Coming to America

Whether they are acquiring an interest in U.S. real property or in a U.S. operating company, foreigners seek to structure their U.S. investments in a tax-efficient manner, so as to reduce their U.S. income tax liability with respect to both the current profits generated by the investment and the gain realized on the disposition of the investment, thereby increasing the return on their investment.

A recent decision by the U.S. Tax Court may mark a significant development in the taxation of the gain realized by a foreigner on the sale of its interest in a U.S. partnership.

Investment in Partnership

Taxpayer was a privately-owned foreign corporation that owned a minority membership interest in LLC, a U.S. limited liability company that was treated as a partnership for U.S. income tax purposes. Taxpayer had no office, employees, or business operation in the U.S.

Redemption

In 2008, LLC agreed to redeem Taxpayer’s membership interest; as a matter of state law, the redemption was to be effective as of December 31, 2008. LLC made two payments to Taxpayer – the first in 2008 and the second in 2009. Taxpayer realized gain on the redemption of its interest.

Tax returns

With its 2008 Form 1065, “U.S. Return of Partnership Income,” LLC included a Schedule K-1 for Taxpayer that reported Taxpayer’s share of LLC’s income, gain, loss, and deductions for 2008. Consistent with that Schedule K-1, Taxpayer filed a Form 1120-F, “U.S. Income Tax Return of a Foreign Corporation,” for 2008, on which it reported its distributive share of LLC’s income, gain, loss, and deductions. However, LLC did not report on that 2008 return any of the gain it had realized that year on the redemption of its interest in LLC.

With its 2009 Form 1065, LLC included a Schedule K-1 for Taxpayer that – consistent with the agreement between Taxpayer and LLC that the redemption of Taxpayer’s entire membership interest was effective as of December 31, 2008 – did not allocate to Taxpayer any income, gain, loss, or deductions for 2009. As in 2008, Taxpayer took the position that the gain realized was not subject to U.S. tax; thus, Taxpayer did not file a U.S. tax return for 2009.

IRS Audit

The IRS audited Taxpayer’s 2008 and 2009 tax years, and determined that Taxpayer should have recognized U.S.-source capital gain for those years from the redemption of its interest in LLC. This determination was based upon the IRS’s conclusion that, as a result of Taxpayer’s membership interest in LLC, its capital gain was effectively connected with a U.S. trade or business (“USTB”).

Taxpayer petitioned the U.S. Tax Court, where the issue for decision was whether the gain from the redemption of Taxpayer’s interest in LLC was U.S.-source income that was effectively connected with a USTB and, therefore, subject to U.S. taxation.

U.S. Taxation of Foreigners

Before reviewing the Court’s opinion, a brief description of how the U.S. taxes foreigners may be in order.

The income of a foreign corporation may be subject to U.S. income tax if: (1) the income is received from sources within the U.S. (“U.S.-source income”), and it is one of several kinds of income enumerated by the Code (including, for example, dividends, interest, and other “fixed or determinable annual or periodic” (“FDAP”) income); or (2) the income is “effectively connected with the conduct of” a trade or business conducted by the foreign corporation within the U.S. (“effectively connected income”).

In general, the gross amount of a foreigner’s FDAP income is subject to U.S. income tax (and withholding) at a flat 30% rate; no deductions are allowed in determining the tax base to which this rate is applied.

With some exceptions, the Code does not explicitly address the taxation of the capital gain realized by a foreigner on the sale of an equity interest in a U.S. business entity; rather, it is by virtue of addressing these exceptions that the general rule – that capital gain is not subject to U.S. tax – arises. Thus, the gain realized by a foreigner from the sale of a capital asset that is sourced in the U.S. is not subject to U.S. tax unless the asset is related to the foreigner’s USTB or the asset is “an interest in U.S. real property,” the sale of which is treated as effectively connected with a USTB.

In contrast to FDAP income, the foreigner is allowed to deduct the expenses incurred in generating its effectively connected income, and that net income is taxed at graduated rates.

Whether a foreigner is engaged in a USTB depends upon the nature and extent of the foreigner’s activities within the U.S. Generally speaking, the foreigner’s U.S. business activities must be “regular, substantial and continuous” in order for the foreigner to be treated as engaged in a USTB. In determining whether a foreigner’s U.S. activities rise to the level of a trade or business, all of the facts and circumstances need to be considered, including whether the foreigner has an office or other place of business in the U.S.

However, a special rule applies in the case of a foreigner that is a partner in a partnership that is, itself, engaged in a USTB; specifically, the foreigner shall be treated as being engaged in a USTB if the partnership of which such foreigner is a member is so engaged.

In that case, provided it is effectively connected with the conduct of a USTB, the foreigner partner must include its distributive share of the partnership’s taxable income in determining its own U.S. income tax liability.

Generally speaking, all income, gain, or loss from sources within the U.S., other than FDAP income, is treated as effectively connected with the conduct of a USTB.

Points of Agreement

Taxpayer conceded that it was engaged in a USTB by virtue of its membership interest in LLC. In fact, Taxpayer reported on Form 1120-F, and paid U.S. income tax on, its distributive share of LLC’s operating income for every tax year that it was a member of LLC, including the year in which its membership interest was redeemed.

In addition, both Taxpayer and the IRS agreed that no part of the redemption payments made to Taxpayer should be treated as a distributive share of partnership income.

The IRS also agreed with the Taxpayer that the payment made by LLC in redemption of Taxpayer’s membership interest should be treated as having been made in exchange for Taxpayer’s interest in LLC’s property. As such, the Taxpayer would recognize gain as a result of the redemption only to the extent that the amount of money distributed exceeded Taxpayer’s adjusted basis for its interest in LLC immediately before the distribution. This gain would be considered as gain from the sale or exchange of the Taxpayer’s membership interest.

Major Disagreement

In general, the gain realized on the sale of a partnership interest is treated as gain from the sale or exchange of “a capital asset.” According to Taxpayer, because the gain realized on the redemption of its membership interest was equivalent to the sale of a capital asset that was not used by Taxpayer in a USTB, it could not be subject to U.S. tax.

The IRS, however, viewed the issue differently. According to the IRS, Taxpayer’s gain did not arise from the sale of a single, indivisible asset – Taxpayer’s interest in LLC – but rather from the sale of Taxpayer’s interest in the assets that made up LLC’s business, in which Taxpayer was treated as having been engaged.

Aggregate vs. Entity

The IRS argued that the Court should employ the so-called “aggregate theory,” under which a partner’s sale of a partnership interest would be treated as the sale by the partner of its separate interest in each asset owned by the partnership.

The Court, however, rejected the IRS’s argument. It noted that the Code generally applies the “entity theory” to sales and liquidating distributions of partnership interests – it treats the sale of a partnership interest as the sale of “a capital asset” – i.e., one asset (a partnership interest) – rather than as the sale of an interest in the multiple underlying assets of the partnership.

The Court then pointed out that the Code explicitly carves out certain exceptions to this general rule that, when applicable, require that one look through the partnership to the underlying assets and deem the sale of the partnership interest as the sale of separate interests in each asset owned by the partnership; for example, where the partnership holds “hot assets,” or where it holds substantial interests in U.S. real property, in which case an aggregate approach is employed in determining the tax consequences of a sale.

Accordingly, the Court determined that Taxpayer’s gain from the redemption of its membership interest was gain from the sale or exchange of an indivisible capital asset: Taxpayer’s interest in LLC.

Effectively Connected?

The Court then considered whether the gain realized on the redemption was taxable in the U.S., which depended upon whether that gain was effectively connected with the conduct of a USTB — specifically, whether that gain was effectively connected with the trade or business of LLC, which trade or business was attributed to Taxpayer by virtue of its being a member of LLC.

The IRS argued that the gain was “effectively connected,” pointing to one of its own published rulings, in which it held that the gain realized by a foreigner upon the disposition of a U.S. partnership interest should be analyzed asset by asset, and that, to the extent the assets of the partnership would give rise to effectively connected income if sold by the entity, the departing partner’s pro rata share of such gain should be treated as effectively connected income.

The Court, however, did not find the ruling persuasive, and declined to follow it. Instead, the Court undertook its own analysis of the issue.

It considered whether the gain from the sale of the membership interest was U.S.-source. Unfortunately, the Code does not specifically address the source of a foreigner’s income from the sale or liquidation of its interest in a partnership.

However, under a default rule for sourcing gain realized on the sale of personal property (such as a partnership interest), gain from the sale of personal property by a foreigner is generally sourced outside the U.S. In accordance with this rule, the gain from Taxpayer’s sale of its LLC interest would be sourced outside the U.S.

The IRS countered, however, that this gain fell under an exception to the default rule: the “U.S. office rule.” Under this exception, if a foreigner maintains a fixed place of business in the U.S., any income from the sale of personal property attributable to such “fixed place of business” is treated as U.S.-source.

Taxpayer’s gain would be taxable under this exception, the Court stated, if it was attributable to LLC’s office, which the Court assumed – solely for purposes of its analysis – would be deemed to have been Taxpayer’s U.S. office.

In order for gain from a sale to be “attributable to” a U.S. office or fixed place of business, the U.S. office must have been a “material factor in the production” of the gain, and the U.S. office must have “regularly” carried on – i.e., “in the ordinary course of business” – activities of the type from which such gain was derived.

The IRS contended: that the redemption of Taxpayer’s interest in LLC was equivalent to LLC’s selling its underlying assets and distributing to each member its pro rata share of the proceeds; that LLC’s office was material to the deemed sale of Taxpayer’s portion of LLC’s assets; and that LLC’s office was material to the increased value of LLC’s underlying assets that Taxpayer realized in the redemption.

The Court responded that the actual “sale” that occurred here was Taxpayer’s redemption of its partnership interest, not a sale of LLC’s underlying assets. In order for LLC’s U.S. office to be a “material factor,” that office must have been material to the redemption transaction and to the gain realized.

The Court noted that Taxpayer’s redemption gain was not realized from LLC’s trade or business, that is, from activities at the partnership level; rather, Taxpayer realized gain at the partner-member level from the distinct sale of its membership interest. Increasing the value of LLC’s business as a going concern, it explained, is a distinct function from being a material factor in the realization of income in a specific transaction. Moreover, the redemption of Taxpayer’s interest was a one-time, extraordinary event, and was not undertaken in the ordinary course of LLC’s business – LLC was not in the business of buying and selling membership interests.

Therefore, Taxpayer’s gain from the redemption of its interest in LLC was not realized in the ordinary course of the trade or business carried on through LLC’s U.S. office, it was not attributable to a U.S. fixed place of business and, therefore, it was not U.S.-source.

Consequently, the gain was not taxable as effectively connected income.

It Isn’t Over ‘til the Weight-Challenged Person Sings

The Tax Court’s decision represents a victory for foreigners who invest in U.S. businesses through a pass-through entity such as a partnership or limited liability company – how significant a victory remains to be seen.

First, the IRS has ninety days after the Court’s decision is entered in which to file an appeal to a U.S. Court of Appeals. Query whether that Court would be more deferential to the IRS’s published ruling, describe above.

Second – don’t laugh – Congress may act to overturn the Tax Court’s decision by legislation. “Why?” you may ask. Foreigners who rely upon the decision will not report the gain from the sale of a partnership interest. If the partnership has in effect an election under section 754 of the Code, the partnership’s basis in its assets will be increased as a result of the sale (as opposed to the liquidation/redemption) of the foreigner’s partnership interest. This will prevent that underlying gain from being taxed to any partner in the future.

Third, the decision did not address how it would apply to “hot assets” — for example, depreciation recapture. As noted above, the Code normally looks through the sale of a partnership interest to determine whether any of the underlying assets are hot assets. Where the foreign partner has enjoyed the benefit of depreciation deductions from the operation of the partnership’s USTB – thereby reducing the foreigner’s effectively connected income – shouldn’t that benefit be captured upon the later sale of the foreigner’s partnership interest?

Finally, there is a practical issue: how many foreigners will invest through a pass-through entity rather than through a U.S. corporation? Although a corporate subsidiary will be taxable, its dividend distributions to the foreign parent will be treated as FDAP and may be subject to a reduced rate of U.S. tax under a treaty. The foreigner’s gain on the liquidation of the subsidiary will not be subject to U.S. tax. Moreover, the foreigner will not have to file U.S. returns.

Stay tuned. In the meantime, if a foreigner has paid U.S. tax in connection with the redemption of a partnership interest – on the basis of the IRS ruling rejected by the Tax Court – it may be a good idea to file a protective refund claim.

Catching up? Start with Part I here.

Sale of USRP – FIRPTA

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

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

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

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

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

FIRPTA – Withholding

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

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

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

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

Withholding as to Corporate Distributions

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

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

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

U.S. Real Property

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

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

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

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

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

Election to be treated as a USRPHC 

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

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

Exceptions to FIRPTA

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

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

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

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

Varieties of Dispositions

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

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

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

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

What’s Next

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

In today’s cautionary tale, we hear about a doctor, his self-directed simplified employee pension (“SEP”) individual retirement account (“IRA”), the investment of IRA funds in a business, and the consequences of crossing over the perilous line between “direction” and “control.”

The Facts

Dr. V., an anesthesiologist, ran a medical practice with three partners (the “Practice”). Prior to the time of this case, the Practice had adopted a self-directed SEP plan arrangement with Investment Firm, through which the Practice made deductible contributions to the Plan, and the contributions were then placed in self-directed IRAs set up for each partner through the SEP plan arrangement.  Investment Firm was the custodian of Dr. V.’s SEP-IRA. shutterstock_104120462

Historically, Dr. V. had instructed Investment Firm to invest the contents of his SEP-IRA in mutual funds and stocks. In 2011, however, upon hearing of an investment opportunity from a friend, Dr. V. decided to try a more adventurous vehicle for the contents of his SEP-IRA.

Dr. V.’s friend, Mr. C., was involved in a publicly-traded company, PubCo. PubCo was looking to raise capital in the short-term, as it expected to receive funding from a large company in the near future.  Trusting his friend’s business sense and descriptions of X’s potential, Dr. V. agreed to loan X $125,000 from his SEP-IRA, and a contract memorializing the same was prepared (the “Agreement”).

The Agreement

The Agreement, titled “Corporate Loan Agreement/Promissory Note,” was between “PubCo or Mr. C.” as the borrower, and “Dr. V., SEP-IRA” as the lender. It specified that it was for $125,000, but not how that sum would be advanced.  It did, however, provide specific details about the maturity date, interest payments, and late fees.  Significantly, as it turned out, the Agreement provided that the borrower would repay the loan to “Dr. V.” at his personal residence, and Dr. V. and Mr. C. each signed the Agreement in their respective personal capacities.  Dr. C. later testified that the Agreement was worded as such because he wanted Dr. V. to know that the funds were specifically for PubCo expenses, but that he, Mr. C., would be responsible for repayment.

Transfer of Funds

Dr. V. then signed a form titled “Retirement Distribution or Internal Transfer” requesting that Investment Firm distribute $125,000 from his SEP-IRA to his joint account with his wife at Investment Firm; wired that amount from the joint account to his personal account at Bank; and then wired the same amount from Bank to an account titled “Mr. C.” at a different bank.

Reporting the Distribution

Using the same accounting firm, M&M, that they had for over twenty years, Dr. V. and his wife (together, the “Taxpayers”) filed a joint Form 1040 for 2011. Dr. V. explained to the return preparer what had happened with the distribution from his SEP-IRA, and documentation reporting the sequence of events leading up to the loan.  On the advice of the M&M accountant, Dr. V. and his wife reported that they had received $125,000 in pensions and annuities, but characterized it as a nontaxable rollover.  They included with their return a copy of the Agreement, as well as a letter from M&M stating that the return preparer believed that the funds were directly rolled over from the SEP-IRA to either PubCo’s account or Mr. C.’s account.

Notice of Deficiency

Following examination of the return, the Commissioner issued a notice of deficiency determining a $52,682 deficiency in income tax, and determining an additional tax under section 72(t) of the Code and an accuracy-related penalty for a substantial understatement of income tax. The Taxpayers petitioned for a redetermination of the deficiency.

The Arguments

The Taxpayers argued that they did not receive a distribution from the SEP-IRA because the various transfers should be stepped together and treated as an investment by the SEP-IRA in PubCo. Alternatively, they contended that the withdrawal was a non-taxable rollover.

The Commissioner argued that the loan was a taxable distribution used to finance a loan from Dr. V. to Mr. C.

The Tax Court Weighs In

Under section 408(d)(1), any amount paid or distributed out of an IRA must be included in the gross income of the payee or distribute as provided in section 72. The Taxpayers argued that Dr. V. did not have a claim of right to the $125,000 withdrawn from the SEP-IRA because he was acting as a mere conduit in transmitting the funds to Mr. C.

Claim of Right

The Court stated that a taxpayer has a claim of right to income if the taxpayer:

  1. Receives the income;
  2. Controls the use and disposition of the income; and
  3. Asserts either a “claim or right” or entitlement to that income.

The Court found that Dr. V. met these requirements, as he had “unfettered control over the funds” at all times.

The Court rejected the Taxpayers’ reliance on two previous cases in which the Court had found taxpayers to be a “custodians” of funds coming out of their self-directed IRAs for various investments. In both of those cases, the taxpayers at issue were never the payees of the funds to be invested.  Rather, they merely assisted in having the funds transferred.  In the case at issue, the Court pointed out, at no time was the note held by Dr. V.’s IRA, and at all times it was payable to Dr. V. personally.

Rollover

Section 408(d)(3) of the Code provides an exception to the general rule that any amount paid or distributed out of an IRA must be included in gross income. It provides that the taxpayer does not have to include such an amount if the entire amount that he or she receives is paid into an IRA or other eligible retirement plan within 60 days of the distribution.

The Taxpayers argued that if the amount at issue was a distribution, it was reinvested in the SEP-IRA within the prescribed 60-day period. In this argument, the Taxpayer essentially asked the Court to disregard the various agreements executed in connection with the transaction, and to find that the distribution was made directly to Mr. C.

The Court also rejected this argument, applying a “strong proof” for the case when taxpayers attempt to disregard the form of their own transactions. The Court found that the substance of what had occurred was entirely consistent with the form.

Conclusion

Self-directed IRAs provide taxpayers with a great deal of freedom in choosing how their retirement funds are invested. Thus a taxpayer may, subject to certain limitations, direct that the IRA funds be invested in a business venture.  It is critical, however, that a taxpayer know where his or her personal involvement must cease.  As Dr. V. learned the hard way, sometimes (and, in the case of handling IRA funds, all the time), it is not enough for one’s transactions to have a permissible objective; that objective must also be reached through a permissible route, with no extra “assistance” to affect its path.

“One Day, Lad, All This Will Be Yours.”

Many a closely-held business was created before its founder became a parent or when the founder’s children were still very young. As the business grew, and as the founder’s children matured, the founder may have entertained the notion of eventually having her children take over the business. In some cases, after finishing school, one or more of the children may have decided to join the business, to the delight of the founder.

From that point on, however, the children and the founder become engaged in a very delicate dance, of which they may not be fully cognizant. One child may be more capable than another; the founder may favor one child over the other. Depending upon the personalities involved, this situation can get ugly, and will sometimes raise unexpected tax issues, as was illustrated in a recent decision of the Tax Court.

 The Business

Father started the Business and, years later, his younger son (Number Two) joined him, followed later by Father’s elder son (Number One). The Business grew to cover many locations, each operated out of a separate corporation. Father, Number One and Number Two eventually came to own various percentages of these various corporations, with Father’s aggregate share being the largest.

In order to consolidate their interests in a single entity, Holding Co was incorporated with Father and his two sons as the original directors and officers.

Upon the incorporation of Holding Co, Father, Number One and Number Two each contributed to it their stock in the pre-existing corporations, in exchange for which each of them received100 shares of voting common stock. This was in keeping with Father’s decision to divide the shares evenly. The stock certificates indicated that they were each registered owners of 100 unrestricted shares of Holding Co common stock.

As it turned out, “[t]he decisions taken at [Holding Co’s] organizational meeting contained the seeds of the problem that would blossom into the tax dispute now before us.” Although Father, Number One and Number Two were each registered owners of 33.33% of Holding Co stock, the values of their capital contributions to Holding Co were disproportionate to their shareholdings, with Father making a disproportionately larger contribution.

The Dispute

As Holding Co continued to prosper, Father gave Number One more public and “glamorous” jobs, while Number Two had principal responsibility for operational and back-office functions. At the same time, Father and Number Two had a falling out as a result of certain non-Business related matters.

Number Two began to feel marginalized within the family business. He became dissatisfied with his role at Holding Co, with certain business decisions that Father and Number One had made, and with what he regarded as a lack of respect for his views. He began to discuss, in general terms, the possibility that he might leave the Business. This possibility became more concrete when Number One, without first discussing the matter with Number Two, hired Outsider to take over part of Number Two’s responsibilities in Holding Co. When Number Two learned of this, he quit the Business.

Upon leaving, Number Two demanded, but did not receive, possession of the 100 shares of stock registered in his name. He took the position that he was legally entitled to, and had an unrestricted right to sell, the shares registered in his name. He threatened to sell the shares to an outsider if Holding Co did not redeem them at an appropriate price.

Vintage Stock Certificate

Number Two’s threat to sell his shares to an outsider irked Father and Number One because they wished to keep control of the Business within the family. Father refused to give Number Two his stock certificates, contending that Holding Co had a right of first refusal to repurchase the shares. Father and his attorneys also developed an argument that a portion of Number Two’s stock, though registered in his name, had actually been held since Holding Co’s inception in an “oral trust” for the benefit of Number Two’s children.

This argument was built on the fact that Father had contributed a disproportionately larger portion of Holding Co’s capital yet had received only 33.33% of its stock. In effect, he contended that he had gratuitously accorded Number Two more stock than he was entitled to, and that, to effectuate Father’s intent, the “extra” shares should be regarded as being held in trust for Number Two’s children.

The parties negotiated for six months in search of a resolution. They explored, without success, various options whereby Number Two would remain in the business as an employee or consultant. Number Two offered to sell his 100 shares back to Holding Co, and the parties explored various pricing scenarios under which this might occur. As the family patriarch, however, Father had most of the leverage, and he insisted that Number Two acknowledge the existence of an oral trust for the benefit of Number Two ‘s children. Father’s insistence on an oral trust was a “line in the sand.”

Upon reaching an impasse, Number Two filed lawsuits against Father, Number One and Holding Co. The actions alleged that Number Two owned 100 shares of voting common stock, that these shares were “unencumbered and unrestricted as to their transferability,” and that the 100 shares should be delivered immediately to Number Two. Father answered that he had possession of all the stock registered in Number Two’s name and that a portion of the shares so registered were “held in trust for the benefit of * * * [Number Two’s] children.”

The Settlement

This litigation became nasty, and its public nature was extremely distressing to the family. In the course of negotiations, it became apparent to Number Two’s attorney that Number Two had to separate completely from Holding Co and that Father would not be placated unless Number Two acknowledged the supposed “oral trust” and placed some of the disputed shares in trust for his children.

Number Two firmly believed he was entitled to all 100 shares of Holding Co stock that were originally registered in his name, and that he had never held any shares under an oral trust for his children. He believed that he was being forced to renounce his ownership interest in the 33 1/3 shares and to acknowledge the existence of an oral trust in order to placate Father and obtain payment for the remaining 66 2/3 shares. However, he accepted his attorney’s advice that it was in his best interest to compromise and settle the litigation.

The parties ultimately reached a settlement along these lines. The parties agreed that Holding Co would purchase from Number Two the 66 2/3 shares of stock that he was deemed to own. They further agreed that his “2/3 stock interest was to be valued at Five Million Dollars for purposes of a settlement agreement” (Settlement Agreement). Number Two transferred these shares to Holding Co in exchange for $5 million.

The Settlement Agreement required Number Two to execute irrevocable declarations of trust for the benefit of his children, with Number One named as the sole trustee of each trust. Number Two assigned 33 1/3 shares of Holding Co stock to these trusts.

Finally, the Settlement Agreement required the parties to execute mutual releases respecting claims concerning Number Two’s ownership interests in Holding Co, and Number Two resigned from all positions he had held in the Business.

The IRS Gets Involved . . .

Number Two did not file a Federal gift tax return for the year of the Settlement Agreement. He did not believe that the Holding Co shares he transferred to the trusts constituted a taxable gift.

Almost thirty – yes, thirty – years later, as a result of some unrelated litigation, Number Two’s transfer of the Holding Co stock came to the attention of the IRS and, after an examination (and shortly after Number Two’s death), the IRS issued a timely notice of deficiency to Number Two’s estate asserting a deficiency of almost $740,000 in Federal gift tax.  The estate filed a petition with the Tax Court.  Tomorrow’s post will review the Court’s decision.

We frequently hear about the many wealthy foreigners who acquire investment interests in New York real property, and the complex tax considerations relating to such investments. Yet, we sometimes forget that there are many US persons outside of NY (New Jersey is still part of the US, right? Oh well) who are drawn to an investment in NY real property for the very same reasons. nyc-lr_0_0

Every now and then, however, NY’s Department of Taxation (the “Tax Department”) reminds us that the tax rules applicable to such an investment by a US person who is not a NY resident can be just as daunting.

A recent advisory opinion illustrated the application of these tax rules. Taxpayer owned stock in an S corporation operating in NY. The S corporation owned NY real estate, and derived 69% of its income from an active parking operation and 31% from real estate rentals. The company had been in business for over twenty years and had no plans to liquidate. In 2012, Taxpayer, who had been a resident of another State (not NJ) and had never been active in the business, sold her entire 33% interest in the S corporation back to the corporation pursuant to a stock redemption plan and received an interest-bearing installment note from the corporation as part of the purchase price for the stock sale.

Taxpayer asked the Tax Department whether the gain from the stock redemption and the interest income on the installment note payments were subject to NY personal income tax.

Disposing of Intangible Property: An Interest in NY Real Property

In general, a non-NY resident is subject to NY personal income tax on his or her NY source income that enters into his or her federal adjusted gross income.

NY source income is defined as the sum of income, gain, loss, and deduction derived from or connected with NY sources. For example, where a non-NY resident sells real property or tangible personal property located in NY, the gain from the sale is taxable in NY.

Under NY tax law (the “Tax Law”), income derived from intangible personal property, including interest and gains from the disposition of such property, constitute income derived from NY sources only to the extent that the property is employed in a business, trade, profession, or occupation carried on in NY.

From 1992 until 2009, this analysis also applied to the gain from the disposition of interests in entities that owned NY real property.

However, in 2009, the Taw Law was amended to provide that items of gain derived from or connected with NY sources include items attributable to the ownership of any interest in NY real property.

For purposes of this rule, the term “real property located in” NY was defined to include an interest in a partnership, LLC, S corporation, or non-publicly traded C corporation with one hundred or fewer shareholders that owns real property located in NY and has a fair market value (“FMV”) that equals or exceeds 50% of all the assets of the entity on the date of the sale of the taxpayer’s interest in the entity.

Only those assets that the entity owned for at least two years before the date of the sale of the taxpayer’s interest in the entity are used in determining the FMV of all the assets of the entity on the sale date.

The gain or loss derived from NY sources from a nonresident’s sale of an interest in an entity that is subject to this rule is the total gain or loss for federal income tax purposes from that sale multiplied by a fraction, the numerator of which is the fair market value of the real property located in NY on the date of the sale and the denominator of which is the FMV of all the assets of the entity on such date.

For most non-NY residents, the rule before the 2009 amendment would have yielded the preferred tax result. Nonresidents who owned interests in partnerships, for example, and that had gains on the sale thereof could, in many cases, sell their partnership interests without triggering NY income tax.

The Department’s Opinion

The Tax Department determined that, if the valuation conditions in the Tax Law were satisfied, a portion of the gain on the redemption of Taxpayer’s stock in the S corporation, reflected in the principal payments on the installment note, would be NY source income subject to NY personal income tax. The portion of the gain that constituted NY source income would be determined by multiplying the amount of the gain by a fraction, the numerator of which was the FMV of the NY real property on the date of the redemption sale and the denominator of which was the FMV of all of the corporation’s assets (owned for at least two years) on the date of the redemption sale. To the extent that this gain was payable to Taxpayer under an installment payment agreement (the note), a portion of each installment payment would be taxed as NY source income when it was received (thereby deferring the tax liability). As to the interest paid on the note, the Tax Department concluded that the note, and not the corporation’s real property, was the income-producing property. Because the note was intangible personal property, and the interest received by Taxpayer was not income attributable to property employed in a business or trade carried on in NY, the interest was not subject to NY personal income tax.

What’s A Nonresident Seller To Do?

As in any sale transaction, a price must be established for a taxpayer’s interest in an entity. This may entail negotiations between the buyer and seller. In each case, it will behoove the seller to understand and to try to quantify the costs (including taxes) of the sale in advance of any discussions. This will enable the seller to settle on the appropriate sales price: one that will yield the desired after-tax economic result.

In the case of a non-NY resident with an interest in an entity that owns at least some NY real property, the taxpayer will need to determine whether the entity meets the 50% threshold described above. In some cases, depending upon the entity’s business or investment purpose, not to mention the level of authority possessed by the non-NY resident, it may be possible to periodically adjust the entity’s investment holdings – being mindful of the two-year “anti-stuffing rule” – so as to fall short of the threshold. Of course, any such adjustments must make sense from a business or investment perspective.

Where the nonresident has little control over the entity, it may be possible to “time” the sale of his or her interest, taking advantage of a drop in real estate values or of an increase in the value of other assets held by the entity (for example, securities). However, this option may be impractical in cases where, for example, a shareholders or operating agreement restricts the sale of interests in the entity.

The important point is to recognize at the inception of one’s investment in an entity that there may be an issue on a subsequent disposition of the investment, to try to account for the ultimate tax cost when pricing the acquisition of the investment and/or its later sale, and to try to secure the periodic valuation of the entity’s underlying assets so as to facilitate any decision as to a disposition, and to support one’s reporting position in the event of a sale.

No, this post is not “Part II” to last week’s piece on the tax consequences of a stock redemption. That being said, it describes an interesting redemption-related ruling that was recently issued by the IRS. The ruling considered a redemption plan proposed to be adopted by a closely-held business. The context for the plan is one that is very common.

Corp was an S corporation. As such, it had only one class of stock outstanding, with all of its shares having identical voting, distribution and liquidation rights. Corp’s stock was owned equally between Shareholder A and A’s family and Shareholder B and B’s family. stock

Corp amended its articles of incorporation in order to create non-voting common stock.

It then declared and issued a dividend of “X” number of shares of non-voting common stock per each share of Corp’s outstanding voting common stock.

Corp next proposed to adopt a stock redemption plan (“Redemption Plan”). The Redemption Plan was voluntary, meaning that a shareholder could, at his or her discretion, decide to offer his or her shares to Corp for redemption on an annual basis. The amount that could be redeemed, however, was capped at a specific cash limit.

Although not stated in the ruling, the purpose for the arrangement was to offer shareholders an opportunity to monetize their non-marketable, closely-held shares (by creating a “market” for them), while at the same time not putting the business in a cash crunch.

The Redemption Plan provided that any shareholder who desired to have his or her Corp stock redeemed had to have his or her non-voting and voting shares redeemed in the ratio of “Y” (non-voting) to “Z” (voting), unless Corp’s board of directors, in its discretion, approved the stock redemption in a different ratio.

This redemption ratio was intended to ensure that the voting power and economic ownership in Corp remained approximately equal between Shareholder A and A’s family and Shareholder B and B’s family. It was also intended to prevent an individual shareholder from owning a disproportionate amount of voting versus nonvoting common stock.

Corp represented to the IRS that, under the Redemption Plan, the redemption price for the stock would be the appraised value of the voting and nonvoting common stock (determined on a minority basis) as shown on the most recent independent appraisal. However, if no independent appraisal had been made within a certain time frame of the redemption, then Corp’s board of directors could determine the value, in good faith, based upon the methodology used by the independent appraisal.

Corp represented that the Redemption Plan was not designed or intended to circumvent or otherwise violate the second class of stock rule. Corp also represented that the Redemption Plan did not establish a purchase price for the stock that, at the time the agreement was entered into, was significantly in excess of or below the fair market value of the stock.

A small business, or “S” corporation, means a domestic corporation that, among other things, does not have more than one class of stock.

IRS Regulations provide that a corporation that has more than one class of stock does not qualify as a small business corporation.  In general, a corporation is treated as having only one class of stock if all of the outstanding shares of stock of the corporation confer identical rights to distribution and liquidation proceeds. Differences in voting rights among shares of stock of a corporation are disregarded in determining whether a corporation has more than one class of stock.

These Regulations further provide that buy-sell agreements among shareholders, agreements restricting the transferability of stock, and redemption agreements are disregarded in determining whether a corporation’s outstanding shares of stock confer identical distribution and liquidation rights, unless: (1) a principal purpose of the agreement is to circumvent the one class of stock requirement, and (2) the agreement establishes a purchase price that, at the time the agreement is entered into, is significantly in excess of or below the fair market value of the stock.

Agreements that provide for the purchase or redemption of stock at book value, or at a price between fair market value and book value, are not considered to establish a price that is significantly in excess of, or below, the fair market value of the stock and, thus, are disregarded in determining whether the outstanding shares of stock confer identical rights. For purposes of this rule, a good faith determination of fair market value will be respected unless it can be shown that the value was substantially in error and the determination of the value was not performed with reasonable diligence.

Based on the foregoing, the IRS concluded that the Redemption Plan would be disregarded in determining whether the outstanding shares of Corp stock conferred identical distribution and liquidation rights. Thus, the Redemption Plan would not cause Corp to be treated as having a second class of stock.

So what’s the big deal? Nothing really. The ruling reminds us, however, that there are many possibilities available to the closely-held business for creating a “liquidity market” for its owners. It also demonstrates that, with proper planning, it may be possible to accomplish important business goals, such as preserving the “balance of power” between two families (or shareholders) without necessarily sacrificing tax efficiencies. You just need to think it through.

Part II of the stock redemption series will appear next week.

 

Every owner of a closely-held corporation has certain property rights, arising from his or her status as an owner, that have economic value to the owner.  At the inception of the business, the owner may count among these rights the ability to share in the profits generated by the business, whether in the form of compensation or distributions.  Taking a longer-term perspective, the owners may contemplate the ultimate sale of the business to a third party, at which point each owner would share in the sale or liquidation proceeds.

 As so often happens, however, the ownership of a closely-held corporation does not remain static.  Sometimes, an owner will leave of his or her own volition; at other times, the owner will be “asked” to leave.  In either case, the business relationship is formally terminated upon the former owner’s disposition of his or her equity interest in the business.

 Although several factors may be considered in determining the “purchase price” for this interest (including the shareholder’s agreement, if any), when the parties ultimately do arrive at a price, this price inevitably will reflect a pre-tax economic result.  The after-tax and true economic result will usually depend upon both the corporation’s tax status and the structure of the disposition.  Nevertheless, it is often the case that insufficient thought is given to this structure, and thus to the tax treatment of the disposition; consequently, the economic cost of the transaction becomes more expensive than it otherwise could have been.

 In disposing of his or her equity in a closely-held corporation, an owner has two basic choices:  a sale to some or all of the other owners (a cross-purchase) or a sale to the business itself (a redemption of the shares of stock).  In some cases, these two structures may be combined.  In others, additional elements may be added to the structural and economic mix.

 Cross-Purchase

A shareholder departing from either a C corporation or an S corporation may sell his or her shares of stock to some or all of the other shareholders.  He or she will realize gain equal to the amount paid for the shares over his or her adjusted basis in the shares.  (Thus, if the seller had inherited the shares with a basis step-up, it is possible that little or no gain may be realized.)  Provided the selling shareholder has held the shares for more than 12 months, the gain recognized will be treated as long-term capital gain.  (Inherited property is deemed to satisfy the long-term holding period.)

 In general, the selling shareholder will recognize, and be taxed on, the gain realized on the sale when he or she receives cash or other property in exchange for his or her shares.

 A shareholder who receives a term-note from the buyer(s), providing for payments after the year of the sale, will recognize a pro rata portion of the gain realized as payments are made on the note.  The gain may thus be deferred under installment method reporting.  If the note bears interest, the receipt of the interest will be taxed as ordinary income.  If the note does not provide for interest, the IRS will impute interest, thereby converting some of the principal payments (otherwise capital gain) into interest (ordinary income). 

 It should be noted that installment reporting is not always available to the selling shareholder (as where the note received is a demand note).  Additionally, even where such reporting is available, certain actions on the part of the seller may accelerate recognition of the otherwise deferred gain (for example, by pledging the note to secure a debt).  Moreover, where the installment obligation exceeds $5 million, a special interest charge will be imposed by the IRS, for the life of the note, which will effectively negate the tax benefit of installment reporting

Redemption

Instead of selling his or her shares to the other shareholders, the corporation itself may buy back the departing owner’s shares.  In the case of most closely-held businesses that are not family-owned, the redemption of all of the seller’s shares should be treated as a sale of the stock, with the seller realizing gain equal to the purchase price for the shares over the seller’s adjusted basis for the shares. The gain recognized should be treated as capital gain (though a special rule applies to the redemption of preferred stock, which may result in some dividend treatment).  If the corporation issues an installment note in consideration for the shares, gain recognition may be deferred under the installment method.

 In the case of a C corporation, these results may change significantly if the redeeming corporation is owned, at least in part, by persons that are “related” to the seller. A redemption in which the seller’s ownership in the corporation is completely terminated is typically treated as a sale. If the seller’s interest  is treated as not having been completely terminated, however, the corporation’s payment may be treated as a dividend distribution to the extent of the corporation’s earning and profits.  In that case, the entire distribution amount may be taxed to the seller; it is not reduced first by the seller’s basis in the redeemed shares.  Moreover, since the redemption is not treated as a sale or exchange for tax purposes, any note distributed by the corporation to the seller is likewise treated as a dividend distribution, in an amount equal to the fair market value of such note; there is no installment reporting.  Thus, the results are less favorable than exchange treatment.

 Attribution Rules

In distinguishing between a sale-redemption and a dividend-redemption, certain attribution rules must be considered.  Under these rules, a selling shareholder disposing of all of his or her shares is nevertheless deemed to own the shares that are actually owned by another, “related” shareholder.  By virtue of this attribution of ownership, the selling shareholder will have failed to terminate his or her interest in the corporation and, so, may be subject to dividend treatment.  However, where the related person is a family member, it may be possible for the redeemed shareholder to “waive” the family attribution rule, provided he or she satisfies certain conditions; for example, immediately after the redemption, the former shareholder cannot be an officer, director or employee of the corporation, though he or she may be a creditor of the corporation.  If these conditions cannot be satisfied (for example, a redeemed parent wants to remain on the board of directors), then waiver of family attribution is not available.

 S Corps

Where the corporation is an S corporation, the tax consequences to the departing shareholder from the sale of her stock in a cross-purchase is the same as described above.  As in the case of a C corporation, the complete redemption of a departing shareholder’s stock is taxable as either a distribution or as a sale, depending upon the application of the ownership attribution rules.  If the S corporation was previously a C corporation with earnings and profits (or if it had acquired a C corporation in a tax-free reorganization), some portion of the redemption proceeds will be taxable as a dividend, as described above, if the redemption fails to qualify as a sale or exchange.  However, if the S corporation has no earnings and profits from a C corporation, the redemption proceeds will be treated first as a tax-free return of stock basis; and then as gain from the sale of the stock, even where the redemption fails to be treated as a sale or exchange.  Thus, in the case of a corporation that has always been an S corporation, the distinction between a dividend-type and a sale-type redemption may be less important. 

Anything Else?

The foregoing is not to say that the only two buyout choices are a cross-purchase or a redemption.  In fact, the two structures may be combined such that the remaining shareholders will purchase some of the departing shareholder’s shares while the corporation redeems the balance.  The tax analysis is the same as set forth above.  However, the tax analysis of a shareholder-buyout is not limited to the actual sale transaction. There are a number of other economic and tax considerations, some of which will be the subject of our next post.

 Last month we considered a situation in which the recapitalization of the equity in a family-controlled business resulted in a taxable gift. Today we will consider how a family-owned corporation’s redemption of shares from a parent-shareholder may be treated as a taxable gift from the parent, and may result in some unexpected consequences for the beneficiaries of such gift.

  Parent “Makes” A Gift 

In 1995, Parent sold his stock in Company back to Company. Because he sold the stock back for a price below its fair market value, this sale increased the value of the stock of the remaining stockholders. At the time of the sale, there were five other Company shareholders including Parent’s Ex-Wife, other individuals, and trusts that held Company stock. Parent passed away later that year.

  The IRS audited Parent’s 1995 gift taxes and determined that Parent had made an indirect gift to the Company shareholders when he sold his stock back for below market value and issued a notice of deficiency. Parent’s Estate challenged the deficiency. After several years of negotiation over Parent’s tax liability for this indirect gift, the IRS and Parent’s Estate entered into a stipulation that determined the value and recipients of the indirect gifts.  However, Parent’s Estate still did not pay the gift tax.

 IRS Seeks to Collect

In 2008, the IRS assessed gift tax liability for Parent’s unpaid gift tax against the donees. Under the Code, a donor’s unpaid gift tax for a period becomes a lien upon all gifts made during that period. If the tax is not paid when due, the donee of any gift shall be personally liable for such tax to the extent of the value of such gift.

In 2010, the IRS brought suit against the donees, seeking to recover the unpaid gift taxes and to collect interest from the beneficiaries. In a series of orders issued in 2012, the district court held for the IRS.

The Court Supports the IRS

The Code imposes a tax on a “transfer of property by gift.” The gift tax applies “whether the gift is direct or indirect,” and includes transfers of property (like stock) when the transfer was “not made for an adequate and full consideration.” When the gift tax is not paid when it is due, the Code imposes interest on the amount of underpayment.

Pointing to IRS Regulations, the Court stated that “[i]t is well-settled that a transfer of property to a corporation for less than adequate consideration is to be treated as a gift to the shareholders to the extent of their proportionate interests in the corporation.” (“A transfer of property by B to a corporation generally represents gifts by B to the other individual shareholders of the corporation to the extent of their proportionate interests in the corporation” where the transfer was not made for adequate and full consideration in money or money’s worth.)

 The Court acknowledged that “[t]he donor, as the party who makes the gift, bears the primary responsibility for paying the gift tax.” However, if the donor fails to pay the gift tax when it becomes due, the Code provides that the donee becomes “personally liable for such tax to the extent of the value of such gift.” The term “tax” includes interest and penalties and, so, the donee can be held liable for the interest and penalties for which the donor is liable.

 The donees argued that the district court erred when it found both that this creates an independent liability on the part of the donee to pay the unpaid gift tax, and further disputed that the donee can be charged interest until the gift tax is paid.

The Court disagreed with their arguments and held that interest accrued on a donee’s liability for the unpaid gift taxes and, moreover, that the interest is not limited to the extent of the value of the gift.

 An Interesting Aside

 One of the “beneficiary-shareholders” – the Ex-Wife – claimed that the “ordinary course of business exception” applied because the IRS did not prove that there was donative intent. She argued that whereas in other cases involving indirect gifts, the ordinary course of business exception did not apply because, given the close family relationship between the donor and the shareholders, courts were able to infer donative intent, Parent and Ex-Wife here had been divorced for many years and each had remarried. Thus, according to Ex-Wife, the IRS failed to prove that there was a close family relationship and that this was a gift.

The Court disagreed. Though under the ordinary course of business exception, “a sale, exchange, or other transfer of property made in the ordinary course of business (a transaction which is bona fide, at arm’s length, and free from any donative intent), will be considered as made for an adequate and full consideration in money or money’s worth,” here the Court found it clear that Parent intended to make a gift.  

  Context Can Be Everything

 A stock redemption provides a means by which a parent may “shift” value to children-shareholders (without actually transferring anything to them), by reducing the parent’s percentage interest in the redeeming business entity and increasing that of the children-shareholders. 

If the redemption is effected for FMV (unlike in the situation considered above), there is no gift to the other shareholders—even though their relative interests increase.  The removal of some of the parent’s equity in the business freezes the value thereof by replacing it with cash that may be spent. The reduction in his or her percentage interest of the total equity may also put the parent in a less-than-controlling position, allowing for a minority discount at the time of his or her death.

Of course, a redemption may also eliminate the ability of the parent’s estate to pay the estate tax attributable to the business in installments, by reducing the percentage of the value of the gross estate that is represented by the business.

Where the redemption is not for FMV, the resulting reduction in estate tax value for the parent’s remaining shares may justify some current gift tax liability. However, the parent needs to be mindful of the fact that a redemption is generally an income-taxable event to the parent, though the specific consequences will depend upon several factors.  In any case, the income tax expense must be weighed against the potential transfer tax savings.

Even where the stock redemption is not made strictly made for FMV, gift treatment may still be avoidable. For example, given the difficulty of valuing closely held stock, a purchase price adjustment clause in the redemption agreement may defeat gift characterization of the transfer in the face of an IRS challenge to the redemption price.

Similarly, the redemption of a parent’s stock as part of the settlement of a bona fide family/shareholder dispute may also be deemed to have been made for adequate and full consideration in the context of the overall settlement.

 What the parent-shareholder, the redeeming corporation, and the other shareholders need to keep in mind is that there are many factors to consider before undertaking a redemption of the parent’s stock. With proper planning, any unpleasant surprises should be avoidable.

One of the issues most often encountered by the owner of a closely held business is succession planning.  This may be especially difficult where no member of the owner’s family is involved in the business.  In that case, the owner may have to consider the liquidation of his interest in the business, either by way of a sale to a third party or by a redemption of his interest by the business itself.  In either scenario, in order to maximize the net economic benefit of such a sale or redemption, it may be necessary to secure the ongoing employment of certain key employees of the business.

The Transaction

In a recent ruling, the IRS considered such a scenario.  A corporation had two equal shareholders.  They wished to retire and transfer the ownership and operation of the corporation to four key employees who were unrelated to the shareholders.

They proposed the following transaction:  the corporation would redeem all of their shares in exchange for promissory notes.  The redemption price was determined by a third-party appraisal; the notes required periodic payments of principal and interest (at a rate in excess of the AFR) over a period of no more than nine years; the payments were not contingent on future earnings or any other similar contingency; the notes were not subordinated to the claims of general creditors of the corporation; the corporation’s stock was not held as security for the notes. 

The Employee Shares

Immediately afterward, the corporation would issue shares of its stock to each of the four key employees.  The shares would be subject to transfer restrictions and service-related risks of forfeiture; in other words, the employees could not freely dispose of the shares and, if they failed to satisfy certain service-related requirements, they would have to return the shares to the corporation. 

Following these transactions, the only outstanding shares of corporation stock would be those owned by the key employees.  The departing shareholders, however, would remain employees of the corporation for a period of time, and they would continue to serve as chairman and vice-chairman of its board of directors.

In general, an employee’s receipt of shares in the employer-corporation would not be immediately taxable to the employee provided the shares were subject to a substantial risk of forfeiture; the taxable event would occur upon the lapse of the risk of forfeiture.  However, in the scenario considered by the ruling, as a condition to receiving the shares of stock, each key employee was required to elect, pursuant to Section 83(b) of the Code, to include the value of such stock in income (as compensation) in the year the stock was received.  (The ruling was silent as to whether the corporation was to “gross-up” the employees for the resulting tax liability.)

The Ruling

Based on the foregoing, the IRS ruled that the redemption of the shares held by the retiring shareholders would qualify as a complete termination of their interests in the corporation under Section 302(b) of the Code, the redemption would be treated as a sale, and the gain realized by the shareholders would be treated as capital gain, which they would report on the installment method as principal payments were made on the notes.  Interest payments received on the notes would be taxable as ordinary income and would be deductible by the corporation.  None of these holdings was surprising.  Nevertheless, the ruling is instructive.

“Security” Arrangement?

The ruling does not indicate the extent to which the term of the promissory notes overlapped with the period during which the risk of forfeiture as to the employees’ shares remained outstanding.  It is not unreasonable to assume, however, that they may have run coterminously.  The fact that the key employees were required to elect under Section 83(b) to include in their income the value of the shares issued to them appears to have been intended to incentivize the employees to remain with the corporation, by having caused them to incur an immediate tax liability (an economic cost) with respect to the shares.  It also gave them the prospect of capital gain (as opposed to ordinary income) treatment on a sale of their shares after the termination of the forfeiture period.  The transfer restrictions, plus the risks of forfeiture attached to the shares, which would cause the employees to forfeit the shares if they left the corporation before the expiration of a specified period of employment, or if they failed to satisfy certain performance targets (each a substantial risk of forfeiture), provided an additional incentive for the employees to remain with the corporation until the lapse of the risks of forfeiture.

 The continuing presence of the two former shareholders as employees of the corporation, and as members of its board of directors, not only ensured them an additional stream of income, but also afforded them the ability to oversee the performance of the four key employees. 

These “security” arrangements for the payment of the promissory notes issued by the corporation, which depended on the performance of the corporation, appears to have been a key element of the buyout.

Take-Away

The buyout arrangement described in the ruling appears to offer a viable and reasonable succession plan, at least for the subject business.  It provided liquidity for the departing shareholders, a measure of security for the payment of the purchase price for their shares, installment reporting (i.e., deferral) for their gain realized on the redemption, and an opportunity for the key employees to assume control and ownership of the business.

Of course, every closely held business is different, and every owner faces a somewhat unique set of circumstances, and has his or her own particular goals.  However, as the ruling demonstrates, there is a set of basic “tools” and principles which provide a common denominator from which an appropriate plan may be structured and implemented to suit the particular business and owner.  The ruling sets forth just one of many possible permutations.