In the weeks preceding the introduction of the bill that was just enacted as the Tax Cuts and Jobs Act (the “Act”), my colleagues teased me, “Lou, what are you going to do when Congress simplifies the Code?”

“Simplify?” I responded as I reached for the Merriam-Webster’s Dictionary that I have used since 1980 – it resides next to the HP scientific calculator that I have used since 1987 – change is not always a good thing – “Congress is incapable of simplifying anything.”

Tax Cuts and Jobs Act

“The word ‘simplify’,” I continued, “is defined as follows: to make simple or simpler; to reduce to basic essentials; to diminish in scope or complexity; to make more intelligible.”

After reviewing the final version of the legislation, two thoughts came to mind: first, Congress must not have a dictionary and, second, the most influential lobbying organization in Washington must be comprised entirely of tax professionals.

In order to better appreciate – if not fully understand – the changes wrought by the Act regarding the Federal taxation of trade or business income that is recognized, “directly or indirectly,” by non-corporate taxpayers, the reader should be reminded of the existing rules, and should also be made aware of the policy underlying the changes.

Pre-2018

A business that is conducted by an individual as a sole proprietorship (whether directly or through a single-member LLC that is disregarded for tax purposes) is not treated as an entity separate from its owner. Rather, the owner is taxed directly on the income of the business.

A business that is conducted by two or more individuals as a general partnership, a state law limited partnership, or a state law limited liability company, is treated as a pass-through entity for tax purposes – a partnership. The partnership is not itself taxable on the income of the business. Rather, each partner/member is taxed on their distributive share of the partnership’s business income.

A corporation that is formed under state law to conduct a business is not itself taxable on the income of the business if it is a “small business corporation” and its shareholders elect to treat it as an S corporation. In that case, the corporation is treated as a pass-through entity for tax purposes. In general, it is not taxable on its business income; rather, its shareholders are taxed on their pro rata share of the S corporation’s business income.

In each of the foregoing situations, the business income of an individual owner of a sole proprietorship, a partnership, or an S corporation (each a “Pass-Through Entity” or “PTE”) is treated for tax purposes as though the owner had realized such income directly from the source from which it was realized by the PTE.

In determining the taxable business income generated by a PTE, the Code allows certain deductions that are “related” to the production of such income, including a deduction for the ordinary and necessary expenses that are paid or incurred by the PTE in carrying on the business.

Because business income is treated as ordinary income (as opposed to capital gain) for tax purposes, the taxable business income of the PTE is taxed to its individual owner(s) at the regular income tax rates.[1]

What’s Behind the Change?

The vast majority of closely-held businesses are organized as PTEs, and the vast majority of newly-formed closely-held businesses are organized as limited liability companies that are treated as partnerships or that are disregarded for tax purposes.[2]

In light of this reality, Congress sought to bestow some unique economic benefit or incentive upon the non-corporate owners of PTEs in the form of a new deduction, and reduced taxes.[3]

However, Congress restricted this benefit or incentive in several ways that reflect a bias in favor of businesses that invest in machinery, equipment, and other tangible assets:[4]

  • in general, it is limited to PTEs that do not involve only the performance of services;
  • it benefits only the net business income of the PTE that flows through to the taxpayer; it does not apply to any amount paid by the PTE to the taxpayer in respect of any services rendered by the taxpayer to the PTE;
  • it does not apply to the PTE’s investment income; it is limited to the PTE’s business income; and
  • the benefit is capped, based upon how much the PTE pays in wages or invests in machinery, equipment, and other tangible property.

Beginning in 2018: New Sec. 199A of the Code

For taxable years beginning after December 31, 2017 and before January 1, 2026, an individual taxpayer[5] (a “Taxpayer”) who owns an equity interest in a PTE that is engaged in a qualified trade or business may deduct up to 20% of the qualified business income allocated to him from the PTE.

Qualified Trade or Business

Taxpayer’s qualified business income (“QBI”) is determined by each qualified trade or business (“QTB”) in which Taxpayer is an owner.[6] A QTB includes any trade or business conducted by a PTE other than a specified service trade or business.[7]

A “specified service trade or business” means any trade or business involving the performance of services in the fields of health, law, accounting, consulting, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees, or which involves the performance of services that consist of investing and investment management, or trading or dealing in securities.[8] However, a trade or business that involves the performance of engineering or architectural services is not a “specified service.”

Qualified Business Income

Taxpayer’s QBI from a QTB for a taxable year means Taxpayer’s share of the net amount of qualified items of income, gain, deduction, and loss that are taken into account in determining the taxable income of the QTB for that year.[9]

Items of income, gain, deduction, and loss are “qualified items” only to the extent they are effectively connected with the PTE’s conduct of a QTB within the U.S.[10]

“Qualified items” do not include specified investment-related income, gain, deductions, or loss; for example, items of gain taken into account in determining net long-term capital gain, dividends, and interest income (other than that which is properly allocable to a trade or business) are not included[11]; nor are items of deduction or loss allocable to such income.

Taxpayer’s QBI also does not include any amount paid to Taxpayer by an S corporation that is treated as reasonable compensation for services rendered by Taxpayer. Similarly, Taxpayer’s QBI does not include any “guaranteed payment” made by a partnership to Taxpayer for services rendered by Taxpayer.[12]

The Deduction

In general, Taxpayer is allowed a deduction for any taxable year of an amount equal to the lesser of:

(a) Taxpayer’s “combined QBI amount” for the taxable year, or

(b) an amount equal to 20% of the excess (if any) of

(i) Taxpayer’s taxable income for the taxable year, over

(ii) any net capital gain for the taxable year.

The combined QBI amount for the taxable year is equal to the sum of the “deductible amounts” determined for each QTB “carried on” by Taxpayer through a PTE.[13]

Taxpayer’s deductible amount for each QTB is the lesser of:

(a) 20% of the Taxpayer’s share of QBI with respect to the QTB, or

(b) the greater of:

(i) 50% of the “W-2 wages” with respect to the QTB, or

(ii) the sum of:

(A) 25% of the W-2 wages with respect to the QTB, plus

(B) 2.5% of the unadjusted basis, immediately after acquisition, of all “qualified property”.[14]

In general, the W-2 wages with respect to a QTB for a taxable year are the total wages subject to wage withholding, plus any elective deferrals, plus any deferred compensation paid by the QTB with respect to the employment of its employees during the calendar year ending during the taxable year of Taxpayer.[15]

“Qualified property” means, with respect to any QTB for a taxable year, tangible property of a character subject to depreciation that is held by, and available for use in, the QTB at the close of the taxable year, which is used at any point during the taxable year in the production of QBI, and for which the depreciable period[16] has not ended before the close of the taxable year.

Example

The taxpayer is single. She is a member of an LLC (“Company”) that is treated as a partnership for tax purposes (a PTE). The company is engaged in a QTB that is not a specified service trade or business.

Taxpayer’s taxable income for 2018 is $500,000 (i.e., gross income of $520,000 less itemized deductions of $20,000), which includes a guaranteed payment from Company of $120,000, for services rendered to Company during 2018, and her allocable share of QBI from Company for 2018 of $400,000. She has no investment income for 2018.

Her allocable share of W-2 wages with respect to Company’s business for 2018 is $300,000.

During 2018, Company purchases machinery and immediately places it into service in its QTB (the machinery is “qualified property”). Taxpayer’s allocable share of the purchase price is $750,000.

The taxpayer is allowed a deduction for the taxable year of an amount equal to the lesser of:

(a) her “combined QBI amount” for the taxable year (the guaranteed payment of $120,000 is not included in QBI), or

(b) 20% of her taxable income of $500,000 for the taxable year, or $100,000.

Taxpayer’s combined QBI amount for 2018 is equal to her “deductible amount” with respect to Company. The deductible amount is the lesser of:

(a) 20% of Taxpayer’s QBI (20% of $400,000 = $80,000), or

(b) the greater of:

(i) 50% of the W-2 wages with respect to the QTB (50% of $300,000 = $150,000), or

(ii) the sum of: 25% of the W-2 wages with respect to the QTB ($75,000), plus (B) 2.5% of the unadjusted basis, immediately after acquisition, of all qualified property (2.5% of $750,000 = $18,750): $75,000 + $18,750 = $93,750.

Thus, Taxpayer’s deductible amount is $80,000. Because this amount is less than $100,000 (20% of her taxable income of $500,000 for the taxable year), Taxpayer will be allowed to deduct $80,000 in determining her taxable income for 2018.

Looking Ahead

It remains to be seen whether the “20% deduction” based upon the QBI of a PTE will be a “game changer” for the individual owners of the PTE.

After all, the deduction is subject to several limitations that may dampen its effect. For example, QBI does not include the amount paid by the PTE to Taxpayer in respect of services rendered by Taxpayer. In addition, the losses realized in one QTB may offset the income realized in another, thereby reducing the amount of the deduction. Finally, the deduction is subject to limits based upon the wages paid and the capital investments made by the QTB.

Maximizing the Deduction?

Might an S corporation shareholder or a partner in a partnership reduce the amount paid to them by the entity for their services so as to increase the amount of their QBI and, so the amount of the deduction? In the case of an S corporation, this may result in the IRS’s questioning the reasonableness (i.e., insufficiency) of the compensation paid to the shareholder-employee.[17]

Or might a PTE decide to invest in more tangible property than it otherwise would have in order to set a greater cap on the deduction?

In any case, the business must first be guided by what makes the most sense from a business perspective.

Becoming a Pass-Through?

What if a business is already organized as a C corporation? Should the QBI-based deduction tip the scales toward PTE status?

Before taking any action with respect to changing its status for tax purposes, a C corporation will have to consider much more than the effect of the deduction for PTEs.

For example, does it even qualify as a small business corporation? If not, what must it do to qualify? Must it redeem the stock owned by an ineligible shareholder, or must it recapitalize so as to eliminate the second class of stock? Either option may prove to be economically expensive for the corporation and the remaining shareholders.

If the corporation does qualify, what assurances are there that all of its shareholders will elect to treat the corporation as an S corporation? Even if the election is made, will the presence of earnings and profits from “C” taxable years implicate the “excess passive income” rules?

In any case, a C corporation that is not otherwise contemplating a change in its tax status, should probably not become an S corporation solely because of the PTE-related changes under the Act, especially if the corporation does not contemplate a sale of its business in the foreseeable future.

Wait and See?

The deduction based on the QBI of a PTE will expire at the end of 2025 unless it is extended before then. It is also possible that it may be eliminated by Congress after 2020.

An existing PTE and its owners should continue to operate in accordance with good business practice while they and their tax advisers determine the economic effect resulting from the application of the new deduction to the PTE.

They should also await the release of additional guidance from the IRS regarding “abusive” situations, tiered entities, and other items.[18]


*This post is the first of several that will be dedicated to those portions of the Tax Cuts and Jobs Act of 2017 (H.R. 1) that are most relevant to the closely-held business and it owners.

[1] The Act reduces the highest income tax rate applicable to the individual owner of a PTE to 37% (from 39.6%) for taxable years beginning after December 31, 2017 and before January 1, 2026. Note that the 3.8% surtax continues to apply to the distributive or pro rata share of an individual partnership or shareholder who does not materially participate in the trade or business conducted by the PTE.

[2] Though occasionally, the owner(s) will elect to treat the LLC as a corporation for tax purposes; for example, to reduce employment taxes.

[3] The Act includes a number of business-related benefits that are applicable to both corporate and non-corporate taxpayers. It also includes some that are unique to corporations, such as the reduction of the corporate income tax rate from a maximum of 35% to a flat 21%.

[4] As we will see in the coming weeks, that Act contains a number of such provisions.

[5] More accurately, the benefit is available to non-corporate owners; basically, individual taxpayers, though trusts and estates are also eligible for the deduction.

[6] A PTE may conduct more than one QTB – different lines of business – or Taxpayer may own equity is more than one PTE.

[7] Also excluded is the trade or business of being an employee.

[8] The exclusion from the definition of a qualified business for specified service trades or businesses is phased in for a taxpayer with taxable income in excess of a “threshold amount” of $157,500 ($315,000 in the case of a joint return). The exclusion is fully phased in for a taxpayer with taxable income at least equal to the threshold amount plus $50,000 ($100,000 in the case of a joint return).

[9] If the net amount of the QBI is a loss (negative), it is treated as a loss from a QTB in the succeeding taxable year.

[10] Generally, when a person engages in a trade or business in the U.S., all income from sources within the U.S. connected with the conduct of that trade or business is considered to be effectively connected income.

[11] Qualified items should include the gain recognized on the sale of business assets.

[12] The IRS is authorized to issue regulations that would exclude any amount paid or incurred by the partnership to Taxpayer for services provided by Taxpayer to the partnership other than in his capacity as a partner.

[13] Taxpayer does not need to be active in the business in order to qualify for the deduction.

[14] This “wage limit” is phased in for a taxpayer with taxable income in excess of the threshold amount. The limit is fully applicable for a taxpayer with taxable income equal to the threshold amount plus $50,000 ($100,000 in the case of a joint return).

[15] In the case of a partnership or S corporation, the provision applies at the partner or shareholder level. Each partner or shareholder, as the case may be, takes into account his allocable or pro rata share of each qualified item of income, gain, deduction, and loss, and is treated as having W-2 wages and unadjusted basis for the taxable year equal to his allocable or pro rata share of the W-2 wages and unadjusted basis of the partnership or S corporation, as the case may be.

[16] The “depreciable period” is the period beginning with the date the qualified property is first placed in service and ending on the later of the date that is 10 years after such date, or the last day of the last full year in the applicable recovery period for the property.

[17] State and local taxes also need to be considered; for example, NYC’s unincorporated business income tax and its general corporation tax.

[18] “What we do in haste, we regret at leisure?”

Worlds Collide?

I like to tell my partners that there are Codes (upper case “C”), and there are codes (lower case “c”). The former include the Ten Commandments, the Code of Hammurabi, the Code of Justinian, and the Internal Revenue Code. The latter include the Pirate’s Code – which, as Captain Barbossa tells us in the movie Pirates of the Caribbean, “is more what you’d call ‘guidelines’ than actual rules” – and the Bankruptcy code.[1]

Notwithstanding the great divide that normally separates these two sets of coda, the space-time continuum is sometimes warped in such a way that they overlap, as they did in a recent decision of the bankruptcy court that considered whether a debtor-corporation’s status as an “S corporation” for tax purposes should be considered “property” for the purposes of the Bankruptcy code (the “BC”).

“S” Election as “Property”?

Debtor was a privately-held company. As a result of a large settlement and the resulting adverse effects on its business, Debtor’s relationship with its secured lender became severely strained. Debtor eventually defaulted under its loan facilities. In response, the lender discontinued debtor’s borrowing ability and cut off its access to its existing accounts. With no ability to access its cash and with no alternative sources of financing immediately available, Debtor was forced to file for protection under Chapter 11 (“reorganization”) of the BC, following which the U.S. Trustee appointed a committee of unsecured creditors.

However, prior to filing its voluntary petition, and with the consent of a majority of its shareholders, Debtor revoked its election to be treated as an S corporation for tax purposes, though it continued to satisfy the criteria for such status.[2]

Pre-Petition

During the period that Debtor was classified as an S corporation, each shareholder – and not Debtor – reported, and paid tax on, his share of Debtor’s taxable income as reflected on the Sch. K-1 issued by Debtor to the shareholder.

In accordance with Debtor’s Shareholders’ Agreement, Debtor made distributions to its shareholders to reimburse them for Debtor’s pass-through tax liability. Debtor also made direct payments of tax to the IRS on behalf of its shareholders.

As a result of revoking its “S” election, Debtor became subject to corporate-level tax as a “C” corporation, and its shareholders – to whom distributions from Debtor would likely have ceased after the filing of its petition – were no longer required to report its income on their personal returns.

C vs S Corps

Under the Code, a corporation’s “default” status is as a “C corporation,” the net income of which is subject to two levels of taxation: once at the corporate level, and then to the shareholders when distributed to them as dividends.[3]

In contrast to C corporation status, S corporation status confers “pass-through taxation.” S corporations pass corporate income, gains, losses, deductions, and credits to their shareholders, who must report their respective shares of the income and losses of the S corporation on their personal income tax returns.

Sale of Assets

A couple of months following Debtor’s petition, the Court entered an order which authorized the sale of substantially all of Debtors’ operating assets to Buyer, and the sale occurred shortly thereafter. The Court then confirmed Debtor’s Plan of Liquidation, pursuant to which the Liquidating Trust was formed as the successor to Debtor and to the unsecured creditors committee.

The Liquidating Trustee filed a complaint against the IRS and Debtor’s shareholders, seeking to avoid the revocation of Debtor’s S corporation status as a fraudulent transfer of property under the BC.[4]

The U.S. filed a motion to dismiss the complaint because, it stated, “a debtor’s tax status is not ‘property’.”

Other Courts

The Court noted that only a handful of courts have considered this issue in the context of fraudulent transfers. Of these courts, only the Third Circuit concluded that S corporation status did not constitute a property right in bankruptcy; all of the others found S corporation status to be a property right in bankruptcy.

Some of the courts that found a property right defined “property” under the BC as something that a person has rights over in order to use, enjoy, and dispose of. These courts reasoned that a debtor corporation did have a property interest in its S corporation status on the date that the status was allegedly “transferred” because the Code “guarantees and protects an S corporation’s right to dispose of [the S corporation] status at will.” Until such disposition, the corporation had the “guaranteed right to use, enjoy, and dispose” of the right to revoke its S corporation status. Consequently, these courts held that the right to make or revoke S corporation status constituted “property” or “an interest of the debtor in property.”

In contrast, the Third Circuit, reviewing a post-petition revocation, concluded that S corporation status did not constitute an interest of a debtor corporation in “property” in a bankruptcy case.

Court’s Analysis

The issue before the Court was whether Debtor’s S corporation status was an interest in “property” that was subject to transfer. If it was not, then the “S” election was not subject to the fraudulent transfer provisions of the BC.

The Court explained that the issue whether S corporation status is “property” for the purposes of the BC was a question of law. The fraudulent transfer provision allows a trustee to avoid obligations voidable under state law. The fraudulent transfer provision allows a trustee to avoid certain transfers that occurred two years prior to the petition date.

The Court acknowledged that the property of the bankruptcy estate is composed of “all legal or equitable interests of the debtor in property as of the commencement of the case.” Congressional intent, it stated, indicates that “property” under the BC is a sweeping term and includes both intangible and tangible property.

Defining “Property”

However, it continued, no BC provision “answers the threshold questions of whether a debtor has an interest in a particular item of property and, if so, what the nature of that interest is.” Property interests are created and defined by state law, unless some countervailing federal interest requires a different result.

Normally, the “federal [tax] statute ‘creates no property rights but merely attaches consequences, federally defined, to rights created under state law.'” Once “‘it has been determined that state law creates sufficient interests in the [taxpayer] to satisfy the requirements of [the statute], state law is inoperative,’ and the tax consequences thenceforth are dictated by federal law.”

In this case, the Court stated, federal tax law governed any purported property right at issue. There was clearly a countervailing federal interest because S corporation status is a creature of federal tax law. State law created “sufficient interests” in the taxpaying entity by affording it the requisite corporate and shareholder attributes to qualify for S corporation status; at that point, “‘state law [became] inoperative,’ and the tax consequences [were] dictated by federal law.” Federal tax law, which was dependent on certain state law conclusions, dictated whether S corporation status was a property right for purposes of the BC.

The Court recognized that certain interests constitute “property” for federal tax purposes when they embody “essential property rights,” which include (1) the right to use; (2) the right to receive income produced by the purported property interest; (3) the right to exclude others; (4) the breadth of the control the taxpayer can exercise over the purported property; (5) whether the purported property right is valuable; and (6) whether the purported right is transferable. A reviewing court must weigh those factors, it stated, in order to determine whether the interest in S corporation status constitutes “property” for federal tax purposes.

Applying these “essential property rights” factors, the Court observed that only one of the factors leaned in favor of classifying S corporation status as property; specifically, Debtor’s ability to use the S corporation tax status to pass its tax liability through to its shareholders. However, according to the Court, the “right to use” factor was the weakest of the “essential property rights.” Without the rights of control and disposition, the right to use was “devoid of any meaningful property interest,” the Court stated. While Debtor may have had the right to use the S corporation status, it lacked the ability to control the use of its tax classification. The right to use the classification existed only until termination.

The second factor, that the tax classification was valuable, did not lean in favor of finding that S corporation status qualified as a property right. The Liquidating Trustee hoped to generate value through avoidance of the “transferred” S corporation revocation, thus retroactively reclassifying Debtor as an S corporation during that taxable year. The Liquidating Trustee believed that by doing so, Debtor’s losses would pass through to its shareholders (to the extent of their basis in Debtor stock), offsetting other income on their personal returns, and thereby generating refunds that the Liquidating Trustee intended to demand from the shareholders for the benefit of the Liquidating Trust and the creditors.[5]

In response to this “plan,” the Court pointed out that, though something may confer value to the estate, it does not necessarily create a property right in it.

Similarly, the Court continued, a corporation cannot claim a property interest to a valuable benefit that another party has the power to legally revoke at any time.

The Court explained that the “S” election removes a layer of taxation on distributed corporate earnings by permitting the corporation to pass its income through to the corporation’s shareholders. The benefit is to the shareholders — it allows them to avoid double taxation. To the extent there is value inherent in the S election, it is value Congress intended for the corporation’s shareholders and not for the corporation.

The remaining factors, the Court continued, also leaned in favor of finding that S corporation status did not constitute a property right under federal tax law. Most importantly, a corporation has very little control over its S corporation status, yet the right to exercise dominion and control over an interest is an essential characteristic defining property.

Shareholders have the overwhelming ability to control the tax status of their corporation. Election of S corporation status may be achieved by one method—unanimous shareholder consent; the corporation does not elect S corporation status. Thus, any interest in electing S corporation status belongs to the shareholders.

The Court stated that an S corporation does not have a vested interest in its tax status after the election has been made. Rather, termination of S corporation status – including by the consent of majority of shareholders – is contingent on shareholder action; the corporation has no unilateral control over the revocation of its S corporation status.

For example, the sale by a shareholder of one share of stock to a partnership would automatically terminate a corporation’s S corporation status. As the S corporation election could be terminated voluntarily by the actions of any one shareholder, it is impossible to state that a corporation has complete control over its S corporation status. Unilateral shareholder action could extinguish S corporation tax status without the corporation taking any action.

The Court observed that S corporation status is not reflected as an asset on a corporation’s balance sheet; it is not something of value that can be transferred by the corporation to an acquiring company; it does not produce income. Rather, S corporation status is a statutory privilege that qualifying shareholders can elect in order to determine how income otherwise generated is to be taxed.

The Court ended its analysis by noting that neither the BC nor the Code allow for a trustee to choose the tax status of the entity. Rather, the BC requires that a trustee furnish returns for any year where a return was not filed as required. Similarly, the Code requires that a trustee “make the return of income for such corporation in the same manner and form as corporations are required to make such returns.” In this case, Debtor was a C corporation for tax purposes. Debtor was required to file as such. The Liquidating Trustee could no use the fraudulent transfer provisions of the BC to maneuver around that requirement.

After weighing all the factors, the Court held that S corporation status was not property under the Code. Although a corporation and its shareholders could elect to use S corporation status in order to avoid double taxation, that factor alone was not enough to outweigh all the remaining characteristics essential to qualify tax status as a property right.

Accordingly, Debtor’s S corporation status could not be considered “property” for the purposes of the BC, and there was no transfer of Debtor’s interest in property that was subject to avoidance under of the BC.

Takeaway?

A financially distressed S corporation make be forced to sell properties in order to generate liquidity with which to pay creditors, or it may negotiate for the cancellation of certain indebtedness owing to such creditors.

These transactions may generate gain or income[1] that will flow through, and be taxable, to the corporation’s shareholders. Moreover, it is likely that the corporation’s creditors will not permit it to make cash distributions to its shareholders to enable them to pay the tax on the flow-through income or gain.

On the other hand, a distressed S corporation has likely generated substantial losses, having lost not only its undistributed income and its shareholders’ capital contributions, but also the funds acquired via loans from third parties and from shareholders.

Some of these losses may have been “suspended,” and remain unused by the shareholders, because the shareholders have exhausted their basis for their shares of stock and for their loans to the corporation.

The flow-through of income or gain to the shareholders would increase their debt and stock bases (in that order), thereby allowing them to utilize some, though perhaps not all, of their suspended losses. It is also possible that the income or gain will exceed the available losses, thus resulting in a net cash outlay by the shareholders for taxes owing.

Of course, if the “S” election were revoked prior to the corporation’s filing its petition, the foregoing issues may be averted, though the corporation’s creditors may object (as the Liquidating Trustee did in the decision discussed above) because any gain or income, and the related tax liability, resulting from the sale or debt cancellation would be captured at the level of the corporate debtor.

At the end of the day, it will behoove the debtor S corporation to consult its tax and bankruptcy advisers well before approaching its creditors, and to thoroughly analyze the foregoing issues and options before deciding to revoke its tax status.


[1] With apologies to the Title 11 Bar? Nah.

[2] Fewer than 100 individual shareholders, one class of stock, etc.

[3] The Tax Cuts and Jobs Act (H.R. 1), on which the House and Senate will be voting this week, would reduce the corporate income tax rate to 21%, effective January 1, 2018. If enacted, we will cover this legislation in later posts.

[4] For example, the trustee may avoid any transfer of a debtor’s interest in property: that was made within 2 years before the date of the filing of the petition if the debtor made such transfer with intent to hinder, delay, or defraud any entity to which the debtor was or became, on or after the date that such transfer was made, indebted; or for which it received less than a reasonably equivalent value in exchange for such transfer; or was insolvent on the date that such transfer was made, or became insolvent as a result of such transfer.

[5] The Trustee’s plan was a bit more convoluted than this. You can’t make this stuff up.

[6] The application of the Code’s bankruptcy and insolvency exceptions to COD income is made at the level of the S corporation.

Old Dog, New Tricks?

It’s a concern for every new investor in a closely held business: will the founding owners continue to operate the business as they always have, or will they recognize that they now have new co-owners to whom they owe a fiduciary duty, and on whom they made be dependent for funding or services, and will this recognition inform their actions with respect to the business and guide their relationship with the new investors?

Because of this concern, the new investor will insist that the owners enter into a shareholders’ or partnership agreement that includes various provisions that seek to protect the new owners’ rights, and to limit the original owners’ ability to ignore those rights and thereby compromise the economic benefits sought by the new investors.

Unfortunately, at least from the perspective of the new investor, it is not unusual for the founder, notwithstanding any shareholders’ or partnership agreement, to “forget” that he has others to whom he has to report. While such “forgetfulness” will strain the relationship among the owners of any business entity, it can be especially stress-inducing in the context of a pass-through entity like a partnership or an S corporation, the income of which is taxed to its owners without regard to any owner’s ability to influence or control the entity’s activities.

Yet Another Example

In a recent case before the Tax Court, the taxpayer tried to convince the Court that she should not be required to include her share of S corporation income in her gross income because the controlling shareholder had effectively prevented her from enjoying the beneficial ownership of her shares.

Corp was created by Founder to operate a diagnostic laboratory. Founder approached Taxpayer – who worked with Merchant Bank (“MB”) – to ask whether she would consider getting involved in Corp. Taxpayer and Founder discussed certain issues that Corp was facing, including its lack of a solid financial infrastructure.

Corp eventually entered into a consulting agreement with MB, under which MB would assist Corp with settling existing liabilities, diversifying the business, and implementing a financial infrastructure. In consideration for these services, Corp would pay MB a fixed monthly fee.

As part of this arrangement, Founder’s ownership of Corp was reduced to 50%, and members of MB or their designees (MB shareholders, including Taxpayer) acquired ownership of the other 50%.

Shareholders’ Agreement

The shareholders of Corp executed a Shareholders’ Agreement. The Agreement named various individuals, including Founder and Taxpayer, as officers of Corp. The board of directors of Corp consisted of its officers, including Taxpayer. The Shareholders’ Agreement stated that “[a]ll matters relating to the management of [Corp’s] business and operations of any kind or nature whatsoever shall be approved by a majority vote of [Corp’s] Board of Directors.” The board of directors, however, met only once after executing the Shareholders’ Agreement.

The Shareholders’ Agreement further stated:

The timing and amount of any distributions of net profits or cash flow from [Corp’s] operations or otherwise (the “Distributions”) to be made by [Corp] to the Shareholders hereunder shall be approved by the Board of Directors . . . . All Distributions shall be made by [Corp] to the Shareholders pari passu in accordance with their proportionate Share ownership hereunder.

In addition, the Agreement implemented a new payment approval procedure for Corp, stating:

The authorizing resolution to be delivered to the bank or other depository of funds of [Corp] shall provide that any officer signing singly may execute all checks or drafts of [Corp] in an amount up to $100,000.00, and two (2) persons consisting of [Founder] and one (1) member of the MB shareholders, shall be authorized as joint signatories in respect of all checks or drafts on behalf of the [Corp] in excess of $100,000.00.

Nevertheless, Corp frequently made payments in excess of $100,000 that were not authorized in conformity with the Shareholders’ Agreement.

Finally, the Agreement gave the shareholders the right to inspect and copy all books and records of Corp. At the beginning of MB’s relationship with Corp, Corp’s CFO distributed copies of monthly financial statements to representatives of the MB shareholders.

The Loan

One concern raised by Corp’s financial statements involved a loan from Founder to Corp close to the time of its organization. General ledgers made available to the MB shareholders, and reviewed as part of MB’s due diligence, showed a loan balance in excess of $7 million. Money paid by Corp on Founder’s behalf, including personal expenses, was charged against this loan, reducing the loan balance, and interest on the loan was paid to Founder monthly.

An audit of Corp’s financial statements found that payments made from Corp to Founder were recorded on the loan payable’s general ledger account, and the loan appeared as a “Note Payable” on the audited financial statements, and appeared as “Liabilities” on Corp’s Federal income tax returns. However, no “Loan from Shareholder” was reflected on the Schedules L of Corp’s Federal income tax returns on Form 1120S.

As Founder’s relationship with MB and the MB shareholders began to deteriorate, Taxpayer approached Founder concerning certain Corp expenses that Taxpayer believed were personal and unrelated to Corp’s business.

At that point, Founder no longer permitted MB and the MB shareholders to enter Corp’s premises, and he instructed Corp’s employees to stop providing financial information to them. Corp also stopped paying MB for its consulting services.

Unbeknownst to the MB shareholders, Founder also filed a complaint seeking judgment against Corp for the loans he claimed to have made to Corp over the course of many years. Founder served the complaint on the comptroller of Corp, Corp did not defend the lawsuit, and a default judgment was entered against Corp.

MB sued Founder for breach of the consulting agreement and failure to pay consulting fees. In reaction to this lawsuit, Founder filed for chapter 11 bankruptcy.

The bankruptcy court appointed a forensic accountant to investigate Corp’s business operations. The accountant’s report determined that the transfers of funds to Founder disputed by MB and the MB shareholders were recorded on the books by Corp as loan repayments. The report also described the default judgment that Founder had obtained against Corp.

As a result of the above findings, the bankruptcy court appointed a trustee as a financial overseer of Founder’s activities at Corp. The trustee was responsible for evaluating the financial status of Corp, taking financial control, and reporting his findings to the bankruptcy court. During the trustee’s time with Corp, payments of expenses or transfers of funds could not be accomplished without his approval. Additionally, the trustee provided Corp’s shareholders with monthly financial reports.

The Tax Returns

When Taxpayer filed her Forms 1040, U.S. Individual Income Tax Return, for the taxable years at issue, she attached to the return a Form 8082, Notice of Inconsistent Treatment or Administrative Adjustment Request. The Form 8082 included the following statement pertaining to Taxpayer’s ownership interest in Corp:

[Corp] has initiated litigation against the [T]axpayer retroactively contesting [T]axpayer’s ownership interest. The entity and certain shareholders have prevented [T]axpayer from exercising [her] shareholder rights including: sale of shares, voting on business matters, exercising dominion and control of the ownership interest, or enjoying any economic benefits or other ownership rights. The referenced Schedule K-1 is inconsistent with the entity’s contention that [T]axpayer is not entitled to any ownership interest. Therefore until legal ownership is resolved by the court, it was improper for the controlling shareholders to issue a Schedule K-1 to [T]axpayer, and those amounts are not reported in this return.

The issue for decision before the Tax Court was whether Taxpayer was a shareholder of Corp during the years in issue and was, therefore, liable for tax on her pro rata share of Corp’s income for the taxable years at issue.

Court’s Analysis

The Code provides that the shareholders of an S corporation are required to take into account their pro rata shares of the S corporation’s income, loss, deductions, and credits for the S corporation’s taxable year ending with or within the shareholders’ taxable year. An S corporation’s shareholders must take into account the corporation’s income regardless of whether any income is distributed to the shareholder.

The Court stated that, in determining stock ownership for Federal income tax purposes, it must look to the beneficial ownership of shares, not to mere legal title. Cases concluding that a shareholder did not have beneficial ownership, the Court continued, have considered both agreements between shareholders that effectively eliminated ownership, and provisions in the corporation’s governing articles affecting ownership rights.

Mere interference, the Court observed, with a “shareholder’s participation in the corporation as a result of a poor relationship between the shareholders * * * does not amount to a deprivation of the economic benefit of the shares.”

Taxpayer contended that while she was issued Corp shares, the removal of her power to exercise shareholder rights, as well as the actions of Founder, “removed” the beneficial ownership of her shares; therefore, Taxpayer asserted, she was not required to include in gross income her “pro rata share” of Corp’s income.

The Court noted, however, that Taxpayer identified no agreement, nor any provisions in Corp’s governing articles, removing her beneficial ownership.

Moreover, Taxpayer identified no authority supporting her position that a violation of a shareholders’ agreement could deprive shareholders of the beneficial ownership of their shares.

Further, Taxpayer cited no authority that allowed a shareholder to exclude her share of an S corporation’s income because of poor relationships with other shareholders.

In the absence of an agreement passing Taxpayer’s rights to her stock to another shareholder, a poor relationship between shareholders did not deprive Taxpayer of the economic benefit of her shares. Indeed, the Court pointed out, Taxpayer ultimately sold her shares for valuable consideration.

The Court held that because Taxpayer remained a shareholder of Corp for the taxable years at issue, she had to include in gross income her pro rata share of Corp’s income for those years.

Takeaway

The Taxpayer was hardly the first to argue that she was not liable for the tax on her share of S corporation income because she was improperly denied the beneficial ownership of shares in the corporation, notwithstanding her record ownership.

As in other cases, the Tax Court rejected Taxpayer’s position, noting that when a controlling shareholder merely interferes with another shareholder’s participation in the corporation, such interference does not amount to a deprivation of the economic benefit of the shares. Thus, the shareholder is not relieved from reporting her share of the S corporation’s income on her tax return.

A minority owner in any pass-through entity must appreciate the risk that she may be denied the opportunity to participate in the business in any meaningful way, that she may be denied any opportunity for gainful employment in the business, and that she may not receive any distributions from the entity.

The minority owner must also recognize that even when she is fortunate to be party to an agreement with the other owners that provides for mandatory tax distributions and for super-majority voting for certain decisions, such an agreement is meaningless in the face of a majority’s disregard of its terms unless the minority owner actually seeks to enforce the agreement.

In the face of a stubborn or determined founder, a minority owner must be prepared to act fairly quickly to protect herself, or “accept” the economic and tax consequences of having to report her share of the entity’s net income on her tax return. In that case, the minority owner must look to her other assets to provide the cash necessary to satisfy the resulting tax liabilities.  This can turn into an expensive proposition.

A post earlier this year considered the basis-limitation that restricts the ability of S corporation shareholders to deduct their pro rata share of the corporation’s losses. It was observed that, over the years, shareholders have employed many different approaches and arguments to increase the basis for their shares of stock or for the corporation’s indebtedness, in order to support their ability to claim their share of S corporation losses.

Many of these arguments have been made in situations in which the shareholder did not make an economic outlay, either as a capital contribution or as a loan to the S corporation.

In a recent decision, however, the Tax Court considered a shareholder who did, in fact, make a significant economic outlay, but who also utilized a form of transaction – albeit for a bona fide business purpose – that the IRS found troublesome. In defending its right to claim a loss deduction, the shareholder proffered a number of interesting arguments.

The Transaction

Taxpayer owned Parent, which was taxed as an S corporation.

Parent acquired 100% of the issued and outstanding stock of Target from Seller through a reverse triangular merger: Parent formed a new subsidiary corporation (“Merger-Sub”), which was then merged with and into Target, with Target surviving. As a result of the merger, Target became a wholly-owned subsidiary of Parent, and the Seller received cash plus a Merger-Sub promissory note; Target became the obligor on the note after the merger.

Immediately after the merger, Target made an election to be treated as a qualified subchapter S subsidiary (“QSub”).

The cash portion of the merger consideration was funded in part by a loan (the “Loan”) from Lender, which was senior to the promissory note held by Seller.

After the merger, Taxpayer decided to acquire the Loan from Lender. However, Taxpayer believed that (i) if he loaned funds directly to QSub to acquire the Loan, or (ii) if he contributed funds to Parent, intending that they be loaned to QSub to repay the Loan in full, his loan would not be senior to the QSub note held by Seller without obtaining Seller’s consent.

In order to make QSub’s repayment of the Loan to Newco senior to QSub’s repayment of the note to Seller, Taxpayer organized another S corporation, Newco, to acquire the Loan from Lender. Taxpayer transferred funds to Newco, which Newco used to purchase the Loan, following which Newco became the holder of the Loan.

Thus, the indebtedness of QSub was held, not directly by Taxpayer, but indirectly through Newco.

During the Tax Year, Parent had ordinary business losses that were passed through to Taxpayer.

The Tax Return

In preparing his return for Tax Year, Taxpayer used his adjusted basis in the Parent stock, and also claimed adjusted basis in what he believed was QSub’s indebtedness to Taxpayer, to claim deductions for the losses passed through to Taxpayer from Parent for the Tax Year.

The IRS reduced the losses Taxpayer could take into account for the Tax Year, thereby increasing Taxpayer’s taxable income by that amount. Taxpayer petitioned the Tax Court.

Taxpayer argued that Newco should be disregarded for tax purposes, and that the Loan should be deemed an indebtedness of Parent (through its disregarded QSub) to Taxpayer. This would allow Taxpayer to count Newco’s adjusted basis in the Loan in calculating the amount of Parent’s flow-through losses that he could deduct for the Tax Year.

The IRS urged the Court to respect Newco’s separate corporate existence, and not to treat the Loan as indebtedness of Parent to Taxpayer.

S Corp. Losses

The Code generally provides that an S corporation’s shareholder takes into account, for his taxable year in which the corporation’s taxable year ends, his pro rata share of the corporation’s items of income, loss, deduction, or credit.

However, the aggregate amount of losses and deductions taken into account by the shareholder is limited: It may not exceed the sum of the adjusted basis of the shareholder’s stock in the S corporation plus the shareholder’s adjusted basis of any indebtedness of the S corporation to the shareholder (the “loss-limitation rule”).

The Code does not define the term “indebtedness of the S corporation to the shareholder” as used in the loss-limitation rule.

QSub

A QSub is a domestic corporation which is wholly-owned by an S corporation, and that elects to be treated as a QSub. In general, a QSub is not treated as a separate corporation, and all of its assets, liabilities, and items of income, deduction, and credit are treated those of the S corporation. Thus, for purposes of the loss-limitation rule, a QSub’s indebtedness to its parent S corporation’s shareholder is treated as the parent’s indebtedness for purposes of determining the amount of loss that may flow through to the parent’s shareholder.

Acquisition of Basis in Indebtedness of Parent

The IRS argued that a shareholder can acquire basis in an S corporation either by contributing capital, or by directly lending funds, to the corporation. The loan must be direct, the IRS maintained; no basis is created where funds are loaned by a separate entity that is related to the shareholder.

The IRS emphasized that the Loan ran to QSub from Newco, not from Taxpayer; thus, the Loan could not be considered in computing the basis of any indebtedness of Parent to Taxpayer.

Taxpayer conceded that the courts have interpreted the loss-limitation rule generally to require that the indebtedness of an S corporation be owed directly to its shareholder. However, the Taxpayer asserted, “form is but one-half of the inquiry, and the transaction’s substance also needs to be considered.”

The IRS asserted that Taxpayer ought to be bound by the form of the transaction chosen, and should not, “in hindsight, recast the transaction as one that they might have made in order to obtain tax advantages.”

Moreover, the IRS pointed out, where the entities involved in transactions are wholly-owned by a taxpayer, the taxpayer bears “a heavy burden of demonstrating that the substance of the transactions differs from their form.”

Taxpayer posited that an intermediary, such as Newco, could be disregarded for tax purposes where it (1) acted as a taxpayer’s incorporated pocketbook, (2) was a mere conduit or agent of the taxpayer, or (3) failed to make an actual economic outlay to the loss S corporation that made the intermediary poorer in a material sense as a result of the loan.

Incorporated Pocketbook

Taxpayer urged the Court to find that Newco acted as the Taxpayer’s incorporated pocketbook in purchasing the Loan from the Lender and holding it thereafter.

Taxpayer emphasized that Newco had no business activities other than holding the Loan and acting as a conduit for payments made by QSub.

The Court observed that the term “incorporated pocketbook” refers to a taxpayer’s habitual practice of having his wholly-owned corporation pay money to third parties on his behalf.

The Court, however, stated that the “incorporated pocketbook” rationale was limited to cases where taxpayers sought to regularly direct funds from one of their entities through themselves, and then on to an S corporation. Here, the Court found, Taxpayer did not use Newco to habitually to pay QSub’s, or his own personal, expenses. “Frequent and habitual payments,” the Court stated, are “key to a finding that a corporation served as an incorporated pocketbook.” Newco did not make frequent and habitual payments on behalf of Taxpayer.

Conduit or Agent

Taxpayer also argued that Newco served as Taxpayer’s agent in purchasing the Loan from Lender and, as such, could be ignored for tax purposes.

Taxpayer pointed out that the Court had previously suggested that, in a true conduit situation, a loan running through a corporate intermediary could instead be considered to run directly from the shareholder for purposes of the loss-limitation rule.

Taxpayer emphasized that Newco had no business activity besides the Loan acquisition, and no assets besides the Loan; all the funds necessary to purchase the Loan came from Taxpayer; thus, Newco served effectively as a conduit for payments from Parent and QSub.

The IRS reminded the Court that, in other cases, it had been reluctant to apply the agency exception to the rule that indebtedness must run directly from the S corporation to its shareholder.

Moreover, the IRS argued, Parent, QSub, Newco and Taxpayer were sophisticated parties who consulted with their advisers before purchasing the Loan from Lender. They consciously chose the form of the transaction to maintain the Loan’s seniority with respect to QSub’s obligations under the notes.

The IRS also asserted that the record was devoid of any indication of an agency relationship.

The Court agreed with the IRS that Newco did not act as Taxpayer’s agent. It set forth several factors that are considered when evaluating whether a corporation is another’s agent, including:

  • whether it operates in the name, and for the account, of the principal,
  • whether its receipt of income is attributable to the services of the principal or to assets belonging to the principal,
  • whether its relations with the principal depend upon the principal’s ownership of it,
  • whether there was an agreement setting forth that the corporation was acting as agent for its shareholder with respect to a particular asset,
  • whether it functioned as agent, and not principal, with respect to the asset for all purposes, and
  • whether it was held out as agent, and not principal, in all dealings with third parties relating to the asset.

The Court reviewed each of these indicia, and concluded that no agency relationship existed between Newco and Taxpayer.

 Actual Economic Outlay

Taxpayer argued that: (i) Newco made no economic outlay to purchase the Loan, (ii) it was he who provided the funds used by Newco to purchase the Loan, (iii) he owned and controlled Newco, (iv) Newco was a shell corporation with no business or other activity besides holding the Loan, and (v) Newco’s net worth both before and after the Loan’s acquisition was the amount of Taxpayer’s capital contribution.

The IRS noted that the amounts contributed by Taxpayer to Newco were first classified by Newco’s bookkeeper as shareholder loans and then as paid-in capital, which increased Taxpayer’s basis in the Newco stock; accordingly, Taxpayer’s capital contributions to Newco, which increased his stock basis in that corporation, could not be used to increase his debt basis in Parent.

The IRS also disputed Taxpayer’s characterization of Newco as a shell corporation, arguing that Taxpayer had a significant business purpose in structuring the transaction as he did: the maintenance of the Loan’s seniority to Seller’s promissory note.

The Court agreed that Taxpayer did make actual economic outlays, and that these outlays were to Newco, a corporation with its own separate existence. It was not simply a shell corporation, but a distinct entity with at least one substantial asset, the Loan, and a significant business purpose. Taxpayer’s capital contributions, combined with Newco’s other indicia of actual corporate existence, were compelling evidence of economic outlay.

The Court also noted that taxpayers generally are bound to the form of the transaction they have chosen. Taxpayer failed to establish that he should not be held to the form of the transaction he deliberately chose. Therefore, any economic outlays by Taxpayer were fairly considered to have been made to Newco, a distinct corporate entity, which in turn made its own economic outlay.

Step Transaction Doctrine (?)

Finally, Taxpayer argued that the Court should apply the step transaction doctrine (really “substance over form”) to hold that Taxpayer, and not Newco, became the holders of the Loan after its purchase from Lender.

The IRS disputed Taxpayer’s application of the step transaction doctrine, arguing that Taxpayer intentionally chose the form of the transaction and should not be able to argue against his own form to achieve a more favorable tax result. The IRS added that because Newco was not an agent of or a mere conduit for Taxpayer, the form and the substance of the Loan acquisition were the same, and the step transaction doctrine should not apply.

Again, the Court agreed with the IRS, stating that Taxpayer’s “step transaction” argument was just another permutation of his other theories, which were also rejected by the Court.

Taxpayers, the Court continued, are bound by the form of their transaction and may not argue that the substance triggers different tax consequences. It explained that they have “the benefit of forethought and strategic planning in structuring their transactions, whereas the Government can only retrospectively enforce its revenue laws.”

Accordingly, the Court found that Taxpayer did not become the holder of the Loan after its acquisition from Lender.

Conclusion

Thus, the Court held that Taxpayer did not carried his burden of establishing that his basis in Parent’s (i.e., QSub’s) indebtedness to Taxpayer was other than as determined by the IRS.

Was it Equitable?

I suspect that some of you may believe that the Court’s reasoning was too formulaic. I disagree.

Both taxpayers and the IRS need some certainty in the application of the Code, so as to assure taxpayers of the consequences of transactions, to avoid abuses of discretion, and to facilitate administration of the tax system, among other reasons.

Of course equitable principles play an important role in the application and interpretation of the Code, but as to the Taxpayer, well, he was fully aware of the applicable loss-limitation rule, chose to secure a business advantage instead (a senior loan position) by not complying with the rule, which in turn caused him to resort to some very creative justifications for his “entitlement” to the losses claimed.

So, was the Court’s decision equitable? Yep.

Choice of Entity

One of the first decisions – and certainly among the most important – that the owner of a new business must make is the form of legal entity through which the business will be operated. This seemingly simple choice, which is too often made without adequate reflection, can have far-reaching tax and, therefore, economic consequences for the owner.

The well-advised owner will choose a form of entity for his business only after having considered a number of tax-related factors, including the income taxation of the entity itself, the income taxation of the entity’s owners, and the imposition of other taxes that may be determined by reference to the income generated by, or withdrawn from, the entity.

In addition to taxes, the owner will have considered the rights given to her, the protections afforded her (the most important being that of limited exposure for the debts and liabilities of the entity), and the responsibilities imposed upon her, pursuant to the state laws under which a business entity may be formed.

The challenge presented for the owner and her advisers is to identify the relevant tax and non-tax factors, analyze and (to the extent possible) quantify them, weigh them against one another, and then see if the best tax and business options may be reconciled within a single form of legal or business entity.

The foregoing may be interpreted as requiring a business owner, in all instances, to select one form of business entity over another; specifically, the creation of a corporation (taxable as a “C” or as an “S” corporation) over an LLC (taxable as a partnership or as a disregarded entity) as a matter of state law. Fortunately, that is not always the case. In order to understand why this is so, a brief review of the IRS’s entity classification rules is in order.

The Classification Regulations

A business entity that is formed as a “corporation” under a state’s corporate law – for example, under New York’s business corporation law – is classified as a corporation per se for tax purposes.

In general, a business entity that is not thereby classified as a corporation – such as an LLC – can elect its classification for federal tax purposes.

An entity with at least two members can elect to be classified as either a corporation (“association” is the term used by the IRS) or a partnership, and an entity with a single owner can elect to be classified as a corporation or to be disregarded as an entity separate from its owner.

Default Classification

Unless the entity elects otherwise, a domestic entity is classified as a partnership for tax purposes if it has two or more members; or it is disregarded as an entity separate from its owner if it has a single owner. Thus, an LLC with at least two members is treated as a partnership for tax purposes, while an LLC with only one member is disregarded for tax purposes, and its sole member is treated as owning all of the LLC’s assets, liabilities, and items of income, deduction, and credit.

Election to Change Tax Status

If a business entity classified as a partnership elects to be classified as a corporation, the partnership is treated, for tax purposes, as contributing all of its assets and liabilities to the corporation in exchange for stock in the corporation, and immediately thereafter, the partnership liquidates by distributing the stock of the corporation to its partners.

If an entity that is disregarded as an entity separate from its owner elects to be classified as a corporation, the owner of the entity is treated as contributing all of the assets and liabilities of the entity to the corporation in exchange for stock of the corporation.

An election is necessary only when an entity chooses to be classified initially (upon it creation) as other than its default classification, or when an entity chooses to change its classification. An entity whose classification is determined under the default classification retains that classification until the entity makes an election to change that classification.

In order to change its classification, a business entity must file IRS Form 8832, Entity Classification Election. Thus, an entity that is formed as an LLC or as a partnership under state law may file Form 8832 to elect to be treated as a corporation for tax purposes.

Alternatively, an LLC or a partnership that timely elects to be an S corporation (by filing IRS Form 2553) is treated as having made an election to be classified as a corporation, provided that it meets all other requirements to qualify as a small business corporation as of the effective date of the election.

Electing S Corporation Status – Why?

Most tax advisers will recommend that a new business be formed as an LLC that is taxable as a pass-through entity (either a partnership or a disregarded entity). The LLC does not pay entity level tax; its net income is taxed only to its members; in general, it may distribute in-kind property to its members without triggering recognition of gain; it may pass through to its members any deductions or losses attributable to entity-level indebtedness; it can provide for many classes of equity participation; it is not limited in the types of person who may own interests in the LLC; and it provides limited liability protection for its owners.

In light of these positive traits, why would an LLC elect to be treated as an S corporation? Yes, an S corporation, like an LLC, is not subject to entity-level income tax (in most cases), but what about the restrictive criteria for qualifying as an S corporation? An S corporation is defined as a domestic corporation that does not: have more than 100 shareholders, have as a shareholder a person who is not an individual (other than an estate, or certain trusts), have a nonresident alien as a shareholder, and have more than one class of stock.

The answer lies, in no small part, in the application of the self-employment tax.

Self-Employment Tax

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

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

Certain items are excluded from self-employment income, including “the distributive share of any item of income . . . of a limited partner.”

That being said, any guaranteed payments made to a limited partner for services actually rendered to or on behalf of the partnership, “to the extent that those payments are established to be in the nature of remuneration for those services . . . ,” are subject to the tax.

In creating the exclusion for limited partners, Congress recognized that certain earnings were basically in the nature of a return on investment. The “limited partner exclusion” was intended to apply to those partners who “merely invest” in, rather than those who actively participate in and perform services for, a partnership in their capacity as partners.

A partnership cannot change the character of a partner’s distributive share for purposes of the self-employment tax simply by making guaranteed payments to the partner for his services. A partnership is not a corporation and the “wage” and “reasonable compensation” rules which are applicable to corporations do not apply to partnerships.

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

Thus, individual partners who are not limited partners are subject to self-employment tax on their distributive share of partnership income regardless of their participation in the partnership’s business or the capital-intensive nature of the partnership’s business.

Unfortunately, the Code does not define the term “limited partner,” though the IRS and the courts have, on occasion, interpreted the term as applied to the members of an LLC; specifically, based upon these interpretations, the level of a member’s involvement in the management and operation of the LLC will be determinative of her status as a “limited partner” and, consequently, of her liability for self-employment tax.

S Corporations

The shareholders of an S corporation, on the other hand, are not subject to employment taxes in respect of any return on their investment in the corporation – i.e., on their pro rata share of S corporation income – though they are subject to employment taxes as to any wages paid to them by the corporation.

For that reason, the IRS has sought to compel S corporations to pay their shareholder-employees a reasonable wage for services rendered to the corporation. In that way, the IRS hopes to prevent an S corporation from “converting” what is actually compensation for services into a distribution of investment income that is not subject to employment taxes.

Why Not Incorporate?

If the self-employment tax on an owner’s share of business income can be legitimately avoided by operating through an S corporation – except to the extent it is paid out as reasonable compensation for services rendered by the owner to the corporation – why wouldn’t the owner just form a corporation through which to operate the business?

The answer is rather straightforward: because tax planning, although a very important consideration, is not necessarily the determinative factor in the choice-of-entity decision.

There may be other, non-tax business reasons, including factors under state law, for establishing a business entity other than a corporation.

For example, in the absence of a shareholders’ agreement – which under the circumstances may not be attainable – shares of stock in a corporation will generally be freely transferable, as a matter of state law; on the other hand, the ability of a transferee of an ownership interest in an LLC to become a full member will generally be limited under state law – in most cases, the transferee of a membership interest in an LLC will, in the absence of a contrary provision in the LLC’s operating agreement, become a mere assignee of the economic benefits associated with the membership interest, with none of the rights attendant on full membership in the LLC.

With that in mind – along with other favorable default rules under a state’s LLC law, as opposed to its corporate law – and recognizing the limitations imposed under the Code for qualification as an S corporation, a business owner may decide to form her entity as an LLC in order to take advantage of the “benefits” provided under state law; but she will also elect to treat the LLC as an S corporation for tax purposes so as to avoid entity-level income tax and to limit her exposure to self-employment tax.

In this way, the business owner may be able to reconcile her tax and non-tax business preferences within a single legal entity. The key, of course, will be for both the owner and her tax advisers to remain vigilant in the treatment of the LLC as an S corporation. The pass-through treatment for tax purposes will be easy to remember, but other tax rules applicable to corporations (such as the treatment of in-kind distributions as sales by the corporation), and to S corporations in particular (such as the single class of stock rule), will require greater attention, lest the owner inadvertently cause a taxable event or cause the LLC to lose its “S” status.

Close Corporations and Compensatory Grants of Equity

It should come as no surprise to readers of this blog that I am not enamored with the notion of issuing equity to employees of a closely-held business. It’s not that these individuals should not be rewarded for their efforts and contributions to the growth, success and stability of the business. Far from it. It’s just that the employer-corporation and the existing shareholders need to fully appreciate the consequences of granting equity, including the fact that state law bestows many rights upon the minority shareholder and imposes many duties upon the majority; moreover, there are other, less compromising, vehicles by which a key employee may be rewarded.

But what if the key employee is already a shareholder of the employee-corporation? Indeed, what if he is a co-founder of the corporation’s business? Does it even make sense that the corporation would make a compensatory grant of stock to such an individual? The answer, of course, depends upon the facts and circumstances.

A recent decision from the U.S. Tax Court described a complex set of transactions involving the grant of stock to the two founders (the “Taxpayers”) of the employer-corporation’s business. The transactions gave rise to several issues, some of which were resolved in favor of the Taxpayers. Unfortunately for the Taxpayers, these proved to be pyrrhic victories, as the IRS ultimately prevailed.

Substantial Risk of Forfeiture

The issue on which we will focus – and on which the Court held for the Taxpayers – was whether the stock issued to the Taxpayers was subject to a substantial risk of forfeiture at the time of issuance.

In general, when stock in the employer-corporation is granted to an employee in consideration of the employee’s services, the employee must include in his gross income the fair market value of such stock.

However, if the stock is subject to substantial risk of forfeiture, the employee does not have to include the stock’s FMV in gross income until the risk of forfeiture lapses (“restricted stock”). Thus, the employee is allowed to defer recognition of income until his rights in the stock become “substantially vested.”

Stock is subject to a substantial risk of forfeiture if the employee’s rights to the stock are conditioned upon the future performance of substantial services by the employee or upon the occurrence of a condition related to the purpose of the transfer; for example, the employee is required to provide a stated number of years of continuous service beginning on the date of grant, or the employee’s division must attain a specified degree of productivity within a stated period of time beginning on such date. Where the employee fails to satisfy the conditions related to the grant, he will be required to return the stock to the employer, usually for no consideration.

Likelihood of Enforcement

An employee will not be required to include the FMV of the stock in his gross income if the possibility of forfeiture is substantial. However, stock is not transferred subject to a substantial risk of forfeiture if at the time of transfer the facts and circumstances demonstrate that the forfeiture condition is unlikely to be enforced.

In determining whether the possibility of forfeiture is substantial in the case of stock transferred to an employee of a corporation who owns a significant amount of the total combined voting power or value of all classes of stock of the employer corporation, there will be taken into account (i) the employee’s relationship to other stockholders and the extent of their control, potential control, and possible loss of control of the corporation, (ii) the position of the employee in the corporation and the extent to which he is subordinate to other employees, (iii) the employee’s relationship to the officers and directors of the corporation, (iv) the person or persons who must approve the employee’s discharge, and (v) past actions of the employer in enforcing the restrictions.

For example, if an employee would be considered as having received rights in property subject to a substantial risk of forfeiture, but for the fact that the employee owns 20 percent of the single class of stock in the employer-corporation, and if the remaining 80 percent of the stock is owned by unrelated individuals so that the possibility of the corporation enforcing a restriction on such rights is substantial, then such rights are subject to a substantial risk of forfeiture. On the other hand, if 4 percent of the voting power of all the stock of a corporation is owned by the president of such corporation and the remaining stock is so widely held that the president, in effect, controls the corporation, then the possibility of the corporation enforcing a restriction on rights in property transferred to the president is not substantial, and such rights are not subject to a substantial risk of forfeiture.

The “Earnout” (?)

In the case considered by the Tax Court, the Taxpayers worked together for many years in the Business. Before Year One, they were the original shareholders and members of a group of related corporations and LLCs (the “Entities”).

Capital Contribution

Toward the end of Year One, the Taxpayers organized, and elected S-corporation status for, a holding company (“Holding Corp.”) to which they contributed their ownership interests in the Entities in exchange for all of the shares of Holding Corp.’s common stock.

Restricted Stock

As part of this exchange, each Taxpayer executed a “Restricted Stock Agreement” (“RSA”) and an “Employment Agreement” with Holding Corp. A principal purpose of these agreements was to require the Taxpayers to perform future services for Holding Corp. in order to acquire full rights in their stock. Read together, these agreements specified a five-year “earnout” period and provided that either Taxpayer would forfeit 50% of the value of his shares if he voluntarily terminated his employment with Holding Corp. before Year Six. Removing or waiving this restriction required consent of the holders of 100% of the shares entitled to vote.

The Taxpayers were the sole directors of Holding Corp. throughout the tax years at issue. Taxpayer A was the company’s president and was responsible for its “front-end” operations. Taxpayer B was its senior executive vice president and was responsible for its “back-end” operations.

Allocation of S Corp. Income

Because the Taxpayers received their Holding Corp. shares in a “tax-free” exchange, they were relieved of any obligation to recognize gain upon receipt of the shares or upon transfer of the ownership interests in the Entities to Holding Corp.

The chief relevance of determining whether the shares were “substantially vested” upon receipt was that this determination controlled whether the Taxpayers’ shares were treated as outstanding stock of the S-corporation for purposes of allocating Holding Corp.’s income to the Taxpayers.

The ESOP

Late in Year One, with the avowed goal of encouraging long-term job retention, the Taxpayers caused Holding Corp. to form an ESOP for its employees, including the Taxpayers.

The company funded the ESOP with a loan, which was used to purchase shares of Holding Corp.’s common stock. Thus, as of the end of Year One, each Taxpayer owned 47.5% of Holding Corp.’s common stock and the ESOP owned the remaining 5%.

The Issue

The Taxpayers discharged their obligations under the RSA and the employment agreements through the end of Year Five and, in Year Six, the restrictions on their stock lapsed accordingly.

The Taxpayers did not report any income from Holding Corp. on their federal income tax returns for Year One, taking the position that their stock was subject to a “substantial risk of forfeiture” and relying on the rule that, for purposes of subchapter S, “stock that is issued in connection with the performance of services * * * and that is substantially nonvested * * * is not treated as outstanding stock of the corporation, and the holder of that stock is not treated as a shareholder solely by reason of holding the stock.”

Under this reasoning, because the shares owned by the Taxpayers were not deemed to be outstanding, Holding Corp. allocated 100% of its income, losses, deductions, and other tax items to the ESOP.

The IRS determined that the Taxpayers’ stock in Holding Corp. was “substantially vested” upon receipt in Year One; that their stock was thereafter “outstanding”; and that they were accordingly required to report their pro rata shares of the company’s income for each year.

The Taxpayers timely petitioned the Tax Court.

The Court’s Analysis

The Court began by stating that a taxpayer’s rights to stock are subject to substantial risk of forfeiture if his rights to full enjoyment of the stock are conditioned upon his future performance of substantial services. The risk of forfeiture analysis, it continued, required the Court to determine whether the property interests transferred by the employer were “capable of being lost.”

The Taxpayers contended that their stock in Holding Corp. was subject to a substantial risk of forfeiture when they received it in Year One and remained subject to a substantial risk of forfeiture until Year Six, when the five-year earnout restriction lapsed.

The IRS contended that the Taxpayers’ stock was substantially vested when they received it in Year One; that their stock was thus “outstanding” for subchapter S purposes throughout the tax years at issue; and that the Taxpayers consequently were required to report their pro rata shares of the company’s income on their tax returns for those years.

After observing that, in prior cases, it had held that an earnout restriction created a “substantial risk or forfeiture,” provided there was a sufficient likelihood that the restriction would actually be enforced, the Court turned to the question of whether the restriction at issue was likely to be enforced.

“Enforceable” Restriction?

Each Taxpayer owned 47.5% of Holding Corp.’s voting common stock, with the ESOP owning the remaining 5%. The Court explained that in situations where nominally restricted property was transferred to an employee “who owns a significant amount of the total combined voting power or value of all classes of stock of the employer corporation,” one must consider several factors in determining whether the possibility of forfeiture was substantial.

The Court emphasized the importance, not just of percentage stock ownership, but of de facto power to control. Under such circumstances, “the possibility of the corporation enforcing a restriction on rights in property transferred to [an employee] is not substantial, and such rights are not subject to a substantial risk of forfeiture.”

The Court stated that if either Taxpayer had quit his job before the end of the five-year earnout period, Holding Corp. would likely have enforced the restriction requiring that he forfeit 50% of the value of his shares.

While both Taxpayers had experience in the Business, the Court reasoned, their skill sets were quite distinct; Taxpayer A performed the front-end work, while Taxpayer B had back-end and back-office responsibilities. According to the Court, the Taxpayers recognized that the success of the Business depended on their both remaining with the company. To incentivize this, they executed reciprocal agreements whereby each would lose 50% of the value of his stock if he left the company within five years. The Taxpayers thus “tied each other to the mast,” the Court said, for a five-year period.

Moreover, removal or waiver of this forfeiture provision required the consent of the holders of 100% of the company’s shares. As a holder of a 47.5% interest facing the holder of another 47.5% interest, neither Taxpayer had power to control the company. Neither Taxpayer could act unilaterally to remove the forfeiture restriction affecting his stock.

If either Taxpayer threatened to leave during the five-year earnout period, the other had a strong incentive, the Court observed, to insist that the forfeiture restriction be enforced as written. First, given the complementary nature of their responsibilities and skill sets, it was in each Taxpayer’s economic interest to have the other remain with the company. Second, if the departing Taxpayer forfeited 50% of the value of his stock, the value of the remaining Taxpayer’s stock (and that of the ESOP) would be increased accordingly. There was no family or other relationship between the Taxpayers, the Court continued, that would have caused either of them to act against his economic interest.

Conceivably, the Court stated, both Taxpayers might have decided independently that they wished to retire early instead of serving out their promised five-year terms. But despite their status as the sole directors of the company, they would have needed the consent of the ESOP to remove the forfeiture provisions. The ESOP, however, would have had a strong economic incentive to refuse such consent. If the Taxpayers left the company, the company might well have folded, and the ESOP beneficiaries would then have lost their jobs.

The IRS nevertheless urged that the Taxpayers could control the ESOP because they served as two of its initial three trustees and the third trustee was subordinate to them. In response, the Court pointed out that the IRS ignored the fiduciary duties that all three owed the ESOP. As trustees, the Taxpayers were personally liable for any breaches of their fiduciary duty.

In sum, the Court concluded that the Taxpayers’ stock was subject to a substantial risk of forfeiture when issued to them in Year One and remained subject to that risk until the restrictions lapsed in January of Year Six. Neither Taxpayer held a controlling position in Holding. If either failed to perform his duties or left the company before the earnout restriction ended, the other would have had every incentive to insist on enforcement of the forfeiture provision according to its terms. The ESOP had even stronger economic incentives to do this.

Because “the possibility of forfeiture * * * [was] substantial,” the Court ruled that the stock held by the Taxpayers did not become “substantially vested” until they completed their promised service through the end of the five-year earnout period.

What Does It Mean?

Granted, the situation presented in the decision described above was somewhat unusual. Moreover, that the Court did not regard as significant the fact that the stock at issue was granted to the Taxpayers in exchange for their capital contributions to Holding Corp. is somewhat surprising, especially in the case of an S-corporation where the issuance of “restricted” stock to certain shareholders would seem to raise the possibility of shifting income or losses among shareholders in violation of the principles underlying the “second-class-of-stock” rule.

Nevertheless, the Court’s opinion should provide some comfort to an employer-corporation that wants to grant restricted stock to individuals who are already shareholders. Provided the stock is issued for a bona fide business reason that is related to the risk of forfeiture, the employer-corporation, the employee-shareholder, and the other shareholders of the corporation should be able to structure the grant so as to ensure that the likelihood of enforcement of a forfeiture condition is substantial, and to thereby avoid the immediate taxation of the stock issued.

Last month, Governor Cuomo presented his budget proposal for NY State’s 2017- 2018 fiscal year. Included in the proposal were a number of tax provisions that should be of interest to closely-held businesses and their owners.

S-Corporation Conformity with IRS Return

Under current NY law, a federal S-corporation that is subject to tax in NY (e.g., the corporation is doing business or owns property in NY) can “elect” to be taxed as an S-corporation or as a C-corporation for NY purposes. If a federal S-corporation is taxed as a NY S-corporation, the corporation is responsible only for the fixed dollar minimum tax, and the corporation’s income is passed through, and taxed, to its shareholders. Conversely, if a federal S-corporation is taxed as a NY C-corporation, it computes and pays tax on its apportioned entire net income or capital base.

Further, if a federal S-corporation has elected to treat its wholly-owned corporate subsidiary as a “qualified subchapter S subsidiary” (QSSS) for federal purposes, the QSSS is ignored as a separate taxable entity, and the assets, liabilities, income and deductions of the QSSS are included on the parent’s return. However, for NY purposes, the tax treatment of the QSSS is not required to be conformed to the federal treatment and the QSSS under certain circumstances can be a stand-alone C-corporation taxpayer.

While the Tax Law was amended a few years back to mandate that a federal S-corporation be treated as a NY S-corporation in any tax year in which its investment income exceeded 50% of its federal gross income, this mandate did not cover the entire universe of federal S-corporations that have elected to be taxed as NY C-corporations.

According to the budget proposal, the failure to mandate consistent treatment at the State level has resulted in a tax avoidance opportunity, as well as confusion and tax filing errors, for S-corporation shareholders.

For example, a federal S-corporation generally may choose to pay tax as a NY C-corporation when paying tax at the entity level reduces the corporation’s tax liability. It also may choose to pay corporate income tax in order to shield its nonresident shareholders from having a NY tax liability.

Under the budget proposal, NY’s tax law would be amended to require a federal S-corporation that is subject to tax in NY, or that has a QSSS subject to tax in NY, to be treated as an S-corporation for NY tax purposes.

According to the proposal, requiring conformity to the federal S-corporation status would simplify the corporation’s and its shareholders’ NY tax filings, and eliminate potential tax avoidance schemes. It would also result in NY-source income for nonresident shareholders.

Real Estate Transfer Tax on the Transfer of a Business Interest

Under current law, the transfer of a “controlling interest” in an entity that owns NY real property is subject to the real estate transfer tax (“RETT”), with the taxable consideration being determined by reference to the relative fair market value (FMV) of the entity’s NY real property. The RETT applies even where the FMV of the NY real property is not a significant part of the entity’s total FMV.

However, members of a closely-held business entity that owns real property are not subject to the RETT when they sell a minority (non-controlling) interest in the entity, even where the primary asset held by the entity is an interest in NY real property.

The budget proposal would amend the definition of “conveyance” to include the transfer of an interest in a partnership, LLC, S-corporation, or non-publicly traded C-corporation with fewer than 100 shareholders that owns an interest in NY real property with a FMV that equals or exceeds 50% of the FMV of all the assets of the entity on the date of the transfer of the interest in the entity. Only those assets that the entity owned for at least two years before the date of the transfer of the taxpayer’s interest in the entity would be used in determining the FMV of all the assets of the entity on the date of the transfer.

The consideration for such a conveyance would be calculated by multiplying (i) the FMV of the NY real property that is owned by the entity; and (ii) the percentage of the entity that is being conveyed.

As an aside, the proposal would effectively align the treatment of these conveyances, for purposes of RETT, with the personal income tax rules for determining the NY-source income of a nonresident individual when that individual sells an interest in an entity that owns NY real property.

Non-Resident Asset Sale “Loophole”

There are instances in which the purchase of a partnership interest may be treated, for federal tax purposes, as a purchase of the partnership’s underlying assets. In those situations, the consideration paid for the partnership interest must be allocated among the partnership’s underlying assets (which are deemed to have been acquired). As a result of this tax treatment, the buyer of the interest may receive a basis step-up with respect to his share of the partnership’s underlying assets. This step-up may afford the buyer additional depreciation deductions against his share of partnership income, and also may reduce the gain allocated to the buyer upon the partnership’s sale of the assets to which the basis step-up is allocated.

The selling partner, however, may nevertheless be treated as having sold his partnership interest, and not the underlying assets. Thus, a NY resident partner who sells his partnership interest will be subject to tax on the gain realized. On the other hand, the sale of an intangible – such a partnership interest – by a nonresident partner is not a taxable transaction, notwithstanding that the buyer may achieve a basis step-up in the partnership’s assets. As a result, non-residents are afforded an opportunity to avoid NY taxation on transactions that, in effect, involve the purchase of NY-source assets.

The budget proposal seeks to close this loophole by treating the transaction as a sale of the partnership’s underlying NY-based tangible assets for both the buyer and seller, so that the gains realized from the sale of an interest in the partnership by nonresident partners would be subject to NY tax as NY-source income.

Extend the Personal Income Tax Top Bracket

Currently, the top personal income tax bracket in NY, along with its associated tax rate of 8.82%, is scheduled to expire for taxable years beginning after 2017. Without legislative action, the top marginal tax rate will decline to 6.85%.

The budget proposal would extend the top tax bracket and the associated 8.82% personal income tax rate for taxable years 2018, 2019 and 2020.

Sales Tax Related Entity “Loopholes”

With certain exceptions, existing NY tax law allows a purchaser to buy tangible personal property or services that are intended for resale without paying sales tax. According to the budget proposal, however, certain related business entities have exploited this exemption by purchasing expensive property “for resale” and then leasing the property to a member or owner of the entity using long-term leases or lease payments that are a small fraction of the FMV of the property.

The budget proposal would amend the sales tax definition of “retail sale”, which currently contains the exception for resale, to include any transfer of tangible personal property to certain entities when the property would be resold to a related person or entities, including: (1) sales to single-member LLCs or subsidiaries that are disregarded for federal income tax purposes, for resale to a member or owner; and (2) sales to a partnership for resale to one or more partners. This change is intended to remove the incentive to use or create such entities to avoid sales tax.

In addition, current law allows a person or entity that is not a resident of NY to bring property or services into the State for use therein without incurring use tax. However, this construct has led to situations where a resident person or entity creates a new, non-NY entity, such as a single-member LLC, to purchase expensive property out-of-state and then bring the property into NY to avoid the use tax.

The budget proposal would provide that the use tax exemption does not apply when a person (other than an individual) brings property or services into NY unless that person has been doing business outside of NY for at least six months prior to the date the property is brought into the State. This amendment would still allow ongoing businesses to move into NY without incurring use tax on property or services brought into the State.

Looking Ahead

And you thought that tax relief was just around the corner. Silly rabbit.

While most eyes are focused on Washington, D.C. and the promised, but yet to be disclosed, “tax reduction and/or reform” legislation, states like NY are busy reviewing and amending their own tax laws and regulations to ensure the collection of much-needed revenues. Thus, in the case of NY, it may be that closely-held businesses and their owners will be faced with increased tax liabilities. We’ll know soon enough – the deadline for approving NY’s budget is April 1, 2017.

Speaking of Washington, the States themselves are undoubtedly waiting to see what comes out of the new administration and Congress and how it will impact them and their finances.

As always, until legislation is passed, it is imperative that taxpayers keep abreast of tax-related legislative developments that may impact their business and wallets. Increased tax liabilities will reduce the yield realized from one’s business efforts and investments; thus, it will be advisable for taxpayers to formulate a plan for addressing these developments and any resulting taxes.

It will be equally important that any business plans considered by a taxpayer be flexible enough to respond to, and accommodate, a changing tax environment, provided that doing so does not compromise business decisions.

Stay tuned.

Whose Tax Liability?

In order to properly assess and collect a tax, the IRS first needs to identify the taxpayer that is responsible for reporting the income, and for collecting and remitting the tax, at issue. This is not always a simple proposition. In the case of a business entity, it may depend, in part, upon the entity’s classification for tax purposes.

Tax LiabilityFor example, a business entity that was incorporated under State law will be treated as a taxable C corporation for tax purposes. The same corporation may file an election with the IRS to be treated as a pass-through small business (“S”) corporation, and it may subsequently elect to revoke its “S” election.

In the case of every other business entity, however, the classification is more “fluid.” In order to provide certainty both to the IRS and to taxpayers, the IRS has issued entity classification regulations. These regulations provide certain “default” classifications that coincide with what most taxpayers would desire for the entity in question. Where the taxpayer wants to elect a classification other than the “preferred” default status, it must affirmatively notify the IRS of its decision.

Thus, an LLC that has only one member is ignored for income tax purposes; it is treated as partnership if it has at least two members; regardless of how many members it has, it may elect to be treated as an association that is taxable as a corporation.

The importance of properly making and filing an election so as to change the classification of a business entity for tax purposes cannot be understated.

An Illustration

Taxpayer was the sole shareholder of Corp., a “C” corporation on behalf of which he consistently filed Form 1120, U.S. Corporation Income Tax Return.

Taxpayer formed LLC at the end of Year 1 and became LLC’s sole member. Immediately after the formation of LLC, Corp. merged with and into LLC, with LLC as the surviving entity, and Corp. ceased to exist. LLC continued to own Corp.’s assets and to operate Corp’s business. Since the merger, LLC filed Forms 1120 using Corp’s employer identification number (“EIN”). However, LLC did not file IRS Form 8832, Entity Classification Election.

Taxpayer filed Forms 940 and 941 on behalf of LLC, but did not make sufficient tax deposits or pay the tax due for its employment tax liabilities for several taxable periods after the merger (but before 2009 – see later).

The IRS issued a Notice of Intent to Levy for these periods and filed a Notice of Federal Tax Lien.

Taxpayer argued that LLC, and not Taxpayer individually, was liable for the employment tax liabilities due from LLC.

The only issue for consideration by the Tax Court was whether Taxpayer, as the sole member of LLC, was personally liable for the payment of the employment tax liabilities of LLC for the taxable periods in question.

Entity Classification

The so-called “check-the-box” regulations allow an “eligible business entity” to elect its classification for federal tax purposes. An eligible business entity is one that is not treated as a corporation, per se, under the regulations.

An eligible entity with a single owner, such as the LLC and Taxpayer in the present case, may elect to be classified as an association – i.e., as a corporation – for tax purposes, or it may choose to be disregarded as an entity separate from its owner.

An eligible entity with a single owner that does not file an election is disregarded as an entity separate from its owner; its default status is that of a disregarded entity.
An election is necessary only when an eligible entity chooses to be classified initially as something other than its default classification, or when an eligible entity chooses to changes its classification.

The tax treatment of a change in the classification of an entity for federal tax purposes by election is determined under all relevant provisions of the Code and general principles of tax law, including the step transaction doctrine.

For example, if an eligible entity that is disregarded as an entity separate from its owner (the default status of a single-member LLC) elects to be classified as an association, the following is deemed to occur: the owner of the eligible entity contributes all of the assets and liabilities of the entity to the association in exchange for stock of the association.

If an eligible entity classified as an association (a business entity that elected to be treated as a corporation for tax purposes) elects to be disregarded as an entity separate from its owner, the following is deemed to occur: the association distributes all of its assets and liabilities to its owner in liquidation of the association.

Form 8832

An entity whose classification is determined under the default classification rules retains that classification until the entity makes an election to change its status by filing IRS Form 8832, Entity Classification Election.

An election will not be accepted unless all of the information required by Form 8832 and its instructions is provided. Further, to avoid penalties, an eligible entity that is required to file a federal tax or information return for the taxable year in which an election is made must attach a copy of Form 8832 to its tax or information return for that year.

Under these rules, LLC was disregarded as a separate entity from Taxpayer, its owner, because it was a single-member LLC that had never filed Form 8832.

Notwithstanding this conclusion, Taxpayer made a number of arguments as to why Form 8832 was not the only method by which an eligible entity could elect to change its classification.

The Taxpayer’s Position

First, Taxpayer argued that the merger of Corp. and LLC was a valid reorganization under Section 368(a)(1)(F) of the Code (an “F reorganization,” or “mere change” in corporate identity or form) and, as a result, LLC should be treated as a corporation for federal tax purposes.

Second, Taxpayer argued that the filing of Forms 1120 for the first year after the merger of Corp. and LLC constituted a valid election for LLC to be taxed as a corporation.

Third, Taxpayer argued that the doctrine of equitable estoppel prevented the IRS from contending that LLC was not a corporation because the IRS had “tacitly acquiesced” to the filings of Forms 1120 for the year of the merger and subsequent years.

The Tax Court’s Response

The Court responded that regardless of whether the merger of Corp. and LLC qualified as a valid F reorganization, LLC never filed Form 8832 electing its classification for federal tax purposes as an association and, thus, was not a corporation but, rather, was disregarded as an entity separate from its owner. (Incidentally, this would have caused the merger to be treated as a taxable liquidation of Corp.)

Next, the Court stated that an eligible entity could not elect its entity classification by filing any particular tax return it wished; it had to do so by filing Form 8832 and following the instructions within the regulations. Thus, LLC could not elect to be treated as an association/corporation merely by filing corporate income tax returns.

Finally, according to the Court, equitable estoppel did not bar the IRS from treating LLC as a disregarded entity. The Court noted that equitable estoppel was to be applied against the IRS with the utmost restraint. The elements of estoppel, it stated, are: “(1) * * * a false representation or wrongful misleading silence; (2) the error must be in a statement of fact and not in an opinion or a statement of law; (3) the person claiming the benefits of estoppel must be ignorant of the true facts; and (4) he must be adversely affected by the acts or statements of the person against whom an estoppel is claimed.” The IRS made no false statement to Taxpayer, and the Court did not agree that the IRS’s failure to reject LLC’s filed Forms 1120 was a wrongful misleading silence. Moreover, Taxpayer knew that LLC had never filed a Form 8832 to elect to be treated as anything other than a disregarded entity.

For the foregoing reasons, the Court rejected Taxpayer’s arguments, and found that LLC was disregarded as an entity separate from Taxpayer.

The Taxes At Issue

The Code requires employers to pay employment taxes imposed on employers and to withhold from employees’ wages certain taxes imposed on employees. Employers are required to withhold from employees’ wages the amounts of federal income tax owed by those employees. The Code also imposes a tax on every employer with respect to individuals in his employ.

For employment taxes related to wages paid before January 1, 2009, a disregarded entity’s activities were treated in the same manner as those of a sole proprietorship, branch, or division of the owner.

Accordingly, the sole member of a limited liability company and the limited liability company itself were treated as a single taxpayer who is personally liable for purposes of the employment tax reporting and wages paid before January 1, 2009. Taxpayer was, therefore, liable for LLC’s unpaid employment tax liabilities arising during the tax periods at issue since they related to wages paid before 2009.

Did the Court Get it Right?

On a strict reading of the regulations, yes, it did.

However, the Court’s decision seems harsh. Taxpayer clearly intended to treat LLC as an association taxable as a corporation for tax purposes. He caused LLC and Corp. to merge as part of a transaction that was reported as a tax-free corporate reorganization, not as a taxable liquidation. He treated LLC as the continuation of Corp. for tax purposes, causing LLC to file income tax returns as a “C” corporation, using Corp.’s EIN, after the merger.

What Taxpayer failed to do was file a Form 8832 to elect to be treated as an association.

Interestingly, an eligible entity, including a single-member LLC, that timely elects to be an S corporation, by filing IRS Form 2553, is treated as having made an election under the regulations to be classified as an association, provided that (as of the effective date of the “S” election) the entity meets all other requirements to qualify as a small business corporation. The deemed election to be classified as an association will apply as of the effective date of the S corporation election and will remain in effect until the entity makes a valid election to be classified as other than an association.

When this provision of the check-the-box regulations was adopted, the IRS explained that requiring eligible entities to file two elections in order to be classified as S corporations – Form 8832 and Form 2553 – creates a burden on those entities and on the IRS. The regulations sought to simplify these paperwork requirements by eliminating the requirement that the entity also elect to be classified as an association by filing Form 8832. Instead, an eligible entity that makes a timely and valid election to be classified as an S corporation by filing Form 2553 will be deemed to have elected to be classified as an association taxable as a corporation.

The regulation also provides that, if the eligible entity’s “S” election is not timely and valid, the default classification rules will apply to the entity unless the IRS provides late S corporation election relief or inadvertent invalid S corporation election relief.

Unless the IRS amends the regulations to expand the relief available thereunder beyond “S” elections, to cover eligible business entities in general, a taxpayer seeking a particular entity classification for tax purposes must file Form 8832. It will not be enough that the taxpayer has otherwise acted consistently with the desired status.