Introduction

In general, self-employed individuals are subject to employment taxes on their net earnings.

The wages paid to individuals who are non-owner-employees of a business are also subject to employment taxes, regardless of how the business is organized.

The shareholders of a corporation are not subject to employment taxes in respect of any return on their investment in the corporation, though they are subject to employment taxes as to any wages paid to them by the corporation.

In the case of an S corporation, the IRS has sought to compel the corporation to pay its shareholder-employees a reasonable wage for services rendered to the corporation, and thus to prevent it from “converting” into a distribution of investment income that is not subject to employment taxes.

Finally, in the case of a partnership, a “limited partner” is generally not subject to employment taxes in respect of his distributive share of the partnership’s income, while the shares of a “general partner” are subject to such taxes, regardless of whether or not the general partner receives a distribution from the partnership.

Application to LLC Members

The U.S. Tax Court recently considered whether the members of an LLC may be treated as limited partners for purposes of applying the self-employment tax to their distributive share of the LLC’s net income.

Specifically, the issue for decision was whether the three member-managers of the LLC (the “Taxpayers”) were entitled to claim the exclusion from self-employment income for limited partners for a portion of their LLC distributions.

The Taxpayers were attorneys who initially practiced law through a general partnership before reorganizing their firm as a member-managed professional limited liability company (the “PLLC”). The PLLC never had a written operating agreement, and it filed federal income tax returns as a partnership.

For the years at issue, the Taxpayers’/members’ compensation agreement required guaranteed payments (i.e., payments to a partner for services, determined without regard to the income of the partnership) to each member that were commensurate with local area legal salaries. Any net profits of the PLLC in excess of the amounts paid out as guaranteed payments were distributed among the members in accordance with the Taxpayers’ agreement.

The Taxpayers reported all of their guaranteed payments from the PLLC as self-employment income subject to self-employment tax. However, they did not remit self-employment tax on the excess of their distributive shares over the guaranteed payments they received, on the grounds that such distributive shares were attributable to the efforts of the PLLC’s other employees (in other words, they represented a return on investment).

The IRS challenged the Taxpayers’ treatment of this excess.

Self-Employment Tax

The Code imposes a tax on the “self-employment income” of every individual for a taxable year (self-employment tax). In general, self-employment income is defined as “the net earnings from self-employment derived by an individual.”

“Net earnings from self-employment” is defined as the gross income derived by an individual from any trade or business carried on by such individual, less allowable deductions which are attributable to such trade or business, plus his distributive share (whether or not distributed) of income or loss from any trade or business carried on by a partnership of which he is a member . . . .”

Certain items are excluded from self-employment income, including “the distributive share of any item of income . . . of a limited partner, as such, other than guaranteed payments to that partner for services actually rendered to or on behalf of the partnership to the extent that those payments are established to be in the nature of remuneration for those services . . . .”

The Taxpayers contended that the above exclusion applied to their distributive shares in excess of the guaranteed payments. The IRS, however, argued that the members were not “limited partners” for purposes of this exclusion and, therefore, the distributive shares constituted self-employment income.

The Tax Court reviewed the history of the exclusion, explaining that it was enacted well before LLCs became widely used. The Court noted that no statutory or regulatory authority defines “limited partner” for purposes of the exclusion.

A “Historical” Digression

Prior to the enactment of the exclusion, the Code provided that a partner’s share of partnership income was includable in his net earnings from self-employment for tax purposes, regardless of the nature of his membership in the partnership.

In creating the exclusion for limited partners, Congress recognized that certain earnings were basically in the nature of a return on investment. Thus, the exclusion was not extended to guaranteed payments received for services actually rendered by the limited partner to the partnership.

In 1997, in response to the proliferation of LLCs, the IRS issued proposed regulations defining “limited partner” for self-employment tax purposes. These generally provided that an individual would be treated as a limited partner unless the individual: (1) had personal liability for the debts of or claims against the partnership by reason of being a partner; (2) had authority to contract on behalf of the partnership; or (3) participated in the partnership’s trade or business for more than 500 hours.

In response to criticism from the business community, Congress imposed a temporary moratorium on finalizing the proposed regulations, which has long since expired, yet the proposed regulations have neither been finalized nor withdrawn.

A number of courts, however, have addressed the attempts by taxpayers to distinguish between a partner’s wages and his share of partnership income. The courts have generally explained that a limited partnership has two fundamental classes of partners: general partners, who typically have management power and unlimited personal liability; and limited partners, who lack management powers but enjoy immunity from liability for debts of the partnership. A limited partner, these courts have pointed out, could lose his limited liability protection were he to engage in the business operations of the partnership. Consequently, the courts have observed that the interest of a limited partner is akin to that of a passive investor.

The Court’s Opinion

The Tax Court followed this line of this reasoning in its analysis of the Taxpayers’ position. The meaning of “limited partner,” it stated, was not confined to the limited partnership context. Therefore, the issue was whether a Taxpayer/member of the member-managed PLLC was functionally equivalent to a limited partner in a limited partnership.

In a limited partnership, the Court highlighted, a limited partner does not become liable as a general partner unless, in addition to the exercise of his rights and powers as a limited partner (e.g., the right to vote on the dissolution of the partnership or the sale of substantially all of its assets), he takes part in the control of the business.

In this case, the management power over the business of the PLLC was vested in each of the Taxpayer-members. The Taxpayers testified that each of them participated equally in all decisions and had substantially identical relationships with the PLLC, including the same rights and responsibilities: for example, they all participated in collectively making decisions regarding their distributive shares, borrowing money, hiring, firing, and rate of pay for employees, they each supervised associate attorneys, and they each signed checks for the PLLC.

There was no PLLC operating agreement or other evidence to suggest otherwise, nor was there any evidence to show that any member’s management power was limited in any way. Indeed, they had previously operated as a general partnership, and there was no evidence that organizing as a PLLC was accompanied by any change in the way they managed the business.

On the basis of the foregoing, the Court held that the respective membership interests held by the Taxpayers could not have been limited partnership interests, and the Taxpayers were not limited partners. Accordingly, the Taxpayers could not exclude any part of their distributive shares of PLLC net income from self-employment income.

Lessons & Planning

The Tax Court’s decision demonstrates that a business organization that is treated as a partnership for tax purposes cannot change the character of a partner/member’s distributive share for purposes of the self-employment tax simply by making guaranteed payments to the partner for his services. A partnership is not a corporation, and the “wage” and “reasonable compensation” rules that are applicable to corporations do not apply to partnerships.

The “limited partner exclusion” provided by the Code was intended to apply to those partners who “merely invest” rather than those who actively participate in and perform services for a partnership in their capacity as partners.

Therefore, a partner who is not a “limited partner” within the meaning of the exclusion is subject to self-employment tax on his full distributive share of the partnership’s income, even in cases involving a capital-intensive (as opposed to a service-intensive) business.

If a member of an LLC truly intends to be a passive investor, his status as such should be memorialized in an operating agreement, it should be reflected in his actions, and the LLC and other members should treat him accordingly.

As always, the taxpayers must be able to support their position, and the first steps in doing so are to adopt a form of operation (and, if relevant, organization) that conforms with the intended result, to contemporaneously memorialize that intention, including the “action plan” for attaining it, and to act consistently with the foregoing.

In General

It is a basic principle of federal tax law that a taxpayer cannot, for purposes of determining the taxpayer’s taxable income, claim a loss with respect to an investment in excess of the taxpayer’s unrecovered economic cost for such investment. If the taxpayer invested $X to acquire a non-depreciable asset – for example, a capital contribution in exchange for shares of stock in a C corporation, or a loan to a corporation in exchange for an interest-bearing note – the amount of loss realized by the taxpayer upon the disposition or worthlessness of the asset will be based upon the amount invested by the taxpayer in acquiring the asset. Where the asset is depreciable by the taxpayer, the loss realized is determined by reference to the taxpayer’s cost basis, reduced by the depreciation deductions claimed by the taxpayer (which represent a recovery of the taxpayer’s cost), i.e., the taxpayer’s adjusted basis.

Application to S-Corps

In the case of an S corporation, a shareholder’s ability to utilize his pro rata share of any deductions or losses realized by the S corporation is limited in accordance with this principle; specifically, for any taxable year, the aggregate amount of losses and deductions that may be taken into account by a shareholder cannot exceed the sum of the adjusted basis of the shareholder’s stock in the S corporation, and the shareholder’s adjusted basis for any bona fide loans made by the shareholder to the S corporation.

Stock Basis

Because an S corporation is treated as a pass-through for tax purposes, its income is generally not subject to corporate-level tax; rather, it is taxed to its shareholders (whether or not it is distributed to them).

In order to preserve this single level of tax, a shareholder’s initial basis for his shares of S corporation stock – which may be the amount he paid to acquire the shares from another shareholder or the adjusted basis of any property he contributed to the corporation in a tax-free exchange for such shares – is adjusted upward by the amount of income that is allocated and taxed to the shareholder; in this way, the already-taxed income may later be distributed to the shareholder without causing him to realize a gain (as where the amount distributed exceeds the stock basis).

By the same token, where already-taxed income has not been distributed to the shareholder, it remains subject to the risks of the business, and the shareholder is effectively treated as having made an “economic outlay” which may be lost in the operation of the business; this is reflected in his stock basis.

Debt Basis

In general, a shareholder’s basis for a cash loan from the shareholder to the corporation is equal to the face amount of the loan.

If the corporation’s indebtedness to the shareholder arose out of a transfer of property by the shareholder to the corporation – basically, a sale of the property in exchange for the corporation’s obligation to pay the purchase price some time in the future – the basis is equal to the face amount of the obligation less the amount of the deferred gain.

As the corporate indebtedness is satisfied, and the amount at economic risk is reduced, the shareholder’s basis in the debt is reduced.

“Necessity” as the Mother of Invention?

Because of this basis-limitation rule, S corporation shareholders, over the years, have proffered many arguments to support their ability to claim their share of S corporation losses – i.e., to increase their stock or debt basis – without having made an economic outlay. A recent decision by the U.S. Tax Court illustrates one such argument.

The Personal Guarantee

The sole issue in this case was whether Taxpayer had a sufficient basis in S-Corp., on account of his obligation with respect to S-Corp’s debt to a third party, to permit Taxpayer to deduct $X, which represented a portion of his distributive share of the corporation’s flow-through losses, on his personal income tax return.

Taxpayer was the sole shareholder of S-Corp. S-Corp. borrowed $Y from Bank, and Taxpayer personally guaranteed the loan. S-Corp. was later liquidated. At the time of liquidation, S-Corp. still owed Bank $X. S-Corp. filed its Form 1120S, U.S. Income Tax Return for an S corporation, on which it reported an ordinary business loss of $X. Taxpayer had no stock or debt basis in S-Corp. when it was liquidated.

According to the record before the Court, after S-Corp. was liquidated, the operations of the business somehow continued under its former name, S-Corp.’s loan with Bank was somehow renewed, and S-Corp. remained the named borrower of the renewed loan. Taxpayer signed the renewal note as president of S-Corp. and was the guarantor of the loan.

Also according to the record, Taxpayer made all loan payments following the liquidation of S-Corp., but the record did not indicate whether he made the payments from his personal funds or merely signed checks drawn on the account of S-Corp.

The IRS examined Taxpayer’s tax return and disallowed the $X loss deduction related to S-Corp., explaining that, because Taxpayer’s share of S-Corp.’s loss was limited to the extent of his adjusted basis for his stock, the amount of loss in excess of such basis was disallowed and was not was not currently deductible.

The Court’s Analysis

The Court began by explaining that an S corporation shareholder may take into account his or her pro rata share of the corporation’s losses, deductions, or credits. It then explained how the Code limits the aggregate amount of losses and deductions the shareholder may take into account to the sum of (A) the adjusted basis of the shareholder’s stock in the S corporation, and (B) the shareholder’s adjusted basis in any indebtedness of the S corporation

Taxpayer conceded that he had no stock or debt basis in S-Corp. at the time of its liquidation. However, he contended that upon the liquidation, he assumed the balance due on the note as guarantor and, because he was the sole remaining obligor, this assumption was effectively a contribution to capital, allowing him to deduct the amount of S-Corp.’s losses. Further, he asserted that, following S-Corp.’s liquidation, the Bank expected him, as guarantor, to repay the loan and that the Bank’s expectation was sufficient to generate basis for Taxpayer in S-Corp.

The Court rejected Taxpayer’s arguments. Merely guaranteeing an S corporation’s debt, it stated, was not sufficient to generate basis. The Court pointed out that, on many prior occasions, it had held that no form of indirect borrowing, be it by guaranty, surety or otherwise, gives rise to indebtedness from an S corporation to its shareholders until and unless the shareholders pay part or all of the obligation. “Prior to that crucial act, ‘liability’ may exist, but not debt to the shareholders.” The Court also stated that a shareholder may obtain an increase in basis in an S corporation only if there was an economic outlay on the part of the shareholder that leaves the shareholder “poorer in a material sense.” In other words, the shareholder must make an actual “investment” in the corporation.

The Court recognized, however, that a shareholder who has guaranteed a loan to an S corporation may increase his or her basis where, in substance, the shareholder has borrowed funds and subsequently advanced them to the corporation. Although, as a general rule, an economic outlay is required before a shareholder in an S corporation may increase his or her basis, this rule does not require a shareholder, in all cases, to “absolve a corporation’s debt before [he or she] may recognize an increased basis as a guarantor of a loan to a corporation.” Observing that “where the nature of a taxpayer’s interest in a corporation is in issue, courts may look beyond the form of the interest and investigate the substance of the transaction.” The Court indicated that a shareholder’s guaranty of a loan to an S corporation “may be treated for tax purposes as an equity investment in the corporation where the lender looks to the shareholder as the primary obligor.”

This determination, the Court stated, was an “inquiry focused on highly complex issues of fact and that similar inquiries must be carefully evaluated on their own facts.” (For example, the testimony of a loan officer stating that the lender-bank looked primarily to the taxpayer, and not the corporation, for repayment of the loan, as well as evidence that the S corporation was thinly capitalized.)

The Court then turned to the facts in the case to determine whether Taxpayer had established that the Bank looked to Taxpayer for repayment and Taxpayer had made economic outlays in making those payments.

The Court found that Taxpayer presented no evidence to support a finding that the Bank looked primarily to him, as opposed to S-Corp., for repayment of the loan, especially given the fact that, even after the corporate liquidation, S-Corp. remained an ongoing business enterprise.

It acknowledged that, according to the stipulation of facts, “[t]he [Taxpayer] continues to make payments on the loan”, but there was no indication, it pointed out, that the loan payments were made from Taxpayer’s personal funds rather than S-Corp.’s funds with Taxpayer signing payment checks as president. Moreover, under the terms of the renewal note, the renewed loan was to S-Corp. and Taxpayer’s obligation was that of a guarantor, not the maker of the loan.

The Court next considered Taxpayer’s assertion that the renewal of the loan to S-Corp. did not affect his position that he became the primary obligor of the loan upon S-Corp.’s liquidation. Taxpayer posited that he assumed the debt at the time of S-Corp.’s liquidation and that “his status as the sole remaining obligor”, for tax purposes, caused the repayments of the loan to be treated as contributions to the capital of S-Corp. The IRS disagreed, arguing that “upon the corporation’s liquidation, the debt remained undisturbed: the corporation did not default on the debt, the terms of the debt were not altered, and payments on the debt continued.”

The Court determined that there was insufficient evidence in the record to support a finding that the loan was made to Taxpayer personally, as opposed to S-Corp., and that Taxpayer, as the borrower, advanced the loan proceeds to S-Corp. Because Taxpayer failed to establish that the Bank looked primarily to Taxpayer to satisfy the debt obligation or that Taxpayer made an economic outlay with respect to the loan, Taxpayer failed to prove he had a basis in S-Corp. sufficient for him to deduct the reported business losses.

Advice to S Corporation Shareholders

What is an S corporation shareholder to do when corporate losses have been allocated to him, but he has no basis in his shares, and he either has no outstanding loan to the corporation or at least not one in which he has any basis? What happens to these excess losses, and how can they be utilized?

The excess losses allocated to a shareholder for a tax year cannot be used by the shareholder to offset ordinary income reported on the shareholder’s tax return for that year. That being said, the shareholder must realize that the excess losses are not lost (sorry for the pun) – they are merely suspended until such time as the shareholder has sufficient basis in his stock, or in a loan made by him to the corporation, to allow the losses to flow through to him. (Even then, however, the losses have to pass muster under the “at risk” and “passive loss” rules before the shareholder can realize their full benefit.)

So, how can a shareholder facilitate or expedite the use of his suspended losses? There are some options to consider:

  • Make a capital contribution to the corporation (using the shareholder’s own funds, or using funds borrowed from a third party; paying off a corporate debt)
  • Forego distributions by the corporation in profitable years (loan the distributed funds back to the corporation)
  • Accelerate the recognition of income by the corporation
  • Defer the deduction of corporate expenses
  • Make a loan to the corporation (using the shareholder’s own funds, or using funds borrowed from a third party; substituting the shareholder’s note for the corporation’s)

Each of these options presents its own risks and issues. For example, what if the shareholder does not receive additional stock in the corporation in exchange for his capital contribution? Has he made a gift to the other shareholders? He has certainly put more of his money at risk.

Of course, the shareholder can wait until the corporation sells its business. The gain from the sale may generate sufficient basis so as to allow the use of the suspended losses for the year of the sale (though the shareholder will thereby likely realize more gain on a subsequent liquidation of his shares).

However, if the disposition of the business is effected through a sale of stock by the shareholders (without an election to treat it as an asset sale), the suspended losses will disappear. They will also be lost if all of the shares are gifted to another (other than the shareholder’s spouse or to a grantor trust) prior to any sale. The suspended losses will also be lost if the shareholder dies before having used the losses – the step-up in basis for the stock that occurs at death does not benefit the deceased shareholder.

Thus, it may behoove the shareholder to find a way to “consume” the suspended losses before it is too late, provided as always, of course, that the means chosen makes sense from a business perspective.

Last week, we reviewed the various U.S. federal income tax consequences that may be visited upon a foreign person who owns and operates U.S. real property (“USRP”). Today we will consider the U.S. federal gift and estate tax consequences of which a foreign individual must be aware when investing in USRP.

Gift Tax

As you probably know, the gift tax is imposed upon the transfer of property by an individual, to or for the benefit of another individual, for less than full and adequate consideration. The typical scenario involves an outright transfer to a family member, or a transfer to an irrevocable trust for the benefit of a family member.

For a U.S. person – meaning a citizen or an alien individual who is domiciled in the U.S. – who makes a gift, the Code currently affords an annual exclusion of $14,000 per donee, plus a combined lifetime/testamentary exemption of $5.49 million, plus an unlimited marital deduction provided the donor’s spouse is a U.S. citizen.  (Note that “domicile” for gift and estate tax purposes is not necessarily the same as “residency” for U.S. income tax purposes; domicile is a more subjective concept: what jurisdiction does the foreign individual consider to be his “permanent home”?)

In the case of a non-U.S. person who is also a non-domiciliary, the Code provides the same $14,000 annual exclusion as above, as well as an annual $149,000 exclusion for gifts to a non-U.S. citizen spouse (not an unlimited marital deduction). There is no other exclusion. The marginal gift tax rate is 40% for taxable gifts over $1 million.

U.S.-Situs Property

In order for the U.S. gift tax to apply to a transfer of property by a non-domiciliary, the property transferred must be located in the U.S. Thus, a gift transfer of USRP is taxable.

Importantly, however, a transfer of intangible property, including shares of stock in a USC, including a U.S. real property holding corporation (USRPHC), is not subject to the gift tax.

As a result, a gift transfer by a foreign individual (“FI”) of shares of USRPHC stock (or of cash to fund a corporation’s acquisition of USRP) to an irrevocable foreign trust for the benefit of the FI’s family is not subject to U.S. gift tax. It is imperative that the foreign donor respect the separate identity of the corporation the stock of which stock is being gifted: the corporation should have its own accounts, act in its own name, hold board meetings, etc. – it may even be advisable that the FI not use the corporation’s USRP without paying a fair market rental rate for such use; otherwise, the IRS may be able to ignore the corporate form and treat the transfer of the stock as a transfer of the underlying USRP.

Similarly, though it is not entirely free from doubt, a transfer of an interest in a partnership that owns USRP should not be subject to gift tax, provided the partnership is not engaged in a U.S. trade or business (USTB).

Estate Tax

We all have to go sometime. It’s the morbid truth. Even wealthy foreigners.

The U.S. estate tax is imposed on the FMV of the U.S. assets of a foreign decedent. This includes the foreigner’s direct interest in USRP.

It also includes the FMV of USRP in a foreign trust if the FI gifted the USRP into the trust and retained an interest in the income from, or in the use of, the trust’s property.

Where the USRP is subject to a nonrecourse debt, the amount of such debt may be applied to reduce the FMV of the property for estate tax purposes. In order to claim a reduction for any recourse debt encumbering the property, the estate of the FI must disclose his/her worldwide assets and claim only a proportionate part of the debt as a deduction, the assumption being that the FI’s worldwide assets are available to satisfy the recourse debt.

The FI’s U.S. gross estate also includes his shares of stock in a U.S. corporation (“USC”), including a USRPHC.

The state of the tax law as to the situs of a partnership interest is not entirely clear, though there is authority for the proposition that U.S. property includes an interest in a partnership that is engaged in a USTB.

The gross estate does not include shares of stock in a foreign corporation (“FC”), however, even if its only asset is USRP, and even if the FC has elected to be treated as a USC for purposes of FIRPTA (see above). Again, it is imperative that the FI have respected the corporate form: it should have its own accounts, act in its own name, etc. (see last week’s post); otherwise, the IRS may be able to ignore the corporate form, treat the FC as a sham, and include the value of the underlying USRP in the FI’s estate.

The FI’s estate does not include an interest in USRP that is held in a foreign trust, provided the FI did not retain (expressly or implicitly) any beneficial interest in, or control over, the trust.

Unlike the estate of a U.S. citizen or domiciliary, the estate of a FI will not have the benefit of the $5.49 million exemption. Rather, there is only a $60,000 exemption amount (though some treaties may provide for a greater amount provided the FI’s estate discloses its worldwide assets). The 40% rate kicks in when the U.S. taxable estate exceeds $1 million in value.

Additionally, there is no unlimited marital deduction unless the FI’s surviving spouse is a U.S. citizen. If the spouse is not a U.S. citizen, a qualified domestic trust (“QDOT”), with a U.S. trustee, will allow an unlimited marital deduction, and the resulting tax deferral benefit, though it is less than ideal for planning purposes. For example, every time principal is distributed to the surviving spouse, the U.S. trustee must report the distribution, and must withhold and transmit the applicable estate tax.

Finally, let’s not forget that any property that is included in the U.S. estate of a FI receives a basis step-up, thereby removing the depreciation in basis during the life of the decedent, and the appreciation in value of the property, from the reach of the U.S. income tax.

Takeaway

Last week’s post explained that the role of the U.S. tax adviser is to educate the foreign client as to basic U.S. tax considerations before the foreigner acquires USRP; to confer with the foreigner’s non-U.S. tax advisers as to the treatment of the investment under foreign tax law; and to see how to accommodate the foreigner’s business, investment, and other goals within a tax-efficient structure.

I can say with some certainty that there is no single structure that satisfies all of a taxpayer’s goals. The many relevant, and oftentimes competing, factors that we have discussed over the last couple of weeks must be identified and weighed, the various options must be formulated and presented to the foreign client, the client must understand the advantages and disadvantages of the options available, and then the best option under the circumstances must be selected.

Catching up? Start with Part I here.

Sale of USRP – FIRPTA

Aside from planning for the taxation of U.S.-sourced rental income, the foreigner must plan for the disposition of the USRP pursuant to a sale.

The taxation of gain realized by a foreigner on the sale of an interest in USRP is governed by FIRPTA (the “Foreign Investment in Real Property Tax Act of 1980”).

Because FIRPTA treats such gain as income that is effectively connected with the conduct of a USTB, the tax rate that is applied to the gain will depend upon whether the foreign seller is an individual or a corporation.

Assuming the property is a capital asset in the hands of a foreign individual (not inventory or otherwise used in a USTB – the sale of either of which would have been taxable as effectively connected income anyway), and has been held by the foreign individual for more than twelve months, the gain from the sale will be taxed as capital gain at a rate of 20%.

If the seller is a FC, the gain will be taxed at the applicable corporate rate, up to 35%.

FIRPTA – Withholding

Upon the foreigner’s sale of USRP, the buyer is required to withhold 15% of the gross purchase price, which amount must be remitted to the IRS. The purchase price includes the amount of any liability assumed or taken subject to. The remaining tax, if any, must be paid by the foreign seller when it files its U.S. income tax return. If the tax withheld exceeds the amount of tax owed as a result of the sale, the foreigner may use the filing of the tax return to claim a refund.

Because the 15% withholding does not necessarily bear any relationship to the amount of tax actually owed – indeed, the sale may have generated a loss – IRS regulations allow a foreign seller to request a certificate from the IRS that directs the buyer to withhold a lesser amount, based upon the information submitted by the foreigner to establish its actual tax liability.

For example, one may apply for a withholding certificate based on a claim that the transfer is entitled to nonrecognition treatment (as in the case of a like-kind exchange for other USRP), or based on a calculation of the foreigner’s maximum tax liability.

There are also other exceptions to FIRPTA withholding, where a USC, the stock of which is sold by a foreigner, certifies that it is not a USRPHC, and has not been one in the last five years.

Withholding as to Corporate Distributions

Note that special withholding rules apply to certain dispositions by corporations.

If a FC distributes USRP to its shareholders, it must withhold tax at a rate equal to 35% of the gain that is recognized by the FC on the distribution. (The distribution of appreciated property by a corporation to its shareholders in respect of their stock is treated as a sale of such property by the corporation.)

In the case of a USRPHC, it must withhold 15% of the amount distributed if the distribution is made in redemption of a foreigner’s shares or in liquidation of the corporation.

U.S. Real Property

The foregoing has assumed that the property being sold by the foreign person is a direct interest in USRP.

FIRPTA, however, covers not only direct interests in USRP, but also certain indirect interests.

Specifically, if the FMV of a USC’s USRP equals or exceeds 50% of the sum of (i) the FMV of all of its real property plus (ii) the FMV of its trade or business assets, then the corporation will be treated as a USRP Holding Corporation (“USRPHC”), and any gain realized on the disposition of any amount of stock in that USRPHC will be subject to tax under FIRPTA (so long as the disposition is treated as a sale or exchange for tax purposes).

What’s more, if a USC was a USRPHC at any time during the five-year period ending with the date of the sale of stock therein by a foreigner, the gain realized will remain subject to FIRPTA even if less than 50% of the value of the corporation is attributable to USRP at the time of the sale.

Fortunately, there is an exception to this five-year rule: under the so-called “cleansing” rule, if the USC disposes of all of its interests in USRP in taxable sales or exchanges, such that the entire gain thereon has been recognized, and the corporation owns no USRP at the time of the stock sale by the foreign person, then the stock sale shall not be taxable under FIRPTA (or at all for that matter).

Election to be treated as a USRPHC 

As you may have gathered, a FC cannot be a USRPHC. Seems straightforward enough, except that there is a special election that allows a FC to elect to be treated as a USRPHC exclusively for purposes of FIRPTA.

Why would a FC make such an election? One reason is to avoid gain recognition upon the transfer of USRP to the FC. Among the requirements that must be satisfied in order for an election to be effective, the FC must satisfy the above “50% of value” test for USRPHCs.

Exceptions to FIRPTA

Not every disposition of USRP by a foreign person is taxable and subject to withholding under FIRPTA.

For example, a foreigner may sell USRP and roll over the net proceeds therefrom as part of a deferred like-kind exchange without incurring a tax liability (provided that the replacement property is also USRP, the subsequent disposition of which would be taxable to the foreign seller).

This principle underlies other exceptions to gain recognition; specifically, if a foreign person exchanges one interest in USRP for another interest in USRP, the gain realized on the exchange may not be taxable if certain regulatory requirements are satisfied.

For example, a foreigner may contribute USRP to a USC (or to a FC that has elected to be treated as a USC under FIRPTA) in exchange for shares of stock in that corporation without incurring a tax liability, provided the foreign person “controls” the USC immediately after the exchange, and provided the transferee USC is a USRPHC after the contribution. (A narrower exception applies for certain transfers by foreigners to a non-electing FC, which is somewhat inconsistent with the above principle.)

Varieties of Dispositions

A sale of USRP is the most common type of disposition that triggers FIRPTA. However, there are many other transactions of which a foreigner needs to be aware.

For example, if a USRPHC redeems some (but not all) of the shares of a foreign shareholder, the redemption may not be subject to FIRPTA, and may instead be treated as a dividend, if the foreigner’s stock ownership is not sufficiently reduced.

If a USRPHC makes a cash dividend distribution to its shareholders in an amount that exceeds its earnings and profits, the distribution may result in taxable gain that will be subject to FIRPTA.

The partnership rules may generate similar results as to both distributions by, and contributions to, partnerships. The disguised sale rules, for example, may convert what appears to be a tax-free contribution of USRP by a foreigner to a partnership in exchange for a partnership interest into a partially taxable sale that is subject to FIRPTA.

What’s Next

Our next post will review the U.S. gift and estate tax consequences of which a foreign investor in USRP must be aware and must consider in structuring the acquisition, operation, and disposition of such property.

A Continuing Investment

In the last two posts, we saw how a Taxpayer who transfers Property A to a partnership (“Partnership”) in exchange for an equity interest therein will not be required to recognize the gain realized on the transfer. This gain will not be included in Taxpayer’s gross income because Taxpayer is viewed under the Code as continuing his investment in Property A, albeit indirectly, through his interest in Partnership; thus, the theory goes, it would not be appropriate to tax him on the gain realized.

We also saw that, because the Code views Taxpayer’s investment in Partnership as a continuation of his investment in Property A, Taxpayer’s basis for his interest in Partnership will be the same basis that he had in Property A at the time of the contribution. In this way, the gain realized by Taxpayer on his transfer of Property A is preserved and may be recognized on the subsequent sale or liquidation of his Partnership interest.

In what may be characterized as the other side of the same coin (I may have mentioned in some earlier post that I am “idiom-challenged”), we saw that Partnership will take Property A with a basis equal to the basis that Taxpayer had in Property A at the time of its contribution to Partnership. Thus, the gain inherent in Property A at the time it was contributed by Taxpayer (the “pre-contribution gain”) will also be preserved in the hands of Partnership, and such gain will be taxed to Taxpayer on Partnership’s taxable disposition of Property A.

An In-Kind Distribution

Distribution to Taxpayer

Instead of selling Property A, what if Partnership simply distributes Property A to Taxpayer? Taxpayer is thereby restored to his pre-contribution position, even if Property A has appreciated in value after its contribution to Partnership (as, presumably, has Taxpayer’s interest in Partnership). Thus, the distribution is not taxable.

Distribution to Another Partner

What if Partnership, instead, distributes Property A to another partner (“Partner”)? At that point, Taxpayer’s indirect interest in Property A is terminated, and Taxpayer no longer has to be concerned that the gain realized by Partnership on a later sale of Property A (to the extent of its pre-contribution gain) will be specially allocated, and taxed, to him. Rather, Partner will now be taxed on his subsequent sale of Property A; without more, and provided the distribution to Partner is not in liquidation of his interest in Partnership, he will take Property A with the same basis that Partnership had in the property. Thus, Taxpayer’s pre-contribution gain may be shifted to Partner. Would it be appropriate to require Taxpayer to recognize the pre-contribution gain at that time?

Distribution of Another Property to Taxpayer

What if Partnership retains Property A, but distributes other property (“Property B”) to Taxpayer? Taxpayer continues to have an indirect interest in Property A, but he has also acquired a property other than the one that he originally contributed to Partnership. Taxpayer’s basis in Property B will be the same basis that Partnership had in the property. If that basis is greater than Partner’s pre-contribution basis in Property A, Taxpayer may sell Property B and realize less gain than if he had sold Property A. In addition, it follows that Taxpayer’s interest in Property A is somewhat reduced as a result of the distribution of Property B to Taxpayer, while Partner’s interest therein has increased. Would it be appropriate to require Taxpayer to recognize the pre-contribution gain in Property A at that time?

A “Deemed” Exchange

In general, a partner who receives a distribution of property from a partnership will not recognize gain on the distribution, except to the extent that the amount of money distributed exceeds the partner’s adjusted basis for his interest in the partnership immediately before the distribution. Likewise, no gain will be recognized to the partnership on the distribution of property to a partner. In short, an in-kind distribution of property will generally not be taxable to the distributee partner or to any other partner.

There are exceptions to this general nonrecognition rule that encompass the situations described above, and that seek to prevent the shifting of the tax consequences attributable to a property’s pre-contribution gain away the contributing partner, and to another partner.

In order to accomplish this goal, these rules – often referred to as the “mixing bowl” rules – effectively treat a partnership’s in-kind distribution of a property to a partner as the second step of a taxable exchange, the first step being that partner’s, or another partner’s, contribution of another property to the partnership. The partnership is treated as a vehicle through which the exchange is effected.

Distribution to Taxpayer

Under the first exception, if property that was contributed by a partner to a partnership is then distributed by the partnership to another partner within seven years of its contribution, then the contributing partner will be required to recognize gain in an amount equal to the gain that would have been allocated to him if the property had been sold at its fair market value at the time of the distribution (the pre-contribution gain). (Congress decided that a seven-year period was necessary in order to ensure that the contribution to, and distribution from, the partnership were independent of one another, and not steps or parts of planned exchange.)

Thus, in the first scenario described above, if Property A is distributed to Partner within seven years of Taxpayer’s contribution of the property to Partnership, Taxpayer will recognize, and be taxed on, Property A’s pre-contribution gain.

Distribution to Another Partner

Under the second exception, if a partnership distributes property to a partner who, within the preceding seven years, contributed other property to the partnership (which the partnership still owns at the time of the distribution – meaning that its pre-contribution gain has not yet been recognized), then such partner shall be required to recognize the pre-contribution gain of the contributed property.

This is the same gain that would have been recognized by the contributing partner if the property which had been contributed to the partnership by such partner within seven years of the distribution, and is held by such partnership immediately before the distribution, had been distributed by the partnership to another partner (as in the first scenario described above).

Thus, in the second scenario described above, if Property B (which had been contributed to Partnership by Partner) is distributed to Taxpayer within seven years of Taxpayer’s contribution of Property A to Partnership, Taxpayer will recognize, and be taxed on, Property A’s pre-contribution gain.

A “Like-Kind” Exchange?

We stated earlier that the above “anti-gain-shifting” rules effectively treat a partnership’s distribution of a property to a partner as the second step of a taxable exchange, with the first step being that partner’s, or another partner’s, contribution of another property to the partnership.

These rules implicitly assume that the properties that are deemed to have been exchanged are not of like-kind and, so, the exchange is taxable. However, what if the properties are, in fact, of “like-kind”? In other words, what if the like-kind properties had exchanged directly, without first passing them through the partnership? In that case, the exchange may have qualified as a “tax-free” exchange under the like-kind exchange rules.

Following this line of thinking, the mixing bowl rules generally provide that if pre-contribution gain property is distributed to a partner other than the contributing partner, and other property of like-kind to the contributed property is distributed from the partnership to the contributing partner within a specified period of time, then the amount of gain that the contributing partner would otherwise have recognized under the above mixing bowl rules is reduced by the amount of built-in gain in the distributed like-kind property in the hands of the contributing partner immediately after the distribution.

Thus, if Property A and Property B are of like-kind to one another and, within seven years of Taxpayer’s contribution of Property A to Partnership, Partnership distributes Property B to Taxpayer and Property A to Partner, then Taxpayer will not have to recognize the pre-contribution gain in Property A to the extent of the gain inherent in Property B after the distribution; at least some of the pre-contribution gain in Property A is preserved in Taxpayer’s hands.

Advice to the Contributing Partner?

Last week we stated that Taxpayer would be well-advised to negotiate for a prohibition, for a period of time, on Partnership’s sale of any property contributed by Taxpayer.

Based upon this week’s discussion, it may behoove Taxpayer to also negotiate for a period of time (say, seven years) during which Partnership will not distribute Property to another partner, at least not without Taxpayer’s prior consent.

Taxpayer may also want to request that, in the event that Partnership has to distribute its properties (e.g., in liquidation), it will do so in a way that minimizes any adverse tax consequences to Taxpayer under the mixing bowl rules. This may include a provision that requires the “return” of Property A to Taxpayer, if feasible (and provided it makes sense from a business perspective).

Alternatively, Taxpayer may try to negotiate for a provision that would require Partnership to make a cash distribution to Taxpayer in an amount sufficient to enable him to satisfy the tax liability resulting from the application of these rules.

As always, it is important that Taxpayer be aware of, and that he consider the potential economic effect of, the foregoing rules prior to his contributing Property to Partnership in exchange for a partnership interest. Armed with this knowledge, Taxpayer may be able to negotiate a more tax-favorable agreement regarding the disposition of his contributed property by the Partnership.

Contributing Property to A Partnership

When a taxpayer (“Taxpayer”) sells a property (“Property”) with a fair market value (“FMV”) in excess of Taxpayer’s basis in Property in exchange for cash in an arm’s-length transaction, the amount of gain that he realizes on the sale is measured by the difference between the amount of cash received by Taxpayer over his basis for Property.

Because Taxpayer has terminated his investment in Property (by exchanging it for cash), he must include the gain realized in his gross income for the year in which the sale occurred.

If Taxpayer instead contributes Property to a partnership (“Partnership”) in exchange for an “equally” valuable equity interest therein, he will still realize a gain on the exchange, but such gain will not be recognized (i.e., it will not be included in Taxpayer’s gross income) because Taxpayer is viewed under the Code as continuing his investment in Property, albeit indirectly, through his partnership interest; thus, it would not be appropriate to tax him on the gain realized.

Preserving the Gain

As we saw last week, because the Code considers Taxpayer’s investment in Partnership as a continuation of his investment in Property, Taxpayer’s basis for his partnership interest will be the same basis that he had in Property. In this way, the gain realized by Taxpayer on his disposition of Property is preserved and may be recognized on the subsequent sale or liquidation of his Partnership interest.

But what if Taxpayer does not dispose of his Partnership interest in a taxable transaction? What if he leaves it to his heirs with a stepped-up basis at his death? What if Partnership disposes of Property? To whom will the gain from a sale of Property be allocated?

Never fear, the Code and the regulations promulgated thereunder have foreseen this possibility and have accounted for it.

First of all, Partnership will take Property with a basis equal to the basis that Taxpayer had in Property at the time of its contribution to Partnership.

Thus, the gain inherent in Property at the time it is contributed by Taxpayer (the “pre-contribution BIG”) will also be preserved in the hands of Partnership.

You may ask, won’t this gain be allocated among all the partners, including Taxpayer, based upon their relative interests in Partnership? Simply put, no, and that is why it is imperative that any taxpayer who intends to contribute appreciated property to a partnership in exchange for a partnership interest therein should be aware of the tax consequences described below and should plan for them.

The Allocation of Pre-Contribution Built-In Gain

In order to prevent the pro rata allocation of the pre-contribution BIG among the contributing and noncontributing partners, and the resultant “shifting” of income tax consequences, the Code and the Regulations provide a set of rules with respect to the allocation of any pre-contribution BIG. These rules require that a partnership must allocate its income, gain, loss and deduction with respect to contributed property so as to take into account the pre-contribution BIG.

In general, these rules require that when a partnership has income, gain, loss or deduction attributable to a property that has pre-contribution BIG, the partnership must make appropriate allocations among its partners to avoid shifting the tax consequences of the pre-contribution BIG away from the contributing partner. (View it as a variation of the “assignment of income” doctrine.)

Allocating Gain

Thus, if Partnership sells Property and recognizes gain, the pre-contribution BIG on Property will first be allocated to Taxpayer as the contributing partner. Then, any remaining gain will be allocated among all of the partners in accordance with their relative interests in Partnership.

Allocating Depreciation Deductions

If Property is subject to depreciation, the allocation of the deductions attributable to the depreciation for tax purposes must take into account the pre-contribution BIG on Property. Specifically, the rules provide that the tax allocation of depreciation deductions to the noncontributing partners must, to the extent possible, equal the “book allocations” of depreciation deductions to those partners. This allocation rule is often referred to as the “traditional method.”

Partnership’s depreciation deduction for tax purposes will be determined by reference to Partnership’s starting basis in Property – the same basis that Taxpayer (as the contributor) had for Property – while its depreciation deductions for financial accounting (or “book”) purposes will be determined based upon Partnership’s book value for Property. A contributed property’s starting “book value” – the amount at which it is recorded on the partnership’s financial accounting records (its “books”) – is equal to its FMV at the time of its contribution.

Where the contributed property has pre-contribution BIG (as in the case of Property), its beginning book value (the property’s FMV) will exceed its basis for tax purposes. Thus, the effect of the above allocation rule, which “matches” the tax allocation of depreciations deductions to the noncontributing partners with the allocation of such deductions to such partners for book purposes, is to shift more of the partnership’s (Partnership’s) taxable income to the contributing partner (Taxpayer) by allocating more of its tax-deductible depreciation deductions to the noncontributing partners.

In this way, over time, an amount equal to Property’s pre-contribution BIG will have been allocated to the Taxpayer, at which point the special allocation rule will cease to apply.

In order to further ensure the intended result of the above allocation rules – i.e., to prevent the shifting of tax consequences with respect to pre-contribution BIG to the noncontributing partners – the special allocation rules provide yet additional rules that may be applied where, contrary to the above matching rule, a noncontributing partner would otherwise be allocated less tax depreciation than book depreciation with respect to the contributed property. (This will usually be the case when talking about appreciated property.) The effect of these so-called “curative” allocation and “remedial” allocation rules is to make up this difference, and to reduce or eliminate the disparity, between the book and tax items of the noncontributing partners. The rules thereby prevent the shifting of any portion of pre-contribution BIG to the noncontributing partners, thus ensuring that the tax consequences attributable to the pre-contribution BIG are visited upon the contributing partner.

Protecting the Contributing Partner

Although a taxpayer generally may contribute appreciated property to a partnership in exchange for an interest therein without incurring an immediate income tax liability, the application of the pre-contribution BIG allocation rules discussed above has the potential to immediately wipe away this deferral. For example, if Partnership decides to sell Property shortly after its contribution, Taxpayer (as the contributing partner) will not have enjoyed the benefit of tax deferral.

Moreover, Taxpayer may find himself in a situation where he must include the pre-contribution BIG in his gross income for tax purposes, but he has not received any cash with which to pay the tax, and he may not be in a position to compel Partnership to make the necessary cash distribution or to give him a loan.

What is Taxpayer to do?

For one thing, it would have behooved Taxpayer to retain a tax adviser who was familiar with the above allocation rules. Such an adviser would have advised Taxpayer to try to negotiate a period during which Partnership would not sell or otherwise dispose of the Property (except as part of a “tax-free” exchange).

Alternatively, the tax adviser might have counseled Taxpayer try to negotiate a provision that would require Partnership to make a cash distribution to Taxpayer in an amount sufficient to enable him to satisfy the tax liability resulting from the application of these rules.

Insofar as the allocation of depreciation deductions pursuant to these rules is concerned, the tax adviser would likely have suggested that Taxpayer negotiate for the use of the “traditional method” so as to maximize the deferral period for “recognition” of the pre-contribution BIG, failing which he may have suggested the use of the “remedial allocation method” over the “curative allocation method,” as the former generally allows the book-tax difference (the excess of book value over tax basis) described above to be spread out over a longer period of time.

Bottom line: the foregoing options may not be available after Taxpayer has already contributed Property to Partnership. The time to consider these issues, to plan for them, and to negotiate ways to reduce any adverse impact is prior to making the contribution.

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

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

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

Gain Recognition

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

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

Continuing the Investment

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

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

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

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

Preserving the Gain

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

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

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

Receipt of Cash

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

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

Contribution to Corp/ Like-Kind Exchange

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

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

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

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

Contribution to a Partnership

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

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

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

Some Examples

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

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

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

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

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

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

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

Is the “Deferral” Worthwhile?

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

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

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

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

But What If?

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

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

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

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

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

Looking Overseas

We have heard a lot about large, publicly-traded U.S. corporations that have parked trillions of dollars overseas to avoid the payment of U.S. income tax. We have heard how the tax system must be seriously broken to have so incentivized so many of these corporations to “relocate” overseas.

What is usually overlooked or omitted in these reports is the number of smaller, closely-held U.S. corporations and partnerships that have established operations overseas in pursuit of legitimate business goals, including the opening of new markets, among others.

Equally absent from these reports is any mention of the number of U.S. citizens living outside the U.S. who own companies that are engaged in business overseas.

Quite often, these closely-held companies are unaware of their U.S. income tax reporting obligations as regards their foreign operations and income. The owner of one of these companies will naturally be focused on the business opportunities, and challenges, presented by establishing an overseas presence and, unless the company’s tax advisers are well-versed in so-called “outbound” transactions, the company may unwittingly fail to satisfy its filing obligations.

This may result in the imposition of steep penalties on the business, as one taxpayer recently discovered to its detriment.

A Taxpayer Can Get Burned

Taxpayer was a U.S. citizen residing in Country. During the years in issue, he operated a business in Country through a foreign corporation (“FC”). At some point during this period, he sold the majority of his stock to a non-U.S. resident of Country. The issue for decision was whether Taxpayer was liable for the penalties assessed against him for his failure to declare, on IRS Form 5471, his ownership interest in FC.

Taxpayer timely filed his Forms 1040, U.S. Individual Income Tax Return, for the years in issue but did not attach IRS Forms 5471 to any of his returns.  Although Taxpayer hired a tax preparation firm in Country to prepare his U.S. tax returns during the years in issue, he did not inform this firm until years later that he held an interest in FC.

Thereafter, the IRS began an examination of Taxpayer’s ownership of FC. Taxpayer then submitted delinquent Forms 5471 regarding his interest in FC, after his tax counsel advised him of his obligation to do so. The Forms 5471 submitted were incomplete.

The IRS assessed penalties for Taxpayer’s failure to timely file completed Forms 5471 declaring his ownership interest in FC.

The Tax Court explained that the Code imposes information reporting requirements on any U.S. person who controls a foreign corporation. A person controls a foreign corporation (a “controlled foreign corporation,” or “CFC”), the Court stated, if he owns (directly or constructively):

  • Stock that that represents more than 50% of the total combined voting power of all classes of voting stock of the corporation, or
  • More than 50% of the total value of shares of all classes of stock of the corporation.

Under the Code, a U.S. person must furnish, with respect to any foreign corporation which that person controls, such information as the IRS may prescribe. Form 5471 is used to satisfy these reporting requirements, and it must be filed with the U.S. person’s timely-filed Federal income tax return. Moreover, a U.S. person who disposes of sufficient stock in a CFC to reduce his interest to less than the above stock ownership threshold is required to provide certain information with respect to the foreign corporation.

Additionally, information reporting requirements are also imposed on any U.S. person treated as a “U.S. shareholder” of a corporation that was a CFC for an uninterrupted period of 30 days during its annual accounting period and who owned stock in the CFC on the last day of the CFC’s annual accounting period. A U.S. shareholder, with respect to any foreign corporation, is a U.S. person who owns, or is considered as owning, 10% or more of the total combined voting power of all classes of stock entitled to vote of the foreign corporation.

To avoid a penalty, a taxpayer must make an affirmative showing that the failure to furnish the appropriate information with his return was due to reasonable cause.

To establish reasonable cause through reliance on a tax adviser’s advice, the taxpayer must prove: (i) the adviser was a competent professional with sufficient expertise, (ii) the taxpayer provided necessary and accurate information to the adviser, and (iii) the taxpayer relied in good faith on the adviser’s judgment.

The Taxpayer could not satisfy these requirements. Thus, the Court found that he failed to show reasonable cause for his failure to file Forms 5471, and the imposition of the penalties was sustained.

But Wait, There’s More

The penalties imposed upon the taxpayer in the decision described above are bad enough, but there are other issues of which such a taxpayer needs to be aware.

Indeed, Congress recognizes that the IRS may not be able to “timely” identify all U.S. persons who conduct business overseas and fail to report their foreign activities and income.

Thus, another consequence of failing to file the requisite returns may be the additional tax for the year in which the event(s) to be reported occurred – meaning that the IRS can impose a tax upon a delinquent taxpayer whenever the IRS discovers the existence of the foreign business activities or transactions.

In other words, these reporting obligations cannot be ignored; they must be taken seriously.

However, these failures, and the resulting consequences, can be avoided relatively easily if the company’s tax adviser or tax compliance officer is familiar with the IRS’s many reporting requirements for U.S. businesses that operate overseas, and understands the underlying purpose for the required filings.

Common Filing Obligations

The following summarizes some of the more common reporting requirements imposed upon a U.S business that operates or holds assets overseas, as well its U.S. owners.

A basic principle of U.S. tax law is that U.S. persons – which includes, for example, U.S. citizens and resident individuals, domestic corporations, and domestic trusts – must file an annual tax return with the IRS to report their worldwide income, regardless of the source or the type of income. This income is taxable in the U.S., notwithstanding that it may also have been taxed by the foreign country in which it was sourced or generated. Of course, the U.S. person may be able to claim a tax credit for any foreign taxes withheld and/or paid on such income in the foreign country; such credit may offset any U.S. income tax that would otherwise be imposed on such income.

If a U.S. person transfers property to a foreign corporation or partnership in what purports to be a tax-free exchange, the U.S. person may have to report the transfer on IRS Form 926.  This filing provides a means by which the IRS confirms the taxable or tax-free nature of the transfer of property by a U.S. person to a foreign jurisdiction, and perhaps beyond the reach of the IRS.

If a U.S. person owns an interest in a foreign corporation, the U.S. person may have to file IRS Form 5471 (as we saw above). The rules for CFCs may require the inclusion of CFC income (so-called “Subpart F” income) in the gross income of a U.S. person even where such income has not been distributed to the U.S. person (i.e., repatriated). In general, this reporting is aimed at situations in which the U.S. person, the CFC, and/or certain other related persons, engage in intercompany transactions of a nature that tends to shift the resulting tax liability to a lower tax jurisdiction.

If a U.S. person owns or acquires an interest in a foreign partnership, IRS Form 8865 may have to be filed.  This form is similar to Form 5471 and to the partnership tax return on Form 1065.  It is intended to assist the IRS in monitoring the overseas business and investment activities of U.S. taxpayers through foreign flow-through entities, the income from which must be reported on the U.S. person’s tax return in the same way that a U.S. person’s distributive share of a domestic partnership’s taxable income must be reported.

If a U.S. person owns an interest in a passive foreign investment company (a “PFIC”; e.g., a foreign mutual fund), and receives certain distributions from the PFIC, or recognizes gain on the disposition of PFIC stock, the U.S. person may have to file IRS Form 8621 and pay a tax, along with a special interest charge that is intended to offset the tax deferral benefit that the U.S. person enjoyed as to the distributed funds and the recognized gain.  The purpose of these rules is to help ensure that U.S. investors in such foreign investment vehicles are taxed on an equal footing with similar investments in domestic investment vehicles.

If a U.S. person has an interest in certain foreign accounts or other foreign financial assets, including accounts in foreign financial institutions and interests in a foreign corporation or partnership, those assets may have to be reported on Form 8938.  This filing is intended to assist the IRS in cracking down on unreported investment income from overseas.

The U.S. person may also have to file FinCEN Form 114 (the well-known “FBAR”) to report accounts held in foreign financial institutions.  The FBAR reporting requirement is aimed at establishing a U.S. taxpayer’s connection to such an account for the purpose of ensuring that the funds deposited therein, as well as the investment income earned thereon, were properly reported and taxed.

Don’t Be Overwhelmed

Granted, this is a daunting litany of reporting obligations, and it may appear overwhelming – “overkill,” some taxpayers may say. From the perspective of the IRS, however, they are necessary if the tax statutes in effect today are to be enforced and their underlying goals accomplished.

The best way to avoid any issues and surprises is, first and foremost, to find a tax adviser who is familiar with the rules and can explain them. The next step is to establish internal procedures to ensure that the necessary information will be collected in a usable form. Finally, the taxpayer must prepare and timely file the proper returns.

Yes, it may be a chore today, but it certainly beats the alternative down the road. Just witness those “poor” taxpayers who failed to timely file their FBARs and are now walking through the OVDP gauntlet.

Roll-Over: Tax Issue

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Before the LOI

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

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

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

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

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

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

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

Roll-Over: PEF’s Perspective

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

Roll-Over: Seller’s Perspective

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

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

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

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

Acquisition Mechanics

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

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

Roll-Over: Mechanics

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

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

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

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

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