already moved, or had decided to move, into Long Island City, N.Y. before the enactment of these incentives as part of the Tax Cuts and Jobs Act (P.L. 115-97).

[viii] Pun intended.

[ix] Assuming all goes well.

[x] The “taxpayer” may be an individual, a C corporation, a partnership, an S corporation, an estate, or a trust.

[xi] Capital gain, which may be realized in a number of different scenarios under a number of Code provisions. The election to defer tax on an eligible gain invested in a QOF is made on Form 8949, Sales and Other Dispositions of Capital Assets, which is attached to a taxpayer’s federal income tax return.

[xii] You can’t have a tax partnership among a grantor, a 100% grantor trust, and an LLC that is wholly-owned by the grantor and disregarded as an entity separate from the grantor.

[xiii] For example, UBS circulated an email to that effect just last week.

[xiv] There’s that word again.

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

[xvi] In addition, if the entity is organized in a U.S. possession, but not in one of the 50 States or in the District of Columbia, then it may be a QOF only if it is organized for the purpose of investing in QOZ property that relates to a trade or business operated in the possession in which the entity is organized.

[xvii] The latter cannot have more than 100 shareholders. IRC Sec. 1361(b).

[xviii] Reg. Sec. 301.7701-3.

[xix] Or as the issuer of “QOZ stock” or of a “QOZ partnership interest.”

[xx] Which requirement, by itself, may prevent a pre-existing entity from qualifying.

[xxi] By “value;” see below.

[xxii] With respect to an entity’s first year as a QOF, if the entity chooses to become a QOF beginning with a month other than the first month of its first taxable year, the phrase “first 6-month period of the taxable year of the fund” means the first 6-month period (i) composed entirely of months which are within the taxable year and (ii) during which the entity is a QOF. For example, if a calendar-year entity that was created in February chooses April as its first month as a QOF, then the 90 percent testing dates for the QOF are the end of September and the end of December. Moreover, if the calendar-year QOF chooses a month after June as its first month as a QOF, then the only testing date for the taxable year is the last day of the QOF’s taxable year. Regardless of when an entity becomes a QOF, the last day of the taxable year is a testing date.

[xxiii] June 30 and December 31 in the case of a taxpayer with a December 31 YE.

[xxiv] Directly or through an underwriter.

[xxv] IRC Sec. 1400Z-2(d)(2)(D)(i)(I), Sec. 179(d)(2).

[xxvi] The IRS did not propose a definition of “original use” and is seeking comments on possible approaches to defining the “original use” requirement, for both real property and other tangible property. For example, what metrics would be appropriate for determining whether tangible property has “original use” in an opportunity zone? Should the use of tangible property be determined based on its physical presence within an opportunity zone, or based on some other measure? See Revenue Ruling 2018-29 regarding the acquisition of an existing building on land within a QOZ. Stay tuned.

[xxvii] Hopefully, the forthcoming second round of proposed regulations will address the meaning of “substantially all” in each of the various places where it appears. The IRS has requested comments.

[xxviii] See below.

[xxix] Although the foregoing guidance is helpful, questions remain. For example, how will a fund’s satisfaction of the “substantial improvement” test be affected if it elects to expense some of its investment under Section 179 of the Code, or if it elects bonus depreciation under Section 168?

[xxx] See the definition of QOZ business property, above. Query how the asset rules will be applied to leases.

[xxxi] Hopefully, this will be defined in the next round of guidance.

[xxxii] Stay tuned for this, too.

[xxxiii] This includes debt, stock, partnership interests, annuities, and derivative financial instruments (for example, options and futures).

[xxxiv] I guess Congress doesn’t want to encourage the presence of such vile establishments in distressed areas.

[xxxv] The value of each asset of the entity as reported on the entity’s “applicable financial statement” for the relevant reporting period is used for determining whether a trade or business of the entity satisfies this requirement. Reg. Sec. 1.475(a)-4(h). If a fund does not have an applicable financial statement, the proposed regulations provide alternative methodologies for determining compliance.

[xxxvi] 31 months?! Has the IRS ever tried to develop property in N.Y.C. or on Long Island? Delays caused by legislators and regulators are standard fare.

[xxxvii] If some financial property is treated as being a reasonable amount of working capital because of compliance with the requirements above regarding the use of working capital, and if the tangible property acquired with such working capital is expected to satisfy the requirements for QOZ business property, then that tangible property is not treated as failing to satisfy those requirements solely because the scheduled consumption of the working capital is not yet complete.

[xxxviii] The requirement that the QOZ business derive at least 50 percent of its income from the QOZ may be more difficult to satisfy.

[xxxix] See EN xxxi. If a QOF does not have an applicable financial statement, it may use the cost of its assets. The IRS has requested comments on the suitability of both of these valuation methods, and whether another method, such as tax adjusted basis, would be better.

[xl] What if a QOF sells its interest in QOZ stock or its QOZ partnership interest? It should have “a reasonable period of time” to reinvest the proceeds therefrom. For example, if the sale occurs shortly before a testing date, the QOF should have a reasonable amount of time in which to bring itself into compliance with the 90 percent test. According to the IRS, soon-to-be-released proposed regulations will provide guidance on these reinvestments by a QOF.

[xli] This expansion of the term “working capital” reflects the fact that the QOZ rules anticipate situations in which a QOF or operating subsidiary may need up to 30 months after acquiring a tangible asset in which to improve the asset substantially. The IRS has requested comments about the appropriateness of any further expansion of the “working capital” concept beyond the acquisition, construction, or rehabilitation of tangible business property to the development of business operations in the opportunity zone.

[xlii] Query whether the IRS will eventually permit some sort of aggregation for purposes of applying this rule.

[xliii] This 70 percent threshold is intended to apply only to the term “substantially all” as it is used in section 1400Z-2(d)(3)(A)(i).

[xliv] If the self-certification fails to specify the month in the initial taxable year that the eligible entity first wants to be a QOF, then the first month of the eligible entity’s initial taxable year as a QOF is the first month that the eligible entity is a QOF.

[xlv] Instructions for Form 8996 were released January 24, 2019. A corporation or partnership will use the form to certify that it is organized to invest in QOZ property; they will also file the form annually to report that they meet the investment standard (or to calculate the penalty if they fail to satisfy the standard).

[xlvi] Form 1120, 1120S or 1065.

[xlvii] A deferral election under section 1400Z-2(a) may only be made for investments in a QOF. Therefore, a proper deferral election under section 1400Z-2(a) may not be made for an otherwise qualifying investment that is made before an eligible entity is a QOF.

[xlviii] IRC Sec. 1400Z-2.

[xlix] This option appears to be more manageable.

[l] There’s that inverse relationship again.

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

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

Economic Risk

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

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

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

Sale of the Business

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

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

Gain Recognition and Economic Risk

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

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

Continuing Investment and Deferral

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

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

Public Policy and Deferral

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

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

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

Enter the Qualified Opportunity Zone

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

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

The Tax Benefits

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

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

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

Eligible Gain

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

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

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

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

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

Eligible Taxpayer

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

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

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

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

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

Temporary Deferral

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

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

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

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

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

Eligible Investment

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

The eligible investment cannot be a debt instrument.

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

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

Partial Exclusion

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

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

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

Gain Recognition

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

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

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

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

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

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

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

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

Death of the Electing Taxpayer

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

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

Exclusion of Appreciation

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

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

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

Investor Beware[xl]

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

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

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

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

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

Example

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

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

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

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

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

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

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

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

What Does It All Mean?

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

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

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

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

————————————————————————————

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

[ii] Think Goldilocks. “Just right.”

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

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

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

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

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

[viii] As in the typical private equity deal.

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

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

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

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

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

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

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

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

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

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

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

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

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

[xx] IRC Sec. 1245.

[xxi] IRC Sec. 1221, 1231.

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

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

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

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

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

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

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

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

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

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

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

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

[xxxiii] 2019 plus 7 equals 2026.

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

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

[xxxvi] For example, before 2026.

[xxxvii] IRC Sec. 691.

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

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

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

[xli] See EN xxxiii and the related text.

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

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

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

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

 

Tax Law for the Closely Held Business blog authors Lou Vlahos and Bernadette Kasnicki presented yesterday, January 17, on how the Tax Cuts and Jobs Act affects not-for-profit organizations. Their presentation–given at the 41st Annual New York State Society Certified Public Accountants (NYSSCPA) Not-for-Profit Conference in New York City–was summarized in article format for The Trusted Professional, the NYSSCPA’s newspaper.

Below is an excerpt from the article:

The Tax Cuts and Jobs Act has a number of provisions that both directly and indirectly affect not-for-profit organizations, but tax attorneys Bernadette Kasnicki and Louis Vlahos—speaking at the Foundation for Accounting Education’s 41st Annual Nonprofit Conference today—said that the targeted provisions seem to focus on narrowing the gap between rules that govern non-profit and for-profit organizations.

For example, Kasnicki, an associate with the firm Farrell Fritz P.C., said that the TCJA imposes a 21 percent excise tax on nonprofits that pay compensation of $1 million or more to any of their five highest-paid employees, which applies to all forms of remuneration of a covered employee. She noted that, in the for-profit world, compensation of top executives cannot be deducted beyond the point of $1 million. She said that, by subjecting nonprofits to a similar rule, the TCJA is attempting to bring exempt organizations into parity with taxable ones.

Vlahos, a partner at the same firm, said that it’s actually a little worse for nonprofits under the new rules. For-profit organizations have two carveouts for the deduction limit: one is if the pay is reasonable for services rendered previously, and the other is for parachute payments that represent payment for services going forward “because we’re not firing you but keeping you.” Not-for-profits, on the other hand, have no such carveouts.

Please click here to read the full article.

 In case you missed it, you may also be interested in reading Lou Vlahos’s latest post on the blog: It’s a Business . . . No, It’s a Charity . . . Wait – It’s a Charity That Is Treated Like a Business?

 

The Business-Charity Connection

As our readers know, this blog is dedicated to addressing the tax-related business and succession planning issues that are most often encountered by the owners of a closely held business. Occasionally, however, we have crossed over into the space occupied by tax-exempt charitable organizations inasmuch as such an exempt organization (“EO”) may be the object of a business owner’s philanthropy, either during the owner’s life or at their demise.

Foundations

For example, we have considered grant-making private foundations (“PF”) that have been funded by the business owner and, thus, are not reliant upon the general public for their financial survival. In particular, we have reviewed a number of the penalty (“excise”) taxes applicable to PFs. These are rooted in the government’s tacit recognition that the activities of such a PF cannot be influenced by the withholding of public support from the foundation. Rather, the threatened imposition of these taxes is intended to encourage certain “good” behavior and to discourage certain “bad” behavior by a PF.[i]

Although PFs are important players in the charitable world, a business owner is far more likely to support charitable activities by making direct financial contributions to publicly-supported charities that operate within their community, rather than to create a PF through which to engage in such charitable giving.[ii]

Board Service

Where the business owner has a personal connection to an EO’s charitable mission, the owner may seek to become a member of the organization’s board of directors. In other cases, the EO itself may solicit the owner’s involvement, in part to help secure their financial support, not to mention the access they can provide to other potential donors from the business world.

Another reason that business owners may be attractive candidates for an EO’s board of directors is that they are experienced in . . . running a business.[iii] This skillset may be especially important in light of recent changes to the Code that reflect Congress’s heightened skepticism toward EOs, and that are aimed at limiting the amount of executive compensation payable by EOs.

Increased Public Scrutiny

Congress’s reaction to EO executive compensation is, in part, attributable to the public’s own changing perspective. As the charitably-inclined segment of the “public” has become more sophisticated, and better informed, it has demanded more accountability as to how its charitable contributions are being utilized, including what percentage of the contributions made to a charity is being used for executive compensation.[iv]

These “economic” concerns are magnified when viewed in light of the reality that the vast majority of charitable organizations are governed by self-perpetuating boards of directors,[v] which in turn hire the executive employees who operate these organizations on a day-to-day basis.

In response to these concerns, Congress has slowly been adding provisions to the Code that are intended (as in the case of the excise taxes applicable to PFs) to dissuade public charities and their boards from engaging in certain behavior.

Until the passage of the Tax Cuts and Jobs Act of 2017,[vi] the most notable of these provisions was that dealing with “excess benefit transactions.”[vii]

Blurring the Lines

As a result of these economic pressures, not to mention the attendant governmental scrutiny, most public charities have sought to fulfill their charitable missions on a more efficient basis. In other words, they have tried to become more “business-like” in performing their charitable functions. In furtherance of this goal, many EOs have tried to attract and retain the services of talented and experienced executives, while also inviting successful business owners onto their boards.

Notwithstanding these efforts, many EOs continue to be in the Congressional crosshairs. In particular, some larger EOs have been accused, in some circles, of taking advantage of their tax-preferred status to generate what critics have characterized as large profits, a not-insignificant portion of which find their way, or so these critics assert, into the hands of the organizations’ key executives in the form of generous compensation packages.

The Act represents the latest Congressional effort to rein in what its proponents perceived as abuses in the compensation of EOs’ top executives.

In order to stem these “abuses,” the Act draws liberally from the tax rules applicable to executive compensation paid or incurred by business organizations. Before delving into these provisions, it would be helpful to briefly review the “for-profit” rules from which they were derived.

For-Profit Compensation Limits

In determining its taxable income from the conduct of a trade or business, an employer may claim a deduction for reasonable compensation paid or incurred for services actually rendered to the trade or business.[viii] Whether compensation is reasonable depends upon all of the facts and circumstances. In general, compensation is reasonable if the amount thereof is equal to what would ordinarily be paid for “like services by like enterprises under like circumstances.”[ix]

However, Congress has determined – without stating that it is per se unreasonable – that compensation in excess of specified levels may not be deductible in certain situations.

Public Corporations

Prior to the Act, and in order to protect shareholders from grasping executives, a publicly-held corporation generally could not deduct more than $1 million of compensation in a taxable year for each “covered employee,”[x] unless the corporation could establish that the compensation was performance-based.[xi]

Golden Parachutes

In addition, a corporation generally cannot deduct that portion of the aggregate present value of a “parachute payment” – generally a payment of compensation that is contingent on a change in corporate ownership or control[xii] – which equals or exceeds three times the “base amount” of certain shareholders, officers and highly compensated individuals.[xiii] The nondeductible excess is an “excess parachute payment.”[xiv]

The purpose of the provision is to prevent executives of widely-held corporations from furthering their own interests, presumably at the expense of the shareholders, in the sale of the business.[xv]

Quite reasonably, certain payments are excluded from “parachute payment status” – in particular, the amount established as reasonable compensation for services to be rendered after the change in ownership or control is excluded.[xvi]

In addition, the amount treated as an excess parachute payment is reduced by the amount established as reasonable compensation for services actually rendered prior to the change in ownership or control.[xvii]

Finally, the individual who receives an excess parachute payment is subject to an excise tax of 20% of the amount of such payment.[xviii]

EO Compensation Limits

Prior to the Act, the foregoing deduction limits generally did not affect an EO.

That being said, there were other provisions in the Code that addressed the payment of unreasonable compensation by an EO to certain individuals.

Self-Dealing

PFs are prohibited from engaging in an act of “self-dealing,” which includes the payment of compensation by a PF to a disqualified person.[xix]

However, the payment of compensation to a disqualified person by a PF for the performance of personal services which are reasonable and necessary to carry out the PF’s exempt purpose will not constitute self-dealing if the compensation is not excessive.[xx]

In other words, the EO-PF may pay reasonable compensation to a disqualified person.[xxi]

Where it has paid excess compensation, the EO is expected to recover the excess from the disqualified person.[xxii]

Excess Benefit Transaction

A public charity is prohibited from engaging in an “excess benefit transaction,” meaning any transaction in which an economic benefit[xxiii] is provided by the organization to a disqualified person if the value of the economic benefit provided exceeds the value of the consideration, including the performance of services, received for providing such benefit.[xxiv]

To determine whether an excess benefit transaction has occurred, all consideration and benefits exchanged between the disqualified person and the EO, and all entities that the EO controls, are taken into account.[xxv]

In other words, the EO-public charity may pay reasonable compensation to a disqualified person without triggering the excess benefit rules.

As in the case of a PF, the public charity is expected to recover the amount of any excess payment made to the disqualified person.[xxvi]

Private Inurement

An organization is not operated exclusively for one or more exempt purposes if its net earnings inure, in whole or in part, to the benefit of private individuals.[xxvii]

Whether an impermissible benefit has been conferred on an individual is essentially a question of fact. A common factual thread running through the cases where inurement has been found is that the individual stands in a relationship with the organization which offers them the opportunity to make use of the organization’s income or assets for personal gain. This has led to the conclusion that a finding of inurement is usually limited to a transaction involving “insiders.”

Whereas the excise taxes on acts of self-dealing and on excess benefit transactions are intended to address situations that do not rise to the level at which the EO’s tax-favored status should be revoked, a finding that the organization’s net earnings have inured to the benefit of its “insiders” connotes a degree of impermissible benefit that justifies the revocation of its tax-exemption.

The Act

Congress must have believed that the foregoing limitations were not adequate to police or control the compensation practices of EOs. The committee reports to the Act, however, do not articulate the reason for the enactment of the provisions we are about to consider.

The only rationale that I can think of is that Congress was attempting to maintain some sort of “parity” between for-profits and EOs with respect to executive compensation.[xxviii]

Thus, the new provision draws heavily from the limitations applicable to business organizations, described above, and its purpose likewise may be deduced from the purposes of such limitations: to prevent certain individuals in the EO from paying themselves “excessive” salaries and other benefits, and thereby ensuring that those amounts are instead used in furtherance of the EO’s exempt purpose and for the benefit of its constituents.[xxix]

The Tax

Under the Act, effective for taxable years beginning after December 31, 2017, an employer (not the individual recipient of the payment) is liable for an excise tax equal to 21 percent[xxx] of the sum of:

(1) any “remuneration” in excess of $1 million paid to a covered employee by an EO for a taxable year, and

(2) any excess parachute payment paid by the EO to a covered employee.[xxxi]

Accordingly, the excise tax may apply as a result of an excess parachute payment, even if the covered employee’s remuneration[xxxii] does not exceed $1 million; in other words, there are two events that may trigger the imposition of the tax.

Where both provisions may apply, the remuneration that is treated as an excess parachute payment is not accounted for in determining if the $1 million limit is exceeded.

Covered Employee

For purposes of the provision, a covered employee is an employee (including any former employee) of an applicable tax-exempt organization if the employee

  • is one of the five highest compensated employees of the organization for the taxable year (the current year; there is no minimum dollar threshold for an employee to be a covered employee), or
  • was a covered employee of the organization (or of a predecessor organization) for any preceding taxable year beginning after December 31, 2016.[xxxiii] Thus, if the individual was a covered employee in a prior year (beginning with 2017), they continue to be treated as such for purposes of determining whether any payments made to them in subsequent years violate one of the two limitations described above.[xxxiv]

Related Persons

Remuneration of a covered employee also includes any remuneration paid with respect to employment of the covered employee by any person related to the EO.

A person is treated as related to an EO if the person:

(1) controls, or is controlled by, the organization,

(2) is controlled by one or more persons that control the organization,

(3) is a supported organization with respect to the organization, or

(4) is a supporting organization with respect to the organization.

Parachute Payments

Under the provision, an excess parachute payment is the amount by which any parachute payment exceeds the portion of the base amount allocated to the payment.

A parachute payment is a payment in the nature of compensation to a covered employee if:

  • the payment is contingent on the employee’s separation from employment and
  • the aggregate present value of all such payments equals or exceeds three times the base amount.[xxxv]

It should be noted that this definition differs from that applicable in the case of a business organization, where the disallowance of the employer’s deduction, and the imposition of the excise tax on the employee-recipient, are not contingent on the employee’s separation from employment.

It should also be noted that the Act did not provide an exception for a payment that represents reasonable compensation. Thus, even where the payment is reasonable in light of the services provided by the employee, and thus would not be trigger an excise tax for self-dealing or an excess benefit, the excise tax will nevertheless be applied.[xxxvi]

Liability

The employer of a covered employee – not the employee – is liable for the excise tax.

This is to be contrasted with the case of an employer that is a business organization. The employer is denied a deduction for the excess parachute payment, but an excise tax is also imposed upon the employee to whom the payment was made.

In addition, if the remuneration of a covered employee from more than one employer is taken into account in determining the excise tax, each employer is liable for the tax in an amount that bears the same ratio to the total tax as the remuneration paid by that employer bears to the remuneration paid by all employers to the covered employee.[xxxvii]

Parting Thoughts

The rules described above are complicated, and the IRS has yet to propose interpretive regulations, though it recently published interim guidance[xxxviii] to assist EOs with navigating the new rule, and on which they may rely, until regulations can be issued.

Of course, an EO will not be impacted by these provisions if it does not pay an employee enough remuneration to trigger the tax; there can be no excess remuneration if an EO (together with any related organization) pays remuneration of less than $1 million to each of its employees for a taxable year, and there can be no excess parachute payment if the EO does not have any “highly compensated” employees for the taxable year.[xxxix]

Does this mean that an EO should not pay any of its executives an amount that would trigger the imposition of the above tax? Should it walk away from candidates whom the EO can only hire by paying a larger amount? Or should it seek out the best people, pay them an amount that would trigger the tax but that the EO determines would be reasonable,[xl] and accept the resulting tax liability as a cost of doing business?[xli]

These are the kind of decisions that I have seen business owners make every day, and these are usually preceded by another set of inquiries: Will the return on our investment (in this case, in intellectual capital) justify the cost? Are we overpaying, or is the amount reasonable under the circumstances? Is there another way by which we can secure the same benefit – perhaps through a different mix of incentives, payable in varying amounts and at different times so as to skirt the literal terms of the Act, while also securing the services of a great executive?

The ability to bring this type of business analysis to an EO’s board discussion on executive compensation may be at least as valuable, in the current environment, as one’s willingness to open one’s wallet to the EO.

———————————————————————————————–

[i] See Subchapter A of Chapter 42 of the Code. Examples include the excise tax on a foundation that fails to pay out annually, to qualifying charities, an amount equal to at least five percent of the fair market value of its non-charitable assets, and the excise tax on certain “insiders” (with respect to the foundation) who engage in acts of self-dealing with the foundation (e.g., excessive compensation).

[ii] There are many reasons a business owner chooses to form a foundation; ego, tax planning, continued control, and family involvement are among these. There are also many reasons not to form one; the resulting administrative burden and the cost of tax compliance should not be underestimated.

[iii] Take a look at the board of any local charity. It is likely populated, in no small part, by the owners of businesses that operate within, or employ individuals from, the locality in which the EO is headquartered or that it services.

[iv] Instead of, say, furthering the charitable mission. It should be noted that these expenditures are not necessarily mutually exclusive.

[v] That’s right. The members of these boards elect themselves and their successors. It is rare for a larger charity to have “members” in a legal, “corporate law” sense– i.e., the counterparts to shareholders in a business organization – with voting rights, including the right to elect or remove directors. Rather, these charities depend upon honest, well-intentioned individuals to ensure that their charitable mission is carried out. Many of these individuals – the directors of the organization – are drawn from the business community. Of course, the Attorney General of the State in which a charity is organized also plays an important role in ensuring that the charity and those who operate it stay the course.

[vi] P.L. 115-97 (the “Act”).

[vii] IRC Sec. 4958; P.L. 104-168; enacted in 1996, it is generally applicable to public charities. More on this rule later.

[viii] IRC Sec. 162(a)(1).

[ix] Reg. Sec. 1.162-7.

[x] Specifically, its CEO, CFO, and the three other most highly compensated officers.

[xi] IRC Sec. 162(m); enacted in 1993 as part of the Omnibus Budget Reconciliation Act, P.L. 103-66. The Act eliminated the exception for performance-based pay.

[xii] IRC Sec. 280G(b)(2) and (c).

[xiii] An individual’s base amount is the average annualized compensation includible in the individual’s gross income for the five taxable years ending before the date on which the change in ownership or control occurs. IRC Sec. 280G(b)(3).

[xiv] IRC Sec. 280G(a) and (b)(1); enacted in 1984; P.L. 98-369.

[xv] The provision does not apply to “small business corporations” or to non-traded corporations that satisfy certain shareholder approval requirements. IRC Sec. 280G(b)(5).

[xvi] IRC Sec. 280G(b)(4)(A).

[xvii] IRC Sec. 280G(b)(4)(B).

[xviii] IRC Sec. 4999. Presumably because they would have been in a position to contractually obligate the corporation to make the payment.

[xix] IRC Sec. 4941. “Disqualified person” is defined in IRC Sec. 4946. https://www.law.cornell.edu/uscode/text/26/4946.

[xx] IRC Sec. 4941(d)(2)(E).

[xxi] The key, of course, is for the board to be able to demonstrate the basis for its determination of reasonableness.

[xxii] A “correction” under IRC Sec. 4941(e). The “obligation” to recover the excess portion is implicit in the calculation of the penalty.

[xxiii] For purposes of this rule, an economic benefit provided by an EO will not be treated as consideration for the performance of services rendered to the EO unless the EO clearly indicated its intent to treat such benefit as compensation.

[xxiv] IRC Sec. 4958(c)(1)(A).

[xxv] Reg. Sec. 53.4958-4. Congress foresaw that some individuals may try to circumvent the proscription by drawing down salaries from non-exempt organizations related to the EO.

[xxvi] IRC Sec. 4958(f)(6).

[xxvii] Reg. Sec. 1.501(a)-1.

[xxviii] Query whether EOs have been enticing executives away from business organizations in droves – I don’t think so.

[xxix] Interestingly, the Act made no distinction between public charities and PFs. In contrast, the comparable limitations for business organizations do not apply to “small business corporations” or certain non-publicly traded corporations.

[xxx] I.e., the newly established flat rate for C corporations – in order to mirror the amount of tax that such a corporation would have to pay in respect of the disallowed portion of the compensation paid to the individual service provider.

[xxxi] IRC Sec. 4960. https://www.law.cornell.edu/uscode/text/26/4960.

[xxxii] Remuneration includes amounts required to be included in the employee’s gross income under IRC Sec. 457(f).

Such amounts are treated as paid (and includible in gross income) when there is no substantial risk of forfeiture of the rights to such remuneration within the meaning of section 457(f). Sec. 4960(c)(3). For this purpose, a person’s rights to compensation are subject to a substantial risk of forfeiture if the rights are conditioned on the future performance of substantial services by any individual, or upon the achievement of certain organizational goals.

Up until now, the only cap on 457(f) arrangements was that the payment be reasonable for the services actually rendered.

In determining reasonableness, one looks to the totality of the recipient’s services to the EO, not only for the year paid; in other words, the payment may be “prorated” over many years for this purpose. Accordingly, the tax imposed by this provision can apply to the value of remuneration that is vested even if it is not yet received. Indeed, the excise tax can apply to amounts that are paid currently though they were earned in earlier years.

[xxxiii] Sec. 4960(c)(2).

[xxxiv] The list of covered employees may grow to include individuals who are no longer included in the five highest paid.

[xxxv] The base amount is the average annualized compensation includible in the covered employee’s gross income for the five taxable years ending before the date of the employee’s separation from employment.

[xxxvi] That being said, the Act does exempt compensation paid to employees who are not “highly compensated” employees from the definition of parachute payment.

Significantly for EO-hospitals, compensation attributable to medical services of certain qualified medical or veterinary professionals is exempted from the definitions of remuneration and parachute payment; remuneration paid to such a professional in any other capacity is taken into account.

Unfortunately, neither the Act nor the committee reports provide any guidance regarding the allocation of a medical professional’s remuneration between their medical services and, say, their administrative functions within the EO-employer.

[xxxvii] It should be noted that the Act authorizes the IRS to issue regulations to prevent the avoidance of the excise tax through the performance of services other than as an employee.

[xxxviii] Notice 2019-09, which consists of ninety pages of Q&A.

[xxxix] Within the meaning of IRC Sec. 414(q).

[xl] It should always be reasonable under the facts and circumstances.

[xli] Assuming the amount is reasonable within the meaning of the self-dealing and excess benefit rules, will there be any argument under state law that the imposition of the tax reflects a per se breach of the board’s fiduciary duty?

If the amount is not reasonable, such that the excise taxes on self-dealing and excess benefits become payable, what is purpose of the new tax?

If there was one part of the Tax Cuts and Jobs Act (“TCJA”) that estate planners were especially pleased to see, it was the increase in the basic exclusion amount from $5.49 million, in 2017, to $11.18 million for gifts made, and decedents dying, in 2018.[i] However, many estate planners failed to appreciate the potential impact of an income tax provision that came late to the party and that was specifically intended to benefit the individual owners of pass-through entities (“PTEs”).

A Brief History

As it made its way through Congress, the TCJA was billed[ii] as a boon for corporate taxpayers, and indeed it was. The corporate tax rate was reduced from 35% to 21%. The corporate AMT was eliminated. The system for the taxation of foreign income was changed in a way that skews in favor of C corporations.

But what about the closely held business – the sole proprietorships, the S corps, the partnerships and LLCs that are owned primarily by individual taxpayers and that often represent the most significant asset in their estates?

These businesses are usually formed as PTEs for tax purposes, meaning that the net operating income generated by these entities is generally not subjected to an entity-level tax; rather, it flows through to the individual owners, who are taxed thereon as if they had realized it directly.

With the introduction of the TCJA, the owners of many PTEs began to wonder whether they should revoke their S corporation elections, or whether they should incorporate[iii] their sole proprietorships and partnerships.

In response to the anxiety felt by individual business owners, Congress enacted a special deduction for PTEs in the form of Sec. 199A.[iv] However, shortly after its enactment on December 22, 2017, tax advisers starting peppering the IRS with questions about the application of 199A.

The IRS eventually proposed regulations in August, for which hearings were held in mid-October.[v]

In September, House Republicans introduced plans for making Sec. 199A “permanent.” Then, during the first week of November, the Republicans lost control of the House.[vi]

Notwithstanding this state of affairs, the fact remains that 199A is the law for at least two more years,[vii] and estate planners will have to deal with it; after all, the income tax consequences arising from an individual’s transfer of an interest in a PTE in furtherance of their estate plan will either enhance or reduce the overall economic benefit generated by the transfer.

In order to better appreciate the application of 199A to such “estate planning transfers,” a quick refresher may be in order.

Sec. 199A Basics

Under Sec. 199A, a non-corporate taxpayer[viii] – meaning an individual, a trust, or an estate – who owns an interest in a PTE that is engaged in a qualified trade or business (“QTB”),[ix] may claim a deduction for a taxable year equal to 20% of their qualified business income (“QBI”)[x] for the taxable year.[xi]

This general rule, however, is subject to a limitation that, if triggered, may reduce the amount of the 199A deduction that may be claimed by the non-corporate taxpayer (the “limitation”).

What triggers the limitation? The amount of the taxpayer’s taxable income from all sources[xii] – not just the taxpayer’s share of the QTB’s taxable income. Moreover, if the taxpayer files a joint return with their spouse, the spouse’s taxable income is also taken into account.

Specifically, once the taxpayer’s taxable income exceeds a specified threshold amount, the limitation becomes applicable, though not fully; rather, it is phased in. In the case of a single individual, the limitation starts to apply at taxable income of $157,500 (the so-called “threshold amount”). The limitation is fully phased in when taxable income exceeds $207,500.[xiii]

This $157,500 threshold amount also applies to non-grantor trusts and to estates.

These thresholds are applied at the level of each non-corporate owner of the business – not at the level of the entity that actually conducts the business. Thus, some owners of a QTB who have higher taxable incomes may be subject to the limitations, while others with lower taxable incomes may not.

The Limitation

As stated earlier, the Sec. 199A deduction for an individual, a trust, or an estate for a particular tax year is generally equal to the 20% of the taxpayer’s QBI for the year.

However, when the above-referenced limitation becomes fully applicable, the taxpayer’s 199A deduction for the year is equal to the lesser of:

  • 20% of their QBI from a QTB, and
  • The greater of:
      • 50% of the W-2 Wages w/r/t such QTB, or
      • 25% of the W-2 Wages w/r/t such QTB plus 2.5% of the “unadjusted basis” of the “qualified property” in such QTB.

In considering the application of this limitation, the IRS recognized that there are bona fide non-tax, legal or business reasons for holding certain properties – such as real estate – separate from the operating business, and renting it to such business. For that reason, the proposed regulations allow the owners of a QTB to consider the unadjusted basis of such rental property in determining the limitations described above – even if the rental activity itself is not a QTB – provided the same taxpayers control both the QTB and the property.[xiv]

Thus, assuming the presence of at least one QTB,[xv] much of the planning for 199A will likely involve the taxpayer’s “management” of (i) their taxable income (including their wages and their share of QBI) and, thereby, their threshold amount for a particular year, (ii) the W-2 Wages paid by the business, (iii) the unadjusted basis of the qualified property[xvi] used in the business, and (iv) the aggregation of QTBs.

Of the foregoing items, the management of the unadjusted basis of qualified property may be especially fruitful in the context of estate planning, as may the management of the threshold amount.

Unadjusted Basis

Generally speaking, the unadjusted basis of qualified property is its original basis in the hands of the QTB as of the date it was placed into service by the business.

Where the business purchased the property, its cost basis would be its unadjusted basis – without regard to any adjustments for depreciation or expensing subsequently claimed with respect to the property – and this amount would be utilized in determining the limitation on an owner’s 199A deduction.

However, where the property was contributed to a PTE in a tax-free exchange for stock or a partnership interest, the PTE’s unadjusted basis would be the adjusted basis of the property in the hands of the contributor at the time of the contribution – i.e., it will reflect any cost recovery claimed by such person.

In the case of an individual who acquires property from a decedent before placing it into service in a QTB, the stepped-up basis becomes the unadjusted basis or purposes of 199A.

However, if the qualified property is held in a partnership, no Section 754 adjustment made at the death of a partner will be taken into account in determining the unadjusted basis for the transferee of the decedent’s interest for purposes of 199A.[xvii]

Based on the foregoing, and depending upon the business,[xviii] a taxpayer who can maximize the unadjusted basis of the QTB’s qualified property will increase the likelihood of supporting a larger 199A deduction in the face of the limitation.

Toward achieving this end, there may be circumstances in which qualified property should be owned directly by the owners of the PTE (say, as tenants-in-common[xix]), rather than by the PTE itself, and then leased by the owners to the business.

For example, if a sole proprietor is thinking about incorporating a business, or converting it into a partnership by bringing in a partner, and the business has qualified property with a relatively low unadjusted basis (say, the original cost basis), the sole proprietor may want to retain ownership of the depreciable property and lease it (rather than contribute it) to the business entity, so as (i) to preserve their original unadjusted cost basis and avoid a lower unadjusted cost basis in the hands of the entity (based on the owner’s adjusted basis for the property) to which it would otherwise have been contributed, and (ii) to afford their successors in the business and to the property an opportunity to increase their unadjusted basis in the property, assuming it has appreciated – basically, real estate – after the owner’s death.

Trusts – the Threshold Amount

A non-grantor trust is generally treated as a form of pass-through entity to the extent it distributes (or is required to distribute) its DNI (“distributable net income;” basically, taxable income with certain adjustments) to its beneficiaries, for which the trust claims a corresponding distribution deduction. In that case, the income tax liability for the income that is treated as having been distributed by the trust shifts to the beneficiaries to whom the distribution was made.

To the extent the trust retains its DNI – i.e., does not make (and is not required to make) a distribution to its beneficiaries – the trust itself is subject to income tax.

In the case of a non-grantor trust, at least in the first instance, the 199A deduction is applied at the trust level. Because the trust is generally treated as an individual for purposes of the income tax, the threshold amount for purposes of triggering the application of the limitation is set at $157,500 (with a $50,000 phase-in range).

Distribution

However, if the trust has made distributions during the tax year that carry out DNI to its beneficiaries, the trust’s share of the QBI, W-2 Wages, and Unadjusted Basis of the QTB in which it owns an interest are allocated between the trust and each beneficiary-distributee.

This allocation is based on the relative proportion of the DNI of the trust that is distributed, or that is required to be distributed, to each beneficiary, or that is retained by the trust. In other words, each beneficiary’s share of the trust’s 199A-related items is determined based on the proportion of the trust’s DNI that is deemed distributed to the beneficiary.

The individual beneficiary treats these items as though they had been allocated to them directly from the PTE that is engaged in the QTB.

Following this allocation, the trust uses its own taxable income for purposes of determining its own 199A deduction, and the beneficiaries use their own taxable incomes.

Based on the foregoing, a trustee may decide to make a distribution in a particular tax year if the trust beneficiaries to whom the distribution is made are in a better position to enjoy the 199A deduction than are the trust and the other beneficiaries.[xx]

In any case, the beneficiaries to whom a distribution is not made may object to the trustee’s decision notwithstanding the tax-based rationale.

Of course, where the trustee does not consider the tax attributes of an individual beneficiary, and makes a distribution to such individual which pushes them beyond the threshold amount, or disqualifies their SSTB from a 199A deduction, the beneficiary may very well assert that the trustee did not act prudently.

Limitations Applied to Non-grantor Trusts

The 199A threshold and phase-in amounts are applied at the level of the non-grantor trust.[xxi]

Because of this, the IRS is concerned that taxpayers will try to circumvent the threshold amount by dividing assets among multiple non-grantor trusts, each with its own threshold amount.

In order to prevent this from happening, the IRS has proposed regulations that introduce certain anti-abuse rules.[xxii]

Specifically, if multiple trusts are formed with a “significant purpose” – not necessarily the primary purpose – of receiving a deduction under 199A, the proposed regulations provide that the trusts will not be “respected” for purposes of 199A.[xxiii] Unfortunately, it is not entirely clear what this means: will the trusts not qualify at all, or will they be treated as a single trust for purposes of the deduction?

In addition, two or more trusts will be aggregated by the IRS, and treated as a single trust for purposes of 199A, if:

  • The trusts have substantially the same grantor(s),
  • Substantially the same “primary” beneficiary(ies), and
  • “A” principal purpose for establishing the trusts is the avoidance of federal income tax.

For purposes of applying this rule, spouses are treated as one person. In other words, if a spouse creates one trust and the other spouse creates a second trust, the grantors will be treated as the same for purposes of the applying this anti-abuse test, even if the trusts are created and funded independently by the two spouses.[xxiv]

If the creation of multiple trusts results in a “significant income tax benefit,” a principal purpose of avoiding tax will be presumed.

This presumption may be overcome, however, if there is a significant non-tax (or “non-income tax”) purpose that could not have been achieved without the creation of separate trusts; for example, if the dispositive terms of the trusts differ from one another.

Grantor Trust

The application of 199A to a grantor trust is much simpler because the individual grantor is treated as the owner of the trust property and income, and the trust is ignored, for purposes of the income tax.[xxv] Thus, any QTB interests held by the trust are treated as owned by the grantor for purposes of applying 199A.

In other words, the rules described above with respect to any individual owner of a QTB will apply to the grantor-owner of the trust; for example, the QBI, W-2 Wages, and Unadjusted Basis of the QTB operated by the PTE in which the trust holds an interest will pass through to the grantor.

Planning?

As we know, many irrevocable trusts to which completed gifts have been made are nevertheless taxed as grantor trusts for income tax purposes. The grantor has intentionally drafted the trust so that the income tax liability attributable to the trust will be taxed to the grantor, thereby enabling the trust to grow without reduction for income taxes, while at the same time reducing the grantor’s gross estate for purposes of the estate tax.

This may prove to be an expensive proposition for some grantors, which they may remedy by renouncing the retained rights or authorizing the trustee to toggle them on or off, or by being reimbursed from the trust (which defeats the purpose of grantor trust status).

The availability of the 199A deduction may reduce the need for avoiding or turning off grantor trust status, thus preserving the transfer tax benefits described above. In particular, where the business income would otherwise be taxed at a 37% federal rate,[xxvi] the full benefit of 199A would yield a less burdensome effective federal rate of 29.6%.

In addition to more “traditional” grantor trusts – which are treated as such because the grantor has retained certain rights with respect to the property contributed to the trust – there are other trusts to which the grantor trust rules may apply and which may, thereby, lend themselves to some 199A planning.

For example, a trust that holds S corporation stock may qualify as a subchapter S trust for which the sole current beneficiary of the trust may elect under Sec. 1361(d) (a “QSST” election) to be treated as the owner of such stock under Sec. 678 of the Code.[xxvii] Or a trust with separate shares for different beneficiaries, each of which is treated as a separate trust for which a beneficiary may elect treatment as a QSST.

Another possibility may be a trust that authorizes the trustee to grant a general power of appointment to a beneficiary as to only part of the trust – for example, as to a portion of one of the PTE interests held by the trust – thereby converting that portion of the trust into a grantor trust under Sec. 678.[xxviii]

What’s Next?

It remains to be seen what the final 199A regulations will look like.[xxix] That being said, estate planners should have enough guidance, based upon what has been published thus far, to advise taxpayers on how to avoid the anti-abuse rules for non-grantor trusts, how to take advantage of the grantor trust rules, and how to maximize the unadjusted basis for qualified property.

Hopefully, the final regulations will provide examples that illustrate the foregoing. Absent such examples, advisers will have to await the development of some Sec. 199A jurisprudence. Of course, this presupposes that 199A will survive through the 117th Congress.[xxx]


[i] The exclusion amount increases to $11.4 million in 2019. It is scheduled to return to “pre-TCJA” levels after 2025. See the recently proposed regulations at REG-106706-18.

[ii] Pun intended. P.L. 115-97.

[iii] Or “check the box” under Reg. Sec. 301.7701-3.

[iv] This provision covers tax years beginning after 12/31/2017, but it expires for tax years beginning after 12/31/2025.

[v] More recently, the IRS announced its 2018-2019 priority guidance project, which indicated that it planned to finalize some of the regulations already proposed, but that more regulations would be forthcoming; it also announced that a Revenue Procedure would be issued that would address some of the computational issues presented by the provision.

[vi] Thus, we find ourselves at the end of November 2018 with a provision that expires after December 31, 2025, for which the issued guidance is still in proposed form.

[vii] Through the next presidential election.

[viii] The deduction is not determined at the level of the PTE – it is determined at the level of each individual owner of the PTE, based upon each owner’s share of qualified business income.

[ix] In general, a QTB includes any trade or business other than a specified service trade or business (“SSTB”) and the provision of services as an employee.

If an individual taxpayer does not exceed the applicable taxable income threshold (described below), their QBI from their SSTB will be included in determining their 199A deduction. If the taxpayer exceeds the applicable threshold and phase-in amounts, none of the income and deduction items from the SSTB will be included in determining their 199A deduction.

[x] Basically, the owner’s pro rata share of the QTB’s taxable income.

[xi] This deduction amount is capped at 20% of the excess of (i) the owner’s taxable income for the year over (ii) their net capital gain for the year.

[xii] Business and investment, domestic and foreign.

[xiii] In the case of a joint return between spouses, the threshold amount is $315,000, and the limitation becomes fully applicable when taxable income exceeds $415,000.

[xiv] Consistent with this line of thinking, and recognizing that it is common for taxpayers to separate into different entities, parts of a business that are commonly thought of as a single business, the IRS will also allow individual owners – not the business entities themselves – to elect to aggregate (to treat as one business) different QTBs if they satisfy certain requirements, including, for example, that the same person or group of persons control each of the QTBs to be aggregated.

It should be noted that owners in the same PTEs do not have to aggregate in the same manner. Even minority owners are allowed to aggregate. In addition, a sole proprietor may aggregate their business with their share of a QTB being conducted through a PTE.

[xv] Whether a QTB exists or not is determined at the level of the PTE. An owner’s level of involvement in the business is irrelevant in determining their ability to claim a 199A deduction. A passive investor and an active investor are both entitled to claim the deduction, provided it is otherwise available.

[xvi] Basically, depreciable tangible property that is used in the QTB for the production of QBI, and for which the “depreciation period” has not yet expired.

[xvii] The Section 754 adjustment is not treated as a new asset that is placed into service for these purposes. Compare Reg. Sec. 1.743-1(j)(4).

[xviii] For example, is it labor- or capital-intensive?

[xix] Of course, this presents its own set of issues.

[xx] Of course, this assumes that the trustee has the relevant beneficiary information on the basis of which to make this decision, which may not be feasible.

[xxi] For purposes of determining whether the trust’s taxable income exceeds these amounts, the proposed regulations provide that the trust’s taxable income is determined before taking into account any distribution deduction. Query whether this represents a form of double counting? The distributed DNI is applied in determining the trust’s threshold, and it is applied again in determining the distributee’s.

[xxii] Under both IRC Sec. 199A and Sec. 643(f).

[xxiii] Prop. Reg. Sec. 1.199A-6(d)(3).

[xxiv] Prop. Reg. Sec. 1.643(f)-1.

[xxv] IRC Sec. 671 through 679.

[xxvi] The new maximum federal rate for individuals after the TCJA.

[xxvii] See Reg. Sec. 1.1361-1(j).

[xxviii] A so-called “Mallinckrodt trust.”

[xxix] The proposed regulations also address the treatment of ESBTs under Sec. 199A. According to the proposed regulations, an ESBT is entitled to the deduction. Specifically, the “S portion” of the ESBT takes into account its share of the QBI and other items from any S corp owned by the ESBT.

The grantor trust portion of the trust, if any, passes its share to the grantor-owner.

The non-S/non-grantor trust portion of the trust takes into account the QBI, etc., of any other PTEs owned by the trust. Does that mean that the ESBT is treated as two separate trusts for purposes of the 199A rules? It is not yet clear.

[xxx] January 2021 to January 2023.