The Joy – and Tax Benefits – of Gifting

As we enter the “season of giving” and the end of yet another year, the thoughts of many tax advisers turn to . . . tax planning.(i) In keeping with the spirit of the season, an adviser may suggest that a client with a closely held business consider making a gift of equity in the business to the owner’s family or to a trust for their benefit.(ii)

Of course, annual exclusion gifts(iii) are standard fare and, over the course of several years, may result in the transfer of a not insignificant portion of the equity in a business.

However, the adviser may also recommend that the client consider making larger gifts, thereby utilizing a portion of their “unified” gift-and-estate tax exemption amount during their lifetime. Such a gift, the adviser will explain, may remove from the owner’s gross estate not only the current value of the transferred business interests, but also the future appreciation thereon.(iv)

The client and the adviser may then discuss the “size” of the gift and the valuation of the business interests to be gifted, including the application of discounts for lack of control and lack of marketability. At this point, the adviser may have to curb the client’s enthusiasm somewhat by reminding them that the IRS is still skeptical of certain valuation discounts, and that an adjustment in the valuation of a gifted business interest may result in a gift tax liability.

The key, the adviser will continue, is to remove as much value from the reach of the estate tax as reasonably possible, and without incurring a gift tax liability – by utilizing the client’s remaining exemption amount – while also leaving a portion of such exemption amount as a “cushion” in the event the IRS successfully challenges the client’s valuation.

“Ask and Ye Shall Receive”(v)

Enter the 2017 Tax Cuts and Jobs Act (the “Act”).(vi) Call it an early present for the 2018 gifting season.

One of the key features of the Act was the doubling of the federal estate and gift tax exemption for U.S. decedents dying, and for gifts made by U.S. individuals,(vii) after December 31, 2017, and before January 1, 2026.

This was accomplished by increasing the basic exemption amount (“BEA”) from $5 million to $10 million. Because the exemption amount is indexed for inflation (beginning with 2012), this provision resulted in an exemption amount of $11.18 million for 2018, and this amount will be increased to $11.4 million in 2019.(viii)

Exemption Amount in a Unified System

You will recall that the exemption amount is available with respect to taxable transfers made by an individual taxpayer either during their life (by gift) or at their death – in other words, the gift tax and the estate tax share a common exemption amount.(x)

The gift tax is imposed upon the taxable gifts made by an individual taxpayer during the taxable year (the “current taxable year”). The gift tax for the current taxable year is determined by: (1) computing a “total tentative tax” on the combined amount of all taxable gifts made by the taxpayer for the current and all prior years using the common gift tax and estate tax rate table; (2) computing a tentative tax only on all prior-year gifts; (3) subtracting the tentative tax on prior-year gifts from the tentative tax computed for all years to arrive at the portion of the total tentative tax attributable to current-year gifts; and, finally, (4) subtracting the amount of the taxpayer’s unified credit (derived from the unused exemption amount) not consumed by prior-year gifts.

Thus, taxable gift transfers(xi) that do not exceed a taxpayer’s exemption amount are not subject to gift tax. However, any part of the taxpayer’s exemption amount that is used during their life to offset taxable gifts reduces the amount of exemption that remains available at their death to offset the value of their taxable estate.(xii)

From a mechanical perspective, this “unified” relationship between the two taxes is expressed as follows:

• the deceased taxpayer’s taxable estate is combined with the value of any taxable gifts made by the taxpayer during their life;
• the estate tax rate is then applied to determine a “tentative” estate tax;
• the portion of this tentative estate tax that is attributable to lifetime gifts made by the deceased taxpayer is then subtracted from the tentative estate tax to determine the “gross estate tax” – i.e., the amount of estate tax before considering available credits, the most important of which is the so-called “unified credit”; and
• credits are subtracted to determine the estate tax liability.

This method of computation is designed to ensure that a taxpayer only gets one run up through the rate brackets for all lifetime gifts and transfers at death.(xiii)

What Happens After 2025?(xvi)

However, given the temporary nature of the increased exemption amount provided by the Act, many advisers questioned whether the cumulative nature of the gift and estate tax computations, as described above, would result in inconsistent tax treatment, or even double taxation, of certain transfers.

To its credit,(xv) Congress foresaw some of these issues and directed the IRS to prescribe regulations regarding the computation of the estate tax that would address any differences between the exemption amounts in effect: (i) at the time of a taxpayer’s death and (ii) at the time of any gifts made by the taxpayer.

Pending the issuance of this guidance – and pending the confirmation of what many advisers believed was an expression of Congressional intent not to punish individuals who make gifts using the increased exemption amount – many taxpayers decided not to take immediate advantage of the greatly increased exemption amount, lest they suffer any of the consequences referred to above.

Proposed Regulations

In response to Congress’s directive, however, the IRS proposed regulations last week that should allay the concerns of most taxpayers,(xvi) which in turn should smooth the way to increased gifting and other transfers that involve an initial or partial gift.

In describing the proposed regulations, the IRS identified and analyzed several situations that could have created unintended problems for a taxpayer, though it concluded that the existing methodology for determining the taxpayer’s gift and estate tax liabilities provided adequate protection against such problems:

Whether a taxpayer’s post-2017 increased exemption amount would be reduced by pre-2018 gifts on which gift tax was paid. If the taxpayer makes additional gifts during the post-2017 increased exemption period, would the gift tax computation apply the increased exemption to the pre-2018 gifts, thus reducing the exemption otherwise available to shelter gifts made during the post-2017 period, effectively allocating credit to a gift on which gift tax in fact was already paid, and denying the taxpayer the full benefit of the increased exemption amount for transfers made during the increased exemption period?

Whether the increased exemption amount available during the increased exemption period would be reduced by pre-2018 gifts on which gift tax was paid. If the taxpayer died during the increased exemption period, would the estate tax computation apply the increased exemption to the pre-2018 gifts, thus reducing the exemption otherwise available against the estate tax during the increased exemption period and, in effect, allocating credit to a gift on which gift tax was paid?

Whether the gift tax on a post-2025 transfer would be inflated by the theoretical gift tax on a gift made during the increased exemption period that was sheltered from gift tax when made. Would the gift tax determination on the post-2025 gift treat the gifts made during the increased exemption period as gifts that were not sheltered from gift tax given that the post-2025 gift tax determination is based on the exemption amount then in effect, rather than on the increased exemption amount, thereby increasing the gift on the later transfer and effectively subjecting the earlier gift to tax even though it was exempt from gift tax when made?

With respect to the first two situations described above, the IRS determined that the current methodology by which a taxpayer’s gift and estate tax liabilities are determined ensures that the increased exemption will not be reduced by a prior gift on which gift tax was paid. As to the third situation, the IRS concluded that the current methodology ensures that the tax on the current gift will not be improperly inflated.

New Regulations

However, there was one situation in which the IRS concluded that the methodology for computing the estate tax would, in effect, retroactively eliminate the benefit of the increased exemption that was available for gifts made during the increased exemption period.

Specifically, the IRS considered whether, for estate tax purposes, a gift made by a taxpayer during the increased exemption period, and that was sheltered from gift tax by the increased exemption available during such period, would inflate the taxpayer’s post-2025 estate tax liability.

The IRS determined that this result would follow if the estate tax computation failed to treat such gifts as sheltered from gift tax.

Under the current methodology, the estate tax computation treats the gifts made during the increased exemption period as taxable gifts not sheltered from gift tax by the increased exemption amount, given that the post-2025 estate tax computation is based on the exemption in effect at the decedent’s death rather than the exemption in effect on the date of the gifts.

For example, if a taxpayer made a gift of $11 million in 2018, (when the BEA is $10 million; a taxable gift of $1 million), then dies in 2026 with a taxable estate of $4 million (when the BEA is $5 million), the federal estate tax would be approximately $3,600,000: 40% estate tax on $9 million – specifically, the sum of the $4 million taxable estate plus $5 million of the 2018 gift that was sheltered from gift tax by the increased exemption. This, in effect, would impose estate tax on the portion of the 2018 gift that was sheltered from gift tax by the increased exemption allowable at that time.

Alternatively, what if the taxpayer dies in 2026 with no taxable estate? The taxpayer’s estate tax would be approximately $2 million, which is equal to a 40% tax on $5 million – the amount by which, after taking into account the $1 million portion of the 2018 gift on which gift tax was paid, the 2018 gift exceeded the BEA at death. This, in effect, would impose estate tax on the portion of the 2018 gift that was sheltered from the gift tax by the excess of the 2018 exemption over the 2026 exemption.

The IRS determined that this problem arises from the interplay between the differing exemption amounts that are taken into account in the computation of the estate tax.

Specifically, after first determining the tentative tax on the sum of a decedent’s taxable estate and their adjusted taxable gifts,(xvii)

i. the decedent’s estate must then determine the credit against gift taxes for all prior taxable gifts, using the exemption amount allowable on the dates of the gifts (the credit itself is determined using date of death tax rates);
ii. the gift tax payable is then subtracted from the tentative tax, the result being the net tentative estate tax; and
iii. the estate next determines a credit based on the exemption amount as in effect on the date of the decedent’s death, which is then applied to reduce the net tentative estate tax.

If this credit (based on the exemption amount at the date of death) is less than the credit allowable for the decedent’s taxable gifts (using the date of gift exemption amount), the effect is to increase the estate tax by the difference between the two credit amounts.

In this circumstance, the statutory requirements for computing the estate tax have the effect of imposing an estate tax on gifts made during the increased exemption period that were sheltered from gift tax by the increased exemption amount in effect when the gifts were made.

In order to address this unintended result, the proposed regulations would add a special computation rule in cases where (i) the portion of the credit as of the decedent’s date of death that is based on the exemption is less than (ii) the sum of the credits attributable to the exemption allowable in computing the gift tax payable. In that case, the portion of the credit against the net tentative estate tax that is attributable to the exemption amount would be based upon the greater of those two credit amounts.

Specifically, if the total amount allowable as a credit, to the extent based solely on the BEA, in computing the gift tax payable on the decedent’s post-1976 taxable gifts, exceeds the credit amount based solely on the BEA in effect at the date of death, the credit against the net tentative estate tax would be based on the larger BEA.

For example, if a decedent made cumulative taxable gifts of $9 million, all of which were sheltered from gift tax by a BEA of $10 million applicable on the dates of the gifts,(xviii) and if the decedent died after 2025 when the BEA was $5 million, the credit to be applied in computing the estate tax would be based upon the $9 million of exemption amount that was used to compute the gift tax payable.

Time to Act?

By addressing the unintended results presented in the situation described – a gift made the decedent during the increased exemption period, followed by the death of the decedent after the end of such period – the proposed regulations ensure that the decedent’s estate will not be inappropriately taxed with respect to the gift.

With this “certainty,” an individual business owner who has been thinking about gifting a substantial interest in their business may want to accelerate their gift planning. As an additional incentive, the owner need only look at the results of the mid-term elections, which do not bode well for the future of the increased exemption amount. In other words, it may behoove the owner to treat 2020 (rather than 2025) as the final year for which the increased exemption amount will be available, and to plan accordingly. Those owners who decide to take advantage of the increased exemption amount by making gifts should consider how they may best leverage it.

And as always, tax savings, estate planning, and gifting strategies have to be considered in light of what is best for the business and what the owner is comfortable giving up.

—————————————————————
(i) What? Did you really expect something else? Tax planning is not a seasonal exercise – it is something to be considered every day, similar to many other business decisions.
(ii) Of course, the interest to be gifted should be “disposable” in that the owner can comfortably afford to give up the interest. Even if that is the case, the owner may still want to consider the retention of certain “tax-favored” economic rights with respect to the interest so as to reduce the amount of the gift for tax purposes.
(iii) Usually into an irrevocable trust, and coupled with the granting of “Crummey powers” to the beneficiaries so as to support the gift as one of a “present interest” in property. A donor’s annual exclusion amount is set at $15,000 per donee for 2018 and $15,000 for 2019.
(iv) In other words, a dollar removed today will remove that dollar plus the appreciation on that dollar; a dollar at death shields only that dollar.
The removal of this value from the reach of the estate tax has to be weighed against the loss of the stepped-up basis that the beneficiaries of the decedent’s estate would otherwise enjoy if the gifted business interest were included in the decedent’s gross estate.
(v) Matthew 7:7-8. Actually, many folks asked for the repeal of the estate tax. “You Can’t Always Get What You Want,” The Rolling Stones.
(vi) P.L. 115-97.
(vii) For purposes of the estate tax, this includes a U.S. citizen or domiciliary. The distinction between a U.S. individual and non-resident-non-citizen is significant. In the absence of any estate and gift tax treaty between the U.S and the foreign individual’s country, the foreign individual is not granted any exclusion amount for purposes of determining their U.S. gift tax liability, and only a $60,000 exclusion amount for U.S. estate tax purposes.
(viii) https://www.irs.gov/pub/irs-drop/rp-18-57.pdf
(ix) Only individual transferors are subject to the gift tax. Thus, in the case of a transfer from a business entity that is treated as a gift, one or more of the owners of the business entity will be treated as having made the gift.
(x) They also share a common tax rate table.
(xi) As distinguished, for example, from the annual exclusion gift – set at $15,000 per donee for 2018 and for 2019 – which is not treated as a taxable gift (it is not counted against the exemption amount).
(xii) An election is available under which the federal exemption amount that was not used by a decedent during their life or at their death may be used by the decedent’s surviving spouse (“portability”) during such spouse’s life or death.
(xiii) A similar approach is followed in determining the gift tax, which is imposed on an individual’s transfers by gift during each calendar year.
(xiv) As indicated above, the increased exemption amount is scheduled to sunset after 2025, at which point the lower, pre-TCJA basic exclusion amount is reinstated, as adjusted for inflation through 2025. Of course, a change in Washington after 2020 could accelerate a reduction in the exemption amount.
(xv) I bet you don’t hear that much these days.
(xvi) https://www.federalregister.gov/documents/2018/11/23/2018-25538/estate-and-gift-taxes-difference-in-the-basic-exclusion-amount; the regulations are proposed to be effective on and after the date they are published as final regulations in the Federal Register.
(xvii) Defined as all taxable gifts made after 1976 other than those included in the gross estate.
(xviii) Post-TCJA and before 2026.

I realize that the last post began with “This is the fourth and final in a series of posts reviewing the recently proposed regulations (‘PR’) under Sec. 199A of the Code” – strictly speaking, it was. Yes, I know that the title of this post begins with “The Section 199A Deduction.” Its emphasis, however, is not upon the proposed regulations, as such; rather, today’s post will consider whether the recently enacted deduction, and the regulations proposed thereunder last month, will play a role in determining a taxpayer’s net economic gain from the sale of the taxpayer’s business.

 It has often been stated in this blog that the less a seller pays in taxes as a result of selling their business – or, stated differently, the more that a seller can reduce their resulting tax liability – the greater will be the seller’s economic return on the sale.[i]

 M&A and the TCJA – In General

The Tax Cuts and Jobs Act (“TCJA”)[ii] included a number of provisions that will likely have an impact upon the purchase and sale a business. Among these are the following:

  • the reduced C corporation income tax rate,
  • the exclusion of self-created intangibles from the definition of “capital asset,”
  • the elimination of the 20-year carryforward period for NOLs,
  • the limitation on a buyer’s ability to deduct the interest on indebtedness incurred to acquire a target company, and
  • the extension of the first-year bonus depreciation deduction to “used” property.

Code Section 199A

As we have seen over the last couple of weeks, Sec. 199A generally allows a non-corporate taxpayer a deduction for a taxable year equal to 20% of the taxpayer’s qualified business income (“QBI”) with respect to a qualified trade or business (“QTB”) for such taxable year.

The QBI of a QTB means, for any taxable year, the net income with respect to such trade or business of the taxpayer for the year, provided it is effectively connected with the conduct of a trade or business in the U.S.

Investment income is not included in determining QBI. Thus, if a taxpayer’s rental activity with respect to a real property owned by the taxpayer does not rise to the level of a trade or business, the taxpayer’s rental income therefrom will be treated as investment income and will not be treated as QBI.

In addition, the trade or business of performing services as an employee is not treated as a QTB; thus, the taxpayer’s compensation in exchange for such services is not QBI.

Limitations

If an individual taxpayer-owner’s taxable income for a taxable year exceeds a threshold amount, a special limitation will apply to limit that individual’s Section 199A deduction. Assuming the limitation rule is fully applicable[iii], the amount of the Section 199A deduction may not exceed the greater of:

  • 50% of the W-2 wages with respect to the QTB that are allocable to QBI, or
  • 25% of such W-2 wages, plus 2.50% of the “unadjusted basis” (“UB”)[iv] of all depreciable tangible property held by the QTB at the close of the taxable year, which is used at any point in the year in the production of QBI, and the depreciable period for which has not ended before the close of the taxable year (“qualified property”).

In addition, the amount of a taxpayer’s Section 199A deduction for a taxable year, determined under the foregoing rules, may not exceed 20% of the excess of:

  1. the taxpayer’s taxable income for the taxable year, over
  2. the taxpayer’s net capital gain for such year.

Pass-Through Entities

If the non-corporate taxpayer carries on the QTB indirectly, through a partnership or S corporation (a pass-through entity, or “PTE”), the Section 199A rules are applied at the partner or shareholder level, with each partner or shareholder taking into account their allocable share of the PTE’s QBI, as well as their allocable share of the PTE’s W-2 wages and UB (for purposes of applying the above limitations).

Because some individual owners of a PTE may have personal taxable income at a level that triggers application of the above limitations, while others may not, it is possible for some owners of a QTB to enjoy a smaller Section 199A deduction than other owners of the same QTB, even where they have the same percentage equity interest in the QTB (or in the PTE that holds the business). Stated differently, one taxpayer may have a different after-tax outcome with respect to the QBI allocated to them than would another taxpayer to whom the same amount of QBI is allocated, notwithstanding that they may have identical tax attributes[v] and have identical levels of participation in the conduct of the QTB.

Income or Gain from the Sale of a PTE’s Business

Although the sale of a business may be effected through various means as a matter of state law[vi], there are basically two kinds of sale transactions for tax purposes:

  1. the owners’ sale of their stock or partnership interests (“equity”) in the PTE that owns the business, and
  2. the sale by such PTE of the assets it uses to conduct the business, which is typically followed by the liquidation of such entity.

The character of the gain realized on the sale – i.e., capital or ordinary – will depend, in part, upon whether the PTE is an S corporation or a partnership, and whether the sale is treated as a sale of equity or a sale of assets.

Sale of Assets

If the PTE sells its assets, or is treated as selling its assets[vii], the nature and amount of the gain realized on the sale will depend upon the kind of assets being sold and the allocation of the purchase price among those assets. After all, the character of any item of income or gain included in a partner’s or a shareholder’s allocable share of partnership or S corporation income is determined as if it were realized directly from the source from which realized by the PTE, or incurred in the same manner as incurred by the PTE.[viii]

Thus, any income realized on the sale of accounts receivable or inventory will be treated as ordinary income.

The gain realized on the sale of property used in the trade or business, of a character that may be depreciable, or on the sale of real property used in the trade or business, is generally treated as capital gain.[ix]

However, some of the gain realized on the sale of property in respect of which the seller has claimed accelerated depreciation will be “recaptured” (to the extent of such depreciation) and treated as ordinary income.[x]

Sale of Equity

If the shareholders of an S corporation sell their shares of stock in the corporation, the gain realized will be treated as gain from the sale of a capital asset.[xi]

When the partners of a partnership sell their partnership interests, the gain will generally be treated as capital gain from the sale of a capital asset, except to the extent that the purchase price for such interests is attributable to the unrealized receivables or inventory items (so-called “hot assets”) of the partnership, in which case part of the gain will be treated as ordinary.[xii]

Related Transactions

Aside from the sale of the business, the former owners of a PTE may also engage in other, closely-related, transactions with the buyer.

For example, one or more of the former owners may become employees of, or consultants to, the buyer; in that case, the consideration paid to them will be treated as compensation received in exchange for services.
One of more of the former owners may enter into non-competition agreements with the buyer; the consideration received in exchange may be characterized as compensation for “negative” services.

If one or more of the former owners continue to own the real property on which the business will be operated, they may enter into lease arrangements with the buyer that provide for the payment of rental income.

Tax Rates

If any of the gain from the sale of the PTE’s business is treated as capital gain, each individual owner will be taxed on their allocable share thereof at the federal capital gain rate of 20%.

If any of such gain is treated as ordinary income, each individual owner will be subject to federal income tax on their allocable share thereof at the ordinary income rate of 37%.

If an owner did not materially participate in the business, the 3.8% federal surtax on net investment income may also be applicable to their allocable share of the above gain and ordinary income.[xiii]

Of course, any compensation for services (or “non-services”) would be taxable as ordinary income, and would be subject to employment taxes.

Any rental income would also be subject to tax as ordinary income, and may also be subject to the 3.8% surtax.[xiv]

Based on the foregoing, one may conclude, generally, that it would be in the best interest of the PTE’s owners to minimize the amount of ordinary income, and to maximize the amount of capital gain, to be realized on the sale of the PTE’s business.[xv]

Of course, the selling PTE and its owners cannot unilaterally, or even reasonably expect to, direct this result. The buyer has its own preferences and imperatives[xvi]; moreover, one simply cannot avoid ordinary income treatment in many circumstances.

Enter Section 199A

No, not astride a horse, but on tip toes, wearing sneakers.[xvii]

The tax treatment of M&A transactions was certainly not what Congress was focused on when Section 199A was conceived. PTEs already enjoyed a significant advantage in the taxation of M&A transactions in that capital gains are taxed to the individual owners of a PTE at a very favorable federal rate of 20%.

Rather, Congress sought to provide a tax benefit to the individual owners of PTEs in response to complaints from the PTE community that the tax bill which eventually became the TCJA was heavily biased in favor of C corporations, especially with the reduction in the federal corporate income tax rate from a maximum graduated rate of 35% to a flat rate of 21%.

It order to redress the perceived unfairness, Congress gave individual business owners the Section 199A deduction as a way to reduce their tax liability with respect to the ordinary net operating income of their PTEs.

Sale of a Business

This is borne out by the exclusion from the definition of QBI of dividends and interest, and by the exclusion of capital gains[xviii], regardless of whether such gains arise from the sale of a capital asset; thus, the capital gain from the sale of a property used in the PTE’s trade or business, and of a character which is subject to the allowance for depreciation, is excluded from QBI.

Does that mean that Section 199A has no role to play in the taxation of M&A transactions? Not quite.

Simply put, a number of the business assets disposed of as part of an M&A transaction represent items of ordinary income that would have been realized by the business and its owners in the ordinary course of business had the business not been sold; the sale of these assets accelerates recognition of this ordinary income.

Ordinary Income Items

For example, the ordinary income realized on the sale, or deemed sale[xix], of accounts receivable and inventory by a PTE as part of an M&A deal should qualify as QBI, and should be taken into account in determining the Section 199A deduction for the individual owners of the PTE.

Unfortunately, neither the Code nor the proposed regulations explicitly state that this is the case, though the latter clearly provide that any ordinary income arising from the disposition of a partnership interest that is attributable to the partnership’s hot assets – i.e., inventory and unrealized receivables – will be considered attributable to the trade or business conducted by the partnership and taken into account for purposes of computing QBI.[xx]

Of course, the partnership rules[xxi] define the term “unrealized receivables” expansively, so they include other items in addition to receivables; for example, the ordinary income – i.e., depreciation recapture – realized on the sale of tangible personal property used in the business, the cost of which has been depreciated on an accelerated basis, or for which a bonus depreciation deduction or Section 179 deduction has been claimed.

In light of the foregoing, the same result should obtain where the inventories and receivables are sold as part of an actual or deemed asset sale, though the proposed regulations do not speak directly to this situation. These assets are not of a kind that appreciate in value, or that generate income, as in the case of investment property. Rather, they represent “ordinary income in-waiting” and should be treated as QBI.

Similarly in the case of tangible personal property used in a business and subject to an allowance for depreciation; taxpayers are allowed to recover the cost of acquiring such assets on an accelerated basis so as to reduce the net cost thereof, and thereby to incentivize taxpayers to make such investments.; i.e., they are allowed to reduce the ordinary income that otherwise would have been realized (and taxed) in the ordinary course of business. The “recapture” of this depreciation benefit upon the sale of such property should, likewise, be treated as QBI.

Compensation

As stated above, a taxpayer’s QBI does not include any amount of compensation paid to the individual taxpayer in their capacity as an employee. In other words, if a former owner of the PTE-operated business is employed by the new owner of the business (for example, as an officer), the compensation paid to the former owner will not be treated as QBI.

If the former owner is not employed by the new owner, but is retained to provide other services as an independent contractor, the payments made to them in exchange for such services may constitute QBI, provided the service provider is properly characterized as a non-employee and the service is not a “specified service trade or business.”[xxii] Query whether the “consulting” services often provided by a former owner to the buyer are the equivalent of providing the kind of “advice and counsel” that the proposed regulations treat as a specified service trade or business, the income from which is not QBI.

Rental

As was mentioned above, it is not unusual for the owners of a PTE to sell their operating business while retaining ownership of the real property on which the business may continue to operate – hopefully, it has been residing in an entity separate from the one holding the business. Under these circumstances, the owners may ensure themselves of a continued stream of revenue, a portion of which may be sheltered by depreciation deductions.

Whether such rental activity will rise to the level of a trade or business for purposes of Section 199A will depend upon the facts and circumstances. However, if the property is wholly-occupied by one tenant – i.e., by the business that was sold, as is often the case – it is unlikely that the rental activity will represent a QTB and, so, the net rental income will not be QBI.

Don’t Forget the Limitations

Even assuming that a goodly portion of the income arising from the sale of a QTB will be treated as QBI, the individual taxpayer must bear in mind the “W-2-based” and “taxable-income-based” limitations described above.

This Time, I Promise

Well, that’s it for Section 199A – at least until the proposed regulations are finalized.

“I’m so glad we had this time together . . .”[xxiii] I know, “Lou, keep you day job.”


[i] The flip-side may be stated as follows: the faster a buyer can recover their investment – i.e., the purchase price – for the acquisition of a business, the greater is the buyer’s return on its investment in the business. See, e.g.

[ii] P.L. 115-97.

[iii] Meaning that the taxpayer’s taxable income for the taxable year exceeds the threshold amount ($315,000 in the case of married taxpayers filed jointly) plus a phase-in range (between the threshold amount and $415,000).

[iv] The term “UB” means the initial basis of the qualified property in the hands of the individual or PTE, depending upon whether it was purchased by or contributed to the PTE.

[v] Other than taxable income.

[vi] For example, a sale of assets may be accomplished through a merger of two business entities; a stock sale may be accomplished through a reverse subsidiary merger in which the target is the surviving entity.

[vii] In the case of an S corporation, where the shareholders make an election under Sec. 336(e), or where the shareholders and the buyer make a joint election under Sec. 338(h)(10), to treat the stock sale as a sale of assets by the corporation followed by the liquidation of the corporation.

In the case of a partnership, a buyer who acquires all of the partnership interests is treated, from the buyer’s perspective, as acquiring the assets of the partnership. Rev. Rul. 99-6.

[viii] Sec. 702 and Sec. 1366.

[ix] Sec. 1231. Specifically, if the “section 1231 gains” for a taxable year exceed the “section 1231 losses” for such year, such gains and losses shall be treated as long-term capital gains or losses, as the case may be.

[x] Sec. 1245.

[xi] Sec. 1221.

[xii] Sec. 741 and Sec. 751.

[xiii] Sec. 1411. The tax is imposed on the lesser of (a) the amount of the taxpayer’ net investment income for the taxable year, or (b) the excess of (i) the taxpayer’s modified adjusted gross income, over (ii) a threshold amount ($250,000 in the case of a married taxpayer filed a joint return).

[xiv] Assuming it is a passive activity. See Reg. Sec. 1.1411-5.

[xv] In the case of a PTE that is an S corporation that is subject to the built-in gains tax, the shareholders may also be interested in allocating consideration away from those corporate assets to which the tax would apply.

[xvi] See endnote “i”, supra.

[xvii] I wish I could recall the name of the presidential scholar who coined the phrase, that I am trying to paraphrase, to describe how presidents get things done. It may have been Prof. Richard Pious of Columbia University.

[xviii] Sec. 199A(c)(3)(B); Prop. Reg. Sec. 1.199A-3(b)(2).

[xix] For example, upon the filing of a Sec. 338(h)(10) election.

[xx] Prop. Reg. Sec. 1.199A-3(b).

[xxi] Sec. 751(c).

[xxii] Prop. Reg. Sec. 1.199A-5.

[xxiii] Remember Carol Burnett’s sign-off song?

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

Earlier posts considered the elements of a “qualified trade or business” under Section 199A https://www.taxlawforchb.com/2018/09/the-proposed-sec-199a-regs-are-here-part-one , the related issue of what constitutes a “specified service trade or business,” the owners of which may be denied the benefit of Section 199A, https://www.taxlawforchb.com/2018/09/the-proposed-sec-199a-regs-are-here-part-two/ , and the meaning of “qualified business income.” https://www.taxlawforchb.com/2018/09/the-proposed-sec-199a-regs-are-here-part-three/. Today, we turn to the calculation of the deduction, the limitations on the amount of the deduction, and some special rules.

 Threshold and Phase-In Amounts

Let’s assume for the moment that our taxpayer (“Taxpayer”) is a married individual, files a joint return with their spouse, and owns an equity interest in a qualified trade or business (“QTB”) that is conducted through a pass-through entity (“PTE”), such as a sole proprietorship,[ii] a partnership, or an S corporation.

At this point, Taxpayer must determine their joint taxable income for the taxable year.[iii]

There are three categories of taxpayers for purposes of Section 199A – those whose joint taxable income[iv]:

  • does not exceed $315,000 (the “threshold”),
  • exceeds $315,000 but does not exceed $415,000 (the “phase-in range”),[v] and
  • exceeds $415,000.[vi]

 

 

 

Below the Threshold

If Taxpayer falls within the first category – joint taxable income that does not exceed $315,000 – they determine their Section 199A deduction by first calculating 20% of their QBI with respect to their QTB (Taxpayer’s “combined QBI amount”).[vii] For this first category of taxpayer, their share of income from a specified service trade or business (“SSTB”) qualifies as QBI.

Taxpayer must then compare their

  • combined QBI amount (determined above) with
  • an amount equal to 20% of the excess of:
    • their taxable income for the taxable year, over
    • their net capital gain for the year.

The lesser of these two amounts is then compared to Taxpayer’s entire taxable income for the taxable year, reduced by their net capital gain. Taxpayer’s Section 199A deduction is equal to the lesser of these two amounts.

Thus, if Taxpayer’s only source of income was their QTB, Taxpayer would be entitled to claim the full “20% of QBI” deduction, with the result that their QBI would be subject to an effective top federal income tax rate of 29.6%[viii]

Above the Threshold and Phase-In

If Taxpayer falls within the third category – joint taxable income for the taxable year in excess of $415,000 – they face several additional hurdles in determining their Section 199A deduction.[ix] It is with respect to these taxpayers that the application of the Section 199A rules becomes even more challenging, both for the taxpayers and their advisers.

To start, no SSTB in which Taxpayer has an equity interest will qualify as a QTB as to Taxpayer.

Moreover, there are other limitations, in addition to the ones described above, that must be considered in determining the amount of Taxpayer’s Section 199A deduction.

N.B.

Before turning to these limitations, it is important to note the following:

  • the application of the threshold and phase-in amounts is determined at the level of the individual owner of the QTB[x], which may not be where the trade or business is operated; and
  • taxpayers with identical interests in, and identical levels of activity with respect to, the same trade or business may be treated differently if one taxpayer has more taxable income from sources outside the trade or business than does the other;
    • for example, a senior partner of a law firm, who has had years to develop an income-producing investment portfolio, vs a junior partner at the same firm, whose share of partnership income represents their only source of income.[xi]

Limitations

The additional limitations referred to above are applied in determining Taxpayer’s “combined QBI amount.”

Specifically, the amount equal to 20% of Taxpayer’s QBI with respect to the QTB must be compared to the greater of:

  • 50% of the “W-2 wages” with respect to the QTB, or
  • The sum of (i) 25% of the W-2 wages plus (ii) 2.5% of the unadjusted basis (“UB”) of qualified property immediately after the acquisition of all qualified property (“a” and “b” being the “alternative limitations”).

The lesser of Taxpayer’s “20% of QBI” figure and the above “W-2 wages-based” figure may be characterized as Taxpayer’s “tentative” Section 199A deduction; it is subject to being further reduced in accordance with the following caps:

  • The Section 199A deduction cannot be greater than 20% of the excess (if any) of:
    • Taxpayer’s taxable income for the taxable year, over
    • Taxpayer’s net capital gain for the year.
  • The resulting amount – i.e., the tentative deduction reduced in accordance with “a” – is then compared to Taxpayer’s entire taxable income for the taxable year, reduced by their net capital gain.

Taxpayer’s Section 199A deduction is equal to the lesser of the two amounts described in “b”, above.

Applied to Each QTB

Under the PR, an individual taxpayer must determine the W-2 wages and the UB of qualified property attributable to each QTB contributing to the individual’s combined QBI. The W-2 wages and the UB of qualified property amounts are compared to QBI in order to determine the individual’s QBI component for each QTB.

After determining the QBI for each QTB, the individual taxpayer must compare 20% of that trade or business’s QBI to the alternative limitations for that trade or business.

If 20% of the QBI of the trade or business is greater than the relevant alternative limitation, the QBI component is limited to the amount of the alternative limitation, and the deduction is reduced.

The PR also provide that, if an individual has QBI of less than zero (a loss) from one trade or business, but has overall QBI greater than zero when all of the individual’s trades or businesses are taken together, then the individual must offset the net income in each trade or business that produced net income with the net loss from each trade or business that produced net loss before the individual applies the limitations based on W-2 wages and UB of qualified property.

The individual must apportion the net loss among the trades or businesses with positive QBI in proportion to the relative amounts of QBI in such trades or businesses. Then, for purposes of applying the limitation based on W-2 wages and UB of qualified property, the net income with respect to each trade or business (as offset by the apportioned losses) is the taxpayer’s QBI with respect to that trade or business.

The W-2 wages and UB of qualified property from the trades or businesses which produced negative QBI for the taxable year are not carried over into the subsequent year.

W-2 Wages

The PR provide that, in determining W-2 wages, the common law employer (such as a PTE) may take into account any W-2 wages paid by another person – such as a professional employer organization – and reported by such other person on Forms W-2 with the reporting person as the employer listed on the Forms W-2, provided that the W-2 wages were paid to common law employees of the common law employer for employment by the latter.[xii]

Under this rule, persons who otherwise qualify for the deduction are not limited in applying the deduction merely because they use a third party payor to pay and report wages to their employees.

The W-2 wage limitation applies separately for each trade or business. Accordingly, the PR provides that, in the case of W-2 wages that are allocable to more than one trade or business, the portion of the W-2 wages allocable to each trade or business is determined to be in the same proportion to total W-2 wages as the ordinary business deductions associated with those wages are allocated among the particular trades or businesses.

W-2 wages must be properly allocable to QBI (rather than, for example, to activity that produces investment income). W-2 wages are properly allocable to QBI if the associated wage expense is taken into account in computing QBI.

Where the QTB is conducted by a PTE, a partner’s or a shareholder’s allocable share of wages must be determined in the same manner as their share of wage expenses.

Finally, the PR provide that, in the case of an acquisition or disposition of (i) a trade or business, (ii) the major portion of a trade or business, or (iii) the major portion of a separate unit of a trade or business, that causes more than one individual or entity to be an employer of the employees of the acquired or disposed of trade or business during the calendar year, the W-2 wages of the individual or entity for the calendar year of the acquisition or disposition are allocated between each individual or entity based on the period during which the employees of the acquired or disposed of trade or business were employed by the individual or entity.

 UB of Qualified Property

The PR provides that “qualified property” means (i) tangible property of a character subject to depreciation that is held by, and available for use in, a trade or business at the close of the taxable year, (ii) which is used in the production of QBI, and (iii) for which the depreciable period has not ended before the close of the taxable year.

“Depreciable period” means the period beginning on the date the property is first placed in service by the taxpayer and ending on the later of (a) the date 10 years after that date, or (b) the last day of the last full year in the applicable recovery period that would apply to the property without regard to whether any bonus depreciation was claimed with respect to the property. Thus, it is possible for a property to be treated as qualified property even where it is no longer being depreciated for tax purposes.

The term “UB” means the initial basis of the qualified property in the hands of the individual or PTE, depending upon whether it was purchased or contributed.

UB is determined without regard to any adjustments for any portion of the basis for which the taxpayer has elected to treat as an expense (for example, under Sec. 179 of the Code). Therefore, for purchased or produced qualified property, UB generally will be its cost as of the date the property is placed in service.

For qualified property contributed to a partnership in a “tax-free” exchange for a partnership interest and immediately placed in service, UB generally will be its basis in the hands of the contributing partner, and will not be changed by subsequent “elective” basis adjustments.

For qualified property contributed to an S corporation in a “tax-free” exchange for stock and immediately placed in service, UB generally will be its basis in the hands of the contributing shareholder.[xiii]

Further, for property inherited from a decedent and immediately placed in service by the heir, the UB generally will be its fair market value at the time of the decedent’s death.

In order to prevent trades or businesses from transferring or acquiring property at the end of the year merely to manipulate the UB of qualified property attributable to the trade or business, the PR provides that property is not qualified property if the property is acquired within 60 days of the end of the taxable year and disposed of within 120 days without having been used in a trade or business for at least 45 days prior to disposition, unless the taxpayer demonstrates that the principal purpose of the acquisition and disposition was a purpose other than increasing the deduction.

For purposes of determining the depreciable period of qualified property, the PR provide that, if a PTE acquires qualified property in a non-recognition exchange, the qualified property’s “placed-in-service” date is determined as follows: (i) for the portion of the transferee-PTE’s UB of the qualified property that does not exceed the transferor’s UB of such property, the date such portion was first placed in service by the transferee-PTE is the date on which the transferor first placed the qualified property in service; (ii) for the portion of the transferee’s UB of the qualified property that exceeds the transferor’s UB of such property, if any, such portion is treated as separate qualified property that the transferee first placed in service on the date of the transfer.

Thus, qualified property acquired in these non-recognition transactions will have two separate placed in service dates under the PR: for purposes of determining the UB of the property, the relevant placed in service date will be the date the acquired property is placed in service by the transferee-PTE (for instance, the date the partnership places in service property received as a capital contribution); for purposes of determining the depreciable period of the property, the relevant placed in service date generally will be the date the transferor first placed the property in service (for instance, the date the partner placed the property in service in their sole proprietorship).

The PR also provide guidance on the treatment of subsequent improvements to qualified property.[xiv]

Finally, in the case of a trade or business conducted by a PTE, the PR provide that, in the case of qualified property held by a PTE, each partner’s or shareholder’s share of the UB of qualified property is an amount that bears the same proportion to the total UB of qualified property as the partner’s or shareholder’s share of tax depreciation bears to the entity’s total tax depreciation attributable to the property for the year.[xv]

Computational Steps for PTEs

The PR also provide additional guidance on the determination of QBI for a QTB conducted by a PTE.

A PTE conducting an SSTB may not know whether the taxable income of any of its equity owners is below the threshold amount. However, the PTE is best positioned to make the determination as to whether its trade or business is an SSTB.

Therefore, reporting rules require each PTE to determine whether it conducts an SSTB, and to disclose that information to its partners, shareholders, or owners.

In addition, notwithstanding that PTEs cannot take the Section 199A deduction at the entity level, each PTE must determine and report the information necessary for its direct and indirect individual owners to determine their own Section 199A deduction.

Thus, the PR direct PTEs to determine what amounts and information to report to their owners and the IRS, including QBI, W-2 wages, and the UB of qualified property for each trade or business directly engaged in.

The PR also require each PTE to report this information on or with the Schedules K-1 issued to the owners. PTEs must report this information regardless of whether a taxpayer is below the threshold amount.

“That’s All Folks!”[xvi]

With the series of posts ending today, we’ve covered most aspects of the new Section 199A rule, as elaborated by the PR, though the following points are also worth mentioning:

  • the Section 199A deduction has no effect on the adjusted basis of a partner’s interest in a partnership;
  • the deduction has no effect on the adjusted basis of a shareholder’s stock in an S corporation or the S corporation’s accumulated adjustments account;
  • the deduction does not reduce (i) net earnings from self-employment for purposes of the employment tax (for example, a partner’s share of a partnership’s operating income), or (ii) net investment income for purposes of the surtax on net investment income (for example, a shareholder’s share of an S corporation’s business in which the shareholder does not materially participate); and
  • for purposes of determining an individual’s alternative minimum taxable income for a taxable year, the entire deduction is allowed, without adjustment.

Stay tuned. Although taxpayers may rely upon the PR, they are not yet final. A public hearing on the PR is scheduled for October 16; the Republicans recently proposed to make the deduction “permanent” (whatever that means); midterm elections are scheduled for November 6; we have a presidential election in 2020; the deduction is scheduled to disappear after 2025. Oh, bother.

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[i] Yes, I know – where has time gone? The fourth already? Seems like just yesterday, I was reading the first. Alternatively: Oh no, not another! It’s like reading . . . the Code? Where are those definitions of SSTB covered? The first or the second installment?

[ii] Including a single-member LLC that is disregarded for tax purposes.

[iii] Of course, we are only considering taxable years beginning after December 31, 2017, the effective date for Section 199A of the Code.

[iv] Regardless of the source or type of the income.

[v] See EN ix, below.

[vi] For our purposes, it is assumed that Taxpayer has no “qualified cooperative dividends,” no “qualified REIT dividends,” and no “qualified publicly traded partnership income.”

[vii] If Taxpayer has more than one QTB, this amount is determined for each such QTB, and these amounts are then added together.

[viii] I.e., 80% of the regular 37% rate.

[ix] Yes, we skipped the second category – taxpayers with taxable income in excess of the threshold amount but within the phase-in range amount.

The exclusion of QBI (for SSTBs), W-2 wages, and UB of qualified property from the computation of the Section 199A deduction is subject to a phase-in for individuals with taxable income within the phase-in range.

[x] Thus, we look at the taxable income of the individual member of the LLC or shareholder of the S corporation – not at the taxable income of the entity.

[xi] Compare to the passive activity loss rules (material participant or not?), and the net investment income surtax rules (modified adjusted gross income in excess of threshold; material participant?).

[xii] In such cases, the person paying the W-2 wages and reporting the W-2 wages on Forms W-2 is precluded from taking into account such wages for purposes of determining W-2 wages with respect to that person.

[xiii] The PR also provide special rules for determining the UB and the depreciable period for property acquired in a “tax-free” exchange.

Specifically, for purposes of determining the depreciable period, the date the exchanged basis in the replacement qualified property is first placed in service by the trade or business is the date on which the relinquished property was first placed in service by the individual or PTE, and the date the excess basis in the replacement qualified property is first placed in service by the individual or PTE is the date on which the replacement qualified property was first placed in service by the individual or PTE. As a result, the depreciable period for the exchanged basis of the replacement qualified property will end before the depreciable period for the excess basis of the replacement qualified property ends.

Thus, qualified property acquired in a like-kind exchange will have two separate placed in service dates under the PR: for purposes of determining the UBIA of the property, the relevant placed in service date will be the date the acquired property is actually placed in service; for purposes of determining the depreciable period of the property, the relevant placed in service date generally will be the date the relinquished property was first placed in service.

[xiv] Rather than treat them as a separate item of property, the PR provides that, in the case of any addition to, or improvement of, qualified property that is already placed in service by the taxpayer, such addition or improvement is treated as separate qualified property that the taxpayer first placed in service on the date such addition or improvement is placed in service by the taxpayer for purposes of determining the depreciable period of the qualified property. For example, if a taxpayer acquired and placed in service a machine on March 26, 2018, and then incurs additional capital expenditures to improve the machine in May 2020, and places such improvements in service on May 27, 2020, the taxpayer has two qualified properties: The machine acquired and placed in service on March 26, 2018, and the improvements to the machine incurred in May 2020 and placed in service on May 27, 2020.

[xv] In the case of qualified property of a partnership that does not produce tax depreciation during the year (for example, property that has been held for less than 10 years but whose recovery period has ended), each partner’s share of the UB of qualified property is based on how gain would be allocated to the partners if the qualified property were sold in a hypothetical transaction for cash equal to the fair market value of the qualified property. In the case of qualified property of an S corporation that does not produce tax depreciation during the year, each shareholder’s share of the UB of the qualified property is a share of the UB proportionate to the ratio of shares in the S corporation held by the shareholder over the total shares of the S corporation.

[xvi] And so ended every episode of Looney Tunes. Thank you Mel Blanc.

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

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

Qualified Business Income – In General

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

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

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

Exclusion from QBI for Certain Items

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

Compensation for Services

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

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

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

Guaranteed Payments

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

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

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

Other Payments to “Partners”

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

Guaranteed Payments for the Use of Capital

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

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

Interest Income

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

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

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

QBI – Special Rules

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

“Hot Asset” Gain

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

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

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

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

Change in Accounting Adjustments

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

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

Previously Suspended Losses

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

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

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

Net Operating Losses

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

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

Property Used in the Trade or Business

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

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

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

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

Effectively Connected With a U.S. Trade or Business

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

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

Determining Effectively Connected Income

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

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

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

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

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

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

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

Allocation of QBI Items

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

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

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

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

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

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

[ii] IRC Sec. 1231.

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

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

[v] There are exceptions.

What follows is the first in a series of posts that will review the long-awaited proposed regulations under Sec. 199A of the Code – the “20% deduction” – which was enacted by the Tax Cuts and Jobs Act to benefit the individual owners of pass-through business entities.

Today’s post will summarize the statutory provision, and will then consider some of the predicate definitions and special rules that are key to its application.

We will continue to explore these definitions and rules in tomorrow’s post.

Congress: “I Have Something for You”

The vast majority of our clients are closely-held businesses that are organized as pass-through entities (“PTEs”), and that are owned by individuals. These PTEs include limited liability companies that are treated as partnerships for tax purposes, as well as S corporations.

As the Tax Cuts and Jobs Act (“TCJA”)[i] moved through Congress in late 2017, it became clear that C corporations were about to realize a significant windfall.[ii] In reaction to this development, many individual clients who operate through partnerships began to wonder whether they should incorporate their business (for example, by “checking the box”[iii]); among those clients that operated their business as S corporations, many asked whether they should revoke their “S” election.

After what must have been a substantial amount of grumbling from the closely-held business community, Congress decided to add a new deduction to the TCJA – Section 199A – that was intended to benefit the individual owners of PTEs for taxable years beginning after 2017 and before 2026.[iv]

“Here It Is”

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

A QTB includes any trade or business other than a “specified service trade or business” (“SSTB”)[v]. It also does not include the trade or business of rendering services as an employee.

An SSTB includes, among other things, any trade or business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees.

The QBI of a QTB means, for any taxable year, the net income or loss with respect to such trade or business of the taxpayer for the year, provided it is effectively connected with the conduct of a trade or business in the U.S. (“effectively connected income,” or “ECI”).

Investment income is not included in determining QBI, nor is any reasonable compensation paid to a shareholder, nor any guaranteed payment made to a partner, for services rendered to the QTB.

If an individual taxpayer-owner’s taxable income for a taxable year exceeds a threshold amount, a special limitation will apply to limit that individual’s Section 199A deduction.

Assuming the limitation rule is fully applicable, the amount of the Section 199A deduction may not exceed the greater of:

  • 50% of the W-2 wages with respect to the QTB that are allocable to QBI, or
  • 25% of such W-2 wages, plus 2.50% of the “unadjusted basis” (“UB”)[vi] of all depreciable tangible property held by the QTB at the close of the taxable year, which is used at any point in the year in the production of QBI, and the depreciable period for which has not ended before the close of the taxable year (“qualified property”).

If the individual taxpayer carries on more than one QTB (directly or through a PTE), the foregoing calculation is applied separately to each such QTB, and the results are then aggregated to determine the amount of the Section 199A deduction.

Thus, a loss generated in one QTB may offset the net income generated in another, thereby denying the taxpayer any Section 199A deduction.

If the taxpayer carries on the business indirectly, through a partnership or S corporation, the rule is applied at the partner or shareholder level, with each partner or shareholder taking into account their allocable share of QBI, as well as their allocable share of W-2 wages and UB (for purposes of applying the above limitation).

Because some individual owners of a PTE may have personal taxable income at a level that triggers application of the above limitation, while others may not, it is possible for some owners of a QTB to enjoy a smaller Section 199A deduction than others, even where they have the same percentage equity interest in the QTB.[vii]

Finally, the amount of a taxpayer’s Section 199A deduction for a taxable year determined under the foregoing rules may not exceed 20% of the excess of (i) the taxpayer’s taxable income for the taxable year over (ii) the taxpayer’s net capital gain for such year.

Taxpayer: “Thank You, But I Have Some Questions”

It did not take long after Section 199A was enacted as part of the TCJA, on December 22, 2017, for many tax advisers and their PTE clients to start asking questions about the meaning or application of various parts of the rule.

For example, what constitutes a “trade or business” for purposes of the rule? Would taxpayers be allowed to group together separate but related businesses for purposes of determining the Deduction? Would they be required to do so? Under what circumstances, if any, would a PTE be permitted to split off a discrete business activity or function into a different business entity? When is the reputation or skill of an employee the principal asset of a business?

Because of these and other questions, most advisers decided it would be best to wait for guidance from the IRS before advising taxpayers on how to implement and apply the new rules.[viii]

The IRS assured taxpayers that such guidance would be forthcoming in the spring of 2018; it subsequently revised its target date to July of 2018; then, on August 16, the IRS issued almost 200 pages of Proposed Regulations (“PR”). https://www.federalregister.gov/documents/2018/08/16/2018-17276/qualified-business-income-deduction

The Proposed Regulations

The PR will apply to taxable years ending after the date they are adopted as final regulations; until then, however, taxpayers may rely on the PR.

Trade or Business – In General

The PR provide that, for purposes of Section 199A, the term “trade or business” shall mean an activity that is conducted with “continuity and regularity” and “with the primary purpose of earning income or making profit.” This is the same definition that taxpayers have applied for decades for purposes of determining whether expenses may be deducted as having been incurred in the ordinary course of a trade or business (so-called “ordinary and necessary” expenses).

However, in recognition of the fact that it is not uncommon, for legal or other bona fide non-tax reasons (for example, to limit exposure to liability), for taxpayers to segregate rental properties from operating businesses, the PR extend the definition of “trade or business” for purposes of Section 199A by including the rental or licensing of tangible or intangible property to a related trade or business – which may not otherwise satisfy the general definition of “trade or business” adopted by the PR (for example, where the entire property is rented only to the operating business) – if the “lessor/licensor trade or business” and the “lessee/licensee trade or business” are commonly controlled (generally speaking, if the same person or group of persons, directly or indirectly, owns 50% or more of each trade or business).

Trade or Business – Aggregation Rules

The above line of reasoning also informed the IRS’s thinking with respect to the “grouping” of certain trades or businesses for purposes of applying Section 199A.

Specifically, the IRS recognized that some amount of aggregation should be permitted because it is not uncommon, for what are commonly thought of as single trades or businesses, to be operated across multiple entities for various legal, economic, or other bona fide non-tax reasons.

Allowing taxpayers to aggregate trades or businesses offers taxpayers a means of combining their trades or businesses for purposes of applying the “W-2 wage” and “UB of qualified property” limitations (described above) and potentially maximizing the deduction under Section 199A. The IRS was concerned that if such aggregation were not permitted, taxpayers could be forced to incur costs to restructure solely for tax purposes. In addition, business and non-tax legal requirements may not permit many taxpayers to restructure their operations.

Therefore, the PR permits the aggregation of separate trades or businesses, provided certain requirements are satisfied; aggregation is not required.[ix]

An individual may aggregate trades or businesses only if the individual can demonstrate that certain requirements are satisfied:

  • Each “trade or business” must itself be a trade or business for purposes of Section 199A.
  • The same person, or group of persons, must directly or indirectly, own a majority interest in each of the businesses to be aggregated for the majority of the taxable year in which the items attributable to each trade or business are included in income. All of the items attributable to the trades or businesses must be reported on tax returns with the same taxable year.
    • The PR provides rules allowing for family attribution.
    • Because the proposed rules look to a group of persons, minority owners may benefit from the common ownership and are permitted to aggregate.
  • None of the aggregated trades or businesses can be an SSTB (more on this tomorrow).
  • Individuals must establish that the trades or businesses to be aggregated meet at least two of the following three factors, which demonstrate that the businesses are in fact part of a larger, integrated trade or business:
    • The businesses provide products and services that are the same (for example, a restaurant and a food truck) or they provide products and services that are customarily provided together (for example, a gas station and a car wash);
    • The businesses share facilities or share significant centralized business elements (for example, common personnel, accounting, legal, manufacturing, purchasing, human resources, or information technology resources); or
    • The businesses are operated in coordination with, or reliance on, other businesses in the aggregated group (for example, supply chain interdependencies).

Trade or Business – Aggregation by Individuals

An individual is permitted to aggregate trades or businesses that the individual operates directly and trades or businesses operated indirectly – or, more appropriately, they may aggregate the businesses they operate directly with their share of QBI, W-2 wages and UB of qualified property from trades or businesses operated through PTEs of which the individual is an owner.

Individual owners of the same PTEs are not required to aggregate in the same manner.

An individual directly engaged in a trade or business must compute QBI, W-2 wages, and UB of qualified property for each such trade or business before applying the aggregation rules.

If an individual has aggregated two or more trades or businesses, then the combined QBI, W-2 wages, and UB of qualified property for all aggregated trades or businesses is used for purposes of applying the W-2 wage and UB of qualified property limitations.

Example. Individual A wholly owns and operates a catering business and a restaurant through separate disregarded entities. The catering business and the restaurant share centralized purchasing to obtain volume discounts and a centralized accounting office that performs all of the bookkeeping, tracks and issues statements on all of the receivables, and prepares the payroll for each business. A maintains a website and print advertising materials that reference both the catering business and the restaurant. A uses the restaurant kitchen to prepare food for the catering business. The catering business employs its own staff and owns equipment and trucks that are not used or associated with the restaurant.

Because the restaurant and catering business are held in disregarded entities, A will be treated as operating each of these businesses directly. Because both businesses offer prepared food to customers, and because the two businesses share the same kitchen facilities in addition to centralized purchasing, marketing, and accounting, A may treat the catering business and the restaurant as a single trade or business for purposes of applying the limitation rules.

Example. Assume the same facts as above, but the catering and restaurant businesses are owned in separate partnerships and A, B, C, and D each own a 25% interest in the capital and profits of each of the two partnerships. A, B, C, and D are unrelated.

Because A, B, C, and D together own more than 50% of the capital and profits in each of the two partnerships, they may each treat the catering business and the restaurant as a single trade or business for purposes of applying the limitation rules.

Trade or Business – Aggregation by PTEs

PTEs must compute QBI, W-2 wages, and UB of qualified property for each trade or business. A PTE must provide its owners with information regarding QBI, W-2 wages, and UB of qualified property attributable to its trades or businesses.

The PR do not address the aggregation by a PTE in a tiered structure.

Trade or Business – Aggregation – Reporting and Consistency

The PR requires that, once multiple trades or businesses are aggregated into a single aggregated trade or business, individuals must consistently report the aggregated group in subsequent tax years.

The PR provides rules for situations in which the aggregation rules are no longer satisfied, as well as rules for when a newly-created or newly-acquired trade or business can be added to an existing aggregated group.

Finally, the PR provides reporting and disclosure requirements for individuals that choose to aggregate, including identifying information about each trade or business that constitutes a part of the aggregated trade or business. The PR allows the IRS to disaggregate trades or businesses if an individual fails to make the required disclosure.


[*] Anyone remember the following scene from “The Jerk”?

Navin: “The new phone book’s here! The new phone book’s here!”
Harry: “Well I wish I could get so excited about nothing.”
Navin: “Nothing? Are you kidding?! Page 73, Johnson, Navin, R.! I’m somebody now! Millions of people look at this book every day! This is the kind of spontaneous publicity, your name in print, that makes people. I’m in print! Things are going to start happening to me now.”

[i] Pub. L. 115-97.

[ii] See, e.g., https://www.taxlawforchb.com/2018/01/some-of-the-tcjas-corporate-tax-changes/ ; https://www.taxlawforchb.com/2018/01/will-tax-reform-affect-domestic-ma/ ; https://www.taxlawforchb.com/2018/06/s-corps-cfcs-the-tax-cuts-jobs-act/.

[iii] https://www.law.cornell.edu/cfr/text/26/301.7701-3

[iv] That’s right – the provision is scheduled to disappear in a few years. However, on July 24, the House Ways and Means Committee released “Tax Reform 2.0 Listening Session Framework” which would make the deduction permanent. These proposals will not be considered until after the Congressional elections this fall. Enough said. https://waysandmeansforms.house.gov/uploadedfiles/tax_reform_2.0_house_gop_listening_session_framework_.pdf

[v] It should be noted that a SSTB will not be excluded from QTB status with respect to an individual taxpayer-owner of the SSTB if the taxpayer’s taxable income does not exceed certain thresholds. It is assumed herein that these thresholds, as well as the range of taxable income above such thresholds within which the benefit of Section 199A is scaled back, are exceeded for every owner of the SSTB.

[vi] In general, the unadjusted basis, immediately after acquisition, of all qualified property.

[vii] Query whether this may influence business and investment decisions.

[viii] Others, however, saw a wasting opportunity, given the scheduled elimination of the deduction after the year 2025, and may have acted hastily. Among other things, many of these advisers and taxpayers sought to bootstrap themselves into a QTB by separating its activities from a related SSTB.

[ix] The IRS is aware that many taxpayers are concerned with having multiple regimes for grouping. Accordingly, it has requested comments on the aggregation method described in the PR, including whether this would be an appropriate grouping method for purposes of the passive activity loss limitation and net investment income surtax rules, in addition to Section 199A.

 

Earlier this month, the IRS proposed regulations regarding the additional first-year depreciation deduction that was added to the Code by the Tax Cuts and Jobs Act (“TCJA”).[i] The proposed rules provide guidance that should be welcomed by those taxpayers that are considering the purchase of a closely held business or, perhaps, of an interest in such a business, and that are concerned about their ability to recover their investment.

Cost Recovery

In general, a taxpayer must capitalize the cost of property acquired for use in the taxpayer’s trade or business – in other words, the cost must be added to the taxpayer’s basis for the property.[ii] The taxpayer may then recover its acquisition cost (its investment in the property) over time – by reducing its taxable income through annual deductions for depreciation or amortization, depending upon the property.[iii] The recovery period (i.e., the number of years) and the depreciation method (for example, accelerated or straight-line) are prescribed by the Code and by the IRS.

In general, the “net cost” incurred by a taxpayer in the acquisition of a business or investment property will be reduced when such cost may be recovered over a shorter, as opposed to a longer, period of time.

In recognition of this basic principle, and in order to encourage taxpayers to acquire certain types of property, Congress has, over the years, allowed taxpayers to recover their investment in such property more quickly by claiming an additional depreciation deduction for the tax year in which the acquired property is placed in service by the taxpayer.[iv]

Pre-TCJA

Prior to the TCJA, the Code allowed a taxpayer to claim an additional first-year depreciation deduction equal to 50% of the taxpayer’s adjusted basis for “qualified” property.[v]

Qualified property included tangible property with a recovery period of twenty years or less, the original use of which began with the taxpayer.[vi] It did not include a so-called “section 197 intangible,” such as the goodwill of a business.

TCJA

In general, for property placed in service after September 27, 2017, the TCJA increased the amount of the additional first-year depreciation deduction to 100% of the taxpayer’s adjusted basis for the qualified property.[vii]

Significantly for transactions involving the purchase and sale of a business, the TCJA also removed the requirement that the original use of the qualified property had to commence with the taxpayer.

Specifically, the additional first-year depreciation deduction became available for “used” property, provided the property was purchased in an arm’s-length transaction, it was not acquired in a nontaxable exchange (such as a corporate reorganization), and it was not acquired from certain “related” persons.

Asset Deals

It is axiomatic that the cost of acquiring a business is reduced where the purchaser can recover such cost, or investment, over a short period of time.

By eliminating the “original use” requirement, the TCJA made the additional first-year depreciation deduction available for qualifying “used” properties purchased in connection with a taxpayer’s acquisition of a business from another taxpayer.

Thus, in the acquisition of a business that is structured as a purchase of assets,[viii] where the purchaser’s basis is determined by reference to the consideration paid for such assets, a portion of the consideration that is allocated to qualifying “Class V” assets (for example, equipment and machinery) may be immediately and fully deductible by the purchaser, instead of being depreciated over each asset’s respective recovery period.

The purchaser’s ability to expense (i.e., deduct) what may be a significant portion of the consideration paid to acquire the business will make the transaction less expensive (and, perhaps, more attractive) for the purchaser by reducing its overall economic cost.

Depending on the circumstances, it may also enable the buyer to pay more for the acquisition of the business.[ix]

Beyond Asset Deals?

Although the application of the expanded first-year depreciation deduction was fairly obvious in the case of a purchase of assets in connection with the acquisition of a business, the TCJA and the related committee reports were silent as to its application in other transactional settings, including, for example, those involving the acquisition of stock that may be treated as the purchase of assets for tax purposes.

Thankfully, the proposed regulations address these situations and provide other helpful guidance as well.

Proposed Regulations

Used Property

The proposed regulations provide that the acquisition of “used”[x] property is eligible for the additional first-year depreciation deduction if the acquisition satisfies the requirements described above – it was acquired in a taxable, arm’s-length transaction – and the property was not used by the taxpayer or a predecessor at any time prior to the acquisition.

The proposed regulations provide that property is treated as used by the taxpayer or a predecessor before its acquisition of the property only if the taxpayer or the predecessor had a depreciable interest in the property at any time before the acquisition,[xi] whether or not the taxpayer or the predecessor claimed depreciation deductions for the property.[xii]

Related Persons

In determining whether a taxpayer acquired the property at issue from a related person – for example, an entity in control of, or by, the taxpayer – the proposed regulations provide that, in the case of a series of related transactions, the transfer of the property will be treated as directly transferred from the original transferor to the ultimate transferee, and the relation between the original transferor and the ultimate transferee will be tested immediately after the last transaction in the series. Thus, a sale of assets between related persons will not qualify for the additional first-year deduction.

Deemed Asset Sales by Corporations

It may be that the assets of the target corporation include assets the direct acquisition of which may be difficult to effectuate through a conventional asset deal. In that case, the buyer may have to purchase the issued and outstanding shares of the target’s stock. Without more, the buyer would only be able to recover its investment on a later sale or liquidation of the target.

In recognition of this business reality, Congress has provided special rules by which the buyer may still obtain a recoverable basis step-up for the target’s assets.

In general, provided: (i) the buyer is a corporation, (ii) the buyer acquires at least 80% of target’s stock, (iii) the target is an S-corporation, or a member of an affiliated or consolidated group of corporations, and (iv) the target’s shareholders consent (including, in the case of an S-corporation target, any non-selling shareholders), then the stock sale will be ignored, and the buyer will be treated, for tax purposes, as having acquired the target’s assets with a basis step-up equal to the amount of consideration paid by the buyer plus the amount of the target’s liabilities (a so-called “Section 338(h)(10) election”).

Where a Sec. 338(h)(10) election is not available – for example, because the buyer is not itself a corporation – the buyer may want to consider a different election (a so-called “Section 336(e) election”).

The results of a Section 336(e) election are generally the same as those of a Section 338(h)(10) election in that the target, the stock of which was acquired by the buyer, is treated as having sold its assets to the buyer, following which the target is deemed to have made a liquidating distribution to its shareholders.

This election, however, may only be made by the seller’s shareholders – it is not an election that is made jointly with the buyer (in contrast to a Section 338(h)(10) election). In the case of an S-corporation target, all of its shareholders must enter into a binding agreement to make the election, and a “Sec. 336(e) election statement” must be attached to the S-corporation’s tax return for the year of the sale.[xiii]

The proposed regulations provide that assets deemed to have been acquired as a result of either a Section 338(h)(10) election or a Section 336(e) election will be treated as having been acquired by purchase for purposes of the first-year depreciation deduction. Thus, a buyer will be able to immediately expense the entire cost of any qualifying property held by the target, while also enjoying the ability to amortize the cost of the target’s goodwill and to depreciate the cost of its non-qualifying depreciable assets.

Partnership Transactions – Cross-Purchase

In general, the purchase of an interest in a partnership has no effect on the basis of the partnership’s assets.

However, in the case of a sale or exchange of an interest in a partnership interest that has made a so-called “Section 754 election,” the electing partnership will increase the adjusted basis of partnership property by the excess of the buyer’s cost basis in the acquired partnership interest over the buyer’s share of the adjusted basis of the partnership’s property.[xiv]

This increase is an adjustment to the basis of partnership property with respect to the acquiring partner only and, therefore, is a “partner-specific” basis adjustment to partnership property.

The basis adjustment is allocated among partnership properties based upon their relative built-in gain.[xv] Where the adjustment is allocated to partnership property that is depreciable, the amount of the adjustment itself is treated as a newly purchased property that is placed in service when the purchase of the partnership interest occurs. The depreciation deductions arising from this “newly acquired” property are allocated entirely to the acquiring partner.

Unfortunately, prior to the TCJA, this basis adjustment would always fail the “original use” requirement because the partnership property to which the basis adjustment related would have been previously used by the partnership and its partners prior to the sale that gave rise to the adjustment.

However, because this basis adjustment is a partner-specific basis adjustment to partnership property, the proposed regulations under the TCJA are able to take an “aggregate view” and provide that, in determining whether a basis adjustment meets the “used property acquisition requirements” described above, each partner is treated as having owned and used the partner’s proportionate share of partnership property.

Thus, in the case of a sale of a partnership interest, the requirement that the underlying partnership property not have been used by the acquiring partner (or by a predecessor) will be satisfied if the acquiring partner has not used the portion of the partnership property to which the basis adjustment relates at any time prior to the acquisition – that is, the buyer has not used the seller’s portion of partnership property prior to the acquisition[xvi] – notwithstanding the fact that the partnership itself has previously used the property.

Similarly, for purposes of applying the requirements that the underlying partnership property not have been acquired from a related person and that the property take a cost basis, the partner acquiring a partnership interest is treated as acquiring a portion of partnership property, the partner who is transferring a partnership interest (the seller) is treated as the person from whom that portion of partnership property is acquired, and the acquiring partner’s basis in the transferred partnership interest may not be determined by reference to the transferor’s adjusted basis.

The same result will apply regardless of whether the acquiring partner is a new partner or an existing partner purchasing an additional partnership interest from another partner. Assuming that the selling partner’s specific interest in partnership property that is acquired by the acquiring partner has not previously been used by the acquiring partner or a predecessor, the corresponding basis adjustment will be eligible for the additional first-year depreciation deduction in the hands of the acquiring partner, provided all other requirements are satisfied.[xvii]

Partnership Transactions – Redemption

By contrast, a distribution of cash and/or property from a Section 754 electing partnership to a departing partner in liquidation of that partner’s interest in the partnership will be treated very differently, even where it results in an increase of the adjusted basis of partnership property.[xviii]

The amount of this increase – equal to the sum of (a) the amount of any gain recognized to the departing partner,[xix] and (b) the excess of (i) adjusted basis (in the hands of the partnership) of any property distributed to the departing partner, over (ii) the basis of the distributed property to the departing partner[xx] – is made to the basis of partnership property (i.e., non-partner-specific basis), and the partnership used the property prior to the partnership distribution giving rise to the basis adjustment.

Thus, the proposed regulations provide that these basis adjustments are not eligible for the additional first-year depreciation deduction.

Planning?

The regulations are proposed to apply to qualified property placed in service by the taxpayer during or after the taxpayer’s taxable year in which the regulations are adopted as final.

However, pending the issuance of the final regulations, a taxpayer may choose to apply the proposed regulations to qualified property acquired and placed in service after September 27, 2017.

Informed by this guidance, a taxpayer that is thinking about purchasing a business may consider the economic savings – and the true cost of the acquisition – that may be realized by structuring the transaction so as to acquire a recoverable cost basis in the assets of the business, whether through depreciation/amortization and/or through an additional first-year depreciation deduction.

Similarly, a seller that recognizes the buyer’s ability to quickly recover a portion of its investment in acquiring the seller’s business may be able to share a portion of that economic benefit in the form of an increased purchase price. Whether the seller will be successful in doing so will depend upon several factors – for example, does the buyer need the seller to make a Section 338(h)(10) election – including their relative bargaining power and their relative desire to make a deal.

As for the buyout of a partner from a Section 754 electing partnership, query whether an acquiring partner’s ability to immediately expense a portion of the basis adjustment to the partnership’s underlying qualifying assets will make a cross-purchase transaction more attractive than a liquidation of the departing partner’s interest by the partnership.

In any case, the buyer and the seller will have to remain mindful of how they allocate the purchase price for the assets as issue. Let’s just say that pigs get fat and hogs get slaughtered.


[i] Public Law 115-97.

[ii] IRC Sec. 263, 1012.

[iii] IRC Sec. 167, 168, 197.

[iv] It should be noted that this so-called “bonus” depreciation is not subject to limitations based on the taxpayer’s taxable income or investment in qualifying property. Compare IRC Sec. 179.

It should also be noted that the “recapture” rules will apply to treat as ordinary income that portion of the taxpayer’s gain from the sale of the property equal to the amount of the bonus depreciation.

[v] The property had to have been placed in service before January 1, 2020. The 50% was phased down over time, beginning in 2018.

A taxpayer’s adjusted basis for a property is a measure of the taxpayer’s unrecovered investment in the property.

In general, the taxpayer’s starting basis will be equal to the amount of consideration paid by the taxpayer to acquire the property; the “cost basis.” It is “adjusted” (reduced) over time for depreciation.

[vi] Among the other properties that qualified is any improvement to an interior portion of a building that is nonresidential real property if such improvement was placed in service after the date the building was first placed in service. However, an improvement attributable to the enlargement of a building, or to the internal structural framework of the building, did not qualify.

[vii] IRC Sec. 168(k). Provided the property is placed in service before January 1, 2023. The amount of the deduction is phased down for property placed in service thereafter.

The TCJA also extended the additional first-year depreciation deduction, from 2020 through 2026.

[viii] IRC Sec. 1060.

The asset purchase may be effected in many different forms; for example, a straight sale, a merger of the target into the buyer in exchange for cash consideration, a merger of the target into a corporate or LLC subsidiary of the buyer, the sale by the target of a wholly-owned LLC that owns the business.

[ix] An important consideration for sellers.

[x] Should we say “pre-owned” but having undergone a painstaking certification process?

[xi] If a lessee has a depreciable interest in the improvements made to leased property and subsequently the lessee acquires the leased property of which the improvements are a part, the unadjusted depreciable basis of the acquired property that is eligible for the additional first-year depreciation deduction, assuming all other requirements are met, must not include the unadjusted depreciable basis attributable to the improvements.

[xii] The IRS is considering whether a safe harbor should be provided on how many taxable years a taxpayer or a predecessor should look back to determine if the taxpayer or the predecessor previously had a depreciable interest in the property.

[xiii] In a complete digression, here is another reason that a controlling shareholder will want to have a shareholders’ agreement in place that contains a drag-along and a requirement to elect as directed.

[xiv] IRC Sec. 743. Without such an election, any taxable gain resulting from an immediate sale of such property would be allocated in part to the buyer notwithstanding that the buyer had not realized an accretion in economic value.

[xv] IRC Sec. 755.

[xvi] Query how this will be determined.

[xvii] This treatment is appropriate notwithstanding the fact that the transferee partner may have an existing interest in the underlying partnership property, because the transferee’s existing interest in the underlying partnership property is distinct from the interest being transferred.

[xviii] IRC Sec. 734.

[xix] In general, because the amount of cash distributed (or deemed to have been distributed) to the departing partner exceeds the partner’s adjusted basis for its partnership interest.

[xx] An amount equal to the adjusted basis of such partner’s interest in the partnership reduced by any money distributed in the same transaction.

Withdrawal of Proposed Regulations

Earlier this year, the President directed the Secretary of the Treasury to review all “significant tax regulations” issued on or after January 1, 2016, and to take steps to alleviate the burden of regulations that meet certain criteria.

Although not falling within the literal reach of this directive, but perhaps in keeping with its spirit, the IRS recently withdrew proposed regulations (issued in 2005) that would have required an exchange or distribution of “net value” among the parties to certain corporate reorganizations in order for the reorganizations to qualify for non-recognition (“tax-free”) treatment under the Code.

Before taxpayers breathe a sigh of relief over the withdrawal of these proposed regulations, they need to understand the IRS’s long-held position – which it sought to formalize in the proposed regulations – that a corporation has to be solvent in order for its shareholders to benefit from favorable tax treatment under the reorganization provisions of the Code.

In particular, taxpayers should note that, in announcing the withdrawal, the IRS explained that “current law” is sufficient to ensure that tax-free treatment is accorded only to those corporate reorganizations that effectuate a “readjustment” of shareholders’ continuing proprietary interests in a corporate-held business, and that it cited various authorities that generally limit reorganization treatment to solvent corporations.

The Reorganization Rules, In Brief

In general, upon a taxpayer’s exchange of property, gain must be recognized and taxed if the new property differs materially in kind from the old property, and the amount realized in the exchange exceeds the taxpayer’s adjusted basis in the property exchanged.

In the context of a corporate reorganization, there are generally two types of exchanges: (1) the exchange in which one corporation exchanges property for stock in a second corporation; and (2) the exchange in which stock in the first corporation is exchanged by its shareholders for stock in the second corporation.

The purpose of the tax-free reorganization provisions of the Code is to except these types of exchanges from the general gain recognition rule where they (i) are incident to a plan to reorganize a corporate structure in one of the particular ways specified in the Code, (ii) are undertaken for bona fide business or corporate purposes, and (iii) effect only a readjustment of the shareholders’ continuing interest in the corporation’s property under a modified corporate form.

In order to effect only a readjustment of the shareholders’ continuing interest in the corporation’s property, and to thereby secure tax-free treatment under the Code, a reorganization must satisfy a “continuity of business enterprise” requirement and a “continuity of interest” requirement.

In general, under the continuity of business enterprise test, the acquiring corporation must either continue the target corporation’s historic business or use a significant portion of the target’s historic business assets in a business.

The continuity of interest test requires that a substantial part of the value of the proprietary interests in the target corporation be preserved in the reorganization. A proprietary interest in the target corporation is preserved if it is exchanged for a proprietary interest in the acquiring corporation.

All facts and circumstances must be considered in determining whether, in substance, a proprietary interest in the target corporation is preserved. Thus, for example, a proprietary interest in the target corporation is not preserved to the extent that creditors of the target corporation that own a proprietary interest in the corporation – for example, because the target corporation’s liabilities exceed the fair market value of its assets immediately prior to the potential reorganization – receive money for their claims prior to the potential reorganization.

The policy underlying these rules is to ensure that tax-free reorganization treatment is limited to those reorganizations and exchanges that effectuate a readjustment of the shareholders’ continuing interests in property under a modified corporate form, and to prevent transactions that resemble sales from qualifying for non-recognition treatment.

The Proposed Regulations

In general, the Code provides that no gain shall be recognized if a shareholder’s stock in a target corporation is exchanged, pursuant to a plan of reorganization, “solely for stock” in the acquiring corporation. It also provides that no gain shall be recognized to the target corporation if it exchanges property, pursuant to a plan of reorganization, “solely for stock” in the acquiring corporation.

The IRS has consistently stated that the language “solely for stock” requires that there be an exchange of net value among the parties to the reorganization, meaning that both the target corporation and the acquiring corporation must be solvent.

According to the IRS, transactions that fail this requirement – that is, transfers of property that are in effect made in exchange for the assumption of liabilities or in satisfaction of liabilities, as in the case of an insolvent corporation – resemble sales and should not receive non-recognition treatment.

The proposed regulations sought to formalize this position by providing that an exchange of net value was requisite to a tax-free corporate reorganization. According to the proposed regulations, an exchange of net value requires that there be both a surrender of net value and a receipt of net value.

Whether there is a surrender of net value is determined by reference to the assets and liabilities of the target corporation. Whether there is a receipt of net value is determined by reference to the assets and liabilities of the acquiring corporation. The purpose of the “exchange of net value” requirement, the proposed regulations stated, is to prevent transactions that resemble sales (including transfers of assets in satisfaction of liabilities) from qualifying for non-recognition treatment.

Thus, in the case of an asset transfer, the fair market value of the property transferred by the target corporation to the acquiring corporation must exceed the sum of the amount of liabilities of the target corporation that are assumed by the acquiring corporation in connection with the exchange and the amount of any money and the fair market value of any other property (other than stock in the acquiring corporation) received by the target corporation in connection with the exchange. Similarly, the fair market value of the assets of the acquiring corporation must exceed the amount of its liabilities immediately after the exchange.

In the case of a stock transfer, the fair market value of the assets of the target corporation must exceed the sum of the amount of the liabilities of the target corporation immediately prior to the exchange and the amount of any money and the fair market value of any other property (other than stock of the acquiring corporation) received by the shareholders of the target corporation in connection with the exchange. The fair market value of the assets of the acquiring corporation must exceed the amount of its liabilities immediately after the exchange.

Withdrawn, But Not Useless

It is doubtful that the withdrawal of the proposed “net value” regulations signals any change in the IRS’s position. Indeed, almost all of the case law addressing the application of the continuity of interest rule to the reorganization of an insolvent corporation is consistent with the proposed regulations.

A taxpayer would be ill-advised to draw any conclusion to the contrary. After all, the IRS did not announce a change in the representations that must be made by a taxpayer in submitting a request to the IRS for a ruling with respect to a proposed reorganization. For example, a taxpayer must still represent that the fair market value of the assets of the target corporation transferred to the acquiring corporation pursuant to the plan of reorganization is at least equal to the sum of the target liabilities assumed by the acquiring corporation, plus the amount of liabilities, if any, to which the transferred assets are subject; in other words, there must be a transfer of net value.

Rather, taxpayers would be well-served to view the withdrawn proposed rules as a useful summary of the IRS’s thinking on “net value” issues, and as a guide for assessing the qualification of a proposed corporate restructuring or acquisition as a tax-free reorganization within the meaning of the Code.

Proposed RegulationsLast week, we considered (i) the context in which the recently proposed regulations under Section 2704 of the Code would eventually be applied, (ii) the principles underlying Section 2704, (iii) the valuation of an interest in a closely-held business, generally, and (iv) the failed legislative efforts to address the issues covered by the proposed regulations. Today, we turn to the proposed rules themselves.

The 2016 Proposed Regulations – In General

The preamble to the proposed regulations could have been lifted verbatim from the 2010 through 2013 Green Books. Indeed, any tax adviser would be hard-pressed to say that he had no idea what was going to be included in the proposed regulations (which is why their prospective effective date is generous).

Main Themes

There are two main themes that permeate the regulations, and they reflect the legislative intent behind Section 2704.

First, if there is a lapse of any voting or liquidation right upon the transfer of an interest in a business entity, and the individual transferor who held such right immediately before the lapse holds control of the entity – with members of his family – both before and after the lapse, such lapse will be treated as a transfer by such individual by gift, or as a transfer which is includible in his gross estate, whichever is applicable.

In other words, because the lapsed right can be restored after the transfer by the transferor and his family, the lapse must have been provided only for valuation purposes, and did not have an independent, non-tax purpose, or so the theory goes.

Second, a restriction that limits the ability of a business entity to liquidate will be disregarded in valuing the transfer of an interest in the business to a member of the transferor’s family if the transferor and members of his family control the entity before the transfer, and the restriction may be removed by them after the transfer.

This echoes the first theme: a restriction that may be toggled on and off by the transferor and his family must not be meaningful, other than for valuation purposes, or so the theory goes.

The elements shared by these themes are (i) the presence of “transferor/family control” of an entity both before and after the transfer of an interest in the entity, and (ii) the ability of the transferor and his family to restore any lapsed rights and to remove any restrictions.

The 2016 Proposed Regulations – Specific Provisions

The following discussion will focus upon what I regard as the principal “entity-planning-related” changes to the current regulations.

Single-Member LLCs

The proposal would clarify that Section 2704 applies to the transfer of an interest in a single-member LLC (and not just to corporations and partnerships, as is literally stated in the statute), even if the LLC is disregarded as an entity separate from its owner for tax purposes.

In other words, an LLC’s classification for other purposes of federal tax law is irrelevant for valuation purposes. A taxpayer’s transfer of a membership interest in his wholly-owned LLC will be treated as a transfer of an interest in a business entity – the LLC – not as a transfer of an interest in its underlying assets; and, thus, the value of such an interest will be determined in accordance with the terms of the LLC’s operating agreement, state law, and – more to the point – the regulations under Section 2704.

This proposed change is aimed at the Tax Court’s decision in Pierre, where the Court determined that valuation discounts may be applied to value the transfer an interest in an LLC that was wholly-owned by the transferor and that she had funded with liquid assets.

Three-Year Rule for “Deathbed (?) Transfers”

The proposal would address so-called “deathbed transfers” (a misnomer) that result in the lapse of a liquidation right.

You will recall the provision in the current regulations under which the transfer of an interest conferring a right is not treated as a lapse of that right if the right is not reduced or eliminated, but simply transferred to another.

For example, the transfer of a minority interest by a controlling shareholder, who thereby ceases to be a controlling shareholder, is not treated as a lapse of voting or liquidation rights as to the controlling shareholder even though it results in the transferor’s loss of control.

This kind of transfer is a staple among estate planners. It enables them to divide the ownership of a business between the taxpayer and his family (e.g., his spouse) without significant economic consequences, while positioning the taxpayer’s interest to be valued as something less than a controlling interest.

The proposed regulations are aimed at exactly this situation. They do not eliminate the exception, but narrow its application to transfers occurring more than three years before the transferor’s death. Thus, if the transferor dies within three years of the transfer, a lapse of a right covered by Section 2704 will be deemed to have occurred upon his death.

For example, in what turns out to be more than three years before his death, D transfers one-half of his X Corp. stock in equal shares to his three children. Section 2704 does not apply to the loss of D’s ability to liquidate X Corp. because the voting rights with respect to the transferred shares are not restricted or eliminated by reason of the transfer, and the transfer occurs more than three years before D’s death. However, had D died within three years of the transfers, the transfers would have been treated as the lapse of D’s liquidation right, occurring at D’s death.

This results in the creation of a phantom asset in the estate on which estate tax will have to be paid. Query how a taxpayer and the executor of his estate may pay for payment of the tax.

According to the proposal, this rule will apply to lapses occurring on or after the date the rules are finalized. Thus, they may cover transfers (and lapses) that have already occurred (before the proposals are finalized) if the transferor dies after the effective date of the regulations and not more than three years after the transfer.

I think it likely that the effective date will be amended to clarify that it covers transfers occurring after the effective date. (This was the approach taken when the subjective “in contemplation of death” provisions of Section 2035 of the Code were replaced by a similar three-year rule.)

The application of this proposed rule is bound to have some unintended consequences; a relatively young, healthy transferor who is hit by the bus while crossing the street is covered as much as a bed-ridden octogenarian who is adjusting his holdings for estate tax valuation purposes. However, the proposed bright-line test is reasonable when one considers its “actuarial underpinnings” and the universe of taxpayers whose estates it is likely to cover.

State Law Restrictions

The proposed regulations would refine the definition of “applicable restriction” by eliminating the comparison to the liquidation limitations of state law.

You will recall the provision in the current regulations that limits the definition of an applicable restriction to one that is more restrictive than the default rules under state law. Under this regulatory exception, a restriction will not be disregarded for valuation purposes if it is not more restrictive than the default rule under the applicable state law.

The proposal would remove this exception. The reasoning for the removal is consistent with the purpose of Section 2704. Any restriction that is not imposed or required by federal or state law is a restriction that the transferor and his family can remove or replace with a less restrictive one. It is an applicable restriction that will be disregarded for valuation purposes.

If an applicable restriction is disregarded, the fair market value of the transferred interest is determined under generally applicable valuation principles as if the restriction did not exist (that is, as if the governing documents and the local law were silent on the question) and, thus, there is deemed to be no such restriction on liquidation of the entity.

The proposal also clarifies that an applicable restriction does not include a restriction that is imposed or required to be imposed by law. A provision of law that applies only in the absence of a contrary provision in the governing documents, or that may be superseded with regard to a particular entity (whether by the shareholders, partners, members and/or managers of the entity or otherwise), is not a restriction that is imposed or required to be imposed by law.

Although I have no argument with this position in the case of a family-owned investment company holding marketable securities (in which liquid assets to pay a withdrawing owner are available or can be readily obtained), its application to a family-owned business or real estate entity seems unreasonable. Most closely-held operating businesses, including those that are family-owned, seek to limit the withdrawal of capital from the entity for bona fide business reasons and, so, restrict the ability of an owner to liquidate his interest in the business.

Assignees

Taxpayers have attempted to avoid the application of Section 2704 through the transfer of a partnership interest to an assignee, rather than to a partner. Again, relying on the regulatory exception for restrictions that are no more restrictive than those under state law, and the fact that an assignee is allocated partnership income, gain, loss, etc., but does not have the rights or powers of a partner, taxpayers have argued that an assignee’s inability to cause the partnership to liquidate his or her partnership interest is no greater a restriction than that imposed upon assignees under state law. Thus, taxpayers have argued that the conversion to assignee status of the transferred partnership interest is not an applicable restriction.

The proposed regulations provide that a transfer that results in the restriction or elimination of any of the rights or powers associated with the transferred interest (an assignee interest) will be treated as a lapse, within the meaning of Section 2704, the value of which will be taxable.

New Disregarded Restrictions

As indicated in the Obama administration’s Green Books, and pursuant to the authority granted under Section 2704 itself, the IRS has identified a new class of restrictions that are to be disregarded for valuation purposes.

According to the proposal, where an interest in a family-controlled entity is transferred, any restriction on an owner’s right to liquidate his interest (as opposed to liquidating the entity) will be disregarded for valuation purposes if the transferor and/or his family may remove or override the restriction.

Under the proposal, a “disregarded restriction” includes one that:

  • limits the ability of the holder to liquidate the interest, or
  • limits the liquidation proceeds to an amount that is less than a “minimum value”, or
  • defers the payment of the liquidation proceeds for more than six months, or
  • permits the payment of the liquidation proceeds in any manner other than cash or “other property” (generally excluding promissory notes).

For purposes of this rule, the “minimum value” of an interest is defined as the interest’s share of the net value of the entity on the date of liquidation or redemption. It is basically a liquidation value: the interest’s share of the proceeds remaining after the deemed sale of the entity’s assets at fair market value, and the deemed satisfaction of its liabilities.

Again, if we are considering a family investment vehicle holding marketable securities, I have no issue with the proposal. Such an entity can easily generate the liquidity needed, or distribute marketable assets, to redeem or liquidate a member’s interest in a timely manner.

What about a family-owned operating business? The IRS acknowledges the “legitimacy” of such a business. For example, a provision in an agreement that permits the payment of the liquidation proceeds by way of a promissory note will not be disregarded under the proposal if the proceeds are not attributable to passive investment assets, and the note is adequately secured, provides for periodic payments, bears a market rate of interest, and has a present value equal to the minimum value.

Even so, the IRS ignores the fact that close businesses will often require a “haircut” on the redemption price for someone’s interest, in part to dissuade owners from withdrawing, whether to prevent competition or to preserve capital for the business, or for some other valid business purpose.

It should be noted that the proposed regulations include an exception to these otherwise disregarded restrictions. Unfortunately, it requires the inclusion of certain provisions in the partnership or shareholders’ agreement that are rarely found even in a business owned by unrelated persons. Specifically, the exception applies if:

  • each owner has the right to put his interest to the business in exchange for cash and/or other property at least equal to the minimum value; and
  • the full amount of such purchase price must be received within six months after the owner has given notice of his intent to exercise his put right; and
  • such “other property” does not include a note, unless the entity is engaged in an active business and the note satisfies certain requirements.

If a restriction is disregarded, the fair market value of an interest in the entity is determined assuming that the disregarded restriction did not exist. The fair market value is determined under generally accepted valuation principles, including any appropriate discounts or premiums.

Ignoring Certain Unrelated “Owners”

In determining whether the transferor and/or the transferor’s family has the ability to remove a restriction, any interest in the entity held by a person who is not a member of the transferor’s family will be disregarded under the proposal if, at the time of the transfer, the interest:

  • has been held by such person for less than three years; or
  • constitutes less than 10 percent of the equity in the entity; or
  • when combined with the interests of all other persons who are not members of the transferor’s family, constitutes less than 20 percent of the equity in the entity; or
  • any such person, as the owner of an interest, does not have an enforceable right to receive in exchange for such interest, on no more than six months’ prior notice, the “minimum value.”

If an ownership interest is disregarded, the determination of whether the family has the ability to remove the restriction will be made assuming that the remaining interests are the sole interests in the entity.

This provision is aimed at the suspect practice of trying to avoid the application of Section 2704 through the transfer of a nominal business interest to a nonfamily member, such as a charity or an employee, to “ensure” that the family alone does not have the power to remove a restriction.

In the case of a charity, it is likely that this practice has been limited to investment entities that hold marketable securities. A charity would likely not be interested in acquiring an interest in an operating business with its potential for generating unrelated business taxable income and a limited ability to monetize its ownership interests.

What’s Next?

Two bills have been introduced in the House of Representatives this month that seek to void the proposed regulations. Neither of these will get very far.

As mentioned in an earlier post, the IRS has scheduled hearings on the proposed regulations for December 1, 2016. It is expected that many comments will be submitted by the November 2 deadline and, hopefully, considered.

Ignoring the fact that the results of the Presidential and Congressional elections may render the proposed regulations moot, my hope is that the IRS will refocus the proposals so that they are limited to family-owned investment entities, and not operating businesses.

As for investment entities, the regulations should distinguish between those that hold real estate and those that hold marketable securities and cash equivalents. Only the latter are appropriate subjects for the proposed rules.

Assuming the IRS proceeds with the hearings scheduled for December 1, and assuming it accepts some of the changes being suggested by the professional community, the regulations will likely not be finalized until at least early 2017. If the IRS rejects this commentary, the regulations may become effective on December 1.

Stay tuned.

In yesterday’s post, we considered the context in which the recently proposed regulations under Section 2704 of the Code will eventually be applied. Today, we will discuss Section 2704 and the valuation of an interest in a closely-held business. We will also review the failed legislative efforts to address the issues covered by the regulations.

Valuation Principles

Both the courts and the IRS have defined the “fair market value” of property as the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell, and both having reasonable knowledge of relevant facts.

According to the IRS, shares of stock of a closely-held corporation should be valued based upon a consideration of the factors affecting its fair market value, including the size of the block of stock to be valued. Indeed, the IRS has concluded in a public ruling that a minority interest in a closely-held corporation is more difficult to sell than a similar block of publicly-traded stock.

The IRS’s regulations echo this point, providing that the fair market value of shares of stock is to be determined by taking into consideration the degree of control of the business represented by the block of stock to be valued. Thus, a willing buyer may not pay a willing seller a proportionate share of the value of a closely-held business when purchasing a minority interest in the business.

Among other factors to be considered in the valuation of closely-held stock, the IRS has noted, is whether the stock is subject to an agreement restricting its liquidation, sale or transfer. The IRS has observed that it is always necessary to consider the relationship between the parties to the agreement, the relative number of shares held by the taxpayer, and other material facts, to determine whether the agreement represents a bona fide business arrangement or a device to pass the taxpayer’s shares to his family for less than an adequate and full consideration in money or money’s worth.

Section 2704 Is Born

The year is 1990. By that time, many courts had held that, because the fair market value of an interest in a family-held business was determined at the moment of death, the value attributable to a voting or liquidation right that lapsed under the terms of a partnership or shareholders’ agreement upon the death of an owner, could not be taken into account in valuing the interest and, thus, was not subject to estate tax.

As a result, the value for transfer tax purposes of the decedent’s equity interest in the business was determined by the courts to be less than its value either in the hands of the decedent immediately before death (i.e., before the lapse) or in the hands of his family immediately after his death (when the family could restore the “lapsed” right).

Congress moved to prevent this result and to tax the “lost” value attributable to the lapsed right, by providing, in new Section 2704 of the Code, that the lapse of a voting or liquidation right in a family-controlled entity results in a transfer by gift or an inclusion in the gross estate.

Example 1. Parent and Child control a corporation. Parent’s stock has a voting right that lapses on Parent’s death. Parent’s stock is valued for Federal estate tax purposes as if the voting right of the parent’s stock were non-lapsing.

Example 2. Father and Child each own general and limited interests in a partnership. The general partnership interest carries with it the right to liquidate the partnership; the limited partnership interest has no such right. The liquidation right associated with the general partnership interest lapses after ten years. There is a gift at the time of the lapse equal to the excess of (1) the value of Father’s partnership interests determined as if he held the right to liquidate over (2) the value of such interests determined as if he did not hold such right.

However, Congress also stated that this new rule regarding lapsing rights would not affect “minority discounts or other discounts” available under the law. In other words, the IRS’s public ruling and regulations described above, that identified the size of one’s holding in a business as a factor to consider in the valuation of such holding, would continue to apply. In other words, Congress did not seek the elimination of valuation discounts by enacting Section 2704.

In addition to the issue of lapsing rights, Congress also addressed restrictions agreed to among the owners of a family business that effectively limited the ability of the family-owned entity to liquidate. Such a restriction, it said, would be ignored in valuing a transfer among family members if (1) the transferor and family members control the business, and (2) the restriction can be removed by the transferor or members of his family, either alone or collectively.

Example 3. Mother and Son are partners in a two-person partnership. The partnership agreement provides that the partnership cannot be terminated. Mother dies and leaves her partnership interest to Daughter. As the sole partners, Daughter and Son acting together could remove the restriction on partnership termination. The value of Mother’s partnership interest in her estate is determined without regard to the restriction.

Recognizing that other situations may present similar valuation issues or potential abuses, Congress authorized the IRS to identify other restrictions that should be disregarded for valuation purposes; specifically, restrictions that reduced the value of the transferred interest for transfer tax purposes but which did not reduce the value of the interest to the transferee.

The First Set of Regulations

Shortly after its passage, in 1991 the IRS proposed regulations under Section 2704.

The IRS explained that the lapse of a voting or liquidation right was a transfer for estate and gift tax purposes only if the holder of the lapsing right and members of his family controlled the business both before and after the lapse; for example, the holder and his family can, immediately after the lapse, liquidate an interest the holder could have liquidated prior to the lapse.

Conversely, if the holder’s family cannot recover the value lost as a result of the lapse, the lapse is not of the type to which Section 2704 is directed.

The IRS explained that a lapse of a right occurs when the right is reduced or eliminated.

This last factor was important because it provided the basis for the following provision of the existing regulations: the transfer of an interest conferring a right is not treated as a lapse of that right if the right was not reduced or eliminated, but simply transferred to another.

For example, the transfer of a minority interest by a controlling shareholder, who thereby ceases to be a controlling shareholder, is not a lapse of voting or liquidation rights as to the controlling shareholder even though it results in the transferor’s loss of control; the voting right associated with the transferred interest continues to exist.

Consistent with Section 2704, the regulations provided that, in valuing a transfer of an interest in a business to a family member, certain restrictions on the ability to liquidate the business are to be disregarded if (1) the transferor’s family controls the business entity immediately before the transfer, and (2) the transferor and members of his family can remove the restriction immediately after the transfer.

Importantly – and notwithstanding the general theme of “family control” under Section 2704 (and its assumption that a family could add or remove a restriction at will) – when the regulations were finalized in 1992, the IRS provided that a restriction would not be disregarded if it was not more restrictive than the default rule under the applicable state law. The fact that the family could agree to a less restrictive provision was not relevant.

“Family Attribution”

In 1993, the year following the issuance of final regulations under Section 2704, the IRS issued a public ruling in which it held that, if a donor transfers shares in a corporation to each of the donor’s children, the factor of corporate control in the family would not be considered in valuing each transferred interest for purposes of the gift tax.

For estate and gift tax valuation purposes, the IRS stated that it would not assume that all voting power held by family members may be aggregated for purposes of determining whether the transferred shares should be valued as part of a controlling interest.

Consequently, a minority discount would not be disallowed, the IRS stated, solely because a transferred interest when aggregated with interests held by family members, would be part of a controlling interest.

It should be noted that the above ruling made no mention of then-recently enacted Section 2704 and the concept that the taxpayer’s family could, if it controlled the entity immediately after the taxpayer’s transfer of an interest in the entity, either restore the lapsed right or remove the restriction. Indeed, it seems reasonable to conclude that the IRS recognized Congress’s intent that Section 2704 did not affect otherwise available “minority discounts or other discounts.”

The Green Books: 1999 through 2001

The IRS’s 1993 ruling opened the flood-gates to the gifting of interests in family-owned business entities. Many advisers and their clients sought to leverage the opportunity for valuation discounting, not only as to family operating businesses and real estate investments but also with respect to liquid investment assets. They prepared partnership and operating agreements with restrictive provisions that literally did not run afoul of Section 2704 and its regulations, and that supported lower values for the business interests being transferred.

According to the Clinton administration’s budget proposals from 1999 through 2001:

Under current law, taxpayers making gratuitous transfers of fractional interests in entities routinely claim discounts on the valuation of such interests.

The concept of valuation discounts originated in the context of active businesses, where it has long been accepted that a willing buyer would not pay a willing seller a proportionate share of the value of the entire business when purchasing a minority interest in a non-publicly traded business.

Without legislation in this area, tax planners have carried this concept over into the family estate planning area, where a now common planning technique is to contribute marketable securities to a family limited partnership or LLC and to make gifts of minority interests in the entity to other family members. Taxpayers then claim large discounts on the valuation of these gifts.

This disappearing value is illusory because family members are not minority interest holders in any meaningful sense.

The Clinton administration’s proposal sought to eliminate valuation discounts except as they applied to active businesses.

The Green Books: 2010 through 2013

The Clinton administration failed in its efforts. The Obama administration then took a different approach to curbing what it saw as valuation abuses in family gift tax planning.

According to its budget proposals from 2010 through 2013:

Section 2704 was enacted to prevent the reduction of taxes through the use of techniques designed to reduce the value of the transferor’s taxable estate and discount the value of the taxable transfer to the beneficiaries of the transferor when the economic benefit to the beneficiaries is not reduced by these techniques.

Generally, section 2704(b) provides that certain ‘applicable restrictions’ (that would normally justify discounts in the value of the interests transferred) are to be ignored in valuing interests in family-controlled entities if those interests are transferred (either by gift or on death) to or for the benefit of other family members.

Without referring to the regulations under Section 2704, it went on to say:

Judicial decisions and the enactment of new statutes in most states have, in effect, made section 2704(b) inapplicable in many situations, specifically by re-characterizing restrictions such that they no longer fall within the definition of an ‘applicable restriction’.

In addition, the IRS has identified additional arrangements to circumvent the application of section 2704.

This proposal would create an additional category of restrictions (‘disregarded restrictions’) that would be ignored in valuing an interest in a family-controlled entity transferred to a member of the family if, after the transfer, the restriction may be removed by the transferor and/or the transferor’s family.

Specifically, the transferred interest would be valued by substituting for the disregarded restrictions certain assumptions to be specified in regulations.
Disregarded restrictions would include limitations on a holder’s right to liquidate that holder’s interest that are more restrictive than a standard to be identified in regulations.

For purposes of determining whether a restriction may be removed by members of the family after the transfer, certain interests (to be identified in regulations) held by charities or others who are not family members of the transferor would be deemed to be held by the family.

After failing to convert any of these proposals into legislation, the Obama administration ceased including them in its budget proposals from 2014 thru 2017.

However, during this period, the IRS indicated that it was working on proposed regulations under Section 2704 – the regulations that were issued last month.

In next week’s post, we will consider these proposed regulations in some detail.

“The” Proposed Regulations

They were years in the making – proposed regulations that seek to address what the IRS believes are abuses in the valuation of family-owned business and investment entities. Based upon the volume of commentary generated in response to the proposed rules, it is clear that the IRS has struck the proverbial raw nerve. It is difficult to recall the last time there was this much interest in proposed estate tax and gift tax rules. Almost every tax adviser under the sun has issued a client advisory. Many of these have been quite critical of the proposed rules. All have urged clients to act now, before the rules are finalized, or face the prospect of paying millions of dollars in transfer tax later.

By way of comparison, when the original version of these regulations was proposed in 1991, the year after the enactment of the legislation under which the regulations are being issued, the IRS received only one set of comments from the tax bar before finalizing them in 1992.

I think it’s safe to say that the IRS will be inundated with comments, questions and suggestions this time around. I daresay that, by the time the November 2, 2016 deadline for such comments arrives, the IRS may decide that it has to add an additional day of hearings to the single, currently scheduled day of December 1, 2016.

Given the importance of these proposed regulations, the amount of attention that they have garnered, and the calls-to-action from the estate tax planning bar, today’s post – which will be the first of three posts on the proposed regulations – will try to provide some historical and theoretical context for the regulations. In this case, historical perspective is important not only for purposes of understanding the regulations, but also in appreciating the “valuation options” that remain available. Tomorrow’s post will consider Section 2704 of the Code and the valuation of an interest in a closely-held business, generally. The third and final post will appear next week, and will discuss and comment on the technical aspects of the proposals, themselves.

Planning, In General

In order to better appreciate the effect of the proposed regulations, we need to first consider the traditional goal of estate tax and gift tax (“transfer tax”) planning, which has been to remove valuable, preferably appreciating, assets from a taxpayer’s hands.

In the case of interests in a family-owned business, a related goal has been to structure and/or reduce the taxpayer’s holdings in the business in such a way so as to reduce their value for purposes of the estate tax, to thereby reduce any resulting tax liability and, thus, to maximize the amount passing to the taxpayer’s family.

Over the years, many transfer techniques and vehicles have been developed to assist the taxpayer in accomplishing the goal of removing assets from his estate, though some of these vehicles/techniques have, themselves, been under attack by the IRS. In connection with the transfer of business interests, planners have used, among other things, GRATs, sales to grantor trusts, sales in exchange for private annuities, sales in exchange for self-cancelling installment notes, recapitalizations into voting and non-voting interests, and simple gifts.

Each of these techniques, standing alone, enables the taxpayer to save transfer taxes on the transfer of an interest in a family-owned entity to members of his family, even without significant valuation discounting.

However, if the interest being transferred is valued on a favorable – i.e., significantly discounted – basis, the tax-saving impact of the transfer is multiplied. The taxpayer is effectively given a “head start.”

Saving On Taxes – It’s Not Everything

Although tax savings are obviously an important considerations in any gift/estate tax plan, the assets to be transferred must be “disposable” insofar as the transferor is concerned.

No doubt, many of you have fond memories of the final days of 2012, when many believed that the transfer tax exemption amount would revert to its 2001 levels. Many taxpayers rushed to make gifts as we approached the end of that year, lest they lose their ability to make large gifts free of transfer tax. Many acted without sufficient regard for their own personal needs, or their tolerance for loss of control. All that seemed to matter was that if they didn’t act right away, they would “lose” the ability to make transfers free of gift tax.

Following the “permanent” restoration of the $5 million exemption (indexed to $5.45 million for 2016; likely to approach $5.5 million in 2017), many of these same taxpayers sought to recover the gifted properties or to rescind the gifts. Clearly, many acted only for the transfer tax benefit. Not a good move.

A Cautionary Note

As stated above, many advisers are urging taxpayers to act quickly, before the proposed regulations are finalized, or face the prospect of enormous tax bills. To this I respond: remember 2012. In other words, does the gifting being considered make sense from a personal and business perspective? If not, then stop right there.

Next, I say, keep in mind the increased (and indexed) exemption amount, not to mention the portability of the exemption amount between spouses, which may allow a taxpayer to hold onto property until his demise.

Closely connected to this is the basis step-up, to fair market value, for property that a taxpayer owns at his date of death, and the ability afforded by the step-up to avoid or reduce future income taxes, capital gains taxes, and the surtax on net investment income.

Many individuals who have already implemented a gift program should also keep in mind that reduced valuation discounts may actually benefit them. For example, a GRAT that is forced to distribute interests in a closely-held business may have to distribute fewer equity units of the business to satisfy the trust’s annuity obligation if the units are valued at a greater amount than would result with the application of large discounts.

The Top Tier

Of course, in the case of more affluent taxpayers, gift tax planning retains its luster. For these folks, the proposed regulations, if finalized in their present form, may present a significant challenge.

For those very affluent individuals who have deferred their gift tax planning, it may be advisable to act now, before the regulations are finalized. The goal in acting now will be to secure larger valuation discounts, and lower transfer tax values, for the closely-held business interests to be transferred.

Even as to these taxpayers, however, caution should be exercised. They have been forewarned that the IRS does not have a favorable view of the items identified in the proposed regulations. In fact, many taxpayers have already experienced the IRS’s suspicion of these items; for the most part, the proposed regulations do not introduce new concepts – rather, they embody the IRS’s historical audit and litigation positions. Thus, these taxpayers (and their advisers) can expect a serious challenge by the IRS, and should be prepared for it.

Prospects for Change Before Going Final?

Many advisers believe that the IRS has exceeded its authority in issuing these regulations. They believe that the courts will strike down the proposed rules if finalized in their current form. That may be, but I would not bet on it, nor would I plan for it; if the courts speak at all, it will likely be years from now – the IRS and death wait for no one.

Moreover, I disagree with this assessment of the IRS’s authority. The 1990 enabling legislation granted the IRS significant authority to interpret the statute and to issue regulations. That being said, my guess is that the IRS will be responsive to some of the comments from the tax bar, which may include some tweaking of the effective date for one provision of the proposed rules.

As regards all other items covered by the proposed regulations, the clock is in fact running. The good thing is that the proposed regulations will be effective prospectively only. Of course, we don’t know when they will go final – December 1, 2016 (the scheduled hearing date) is a possibility, as is early 2017. Of course, we also have to await the outcome of the presidential election in November.

Tomorrow’s Post

Before we turn to the proposed regulations, tomorrow’s post will briefly describe some of the factors that are typically considered by the IRS in determining the value of an interest in a closely-held business, including the rules under Section 2704 of the Code.