Roll-Over: Tax Issue

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Before the LOI

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

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

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

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

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

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

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

Roll-Over: PEF’s Perspective

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

Roll-Over: Seller’s Perspective

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

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

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

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

Acquisition Mechanics

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

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

Roll-Over: Mechanics

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

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

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

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

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

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.


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.


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.

In General

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

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

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

What is a NQDC Plan?

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

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

NQDC plans typically fall into four categories:

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

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

Unfunded Plans

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

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

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

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

Audit Potential

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

When are deferred amounts includible?  

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

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

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

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

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

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

General Audit Steps

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

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

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

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

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

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

Audit Techniques

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

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

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

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

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

IRC § 409A

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

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

Forewarned is Forearmed

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

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

“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.

Davidson was dead to begin with. Dead as a door-nail. His death did not come as a great surprise, at least to some, though few (other than the IRS) expected him to go as quickly as he did. And that was the root of the problem. But I don’t want to get ahead of myself.


It Was the Best of Times . . .

During life, he had done well for himself. He had accumulated great wealth as the majority shareholder, President, Chairman and CEO of one of the world’s leading manufacturers of glass, automotive and building products. He was worth billions of dollars and, like so many other similarly-situated individuals, he indulged himself in acquiring professional sports teams.


moneyAlthough he was obviously not like most men in terms of the wealth he controlled and the power he derived from it, he was just like any other “Joe” in that, sooner or later, he’d have to meet his maker.


As his health began to deteriorate, and he started thinking about his death, he wondered how he could pass along his great wealth to his family. He became especially concerned about avoiding the significant estate tax liability that would be borne by his beneficiaries upon his passing.


He consulted some of the best minds in the country. The estate tax could be avoided, he was told, by removing assets from his estate. “OK,” he thought, “tell me something I don’t know.” One way to remove assets from his estate would be for him to make substantial gifts of property while he was alive. “Great. Let’s do it,” he said. “Unfortunately,” his lawyers told him, “gifts of the size being contemplated would themselves be subject to gift tax.”

“So what’s the alternative?” he asked them. “I’m paying you by the hour, and I’m not getting any younger.”

Sale to A Trust

A sale, they replied. He could sell shares of stock in his company to his family. Better yet, these sales could be made to trusts that would be created and operated for the benefit of his family. A sale would not be treated as a gift for gift tax purposes provided the trusts paid him an amount equal to the fair market value of the shares being transferred. The trusts could also provide some asset protection for the family.

Now this was sounding good. A transfer of stock to a trust for his family that would escape the estate tax and that would not be subject to the gift tax. But wait, he thought, wouldn’t a sale subject me to capital gains tax? And how will these newly created trusts be able to pay me anyway?

Again, he gave his lawyers a searching look. “What are they thinking?”

“You’re probably wondering what we’re thinking,” they said to him. “Each trust will be structured as a so-called ‘grantor trust.’ Although you will not have any beneficial interest in the trust, you will retain certain ‘rights’ or ‘powers’ in respect of the trust property such that you will continue to be treated as owning the trust and all of its assets for purposes of the income tax. Since you cannot sell property to yourself, the ‘sale’ will not result in any taxable gain.”

“So wait,” he stopped them, “you mean to tell me that I can sell property to these trusts, but that the sale will not be treated and taxed as a sale?”

“That’s almost correct,” the lawyers replied. “You need to understand that there are two types of taxes at work here: the gift tax and the income tax. There is a ‘sale’ for purposes of the gift tax – it provides the consideration that prevents the transfer from being treated as a taxable gift. However, because the trust is ‘ignored’ for purposes of the income tax – you are treated as owning it – there is no sale for purposes of the income tax.”

Hmm, he thought, these guys are pretty smart after all.

Sale to a Trust for a Note

The lawyers continued, “As for funding the purchase by the trust, the trust will issue a promissory note to you in exchange for the shares.”

“So let me get this straight, I sell my shares to a trust in exchange for a note? Don’t I own the note? If I die before the note is paid off, won’t the value of the note be included in my estate? Am I just substituting one asset in my estate for another?”

After a pause, he continued, “You know, I’m no spring chicken, I’ve had my share of health issues, some of them serious. You may have noticed that I’m sitting in a wheel chair? What would this note look like?”

The lawyers confirmed that, “without more,” the note would be included in his estate upon his death if it were still outstanding at that time. Of course, they added, if the shares appreciated at a rate in excess of the interest accrued on the note, the net result would be positive insofar as removing value from his estate was concerned.

Sale to a Trust for a Self-Canceling Note

After some further deliberation, the lawyers peppered him with all sorts of questions about his health. “I thought you guys were lawyers? You do know that it’s illegal to practice medicine without a license?”

“Medicine? No. We’re tax lawyers. We answer to a higher authority.”

“What if we told you that there was a way to exclude the note from your estate upon your passing?” they asked him.

Picture the cartoon thought bubble that appeared above his head at that point. “I sure hope the chauffer has the limo running. These guys have had too much Kool-Aid.”

“OK, I’m game,” he humored them, “how does the note disappear?”

“It doesn’t really disappear. It cancels itself if you die before the end of the note term. Based on your age, your life expectancy is almost six years. Assume the note has a term of 5 years (less than your life expectancy). You die in the second year of the term. The remaining balance of the note is canceled and never has to be satisfied. They’re called self-cancelling installments notes, or ‘SCINs’.”

The Devil is in the Details

Well, the planning moved pretty quickly from there. Davidson was stuck, poked, prodded and probed by four physicians, each of whom concluded that he had a greater than 50% probability of living for at least one year. According to the lawyers, this was a key factor. With that prognosis, he was not deemed to be “terminally ill” within the meaning of those IRS regulations that would be used to calculate the actuarial fair market value of the notes based upon his actuarial life expectancy. The regulations would not have been available otherwise.

The lawyers obtained appraisals for the shares to be transferred to the trusts, and prepared the documentation needed to effect the transfers, including the five-year SCINs.

Importantly, they also obtained valuations for the “premium” that each trust would have to pay in exchange for the self-canceling feature. After all, why would a note holder allow a self-cancelation provision in the note without being compensated for the actuarial risk of his or her premature death? In the case of some of the notes, this premium took the form of an increased amount of principal. In others, it was reflected as an increased rate of interest.

The notes were secured by the shares being transferred and by other assets that had been contributed to the trusts at their creation. They provided for annual payments of interest and a balloon payment of principal (either in cash or in kind) at the end of the five-year term.

Death Waits for No One

In December 2008, the various trusts were created and “seeded” with some assets. In January 2009, the stock transfers to the trusts were completed. In March 2009, Davidson died and, as per the terms of the SCINs, the notes were canceled. grave

His estate filed his 2009 gift tax returns (on Form 709), on extension, in May of 2010. These disclosed the transfers of stock in exchange for the SCINs. (The Form 709 for 2008 disclosed the creation of the trusts.) His estate tax return was filed (on Form 706), on extension, in June of 2010.

Death & Taxes

The IRS examined these returns. With respect to the estate tax return, the IRS determined an estate tax deficiency of over $1.87 billion (not a typo). It also determined gift tax and generation-skipping transfer taxes of approximately $846 million for 2009. Over $2.7 billion in the aggregate (plus interest and penalties) – did Davidson roll over in his grave?

The IRS arrived at this figure, in part, by challenging (practically a given) the reported fair market value for Davidson’s company.

It also refused to treat the SCINs as bona fide consideration equal in value to the Company stock he had transferred to the trusts in exchange for the SCINs.

The IRS asserted that the regulations utilized to calculate the actuarial fair market value of the notes were inapplicable because Davidson’s life expectancy was less than the terms of the notes. Instead, the IRS determined that his life expectancy was approximately 2.5 years. The IRS asserted that the SCINs should have been valued using this life expectancy, which would have significantly reduced their value.

According to the IRS, Davidson never intended or expected to collect all payments due under the SCINs. Moreover, the IRS said, the trusts would not have been able to make payments on the SCINs when due. Thus, the IRS concluded, the SCINs were not bona fide debt.

In June 2013, Davidson’s estate filed a petition with the U.S. Tax Court in which it challenged the IRS’s assertions.  Trial was set for April 2014, but was subsequently continued (often done where the parties are engaged in serious settlement negotiations) and stricken from the Court’s calendar. The Court, however, retained jurisdiction of the case, and required the parties to file a joint status report with the Court every three months.

And So I Face The Final Curtain

In July of 2015, Davidson’s estate and the IRS submitted a stipulated decision in which they agreed to deficiencies of gift tax for 2009 of approximately $178 million, of estate tax of approximately $153 million, and of 2009 GST tax of approximately $46 million. A total of $377 million, as opposed to the approximately $2.7 billion originally sought by the IRS.

Although the basis for the decision was not spelled out, it seems reasonable to surmise that the settlement was based upon a compromise regarding the valuation of the shares transferred – not at all unusual – and that the SCINs were otherwise not implicated in the decision.

The Hereafter?

The story set out in this post is based upon a real taxpayer. The narrative, of course, is pure conjecture. It is, however, based upon discussions that I have had with many clients (except the part about the Kool-Aid).

There’s a lesson in almost every story, fictional or not. The take-away here is straightforward: know all the rules, pay attention to the details, implement and document the plan completely, and educate the client. Having done this, you will be in a strong position to withstand any IRS scrutiny.

Incentive Compensation

It is not uncommon for a closely-held business to provide an economic incentive to its key employee. Often, the incentive takes the form of an annual cash bonus. Alternatively, the business may provide the key employee with a longer-term incentive, in the form of a deferred compensation arrangement that may be payable on retirement or upon the sale of the business. In other situations, the key employee may be granted an equity interest in the business, or the right to purchase such an interest.

In each of these scenarios, both the employer and the employee must pay close attention to the rules and principles that govern the income tax treatment of the compensation arrangement. Only by doing so can the employee avoid being taxed prematurely on (i.e., before its actual receipt of) the value of the compensation provided. Where the incentive granted is an option to purchase equity in the business, the parties must be especially aware of IRC Sec. 409A.

Section 409A, In Brief

Under Section 409A, all amounts deferred under a nonqualified plan (for both the current and all preceding taxable years) are currently includible in the employee’s gross income to the extent they are not subject to a “substantial risk of forfeiture”—in other words, to the extent that the employee’s rights to the compensation are conditioned upon the performance of substantial services or the occurrence of a condition related to a purpose of the compensation, such as the attainment of a prescribed level of earnings or the sale of the business – unless certain requirements are satisfied relating to the timing of the distribution of the deferred compensationStock-Protection-Using-Stock-Options

The Options At Issue

A recent IRS advisory reviewed the income tax consequences of one equity-based compensation arrangement.  The advisory arose out of an examination of the “Employee’s” tax return for Year 3. Two years prior to the tax year under examination (Years 1 and 2), “Employer” had granted Employee a nonstatutory stock option (“Option”) to purchase a certain number of shares (“Option Shares”) of Employer’s common stock. These two tax years were closed at the time the IRS examined Year 3.

Employer and Employee executed an option agreement (“Agreement”) providing for the grant of the Option under the terms of a “Plan.” Plan provided that the Option would be granted on Date.

The consideration for the grant of Option was Employee’s provision of future services to Employer. Employee was not required to pay any additional amount in exchange for grant of Option.

The option agreement provided that “Exercise Price” was the strike price per Option Share.

Under the terms of the option agreement, a certain number of Option Shares would vest each year following the grant date. The vested Option Shares could then be exercised at any time during a specified number of years from the vesting date.

Two days prior to Date, Employer’s common stock began trading on an over-the-counter market.  Trades made on Day 1, Day 2, and on Date were on a “when, as and if issued” (commonly called a “when issued”) basis.

The lowest when-issued trading price for Day 1, Day 2, and Date was at least $X more than Exercise Price. On Date, the lowest when-issued trading price was over $Y more than Exercise Price.

Employee became vested in a number of Option Shares in Year 2 and in Year 3, and exercised Option as to these shares.

Section 409A Failure

The Section 409A regulations provide that an NSO to purchase a fixed number of shares of employer stock is not treated as a nonqualified deferred compensation plan subject to section 409A (and therefore is exempt from section 409A) if the exercise price is not less than the fair market value (“FMV”) of the underlying stock on the grant date of the option and certain other requirements are met.

Conversely, if the exercise price is less than such FMV, the option is treated as a nonqualified deferred compensation plan subject to section 409A that must meet the time and form of payment requirements under the section 409A regulations.

A nonqualified deferred compensation plan subject to section 409A(a) must provide, upon adoption of the plan, for a deferred amount to be paid at a time and in a form meeting the section 409A time and form of payment requirements. To satisfy the time and form of payment requirements, the plan must designate that a specified nondiscretionary and objectively determinable deferred amount may be paid only upon a specified (or the earlier or later of certain specified) permissible payment event (or events), such as a specified time or date, death, disability, separation from service, or a change in control event, or a permissible period following the applicable payment event.

For an NSO that is treated as a nonqualified deferred compensation plan, the terms of the option must designate the nondiscretionary and objectively determinable number of shares that may be purchased through full or partial exercise of the option upon a permissible payment event, or a permissible period following the payment event.

For purposes of determining the FMV of employer stock underlying an NSO intended to be exempt from section 409A, the regulations provide that, for stock that is readily tradable on an established securities market, the FMV of the stock on the grant date of the option is determined based on a reasonable method using actual transactions in the stock as reported by the established securities market.

The regulations further provide that, for employer stock that is not readily tradable on an established securities market, the FMV of the stock on the grant date of an NSO is determined based on the reasonable application of a reasonable valuation method, taking into consideration events occurring after the date of the calculation that may materially affect the value of the employer stock.

Employer’s common stock was traded on a when-issued basis on an OTC market on Date (the grant date of Option). According to the IRS, the OTC market on which Employer’s stock was traded was an established securities market for purposes of Sec. 409A. Therefore, the stock underlying the NSO was treated for purposes of section 409A as having been readily tradable on an established securities market on the grant date of Option.

However, the IRS found that the FMV of a share of Employer’s stock on Date, the grant date of Option, was higher than Exercise Price, the strike price per Option Share under the terms of the option agreement.

As a result, the Option did not meet the regulatory requirements for exemption from section 409A. Thus, the Option was treated as a nonqualified deferred compensation plan subject to section 409A from the grant date until the end of the taxable year during which the Option was either fully exercised or expired.

Because the Agreement generally provided that Option Shares could be purchased through Option exercise at any time following vesting, the Option terms did not designate a permissible payment event as the only time that Option Shares could be purchased. Therefore, Option failed to meet the requirements of Section 409A from the grant date.

Check in tomorrow for a discussion of the income tax consequences arising from this failure.

A taxpayer has the legal right to minimize his or her taxes, or to avoid them completely, by any means that the law allows. However, this right does not give the taxpayer the right to structure his or her affairs by using “business entities” that have no economic reality and that are employed only to avoid taxes. One business owner recently learned this lesson the hard way: the Tax Court was his teacher.

Wheeler v. Commissioner

In Wheeler v. Comr., Taxpayer owned and operated a business out of an S corporation from the late 1980s until 2002, when the corporation (“Corp”) was liquidated and distributed its assets to Taxpayer.  Corp’s assets, which Taxpayer presumably took with a fair market value basis, consisted primarily of equipment and inventory, and Corp operated in a factory building owned by Taxpayer. After Corp liquidated, its business continued in the same location through a separate limited liability company (“LLC”) that was managed by one of Taxpayer’s daughters. In late 2002, an entity that purported to be a “business trust” (“Trust”) was formed, and its capital units were issued to Taxpayer’s daughters.

In early 2003, Taxpayer and Trust entered into an agreement by which Taxpayer purported to grant Trust the option to purchase Taxpayer’s factory and equipment. The exercise price for the option was $1.65 million, payable with two promissory notes. The agreement was contingent upon a separate rental agreement between Trust and LLC for the latter’s use of the factory and equipment. Both agreements were drafted by Taxpayer, who also unilaterally determined their economic terms.

Notwithstanding the fact that Trust did not exercise the option to purchase the factory and equipment until 2004, LLC began making significant rental payments to Trust in 2003.  Trust in turn paid the exact same amounts to Taxpayer, presumably in partial satisfaction of the promissory notes.

In mid-2004, LLC stopped making rental payments to Trust, and Trust stopped making note payments to Taxpayer. In fact, Taxpayer explained that the remaining payments owed to him under the option notes were “gifted” to Trust.

After examining the foregoing arrangement, the IRS asserted that Taxpayer’s sale of the factory and equipment to Trust should be disregarded because Trust was a sham entity and the lease payments from LLC to Trust were merely lease payments to Taxpayer.

According to the Court, the “true earner” of income is the person or entity who controls the earning of such income, and not necessarily the person or entity who receives the income. “‘The crucial question,” the Court stated, “[is] whether the assignor retains sufficient power and control over the assigned property or over receipt of the income to make it reasonable to treat him as the recipient of the income for tax purposes. . . . An anticipatory assignment of income from a true income earner to another entity by means of a contractual arrangement does not relieve the true income earner from tax and is not effective for Federal income tax purposes regardless of whether the contract is valid under State law.”

The Court concluded that Taxpayer was the true earner of the rental income paid from LLC to Trust. First, Taxpayer owned the assets that Trust leased to LLC throughout the period at issue up until March 2004, when he deeded the assets to Trust. Therefore, at a minimum, LLC’s 2003 rental payments and its first few 2004 rental payments were properly allocable to Taxpayer as the owner of that property.

Second, Trust acted as a mere conduit for the flow of income from LLC to Taxpayer. Trust received income attributable to Taxpayer’s assets and subsequently paid petitioner the same amounts it received from LLC. When LLC suspended rental payments to Trust in June 2004, Trust ceased making payments to Taxpayer.

Finally, there was no separation of Trust administration from the operation of LLC, and Taxpayer retained substantive control over Trust. Taxpayer drafted the contract between Trust and LLC. Neither Trust nor LLC negotiated the terms of the contract, and Taxpayer set the price for the lease. When LLC ceased its rental payments, Trust did not take any action to enforce the lease terms because the trustee felt that it was a “family matter” and he could not take action. Similarly, Taxpayer testified that the remaining payments owed to him under the option contract were a “gift” to Trust. Taxpayer failed to provide persuasive evidence that the option contract and the lease were entered into in good faith and that the parties to these contracts intended to be bound by their respective agreements and expected to have to honor them. Instead, the Court concluded that the agreements were shams.

Because Taxpayer had sufficient power and control over Trust’s receipt of income from LLC, he was the true earner of the income. As the payments were rental payments to Taxpayer in substance, Taxpayer could not use the alleged basis he had in the assets to offset this income. Consequently, the rental income paid by LLC to Trust was taxable to Taxpayer in its entirety.

The Economic Substance Doctrine 

The foregoing discussion highlights one application of the economic substance doctrine. Under this doctrine, a court may deny a taxpayer any tax benefit arising from a transaction that does not result in a meaningful change to the taxpayer’s economic position other than a reduction in federal income tax.  In other words, a transaction that would otherwise result in beneficial tax treatment for a taxpayer will be disregarded if the transaction lacks economic substance.

The tax advisers to closely held businesses need to familiarize themselves with the economic substance doctrine. It is in the context of such a business (as in Wheeler) that one will frequently encounter transactions between the business and its owners, or between the business and a related entity. As a general rule, the relevant question should be whether the transaction that generated the claimed tax benefit also had economic substance and/or a business purpose in order for the transaction to withstand IRS scrutiny. In making that determination, it may help to compare the transaction at issue with transactions between unrelated parties in a bona fide business setting.

In all cases, these inquiries should be made, and the responses thereto should be memorialized, in advance of the transaction. The taxpayer and his or her advisers should never forget that the taxpayer will bear the burden of proof in any examination by the IRS.

Our last post described the portions of an executive employment agreement that may be impacted by Section 409A.  However, Section 409A may also impact the structure of other, less traditional compensation paid to key employees.  In the context of a closely-held business, two commonly-encountered alternative compensation arrangements used outside of the context of an individual employment agreement are (1) a stand-alone deferred compensation plan and (2) phantom equity arrangements.

(1) Nonqualified Deferred Compensation Plans

Nonqualified deferred compensation plans are often used to supplement retirement savings for those executives who have maxed out their contributions to qualified retirement plans.  An example of such a plan would be a supplemental executive retirement plan (“SERP”), under which the company would agree to provide a stated amount of supplemental retirement income to the executive and/or his/her family once certain vesting conditions are met by the executive. Amounts are typically paid out of a SERP upon a stated retirement age or upon the death or disability of the executive.   In terms of Section 409A compliance, the burden at the outset on the Company is relatively low, as SERPs typically provide for payment upon otherwise permissible Section 409A payment events.    If kept fairly simple and straightforward, and operated strictly in accordance with the terms of the plan, a SERP will generally comply with Section 409A.

On the other hand, if the executive is given flexibility with respect to elective salary deferrals, deferrals of amounts otherwise payable under the SERP, or acceleration of payments scheduled to be made from a SERP, Section 409A will once again provide a fairly stringent roadmap for how to draft these additional pieces of the plan.   For example, the Treasury Regulations under Section 409A provide specific rules as to the timing of both initial and subsequent deferrals of deferred compensation.   There are also restrictions on an executive’s ability to accelerate payments under a plan subject to Section 409A.  If these provisions are not carefully drafted, all amounts under the plan may be subject to penalties under Section 409A, whether or not the executive ever actually receives the payments.

 (2) Phantom Equity

Sometimes, the closely-held business owner wants the ownership of the company to stay within the hands of a small group, particularly in the context of a family-owned business.  Notwithstanding that desire, savvy business owners often recognize that the best way to incentivize a key member of their staff is to provide them with a share in the economic growth of the company.   The issuance of phantom equity often bridges this gap.   Phantom equity provides a contractual right to the economic equivalent of equity ownership in a business, without the issuance of an actual equity interest.   When granted to a service provider, phantom equity results in compensation to the individual that, when payable in future years, falls squarely within the definition of deferred compensation for Section 409A purposes.

Phantom equity must be structured to comply with, or be exempt from, Section 409A.  An advantage to drafting deferred compensation to be exempt from Section 409A is that the executive and the company will have greater flexibility in subsequently deferring and/or accelerating these amounts, as the restrictions contained within Section 409A will not apply to amounts that are not subject to Section 409A.    The short-term deferral exception can be used to exempt payments in respect of phantom equity if the executive must be employed by the company on, or closely within proximity of, the specified payment date, as this employment condition gives rise to a substantial risk of forfeiture.   In that instance, payment will always be made within the short-term deferral window (i.e., within 2 ½ months following the end of the calendar year in which the substantial risk of forfeiture lapses).

If the goal is provide for an incentive that can be earned and vested over some period of time, regardless of the executive’s provision of services through the payment date, phantom equity will become deferred compensation and must be paid only on a permissible Section 409A payment event.  Change in control, separation from service, death and disability are common permissible Section 409A triggers for payments in respect of phantom equity.   Other events, such as the occurrence of an IPO or the achievement of a revenue threshold, are not among the stated permissible Section 409A triggers and thus cannot be used for this purpose.

In our final post, we will move to Section 409A considerations for traditional equity incentive awards, with a discussion of the importance of proper valuation in this context.

Ask most closely-held business owners what words come to mind when they hear the names “Enron” and “Worldcom” and many would say things like “bankruptcy,” “failure,” “scandal” and “greed.”    Ask those same business owners what impact those two names had on the ways they are able compensate their key employees and most would likely say there couldn’t possibly be a connection between these two multibillion dollar collapses and their own businesses.     They would be wrong.

Shortly before each of Enron and Worldcom declared bankruptcy, executives of each withdrew their account balances from nonqualified deferred compensation plans, accelerating these companies’ bankruptcies while simultaneously leaving the rank and file employees, as well as the companies’ shareholders, with little or nothing.  In 2004, in order to prevent similar abuses in the future, Congress enacted Section 409A of the Internal Revenue Code.  Section 409A imposes a significant series of restrictions on a broad variety of compensation arrangements that fit within the definition of “nonqualified deferred compensation,” with harsh consequences for failure to comply with this complicated new regime.

What is Section 409A?

The IRS spent over 400 pages describing the intricate workings of Section 409A in detailed Treasury Regulations that became final on January 1, 2010.  Simply stated, under Section 409A, certain requirements relating to the timing of payments of deferred compensation must be satisfied.  If they are not, all amounts deferred under a nonqualified plan (for all taxable years) are currently includible in the service provider’s gross income to the extent they are not subject to a “substantial risk of forfeiture” (i.e., the service provider’s rights to the compensation are conditioned upon the performance of substantial services or upon the occurrence of a condition related to a purpose of the compensation, such as the attainment of a prescribed level of earnings).

Those payment timing requirements provide that if a service provider has a legally binding right to compensation that is, or could be, payable in a future taxable year, that compensation must be required to be paid, and may only be paid, upon one of six permissible payment triggers:

  • (i) death,
  • (ii) disability,
  • (iii) a “separation from service”,
  • (iv) a “change in control”,
  • (v) an unforeseeable emergency or
  • (vi) on a fixed date or pursuant to a fixed schedule, each as specifically defined for purposes of Section 409A.

This seems simple enough and, yet, the sheer volume of the applicable Treasury Regulations should serve to alert any tax practitioner that complying with Section 409A is anything but simple.

There are per se, definitional and statutory exceptions and exemptions to Section 409A, such as tax-qualified plans, “short-term deferrals” and “separation pay plans.”

Furthermore, there are the all of the additional nuances embedded within these central concepts – rules applicable to key employees of public companies only, provisions that must be contained in writing in order to be operative, documentary failures, operational failures, permissible accelerations, rules surrounding initial and subsequent deferrals, and aggregation rules among different types of plans.   The list goes on and on.

 What Types of Arrangements are Subject to Section 409A?

Rather than amend the Bankruptcy Code, or draft targeted regulations to address the bad acts of a select few in positions to wreak havoc on public company shareholders, Congress took a “one size fits all” approach to answering this question.   Painting with a broad brushstroke, Congress swept up a variety of compensation arrangements into the panoply that is the domain of Section 409A.  These include:

Employment agreements providing for severance

  • Bonus plans
  • Stock options and other types of equity compensation
  • Post-retirement reimbursements
  • Supplemental executive retirement plans
  • Change in control arrangements
  • Retention bonuses
  • Employee elective salary/bonus deferrals

Any of the above may give rise to nonqualified compensation which must be paid in accordance with Section 409A.

What happens is I get it wrong?

A violation of Section 409A results in immediate taxation to the executive of all vested rights under any covered compensation arrangement prior to payment, in addition to a 20% penalty and premium interest charges.  This draconian result is even harder to swallow in light of the following two points:  (i)  compliance with Section 409A can be a daunting task, requiring strict adherence to detailed regulations which little or no room for error; and (ii) despite the fact that the company usually dictates the terms of payment, it is the service provider who is hit with the lion’s share of consequences for failures to comply with Section 409A.

Looking Ahead

Closely held businesses are uniquely challenged to incentivize and motivate key employees, particularly when subsequent generations may not be interested in, or capable of, managing the company.    Unfortunately, Section 409A is often overlooked by many smaller, privately held companies, as there is still, a decade after its enactment, a pervasive misconception that Section 409A only applies to publicly traded companies.  In our next post, we will touch upon some typical executive compensation structures with an eye toward compliance with Section 409A.    Thereafter, we will focus on equity compensation and, in particular, the role of proper valuation in Section 409A compliance.