Woe to the Oppressed Shareholder
As I write this post on Bastille Day, I am reminded how an oppressed people, realizing the injustice of their circumstances, and having reached the limits of their endurance, took the first step toward “replacing” the lords and ladies that had long lived lavishly on their labors. [1]

If only it were so straightforward for an oppressed shareholder, especially in a pass-through entity such as an S corporation. As a minority owner, they have little to no say in the management or operation of the business, or in the distribution of the profits therefrom. Oftentimes, they are denied information regarding the finances of the business, with one exception: every year they receive a Schedule K-1 that sets forth their share of the corporation’s items of income, deduction, gain, loss, and credit for the immediately preceding year.

As a matter of Federal tax law, they are required to report these K-1 items on their own income tax returns, and – regardless of whether or not they received a distribution from the corporation – they must remit to the IRS the resulting income tax liability.

As one might imagine, this may create a cash flow problem for the oppressed shareholder. They are typically denied employment in the business and, so, do not receive compensation from the corporation. Thus, in order to satisfy their tax liability attributable to the S corporation, they are often forced to withdraw cash from other sources, or to liquidate personal assets (which may generate additional taxes).

In some cases, the oppressed shareholder in an S corporation has sought to “revoke” the “S” election and, thereby, to stop the flow-through of taxable income and the resulting outflow of cash. [2]

An S corporation may lose its tax-favored status by ceasing to qualify as a “small business corporation,” which means that it admits an ineligible person as an owner, or it has more than one class of stock outstanding. The Tax Court recently considered a situation in which an oppressed shareholder sought to use the disproportionate sharing of economic benefits between the shareholders as a basis for concluding that the corporation had more than one class of stock.

So Much for Egalité et Fraternite
Taxpayer and his brother (“Bro”) incorporated Corp. During the years in issue, Taxpayer owned 49% of the shares of Corp, and Bro owned 51%. The brothers elected to treat Corp as an S corporation for Federal income tax purposes. They also agreed that distributions would be proportional to their ownership shares.

Taxpayer, Bro and Bro’s spouse (“B-Spouse”) were the directors of Corp, and each participated in its business. Bro served as Corp’s president, B-Spouse as corporate secretary, and Taxpayer as vice president. Bro directed the administrative aspects of Corp’s business, while B-Spouse was Corp’s office manager. Bro and B-Spouse were responsible for the corporation’s bookkeeping and accounting.

Taxpayer’s work for Corp primarily involved managing operations in the field. He spent most of his working hours at jobsites, not in the office. Taxpayer received compensation as an employee of Corp for the years in issue.

Prior to the years in issue, Corp filed Forms 1120S, U.S. Income Tax Return for an S Corporation, and issued Schedules K-1 to Bro and Taxpayer. These filings reflected that the shareholders received cash distributions from Corp proportional to their stock ownership.

During the years in issue, Taxpayer began to examine more closely the administration of Corp’s business.

Taxpayer noticed that certain credits cards in his name, which he maintained for business purposes, were being used without his authorization to pay personal expenses of Bro’s children. Shortly thereafter, he reviewed the corporation’s QuickBooks records and determined that numerous items, including handwritten checks drawn on its bank accounts, had not been entered into the corporation’s accounting records. He also obtained and reviewed online banking statements for the corporation’s bank accounts. Taxpayer determined that, during the years in issue, Bro and B-Spouse had been making substantial check and ATM withdrawals from Corp’s bank accounts without his knowledge. [3]

Also during this period, Corp’s business began to struggle. Taxpayer received calls from Corp’s vendors who had tried unsuccessfully to contact Bro and B-Spouse regarding payments that they were owed and wanted to know when they would be paid. Corp had trouble paying its employees, and some of its checks were returned. Taxpayer had multiple discussions with Bro and B-Spouse about Corp’s cash flow problems. They told him that they were working on getting more money into the business.

Taxpayer became frustrated with the progress of Corp’s business and with the discussions that he was having with Bro. Finally, Taxpayer sent Bro an email stating that if Bro would not help him try to remedy the business, then Taxpayer would have no choice but to resign and sell his shares to Bro for a nominal amount. Bro responded that he would accept that offer effective immediately.

With that, Taxpayer completed some tasks for ongoing projects, and then quit his work for Corp. He never received payment from Bro for his shares of Corp.

The IRS Audit
Taxpayer filed Federal income tax returns for the years in issue. He attached Schedules E to the returns for these years, on which he listed Corp as an S corporation in which he held an interest. Taxpayer did not report any items of income or loss from Corp for the years in issue – these lines were left blank.

Taxpayer also attached to these returns Forms 8082, Notice of Inconsistent Treatment, relating to his interest in Corp, on which Taxpayer notified the IRS that he had not received Schedules K-1 from Corp.

Corp did not file Forms 1120S or issue Schedules K-1 for the years in issue. The IRS examined Corp, and prepared substitute tax returns using Corp’s banking records, general ledger, available employment tax returns, and other records to determine the corporation’s income and allowable deductions. The IRS allocated Corp’s net income as ordinary income to Taxpayer and Bro according to their 49% and 51% ownership shares, respectively.

The IRS also analyzed the shareholders’ distributions for the years in issue. For one year, the IRS determined that Taxpayer received less than one-third the amount of the distributions actually or constructively received by Bro; for the other year, it found that Taxpayer received less than one-ninth the amount of the distributions received by Bro. The IRS prepared basis computation worksheets for Taxpayer’s shares of Corp, and determined that Taxpayer was not required to include the distributions that he received in gross income for the years in issue because the amounts did not exceed his adjusted stock basis.

The notice of deficiency issued to Taxpayer determined increases to his Schedule E flow-through income for the years in issue, based upon the determinations set forth in the substitute returns prepared by the IRS for Corp.

Taxpayer disagreed with the IRS’s determination, and timely petitioned the Tax Court. Taxpayer contended that the income determined for Taxpayer – i.e., 49% of Corp’s net income for each of the years in issue – should not be attributable to him. [4]

Second Class of Stock?
Generally, an S corporation – or an electing “small business corporation” – is not subject to Federal income tax; rather, it is a conduit in that its income “flows through” to its shareholders, who are required to report and pay taxes on their pro rata shares of the S corporation’s taxable income.

The Code defines a small business corporation as a domestic corporation which must satisfy a number of requirements, including the requirement that it not have “more than 1 class of stock.” [5]

Generally, a corporation will be treated as having only one class of stock “if all outstanding shares of stock of the corporation confer identical rights to distribution and liquidation proceeds.” [6]
Once an eligible corporation elects S corporation status, that election is effective for the tax year for which it is made and for all succeeding tax years until it is terminated. The Code provides that an election shall be terminated automatically whenever the corporation ceases to qualify as a small business corporation.

When Taxpayer and Bro organized Corp, they clearly intended to create one class of stock. They agreed that all distributions would be proportional to their stock ownership, and their tax filings before the years in issue reflected that their shares of stock each had equal rights to distributions. Corp elected to be treated as an S corporation. For years before the years in issue it filed Forms 1120S and issued Schedules K-1 to Taxpayer reflecting his pro rata shares of the corporation’s taxable income.

Taxpayer contended that Corp’s “S” election was terminated during the years in issue because it ceased to be a small business corporation. Specifically, he contended that Corp no longer satisfied the requirement that it have only one class of stock – Bro withdrew large sums of money from Corp’s bank accounts during the years in issue without Taxpayer’s knowledge, and the IRS’s computations showed that Bro and Taxpayer received distributions for the years in issue that were not proportional to their stock ownership. Taxpayer argued that “these substantially disproportionate distributions appear to create a preference in distributions and . . . effectively a second class of stock”. He contended that Corp should be treated as a C corporation, and that Taxpayer should be taxed only on the distributions that he received, which he contended should be treated as dividends.

The Court’s Analysis
According to the Court, in determining whether a corporation has more than one class of stock, the rights granted to shareholders in the corporation’s organizational documents and other “binding agreements” between shareholders have to be considered. The applicable IRS regulations, the Court stated, provide that “[t]he determination of whether all outstanding shares of stock confer identical rights . . . is made based on the corporate charter, articles of incorporation, bylaws, applicable state law, and binding agreements relating to distribution and liquidation proceeds (collectively, the governing provisions).”

Evidence of distributions paid to one shareholder and not to others over the course of multiple years was insufficient on its own, the Court stated, to establish that a separate class of stock was created.

The Court concluded that Taxpayer had failed to prove that a binding agreement existed that granted Bro enhanced or disproportionate “rights to distribution and liquidation proceeds.” Rather, the Court found that, at most, there had been “an informal, oral understanding among the board members/shareholders”, and there was no evidence that the directors or shareholders ever took “formal corporate action to implement that understanding.”

The original, operative agreement between Corp’s shareholders (Taxpayer and Bro) was that distribution rights for each of their shares would be identical. Taxpayer testified that he and Bro never discussed changing the agreement regarding distributions and, during the years in issue, his understanding continued to be that distributions should be proportional to stock ownership. The record reflected that the shareholders never reached, or even considered, a new binding agreement that would change their relative rights to distributions.

Taxpayer argued that Bro’s withdrawals “effectively changed . . . [the shareholders’ agreement] by majority action.” However, the Court replied, nothing in the record indicated that Bro intended to act as Corp’s majority shareholder to grant himself rights to disproportionate distributions. Taxpayer offered no evidence of any actions taken at the corporate level to redefine shareholders’ rights or to issue a new class of stock. Moreover, he did not establish that a unilateral change of the kind described (i.e., the creation of a new class of stock) would be allowable under the applicable State law.

Taxpayer contended that the Court should regard “the substance of the actions” taken by Bro as creating a second class of stock. The Court noted, however, that Taxpayer’s own tax returns for the years in issue identified Corp as an S corporation. It then explained that taxpayers are generally bound by the form of the transaction that they choose unless they can provide “strong proof” that the parties intended a different transaction in substance. There was no proof, the Court observed, that either Taxpayer or Bro intended an arrangement different from that which they agreed to and reported consistently on their tax filings.

In short, Bro’s withdrawals during the years in issue did not establish that he held a different class of stock with disproportional distribution rights. Taxpayer failed to show that there were any changes to Corp’s governing provisions. Thus, he failed to carry his burden of proving that Corp’s election to be treated as an S corporation terminated during the years in issue and, consequently, the Court sustained the IRS’s determination that Taxpayer should be allocated 49% of Corp’s net income for each of the years in issue.

C’mon . . .?
Yes, on some visceral level, the Court’s decision seems harsh. But it is important to distinguish between the administration of the Federal tax system, on the one hand, and the protection of an oppressed shareholder, on the other. The latter may suffer certain adverse tax consequences as a result of a controlling shareholder’s inappropriate behavior, but they should not expect the Federal government to right those wrongs; rather, they have recourse to the courts and the laws of the jurisdiction under which the corporation was formed, and which govern the relationships among the shareholders and with the corporation itself.

That being said, shareholders have to be aware of what the Federal tax laws provide in order that they may take the appropriate steps to protect themselves, regardless of the size of their stockholdings. These steps are typically embodied in the terms of a shareholders’ agreement. [7]

As the Court explained, a determination of whether all outstanding [8] shares of stock confer identical rights to distribution and liquidation proceeds – i.e., whether there is only one class of stock – is made based on the corporate charter, articles of incorporation, bylaws, applicable state law, and binding agreements relating to distribution and liquidation proceeds (for example, a shareholders’ agreement).

Although a corporation is not treated as having more than one class of stock so long as these governing provisions provide for identical distribution and liquidation rights, any distributions (including actual, constructive, or deemed distributions) that differ in timing or amount are to be given appropriate tax effect in accordance with the facts and circumstances.

A commercial contractual agreement, on the other hand, such as a lease, employment agreement, or loan agreement – such as may be entered between the corporation and a controlling shareholder – is not treated as a binding agreement relating to distribution and liquidation proceeds unless a principal purpose of the agreement is to circumvent the one class of stock requirement (for example, where the terms are not at arm’s-length).

Similarly, buy-sell agreements among shareholders, agreements restricting the transferability of stock, and redemption agreements are disregarded in determining whether a corporation’s outstanding shares of stock confer identical distribution and liquidation rights. Although such an agreement may be disregarded in determining whether shares of stock confer identical distribution and liquidation rights, payments pursuant to the agreement may have other tax consequences. [9]

However, if a principal purpose of the agreement is to circumvent the one class of stock requirement, and the agreement establishes a purchase price that, at the time the agreement is entered into, is significantly in excess of or below the FMV of the stock, the one-class of stock rule may be violated.

Again, it will behoove a shareholder of an S corporation to appreciate the parameters described above.

——————————————————————

[1] Alliteration has its place.

[2] This raises the question: do the shareholders have a shareholders’ agreement and, if they do, does it restrict the transfer of shares, or require that the shareholders preserve the corporation’s tax status?

[3] Basically, constructive dividends. Less euphemistically, theft?

[4] The Court began its discussion by pointing out that, in general, the taxpayer bears the burden of proving that the IRS’s determinations set forth in the notice of deficiency are incorrect. In cases of unreported income, however, the IRS bears the initial burden of producing evidence linking the taxpayer with the receipt of funds before the general presumption of correctness attaches to a determination. Once the IRS meets this burden of production, the Court explained, the burden of persuasion remains with the taxpayer to prove that the IRS’s deficiency calculations were arbitrary or erroneous.

Corp failed to file income tax returns or to maintain adequate books and records for the years in issue. The IRS obtained banking records and conducted bank deposits analyses to determine the company’s net income. Bank deposits are prima facie evidence of income, the Court stated, and the “bank deposits method” was an acceptable method of computing unreported income.

The Court found that the IRS satisfied the burden of production with respect to the unreported income items at issue.

[5] https://www.law.cornell.edu/uscode/text/26/1361 .

[6] Reg. Sec. 1.1361-1(l). https://www.law.cornell.edu/cfr/text/26/1.1361-1.

[7] When Taxpayer and Bro were still on good terms, they should have agreed that Corp would make regular tax distributions, at least annually.

[8] The reference to “outstanding” shares is important; an S corporation’s certificate of incorporation may authorize the issuance of a preferred class of stock, but so long as such preferred class has not been issued and remains outstanding, the “S” election will remain in effect.

[9] For example, gift tax.

 

 

 

Decisions, Decisions

The reduction in the Federal income tax rate for C corporations, from a maximum of 35-percent to a flat 21-percent, along with several other changes made by the Tax Cuts and Jobs Act (the “Act”) that generally reflect a pro-C corporation bias, have caused the owners of many pass-through entities (“PTEs”) to reconsider the continuing status of such entities as S corporations, partnerships, and sole proprietorships.

Among the factors being examined by owners and their advisers are the following:

  • the PTE is not itself a taxable entity, and the maximum Federal income rate applicable to its individual owners on their pro rata share of a PTE’s ordinary operating income is 37-percent[i], as compared to the 21-percent rate for a C corporation;
  • the owners of a PTE may be able to reduce their Federal tax rate to as low as 29.6-percent if they can take advantage of the “20-percent of qualified business income deduction”;
  • a PTE’s distribution of income that has already been taxed to its owners is generally not taxable[ii], while a C corporation’s distribution of its after-tax earnings will generally be taxable to its owners at a Federal rate of 23.8%, for an effective combined corporate and shareholder rate of 39.8%;
  • the capital gain from the sale of a PTE’s assets will generally not be taxable to the PTE[iii], and will generally be subject to a Federal tax rate of 20-percent in the hands of its owners[iv], while the same transaction by a C corporation, followed by a liquidating distribution to its shareholders, will generate a combined tax rate of 39.8%.[v]

The application of these considerations to the unique facts circumstances of a particular business may cause its owners to arrive at a different conclusion than will the owners of another business that appears to be similarly situated.

Even within a single business, there may be disagreement among its owners as to which form of business organization, or which tax status, would optimize the owners’ economic benefit, depending upon their own individual tax situation and appetite.[vi]

In the past, this kind of disagreement in the context of a closely held business has often resulted in litigation of the kind that spawned the discovery issue described below. The changes made by the Act are certain to produce more than their share of similar intra-business litigation as owners disagree over the failure of their business to make or revoke certain tax elections, as well as its failure to reorganize its “corporate” structure.

A Taste of Things to Come?

Corporation was created to invest in the development, production, and sale of a product. Among its shareholders was a limited partnership (“LP”), of which Plaintiff was the majority owner.

Plaintiff asserted that Corporation’s management (“Defendants”) had breached their fiduciary duty to LP and the other shareholders. This claim was based upon the fact that Corporation was a C corporation and, as such, its dividend distributions to LP were taxable to LP’s members, based upon their respective ownership interest of LP.[vii]

Plaintiff claimed that this “double taxation” of Corporation’s earnings – once to Corporation and again upon its distribution as a dividend to its shareholders – had cost the business and its owners millions of dollars over the years, was “unnecessary,” had reduced the value of LP, and could have been avoided if Corporation had been converted into an S corporation, at which point LP would have distributed its shares of Corporation stock to its members, who were individuals.

Plaintiff stated that it had made repeated requests to Defendants to “eliminate this waste,” but to no avail.

Thus, one of the forms of relief requested by Plaintiff was “[p]ermanent injunctive relief compelling the Defendants to take all appropriate actions necessary to eliminate the taxable status of [Corporation] that results in an unnecessary level of taxation on distributions to the limited partners of [LP].”

“Prove It”

Defendants asked the Court to compel Plaintiff to produce Plaintiff’s tax returns for any tax year as to which Plaintiff claimed to have suffered damages based upon Corporation’s tax status.

Defendants asserted that, in order to measure any damages that were suffered by Plaintiff by reason of Corporation’s status, Defendants needed certain information regarding Plaintiff’s taxes, including Plaintiff’s “tax rate, deductions, credits and the like.”

Plaintiff responded that their “tax returns have no conceivable relevance to any aspect of this case.” Among other reasons, Plaintiff asserted that the action was brought derivatively on behalf of LP such that Plaintiff’s personal tax returns were not germane.

Defendants countered that, even if Plaintiff’s claims were asserted derivatively, the tax returns nevertheless were relevant since Plaintiff was a member of LP, the entity on whose behalf the claims were made.

The Court’s Decision

According to the Court, tax returns in the possession of a taxpayer are not immune from civil discovery. It noted, however, that courts generally are “reluctant to order the production of personal financial documents and have imposed a heightened standard for the discovery of tax returns.”

The Court explained that a party seeking to compel production of tax returns in civil cases must meet a two-part test; specifically, it must demonstrate that:

  • the returns are relevant to the subject matter of the action; and
  • there is a compelling need for the returns because the information contained therein is not otherwise readily obtainable.

Limited partnerships, the Court continued, “are taxed as ‘pass-through’ entities, do not pay any income tax, but instead file information returns and reports to each partner on his or her pro-rata share of all income, deductions, gains, losses, credits and other items.” The partner then reports those items on his or her individual income tax return. “The limited partnership serves as a conduit through which the income tax consequences of a project or enterprise are passed through to the individual partners.”

The Court found that Plaintiff’s tax returns were relevant to the claims asserted. The crux of Plaintiff’s argument regarding Corporation’s status, the Court stated, was that LP’s partners, including Plaintiff, were subject to “double taxation” and were thereby damaged.

The Court also found that Defendants had established a compelling need. The Court was satisfied that, in order for Defendants to ascertain whether or not Plaintiff, who owned a majority interest in LP, would have paid less tax if Corporation had been converted to an S corporation, Plaintiff had to produce their tax returns to Defendants. The tax returns would disclose, among other things, Plaintiff’s tax rate, deductions and credits that affected the tax due by Plaintiff.

Furthermore, the Court continued, Plaintiff failed to demonstrate that there were alternative sources from which to obtain the information. “While the party seeking discovery of the tax returns bears the burden of establishing relevance, the party resisting disclosure should bear the burden of establishing alternative sources for the information.”

Any concerns that existed regarding the private nature of the information contained in the tax returns could be addressed, the Court stated, by making the tax returns subject to the terms of the “stipulation and order of confidentiality” previously entered in the case.[viii]

Accordingly, the Court granted Defendants’ motion.

What’s Good for the Goose?

For years, oppressed or disgruntled shareholders and partners have often found in the tax returns of the business, of which they are owners, the clues, leads, or circumstantial evidence that help support their claims of mismanagement or worse by those in control of the business.

As a result of the Act, it is likely that some non-controlling owners will find cause for questioning or challenging the “choice of entity” decisions made on behalf of the business by its controlling owners.[ix]

In some cases, their concerns will be validated by what turn out to be true instances of oppression intended to cause economic harm and, perhaps, to force out the intended target.

In others, however, the controlling owner’s decision will have been reached only after a lot of due diligence, including financial modelling and consulting with tax advisers. In such cases, the controlling owner may want to examine the complaining party’s tax return, as in the Court’s decision described above, so as to ascertain whether the loss claimed was actually suffered.

It bears repeating, though, that even if the tax return information may be relevant to the controlling owner’s defense, there is a judicial bias against the disclosure of such information that is manifested in the application of “a heightened standard for the discovery of tax returns.” As stated earlier, the requesting party has to demonstrate that there is a “strong necessity” for the returns, and that the return information is not readily obtainable from other sources.

In the end, the best course of action for the “choice-of-entity” decision-maker, and their best defense against any claims of oppression or mismanagement, is to demonstrate that they acted reasonably and responsibly; they should thoroughly document the decision-process, and explain the basis for their decision. With that, a potential owner-claimant would be hard-pressed to second-guess them with any reasonable likelihood of success.


[i] If the PTE’s business is a passive activity with respect to the owner, the 3.8% Federal surtax on net investment income may also apply, bumping their maximum Federal tax rate up from 37% to 40.8%.

[ii] Because of the upward basis adjustment to the owner’s partnership interest or S corp. stock resulting from the inclusion of the PTE’s income or gain in the owner’s gross income.

[iii] There are exceptions; for example, the built-in gains tax for S corps. https://www.taxlawforchb.com/2013/09/s-corp-sales-built-in-gain-and-2013/ . In addition, the gain from the sale of certain assets may generate ordinary income that would be taxable to the PTE’s owners at a Federal rate of 37%; for example, depreciation recapture.

[iv] But see endnote i, supra.

[v] The operating income and capital gain of a C corporation are taxed at the same rate; there is no preferential Federal capital gain rate as in the case of individuals.

[vi] You may have heard your own clients debating the pros and cons of spinning off “divisions” so as to position themselves for maximizing the deduction based on qualified business income. All this before the issuance of any guidance by the IRS (which is expected later this month), though the Service intimated last month that taxpayers may not be pleased with its position regarding such spin-offs.

[vii] See the third bullet point, above.

[viii] Such an order may be used in cases requiring the exchange, as part of the discovery process, of what the parties to the law suit believe is confidential information.

[ix] For example, a shareholder of an S corporation that does not make distributions, who is not employed by the business, who is a passive investor in the business, and whose pro rata share of the corporation’s income is subject to federal tax at a rate of 40.8%, may wonder why the controlling shareholder does not agree to revoke the “S” election, to at least start making tax distributions.

Last week’s post may have left some readers feeling lightheaded or anxious. [1] It is highly unlikely that this week’s post will leave these individuals in a greatly altered state, though it may alleviate their condition to some extent, at least momentarily.

That is not to say that the issue at the root of today’s post is not controversial or divisive. Indeed, the Federal government continues to treat the production and sale of marijuana as an illegal activity, while the states are split in their stance on the legalization of marijuana. [2] At present, the likelihood that these parties will hash out a resolution of their differences seems remote.

A “Grass” Roots Debate
Both sides of the debate are driven, in part, by economic considerations, including the anticipated economic benefits and burdens. Among proponents of legalization, the opportunity to generate tax revenues from this growing industry – which may be used to fund social and other government-sponsored programs – presents a compelling case. Those opposed to legalization discount the projected tax revenues and point to the opportunity costs – including the attendant economic costs of treatment – that are associated with the increased use of any drug.

Even the Code itself is somewhat inconsistent in its treatment of the marijuana business, as was illustrated in a recent Tax Court decision. https://www.ustaxcourt.gov/ustcinop/OpinionViewer.aspx?ID=11681

“Let It Grow” [3]
Corp. was a corporation organized under the laws of State. Taxpayers were the sole shareholders of Corp. and also served as its officers during the years in issue. State licensed Corp. to grow and sell medical marijuana.

For the years in issue, Corp. elected to be treated as an S corporation for Federal income tax purposes.

Corp. claimed deductions from its gross income for expenses that would normally be characterized as “ordinary and necessary” business expenses, including deductions for items such as officer compensation officers, wages, repairs and maintenance, rents, taxes and licenses, interest, depreciation, advertising, employee benefit programs, and “other deductions,” which it detailed on statements attached to its tax return.

Taxpayers filed joint income tax returns for the years in issue. They received income from Corp., both as pass-through income (in their capacity as shareholders of an S corporation) and as officer compensation (in their capacity as employees of the corporation).

Taxpayers reported the pass-through income from Corp. on their Schedules E, Supplemental Income and Loss, Part II, Income or Loss from Partnerships and S Corporations, attached to their income tax returns for the years in issue.

Taxpayers reported the wages they received from Corp. for the years at issue on their jointly filed Forms 1040, U.S. Individual Income Tax Return. These wage payments, or expenses, were included as a part of Corp.’s “ordinary and necessary” business deductions.

IRS “Enforcement” of Federal Drug Laws?
The IRS examined Corp.’s tax returns for the years in issue. Following the exam, the IRS adjusted Corp’s items of deduction that flowed through to the Taxpayers, thereby increasing their pass-through taxable income for the years at issue.

Specifically, the IRS determined that Corp.’s deductions for the wages paid to Taxpayers should be disallowed as current deductions because they were paid in carrying on an illegal drug business. [4]

At the same time, the IRS allowed Corp.’s cost of goods sold (“COGS”), to the extent they were substantiated.

Taxpayers and the IRS agreed that these disallowed wage deductions could not be characterized as COGS, and that in disallowing the wage deductions, Taxpayers’ flow-through income from Corp. would increase.

They disputed whether Corp. could deduct the wages that it paid to Taxpayers. to the extent that the IRS had disallowed the deductions.

Taxpayers petitioned the U.S. Tax Court, where the issue for consideration was whether the deductions claimed by Corp. for the wages it paid to Taxpayers that were not attributable to COGS for the years in issue should be disallowed.

Getting Into the Weed(s)
The Court began by restating the ground rules: (i) the taxpayer generally bears the burden of proving that the IRS’s determinations, as set forth in the notice of deficiency, are erroneous; and (ii) the taxpayer bears the burden of proving their entitlement to a deduction and of substantiating the amount of the item underlying the claimed deduction.

Deductions, the Court continued, are a matter of legislative grace, and a taxpayer must prove their entitlement to a particular deduction.

Ordinary and Necessary Expenses
The Code allows taxpayers to deduct “ordinary and necessary expenses,” [5] including a “reasonable allowance for salaries or other compensation for personal services actually rendered.” Thus, compensation is deductible in determining the taxable income of a business only if it is (1) reasonable in amount and (2) paid or incurred for services actually rendered.

COGS
However, it is important to separate business expenses from the expenses used to figure the COGS. If a business manufactures products, or purchases them for resale, it generally must value its inventory at the beginning and end of each tax year to determine its COGS. Some of its expenses, including wages, may be included in figuring the COGS.

Under the uniform capitalization rules, a business must capitalize, and include in its COGS, the direct costs and part of the indirect costs for certain production or resale activities. [6]

The COGS is not a “deduction” within the meaning of the Code, but it is subtracted from the gross receipts of the business to determine its gross profit for the year; the costs included in COGS are recovered upon the sale of the product (as opposed to the tax year in which they were paid or incurred).

If a business includes an expense in the COGS, it cannot deduct that expense again as a business expense. [7]

“Expenditures in Connection With the Illegal Sale of Drugs”

The Code precludes taxpayers from deducting any expense related to a business that consists of trafficking in a controlled substance.

No deduction or credit shall be allowed for any amount paid or incurred during the taxable year in carrying on any trade or business if such trade or business (or the activities which comprise such trade or business) consists of trafficking in controlled substances (within the meaning of schedule I and II of the Controlled Substances Act) which is prohibited by Federal law or the law of any State in which such trade or business is conducted. [8]

The Court noted that marijuana was a controlled substance. It then stated that the dispensing of medical marijuana, while legal in State, was illegal under Federal law. Congress set this illegality under Federal law, the Court said, as one trigger to preclude a taxpayer from deducting expenses incurred in a medical marijuana dispensary business, even if the business is legal under State law. [9]

Interestingly, although the Code disallows deductions only for the expenses paid or incurred by a business in the illegal sale of drugs, it does not preclude a taxpayer from taking into account its COGS – in other words, the disallowance does not affect the COGS; if appropriate, the expense may still be included in the taxpayer’s COGS and may be subtracted in determining the taxpayer’s profits from the sale of the drug. [10]

Taxpayers’ Arguments
Taxpayers argued that the disallowance of the wages paid to them by Corp. resulted in discriminatory treatment of S corporation owners of marijuana businesses in violation of subchapter S. They argued that the IRS’s treatment of their wage income as an expense subject to disallowance caused the same income to be taxed twice, once as wages, and a second time (because of the disallowance of the deduction) as S corporation income. They contended that this resulted in the disallowed wage deductions attributable to “drug trafficking” being included in Taxpayers’ earnings, which flowed through to them without any deduction for the wages.

Taxpayers contended that this discriminatory treatment resulted from an S corporation’s being “required” to pay a reasonable wage to its officers, [11] while other entities (for example, a partnership) were not subject to this reasonable wage requirement.

The Court’s Response
The Court pointed out that Taxpayers’ argument of double taxation assumed that there was no distinction between gross income from wages, on the one hand, and pass-through income from the ownership of an S corporation, on the other. The economic considerations for these two items of income differed, according to the Court, as did their tax treatments.

S Corp. Basics
The S corporation rules were designed, the Court explained, to create a pass-through taxation system under which income was subjected to only one level of taxation: to the shareholders and not the corporation.

The Code provides that items of income, loss, deduction, and credit of an S corporation are passed through pro rata to its shareholders and reported on their individual tax returns. The character of each item of income in the hands of a shareholder is determined as if it were directly from the source from which the corporation realized it or incurred in the same manner as it was by the corporation. A shareholder’s gross income includes their pro rata share of the S corporation’s gross income.

Thus, Corp.’s income passed through to Taxpayers, and they had to report it on their individual tax returns. Separately, and in addition to Corp.’s pass-through income, Taxpayers had to report the compensation they received as officers of Corp. as a part of their gross income on their individual returns.

Accordingly, Taxpayers had to include in their gross income not only their pro rata shares of Corp.’s income, but also their wages separately received for providing services to Corp.

The Court further stated that Taxpayers’ contention that the application of deduction-disallowance rule resulted in disparate treatment was misplaced. An S corporation subject to this rule remained a flow-through entity with one tax imposed at the shareholder level, as prescribed by subchapter S.

No Dope
The Court illustrated its point with the following example: If Taxpayers had hired a third party to perform the officer duties that they performed, and they paid that third party an amount equal to that included as wages in Taxpayers’ gross income, their gross income would not include the third party’s wages from Corp.; Taxpayers would ultimately have less income, but they would not owe Federal income tax on the wages paid to the third party. However, the deduction-disallowance rule would still disallow Corp.’s wage expense deductions not attributable to COGS. Taxpayers’ flow-through income would be the same. Thus, the application of the rule to deny Corp.’s wage expense deductions was not discriminatory; it applied equally, regardless of whether Taxpayers themselves or a third party received the wages.

To the extent that Taxpayers believed they received disparate tax treatment as a result of organizing their marijuana business as an S corporation, the Court continued, they were free to operate as any form of business entity and in other trades. Taxpayers chose to operate Corp. as an S corporation in the marijuana business. They were responsible for the tax consequences of their decision.

Wait for Pot Luck?

Until the Code is amended, or until Congress decides that marijuana should not be illegal under Federal law, taxpayers who engage in the marijuana business in those States in which it is legal to do so will have to contend with increased income tax liability resulting from the deduction-disallowance rule described above.

However, because this rule does not apply to figuring the COGS, taxpayers engaged in a marijuana-related production or resale business will have to be careful about maintaining meticulous records in order to substantiate their COGS and support the gross profit reported from the sale of their products.

As in the case of other businesses that produce property for sale or that acquire property for resale, it may be possible to increase one’s COGS. Yes, this seems counterintuitive, but not where the alternative is the disallowance of a business expense deduction.

In any case, the method by which this result is achieved must be undertaken for a bona fide and substantial non-tax business reason. [12] At the same time, it must comply closely with the uniform capitalization rules so as to squeeze as much juice from them as reasonably possible.

Time will tell.

______________________________________

[1] Regarding the Federal tax treatment of CFCs that are owned by S corporations following the Tax Cuts and Jobs Act. https://www.taxlawforchb.com/2018/06/s-corps-cfcs-the-tax-cuts-jobs-act/

[2] Polls indicate that a majority of Americans support the legalization of marijuana. Nine States and the District of Columbia have legalized the recreational use of marijuana. Another 29 States have legalized so-called “medical marijuana.” A handful have decriminalized its use. Last week, Canada became the second nation to legalize marijuana use.

[3] With apologies to the Grateful Dead.

[4] The disallowance of Corp.’s deduction does not necessarily change the tax treatment for Taxpayers of the wages paid to them. For example, the wages were not re-characterized as distributions made to Taxpayers in respect of the shares of Corp. stock.

[5] An ordinary expense is one that is common and accepted in your trade or business. A necessary expense is one that is helpful and appropriate for your trade or business. An expense does not have to be indispensable to be considered necessary.

[6] Indirect costs include rent, interest, taxes, storage, purchasing, processing, repackaging, handling, and administrative costs.

[7] The following are types of expenses that go into figuring COGS: The cost of products or raw materials, including freight; storage; direct labor costs (including contributions to pension plans) for workers who produce the products; factory overhead.

[8] Cannabis remains illegal under federal law. Controlled Substances Act (P.L. 91-513), as amended. IRC Sec. 280E was added to the Code in 1982 by P.L. 97-248 (“TEFRA”). Query how a court would react to a taxpayer’s invoking the Fifth Amendment in response to an information document request from the IRS. Query how new IRC Sec. 199A and its “20%-of-qualified business income deduction” will be applied to a marijuana business; after all, unlike business expenses, the “deduction” is taken after adjusted gross income is determined.

[9] At some point, Congress or the Courts will have to address the conflict between those States that have legalized the marijuana business and the Code’s deduction-disallowance rule.

[10] This rule does not appear in the Code; rather, it is found in the Senate Finance Committee Report to TEFRA 1982. Thus, for example, the costs of growing marijuana or of manufacturing marijuana products may be included in COGS.

[11] For many years, the shareholders of S corporations who were employed by, and actually provided services to, their corporations, chose not to pay themselves any salary in exchange for such services. In this way, they sought to avoid the employment taxes that are required to be imposed upon salaries; the employment taxes do not apply to a shareholder’s pro rata share of S corporation income or to the distribution of such income. The IRS has successfully challenged this gambit.

[12] In a sense, the conceptual ideas for maximizing a taxpayer’s benefit under IRC Sec. 199A may be applicable here as well.

 

Pro “C” Corporation Bias?

Although closely-held businesses have generally welcomed the TCJA’s[i] amendments to the Code relating to the taxation of business income, many are also frustrated by the complexity of some of these changes. Among the provisions that have drawn the most criticism on this count are the changes to the taxation of business income arising from the foreign (“outbound”) activities of U.S. persons.

Because more and more closely-held U.S. businesses, including many S corporations, have been establishing operations overseas – whether through branches or corporate subsidiaries[ii] – the impact of these changes cannot be underestimated.

Moreover, their effect may be more keenly felt by closely-held U.S. businesses that are treated as pass-through entities[iii]; in other words, there appears to be a bias in the TCJA in favor of C corporations.

Overview: Deferred Recognition of Foreign Income – Pre-TCJA

In general, the U.S. has taxed U.S. persons on their worldwide income, although there has been some deferral of the taxation of the foreign-sourced income[iv] earned by the foreign corporate (“FC”) subsidiaries of U.S. businesses.[v]

The Code defines a “U.S. person” to include U.S. citizens and residents.[vi] A corporation or partnership is treated as a U.S. person if it is organized or created under the laws of the U.S. or of any State.[vii]

In general, income earned directly by a U.S. person from the conduct of a foreign business – for example, through the operation of a branch in a foreign jurisdiction – is taxed on a current basis.[viii]

Historically, however, active foreign business income earned indirectly by a U.S. person, through a FC subsidiary, generally has not been subject to U.S. tax until the income is distributed as a dividend to the U.S. person – unless an anti-deferral rule applies.

The CFC Regime

The main U.S. anti-tax-deferral regime, which addresses the taxation of income earned by controlled foreign corporations (“CFC”), may cause some U.S. persons who own shares of stock of a CFC to be taxed currently on certain categories of income earned by the CFC, regardless of whether the income has been distributed to them as a dividend.[ix]

CFC

A CFC is defined as any FC if U.S. persons own (directly, indirectly, or constructively[x]) more than 50-percent of the corporation’s stock (measured by vote or value), taking into account only those U.S. persons who own at least 10-percent of the FC’s stock (measured by vote or value; each a “United States shareholder” or “USS”).[xi]

Subpart F Income

Under the CFC rules, the U.S. generally taxes the USS of a CFC on their pro rata shares of the CFC’s “subpart F income,” without regard to whether the income is distributed to the shareholders. In effect, the U.S. treats the USS of a CFC as having received a current distribution of the CFC’s subpart F income.

In the case of most USS, subpart F income generally includes “foreign base company income,” which consists of “foreign personal holding company income” (such as dividends, interest, rents, and royalties), and certain categories of income from business operations that involve transactions with “related persons,” including “foreign base company sales income” and “foreign base company services income.”[xii]

One exception to the definition of subpart F income permits continued U.S.-tax-deferral for income received by a CFC in certain transactions with a related corporation organized and operating in the same foreign country in which the CFC is organized (the “same country exception”). Another exception is available for any item of income received by a CFC if the taxpayer establishes that the income was subject to an effective foreign income tax rate greater than 90-percent of the maximum U.S. corporate income tax rate (the “high-tax exception”).[xiii]

Actual Distributions

A USS may exclude from its income actual distributions of earnings and profits (“E&P”) from the CFC that were previously included in the USS’s income under the CFC regime.[xiv] Ordering rules provide that distributions from a CFC are treated as coming first out of E&P of the CFC that were previously taxed under the CFC regime, then out of other E&P.[xv]

Foreign Tax Credit

Subject to certain limitations, U.S. persons are allowed to claim a credit for foreign income taxes they pay. A foreign tax credit (“FTC”) generally is available to offset, in whole or in part, the U.S. income tax owed on foreign-source income included in the U.S. person’s income; this includes foreign taxes paid by an S corporation on any of its foreign income that flows through to its shareholders.

A domestic corporation is allowed a “deemed-paid” credit for foreign income taxes paid by the CFC that the domestic corporation is deemed to have paid when the related income is included in the domestic corporation’s income under the anti-deferral rules.[xvi]

Unfortunately for S corporations, they are treated as partnerships – not corporations – for purposes of the FTC and the CFC rules; thus, they cannot pass-through any such deemed-paid credit to their shareholders.

However, any tax that is withheld by the CFC with respect to a dividend distributed to an S corporation will flow through to the S corporation’s individual shareholders.

TCJA Changes

The TCJA made some significant changes to the taxation of USS that own stock in CFCs.

Transition Rule: Mandatory Inclusion

In order to provide a clean slate for the application of these new rules, the TCJA provides a special transition rule that requires all USS of a “specified foreign corporation” (“SFC”) to include in income their pro rata shares of the SFC’s “accumulated post-1986 deferred foreign income” (“post-1986-DFI”) that was not previously taxed to them.[xvii] A SFC means (1) a CFC or (2) any FC in which a domestic corporation is a USS.[xviii]

The mechanism for the mandatory inclusion of these pre-effective-date foreign earnings is the CFC regime. The TCJA provides that the subpart F income of a SFC is increased for the last taxable year of the SFC that begins before January 1, 2018.

This transition rule applies to all USS of a SFC, including individuals.

Consistent with the general operation of the CFC regime, each USS of a SFC must include in income its pro rata share of the SFC’s subpart F income attributable to the corporation’s post-1986-DFI.

Reduced Tax Rate

Fortunately, the TCJA allows a portion of that pro rata share of deferred foreign income to be deducted. The amount deductible varies, depending upon whether the deferred foreign income is held by the SFC in the form of liquid or illiquid assets. To the extent the income is not so deductible – i.e., is included in the income of the USS – the USS may claim a portion of the foreign tax credit attributable thereto.

The total deduction from the amount included under the transition rule is the amount necessary to result in a 15.5-percent tax rate on post-1986-DFI held by the SFC in the form of cash or cash equivalents,[xix] and an 8-percent tax rate on all other earnings.

The calculation of the deduction is based on the highest rate of tax applicable to domestic corporations in the taxable year of inclusion, even if the USS is an individual.

However, an individual USS – including the shareholder of an S corporation – will be taxed on the amount included in their income at the higher federal tax rate applicable to individuals.[xx]

That being said, an individual USS, including one who is a shareholder of an S corporation, generally may elect application of the corporate tax rates for the year of inclusion.[xxi]

Deferred Payment of Tax

A USS may elect to pay the net tax liability resulting from the mandatory inclusion of post-1986-DFI in eight unequal installments.[xxii] The timely payment of an installment does not incur interest.[xxiii]

The provision also includes an acceleration rule. If (1) there is a failure to pay timely any required installment, (2) there is a liquidation or sale of substantially all of the USS’s assets, (3) the USS ceases business, or (4) another similar circumstance arises, the unpaid portion of all remaining installments will become due immediately.

Special Deferral for S corporation Shareholders

A special rule permits deferral of the above transitional tax liability for shareholders of a USS that is an S corporation.

The S corporation is required to report on its income tax return the amount includible in gross income by reason of this provision, as well as the amount of deduction that would be allowable, and to provide a copy of such information to its shareholders.

Any shareholder of the S corporation may elect to defer their portion of the tax liability until the shareholder’s taxable year in which a “triggering event” occurs.[xxiv]

Three types of events may trigger an end to deferral of this tax liability. The first is a change in the status of the corporation as an S corporation. The second category includes liquidation, sale of substantially all corporate assets, termination of the company or end of business, or similar event, including reorganization in bankruptcy. The third type of triggering event is a transfer of shares of stock in the S corporation by the electing taxpayer, whether by sale, death or otherwise, unless the transferee of the stock agrees to be liable for tax liability in the same manner as the transferor.[xxv]

If a shareholder of an S corporation has elected deferral under this special rule, and a triggering event occurs, then the S corporation and the electing shareholder will be jointly and severally liable for any tax liability (and related interest or penalties).[xxvi]

After a triggering event occurs, an electing shareholder may elect to pay the tax liability in eight installments, subject to rules similar to those generally applicable absent deferral. Whether a shareholder may elect to pay in installments depends upon the type of event that triggered the end of deferral. If the triggering event is a liquidation, sale of substantially all corporate assets, termination of the company or end of business, or similar event, the installment payment election is not available. Instead, the entire tax liability is due upon notice and demand.[xxvii]

The New CFC Regime

With the mandatory “repatriation” of the post-1986-DFI of SFC, the TCJA implemented a new “participation exemption” regime for the taxation of USS of “specified 10-percent-owned FCs,”[xxviii] effective for taxable years of FCs beginning after December 31, 2017.

Dividends Received Deduction

Specifically, it allows an exemption for certain foreign income by means of a 100-percent deduction for the foreign-source portion of dividends[xxix] received from a specified-10%-owned FC by a domestic corporation that is a USS of such FC.[xxx]

The term “dividends received” is intended to be interpreted broadly; for example, if a domestic corporation indirectly owns stock of a FC through a partnership, and the domestic corporation would qualify for the DRD with respect to dividends from the FC if the domestic corporation owned such stock directly, the domestic corporation would be allowed a DRD with respect to its distributive share of the partnership’s dividend from the FC.[xxxi]

This DRD is available only to regular domestic C corporations that are USS, including those that own stock of a FC through a partnership; it is not available to C corporations that own less than 10% of the FC. The DRD is available only for the foreign-source portion of dividends received by a qualifying domestic corporation from a speficied-10-percent-owned FC.

No foreign tax credit or deduction is allowed to a USS for any foreign taxes paid or accrued by the FC (including withholding taxes) with respect to any portion of a dividend distribution that qualifies for the DRD.[xxxii]

Significantly, the DRD is not available to individuals; nor is it available to S corporations or their shareholders. Considering that an S corporation is not entitled to the deemed-paid credit for foreign income taxes paid by its foreign subsidiary, the income of the foreign subsidiary may be taxed twice: once by the foreign country and, when distributed, by the U.S.[xxxiii]

Holding Period

A domestic corporation is not permitted a DRD in respect of any dividend on any share of stock of a specified-10-percent-owned FC unless it satisfies a minimum holding period.

Specifically, the FC’s stock must have been held by the domestic corporation for at least 365 days during the 731-day period beginning on the date that is 365 days before the date on which the share becomes ex-dividend with respect to the dividend. For this purpose, the holding period requirement is treated as met only if the specified-10-percent-owned FC qualifies as such at all times during the period, and the taxpayer is a USS with respect to such FC at all times during the period.

GILTI

Having captured and taxed the post-1986-DFI of SFC (through 2017), and having introduced the DRD, the TCJA also introduced a new class of income – “global intangible low-taxed income” (“GILTI”) – that must be included in income by a USS of a CFC, and which further erodes a taxpayer’s ability to defer the U.S. taxation of foreign income.

Amount Included

This provision requires the current inclusion[xxxiv] in income by a USS of (i) their share of all of a CFC’s non-subpart F income (other than income that is effectively connected with a U.S. trade or business and income that is excluded from foreign base company income by reason of the high-tax exception),[xxxv] (ii) less an amount equal to the USS’s share of 10-percent of the adjusted basis of the CFC’s tangible property used in its trade or business and of a type with respect to which a depreciation deduction is generally allowable (the difference being GILTI).[xxxvi]

In the case of a CFC engaged in a service business or other business with few fixed assets, the GILTI inclusion rule may result in the U.S taxation of the CFC’s non-subpart F business income without the benefit of any deferral.

This income inclusion rule applies to both individual and corporate USS.

In the case of an individual, the maximum federal tax rate on GILTI is 37-percent.[xxxvii] This is the rate that will apply, for example, to a U.S. citizen who directly owns at least 10-percent of the stock of a CFC, or to one who indirectly owns such CFC stock through an S corporation.

C Corporations

More forgiving rules apply in the case of a USS that is a C corporation. For taxable years beginning after December 31, 2017, and before January 1, 2026, a regular domestic C corporation is generally allowed a deduction of an amount equal to 50-percent of its GILTI; thus, the federal corporate tax rate for GILTI is actually 10.5% (the 21% flat rate multiplied by 50%).[xxxviii]

In addition, for any amount of GILTI included in the gross income of a domestic C corporation, the corporation is allowed a deemed-paid credit equal to 80-percent of the foreign taxes paid or accrued by the CFC with respect to such GILTI.

Based on the interaction of the 50-percent deduction and the 80-percent foreign tax credit, the U.S. tax rate on GILTI that is included in the income of a regular C corporation will be zero where the foreign tax rate on such income is 13.125%.[xxxix]

S Corporations

Because an S corporation’s taxable income is computed in the same manner as an individual, and because an S corporation is treated as a partnership for purposes of the CFC rules, neither the 50-percent GILTI deduction nor the 80-percent deemed-paid credit apply to S corporations or their shareholders. Thus, individuals are treated more harshly by the GILTI inclusion rules than are C corporations.

What is an S Corp. to Do?

So what is an S corporation with a FC subsidiary to do when confronted with the foregoing challenges and the TCJA’s pro-C corporation bias?

C Corporation?

One option is for the S corporation to contribute its FC shares to a domestic C corporation, or the S corporation itself could convert into a C corporation (its shareholders may revoke its election, or the corporation may cease to qualify as a small business corporation by providing for a second class of stock or by admitting a non-qualifying shareholder).

However, C corporation status has its own significant issues (like double taxation), and should not be undertaken lightly, especially if the sale of the business is reasonably foreseeable.

Branch?

Another option is for the S corporation to effectively liquidate its foreign subsidiary and to operate in the foreign jurisdiction through a branch, or through an entity for which a “check-the-box election” may be made to disregard the entity for tax purposes.

This would avoid the CFC and GITLI rules entirely, and it would allow the shareholders of the S corporation to claim a credit for foreign taxes paid by the branch.

Of course, operating through a branch would also prevent any deferral of U.S. taxation of the foreign income, and may subject the U.S. person to a branch profits tax in the foreign jurisdiction.[xl]

It should be noted, however, that the liquidation or reorganization of a CFC into a branch will generally be a taxable event, with the result that the accumulated foreign earnings and profits of the CFC will be included in the income of the USS as a “deemed dividend.”

That being said, the rules for determining such accumulated earnings and profits generally exclude amounts previously included in the gross income of the USS under the CFC rules. To the extent any amount is not so excluded, the S corporation shareholder of the CFC will not be able to utilize the DRD to reduce its tax liability.[xli]

Section 962 Election?

Yet another option to consider – which pre-dates the TCJA, but which seems to have been under-utilized – is a special election that is available to an individual who is a USS, either directly or through an S corporation.

This election, which is made on annual basis, results in the individual being treated as a C corporation for purposes of determining the income tax on their share of GILTI and subpart F income; thus, the electing individual shareholder would be taxed at the corporate tax rate.[xlii]

The election also causes the individual to be treated as a C corporation for purposes of claiming the FTC attributable to this income; thus, they would be allowed the 80-percent deemed-paid credit.

Of course, like most elections, this one comes at a price. The E&P of a FC that are attributable to amounts which were included in the income of a USS under the GILTI or CFC rules, and with respect to which an election was made, shall be included in gross income, when such E&P are actually distributed to the USS, to the extent that the E&P so distributed exceed the amount of tax paid on the amounts to which such election applied.[xliii]

No Easy Way Out[xliv]

We find ourselves in a new regime for the U.S. taxation of foreign income, and there is still a lot of guidance to be issued.

In the meantime, an S corporation with a foreign subsidiary would be well-served to model out the consequences of the various options described above, taking into account its unique circumstances – including the possibility of a sale – before making any changes to the structure of its foreign operations.


[i] “TCJA”. Public Law No. 115-97.

[ii] These may be wholly-owned, or they may be partially-owned; the latter often represent a joint venture with a foreign business.

[iii] The “20% of qualified business income deduction” for pass-through entities does not apply to foreign-source income.

[iv] The Code provides sourcing rules for most categories of business income. It should be noted that, in certain cases, a foreign person that is engaged in a U.S. trade or business may have limited categories of foreign-source income that are considered to be effectively connected such U.S. trade or business.

[v] Special rules apply where the foreign subsidiary engages in business transactions with its U.S. parent or with another affiliated company. A basic U.S. tax principle applicable in dividing profits from transactions between related taxpayers is that the amount of profit allocated to each related taxpayer must be measured by reference to the amount of profit that a similarly situated taxpayer would realize in similar transactions with unrelated parties. The “transfer pricing rules” of section 482 seek to ensure that taxpayers do not shift income properly attributable to the U.S. to a related foreign company through pricing that does not reflect an arm’s-length result.

[vi] Noncitizens who are lawfully admitted as permanent residents of the U.S. (“green card holders”) are treated as residents for tax purposes. In addition, noncitizens who meet a “substantial presence test” (based upon the number of days spent in the U.S.) are also, generally speaking, taxable as U.S. residents.

[vii] It should be noted that an unincorporated entity, such as a partnership or limited liability company, may elect its classification for Federal tax purposes – as a disregarded entity, a partnership or an association – under the “check-the-box” regulations. See Treas. Reg. 301.7701-3.

[viii] The same goes for income that is treated as having been earned directly, as through a partnership. IRC Sec. 702(b).

[ix] The other main anti-deferral regime covers Passive Foreign Investment Companies (“PFIC”). There is some overlap between the CFC and PFIC regimes; the former trumps the latter.

[x] The TCJA amended the applicable ownership attribution rules so that certain stock of a FC owned by a foreign person is attributed to a related U.S. person for purposes of determining whether the related U.S. person is a USS of the FC and, therefore, whether the FC is a CFC. The pro rata share of a CFC’s subpart F income that a USS is required to include in gross income, however, continues to be determined based on direct or indirect ownership of the CFC, without application of the new downward attribution rule. In making this amendment, the TCJA intended to render ineffective certain transactions that were used to as a means of avoiding the CFC regime. One such transaction involved effectuating “de-control” of a foreign subsidiary, by taking advantage of the prior attribution rule that effectively turned off the constructive stock ownership rules when to do otherwise would result in a U.S. person being treated as owning stock owned by a foreign person.

[xi] The TCJA expanded the definition of USS under subpart F to include any U.S. person who owns 10 percent or more of the total value of shares of all classes of stock of a FC. Prior law looked only to voting power. The TCJA also eliminated the requirement that a FC must be controlled for an uninterrupted period of 30 days before subpart F inclusions apply.

[xii] The 10-percent U.S. shareholders of a CFC also are required to include currently in income for U.S. tax purposes their pro rata shares of the CFC’s untaxed earnings invested in certain items of U.S. property. This U.S. property generally includes tangible property located in the U.S. stock of a U.S. corporation, an obligation of a U.S. person, and certain intangible assets, such as patents and copyrights, acquired or developed by the CFC for use in the U.S. The inclusion rule for investment of earnings in U.S. property is intended to prevent taxpayers from avoiding U.S. tax on dividend repatriations by repatriating CFC earnings through non-dividend payments, such as loans to U.S. persons.

[xiii] Before the TCJA reduced the tax rate on C corporations to a flat 21 percent, that meant more than 90 percent of 35 percent, or 31.5 percent. The reduced corporate tax rate should make it easier for a CFC to satisfy this exception; 90% of 21% is 18.9%.

[xiv] This concept, as well as the basis-adjustment concept immediately below, should be familiar to anyone dealing with partnerships and S corporations.

[xv] In order to ensure that this previously-taxed foreign income is not taxed a second time upon distribution, a USS of a CFC generally receives a basis increase with respect to its stock in the CFC equal to the amount of the CFC’s earnings that are included in the USS’s income under the CFC regime. Conversely, a 10-percent U.S. shareholder of a CFC generally reduces its basis in the CFC’s stock in an amount equal to any distributions that the 10-percent U.S. shareholder receives from the CFC that are excluded from its income as previously taxed under subpart F.

[xvi] The deemed-paid credit is limited to the amount of foreign income taxes properly attributable to the subpart F inclusion. The foreign tax credit generally is limited to a taxpayer’s U.S. tax liability on its foreign-source taxable income. This limit is intended to ensure that the credit serves its purpose of mitigating double taxation of foreign-source income without offsetting U.S. tax on U.S.-source income.

[xvii] Basically, foreign earnings that were not previously taxed, that are not effectively connected to the conduct of a U.S. trade or business, and that are not subpart F income.

[xviii] Such entities must determine their post-1986 deferred foreign income based on the greater of the aggregate

post-1986 accumulated foreign earnings and profits as of November 2, 2017 or December 31,

[xix] The cash position of an entity consists of all cash, net accounts receivables, and the fair market value of similarly liquid assets, specifically including personal property that is actively traded on an established financial market, government securities, certificates of deposit, commercial paper, and short-term obligations.

[xx] It should be noted that the increase in income that is not taxed by reason of the deduction is treated as income that is exempt from tax for purposes of determining (i.e., increasing) a shareholder’s stock basis in an S corporation, but not as income exempt from tax for purposes of determining the accumulated adjustments account (“AAA”) of an S corporation (thus increasing the risk of a dividend from an S corporation with E&P from a C corporation).

[xxi] IRC Sec. 962. However, there are other consequences that stem from such an election that must be considered,

[xxii] The net tax liability that may be paid in installments is the excess of the USS’s net income tax for the taxable year in which the pre-effective-date undistributed CFC earnings are included in income over the taxpayer’s net income tax for that year determined without regard to the inclusion. https://www.taxlawforchb.com/?s=foreign

[xxiii] If a deficiency is determined that is attributable to an understatement of the net tax liability due under this provision, the deficiency is payable with underpayment interest for the period beginning on the date on which the net tax liability would have been due, without regard to an election to pay in installments, and ending with the payment of the deficiency.

[xxiv] The election to defer the tax is due not later than the due date for the return of the S corporation for its last taxable year that begins before January 1, 2018.

[xxv] Partial transfers trigger the end of deferral only with respect to the portion of tax properly allocable to the portion of stock sold.

[xxvi] Query how the shareholders’ agreement for an S corporation should be amended to address this possibility.

[xxvii] If an election to defer payment of the tax liability is in effect for a shareholder, that shareholder must report the amount of the deferred tax liability on each income tax return due during the period that the election is in effect. Failure to include that information with each income tax return will result in a penalty equal to five-percent of the amount that should have been reported.

[xxviii] In general, a “specified 10-percent owned foreign corporation” is any FC (other than a PFIC) with respect to which any domestic corporation is a USS.

[xxix] A distribution of previously-taxed income does not constitute a dividend, even if it reduced earnings and profits.

[xxx] The “dividends received deduction” (“DRD”).

[xxxi] In the case of the sale or exchange by a domestic corporation of stock in a FC held for one year or more, any amount received by the domestic corporation which is treated as a dividend for purposes of Code section 1248, is treated as a dividend for purposes of applying the provision. Thus, the DRD will be available to such a deemed dividend. Sec. 1248 is intended to prevent the conversion of subpart F income into capital gain.

[xxxii] In addition, the DRD is not available for any dividend received from a FC if the dividend is a “hybrid dividend.” A hybrid dividend is an amount received from a FC for which a DRD would otherwise be allowed and for which the specified-10-percent-owned FC received a deduction (or other tax benefit) with respect to any income taxes imposed by any foreign country.

[xxxiii] Of course, we also have to consider any withholding tax that the foreign country may impose of the foreign corporation’s dividend distribution to its S corporation shareholder. This tax will be creditable by the shareholders of the S corporation.

[xxxiv] For purposes of the GILTI inclusion, a person is treated as a U.S. shareholder of a CFC for any taxable year only if such person “owns” stock in the corporation on the last day, in such year, on which the corporation is a CFC. A corporation is generally treated as a CFC for any taxable year if the corporation is a CFC at any time during the taxable year.

[xxxv] Thus, subpart F income, effectively connected income, and income that is subject to foreign tax at a rate greater than 18.9% is not GILTI. For example, the corporate tax rate is 19% in the U.K., 24% in Italy, 25% in Spain 25%, 18% in Luxembourg, and 25% in the Netherlands.

[xxxvi] “Qualified business asset investment (“QBAI”). The CFC’s intangible property is not included in QBAI.

The 10% represents an arbitrary rate of return on the “unreturned capital” (i.e., tangible property) of the CFC, represented by its adjusted basis, for which continued deferral is permitted. Anything in excess thereof must be included in the gross income of the USS on a current basis.

[xxxvii] The maximum individual tax rate applicable to ordinary income.

[xxxviii] For taxable years beginning after December 31, 2025, the deduction is lowered to 37.5-percent.

It should be noted that it is intended that the “50-percent of GILTI deduction” be treated as exempting the deducted income from tax. Thus, for example, the deduction for GILTI could give rise to an increase in a domestic corporate partner’s basis in a domestic partnership that holds stock in a CFC.

[xxxix] 13.125% multiplied by 80% equals 10.5 percent.

[xl] Of course, an income tax treaty between the U.S. and the foreign jurisdiction may affect this result.

[xli] The applicable regulations have yet to be amended to reflect the changes made by the TCJA.

[xlii] However, the shareholder will not be allowed the 50-percent GILTI deduction. This deduction is not part of the CFC or FTC rules.

[xliii] In other words, the regular double taxation rules for C corporations will apply; the corporation is treated as having distributed its after-tax E&P.

[xliv] Remember “Rocky IV”?

It is said that repetition is the mother of all learning. It is also said that insanity is repeating the same mistake and expecting a different result. It is my hope that the result of the former will overwhelm the source of the latter before it is too late.

However, based upon the seemingly continuous flow of decisions from the Tax Court rejecting taxpayers’ characterization of their outlays of funds as indebtedness, it may be a forlorn hope.

What follows is a summary of one especially ill-advised or misguided taxpayer.

Debts and Distributions

Taxpayer was the sole shareholder of S-Corp.[i] The corporation operated a mortgage broker business. It acted as an intermediary between borrowers and lenders; it did not hold any loans itself. https://www.ustaxcourt.gov/USTCInOP/OpinionViewer.aspx?ID=11650

Bad Debts?

In Tax Year, S-Corp. to make a series of advances to Borrower. The advances were made by checks, credit card payments, and wire transfers. Each advance was recorded on S-Corp.’s general ledger as a loan receivable from Borrower.

Borrower did not execute any notes for the advances received during Tax Year. The advances were unsecured, and neither S-Corp. nor Taxpayer made a public filing to record a debt in connection with the advances. Taxpayer did not know the business activities that Borrower conducted.

An adjusting entry in S-Corp.’s general ledger for December 31 of Tax Year reflected that Taxpayer instructed that the loan receivable for the Tax Year advances be written off.

On its return for Tax Year, S-Corp. claimed a large deduction for bad debts; the debt deduction was attributable to a write off for advances made to Borrower.

S-Corp.’s trial balance for the following tax year reflected that it made another loan to Borrower in that year. Taxpayer claimed not to know the purpose for that advance.

“Bad” Distributions?

As S-Corp.’s president and sole shareholder, Taxpayer authorized distributions to himself during the two years in issue. In Tax Year, Taxpayer received total distributions in excess of $1.6 million. In the following year, he received distributions in excess of $2 million.

For the years in issue, S-Corp. reported ordinary business losses, based in part on the bad debt deduction claimed for the advances made to Borrower. Taxpayer claimed S-Corp.’s losses on the Schedules E, Supplemental Income and Loss, Part II, Income or Loss from Partnerships and S Corporations, attached to his Forms 1040, U.S. Individual Income Tax Return. He engaged the same CPA firm to prepare S-Corp.’s returns and his individual returns for the years in issue.

For the years in issue, S-Corp. reported on its returns the distributions to Taxpayer. It issued Schedules K-1, Shareholder’s Share of Income, Deductions, etc., for Taxpayer that reflected the distributions and reported them as “[i]tems affecting shareholder basis”.

Taxpayer did not report any of the distributions that he received from S-Corp. for the years in issue on his individual returns.

The IRS Disagrees

The IRS examined Taxpayer’s income tax returns for the years in issue, and then issued a notice of deficiency in which it: (i) disallowed the full amount of S-Corp.’s claimed bad debt deduction for Tax Year – this adjustment flowed through to Taxpayer and was reflected as an increase to the income reported on his Schedule E; and (ii) determined that Taxpayer had unreported long-term capital gains for the years in issue.

Taxpayer petitioned the U.S. Tax Court.

Bad Debt Deduction

The Code allows a deduction for a taxable year for any debt that becomes wholly worthless within the taxable year. To deduct a business bad debt, the taxpayer must establish the existence of a valid debtor-creditor relationship, that the debt was created or acquired in connection with a trade or business, the amount of the debt, the worthlessness of the debt, and the year that the debt became worthless.

The IRS contended, and the Court agreed, that Taxpayer failed to establish any of these elements as they relate to the advances made by S-Corp. to Borrower during Tax Year.

A bad debt is deductible only for the year in which it becomes worthless. The Court explained that the subjective opinion of the taxpayer that the debt is uncollectible, without more, is not sufficient evidence that the debt is worthless.

The Court observed that Taxpayer failed to present any evidence that the alleged debt was objectively worthless in Tax Year. He testified only as to his subjective belief. Taxpayer did not identify any events during Tax Year which showed that the alleged debt was uncollectible. He testified that Borrower told him early in the following year that he could not repay the Tax Year advances, but he offered no reasoning as to why in that case the alleged debt should be treated as being worthless at the end of Tax Year.

Even accepting Taxpayer’s uncorroborated testimony, Borrower’s statement early in the following year was not enough to establish that the alleged debt to S-Corp. was objectively worthless at the end of Tax Year. Taxpayer did not describe any actions taken to try to collect the alleged debt, and he testified that he did not know whether Borrower was actually insolvent in the following year. Moreover, there was no reasonable explanation for advancing more funds to Borrower the next year if the prior advances were deemed totally unrecoverable.

Bona Fide Debt?

Taxpayer also failed to establish that the advances constituted a bona fide debt – “a valid and enforceable obligation to pay a fixed or determinable sum of money” – and that the parties intended to create a bona fide debtor-creditor relationship. Generally a debtor-creditor relationship exists if the debtor genuinely intends to repay the loan and the creditor genuinely intends to enforce repayment.

Factors indicative of a bona fide debt include: (1) whether the purported debt is evidenced by a note or other instrument; (2) whether any security was requested;

(3) whether interest was charged; (4) whether the parties established a fixed schedule for repayment; (5) whether there was a demand for repayment; (6) whether any repayments were actually made; and (7) whether the parties’ records and conduct reflected the transaction as a loan.

Borrower did not execute any notes, and Taxpayer did not request any collateral or other security for the advances. Taxpayer did not provide any documents reflecting the terms for the purported loan.

Apart from the way that the advances were recorded in S-Corp.’s general ledger, the parties’ conduct did not reflect that the advances were intended as a bona fide loan. S-Corp. made a series of unsecured advances to Borrower, and as the balance of the advances rapidly increased S-Corp. did not receive any offsetting payments or obtain any guaranties of repayment. Taxpayer did not claim that he and Borrower agreed to a schedule for repaying the advances or that he ever demanded repayment. Rather, he contended that he determined that the advances were uncollectible as of the end of Tax Year, only 10 days after the last advance had been made and without making any efforts to collect the amounts allegedly owed. He testified that by early the next year, he believed Borrower would not be able repay the advances, but he continued to direct S-Corp. to advance him more funds.

Taxpayer contended that he had a “good-faith expectation” that Borrower would repay him. He testified about his prior business dealings with Borrower, but the objective evidence and the preponderance of all evidence suggested that Taxpayer had no genuine intention of requiring Borrower to repay the advances. The real purpose of the advances remained unexplained.

The Court was not persuaded that a bona fide debt was created. It held that Taxpayer had failed to establish whether and when the advances became worthless or that the advances should even be considered a bona fide debt for tax purposes. Accordingly, the Court sustained the IRS’s determination to disallow the bad debt deduction in full.

Distributions from S-Corp.

The IRS contended that Taxpayer failed to report capital gains from the distributions that he received from S-Corp., during the years in issue. According to the IRS, the distributions were in excess of Taxpayer’s adjusted basis in S-Corp’s stock.

Under the Code, a shareholder of an S corporation takes into account their pro rata share of the corporation’s items of income, loss, deduction, or credit for the corporation’s taxable year ending with or in the shareholder’s taxable year. The Code also provides that a shareholder’s basis in their stock of the S corporation is increased by items of income passed through to the shareholder, and decreased by passed through items of loss and deduction. A shareholder’s stock basis is also decreased by distributions received from the S corporation that are not includible in the shareholder’s income. A distribution is not included in the gross income of a shareholder to the extent that it does not exceed the shareholder’s adjusted basis for the stock. The portion of a distribution that exceeds this adjusted basis is treated as gain from the sale or exchange of property.

Taxpayer contended that he did not take distributions in excess of basis. He claimed that he was personally liable to S-Corp. for the distributions that he received during the years in issue because he received them in violation of State law. Under State law, Taxpayer claimed, a shareholder who knowingly receives any distribution that exceeds the amount of the corporation’s retained earnings immediately prior to the distribution is liable to the corporation for the amount so received. For each of the years in issue, S-Corp.’s tax return reflected that it had negative retained earnings.

At this point, one might have expected Taxpayer to characterize the erstwhile “distributions” as loans from the corporation; after all, if his description of the result under State law was accurate, the funds had to be returned. However, Taxpayer instead contended that his liability to S-Corp. under State law “increased his debt basis in the corporation.” How this would have been relevant in determining the proper tax treatment of the distributions made to Taxpayer is anyone’s guess.

The Court stated that Taxpayer had misinterpreted the Code in arguing that his purported obligation to repay the distributions created debt basis. The Court then pointed out that even if Taxpayer established that he had basis in some bona fide indebtedness of S-Corp., it would not affect the taxability of the distributions that he received. The Court pointed out that the Code’s S-corporation-distribution provisions do not identify distributions that decrease a shareholder’s stock basis as an item to be applied to a shareholder’s debt basis after the stock basis has been reduced to zero.

The Court agreed with the IRS that the distributions had to be reported as income and treated as capital gain to the extent that they exceeded Taxpayer’s basis in S-Corp.’s stock. Taxpayer did not dispute the IRS’s calculations of his stock basis for the years in issue. Thus, the Court sustained the determination that Taxpayer had unreported capital gain for the years in issue.

Another One Bites the Dust

Taxpayer did not fare well, but he received his “just deserts.” He totally failed to establish that the advances to Borrower were real debts. The disallowance of the bad debt deduction claimed by Taxpayer resulted in an increase of his “flow-through” S corporation income and, thereby, an increase in his basis for his S-Corp. stock.

The interplay of the disallowed bad debt deduction for Tax Year, and the tax treatment of the distribution made to Taxpayer that year, affords us an opportunity to consider the order in which stock basis is increased or decreased under the Code, and the importance thereof.

The taxability of a distribution and the deductibility of a loss are both dependent on stock basis; for this reason, there is an ordering rule in computing stock basis. Under this rule – which favors tax-free distributions over currently deductible losses – stock basis is adjusted annually, as of the last day of the S corporation’s tax year, in the following order:

  1. Increased for income items;
  2. Decreased for distributions;
  3. Decreased for non-deductible, non-capital expenses; and
  4. Decreased for items of loss and deduction.

When determining the taxability of a distribution, the shareholder looks solely to their stock basis; debt basis is not considered, as Taxpayer learned.

Thus, there was a “silver lining” in the denial of Taxpayer’s loss deduction in that his stock basis was increased, thereby sheltering some of the distribution from S-Corp. – small comfort, though, because he recognized more ordinary income in exchange for less capital gain. Oh well.

 

[i] The corporation was always treated as an S corporation for tax purposes, and had no earnings and profits accumulated from the operations of any C corporation tax years.

Passing Through Losses

There is a problem that will sometimes plague the shareholders of an S corp that is going through challenging financial times. Whether because of a downturn in the general economy or in its industry, whether because of stiff competition or poor planning, the S corp is suffering operating losses. As if this wasn’t disturbing enough, the corporation may have borrowed funds from a bank or other lender, including its shareholders, in order to fund and continue its operations.

Because the S corp is a “pass-through entity” for tax purposes – meaning, that the S corp is not itself a taxable entity but, rather, its “tax attributes,” including its operating losses – flow through to its shareholders and may be used by them in determining their individual income tax liability.

Although this is generally the case, there are a number of limitations upon the ability of a shareholder of an S corp to utilize the corporation’s losses. Under the first of these limitations, the corporate losses which may be taken into account by a shareholder of the S corporation – i.e., his pro rata share of such losses – are limited to the sum of the shareholder’s adjusted basis in his stock plus his basis in any debt of the corporation that is owed to the shareholder.[1] Any losses in excess of this amount are suspended and are generally carried forward until such time as the shareholder has sufficient basis in his stock and/or debt to absorb such excess.[2]

Over the years, shareholders who are aware of this limitation have tried, in various ways – some more successful than others – to generate basis in an amount sufficient to allow the flow-through of a shareholder’s pro rata share of the S corp’s losses.[3]

As for those shareholders who became aware of the limitation only after the fact, well, they have often put forth some creative theories to support their entitlement to a deduction based upon their share of the S corp’s losses. Today’s blog will consider such a situation, as well as the importance – the necessity – of maintaining accurate records and of memorializing transactions.

Creative Accounting?

Taxpayer was a real estate developer who held interests in numerous S corps, partnerships, and LLCs. One of these entities was Corp-1, which had elected “S” status, and in which Taxpayer held a 49% interest.

In 2004, Corp-1 sought to purchase real property out of a third party’s bankruptcy. The court approved the sale to Corp-1, but required that Corp-1 make a significant non-refundable deposit. To raise funds for his share of the deposit, Taxpayer obtained a personal loan from Bank of approximately $5 million, which were transferred into Corp-1’s escrow account to cover half of the required deposit.

During the tax years at issue, Corp-1 had entered into hundreds of transactions with various partnerships, S corps, and LLCs in which Taxpayer held an interest (collectively, the “Affiliates”). The Affiliates regularly paid expenses (such as payroll costs) on each other’s or on Corp-1’s behalf to simplify accounting and enhance liquidity. The payor-company recorded these payments on behalf of its Affiliates as accounts receivable, and the payee-company recorded such items as accounts payable.[4]

For a given taxable year, CPA – who prepared the tax returns filed by Taxpayer, Corp-1 and the Affiliates –would net Corp-1’s accounts payable to its Affiliates, as shown on Corp-1’s books as of the preceding December 31, against Corp-1’s accounts receivable from its Affiliates. If Corp-1had net accounts payable as of that date[5], CPA reported that amount as a “shareholder loan” on Corp-1’s tax return and allocated a percentage of this supposed Corp-1 indebtedness to Taxpayer, on the basis of Taxpayer’s ownership interests in the various Affiliates that had extended credit to Corp-1.

In an effort to show indebtedness from Corp-1 to Taxpayer, CPA drafted a promissory note whereby Taxpayer made available to Corp-1 an unsecured line of credit at a fixed interest rate. According to CPA, he would make an annual charge to Corp-1’s line of credit for an amount equal to Taxpayer’s calculated share of Corp-1’s net accounts payable to its Affiliates for the preceding year.

But there was no documentary evidence that such adjustments to principal were actually made, or that Corp-1 accrued interest annually on its books with respect to this alleged indebtedness. Moreover, there was no evidence that Corp-1 made any payments of principal or interest on its line of credit to Taxpayer. And there was no evidence that Taxpayer made any payments on the loans that Corp-1’s Affiliates extended to Corp-1 when they transferred money to it or paid its expenses.

The IRS Disagrees with the Loss Claimed

In 2008, Corp-1 incurred a loss of $26.6 million when banks foreclosed on the property it had purchased in 2004. Corp-1 reported this loss on Form 1120S, U.S. Income Tax Return for an S Corporation. It allocated 49% of the loss to Taxpayer on Schedule K-1.

Taxpayer filed his federal individual income tax returns for 2005 and 2008. On his 2005 return, he reported significant taxable income and tax owing. On his 2008 return, he claimed an ordinary loss deduction of almost $11.8 million.[6] This deduction reflected a $13 million flow-through loss from Corp-1 ($26.6 million × 49%), netted against gains of $1.2 million from two other S corporations in which Taxpayer held interests.

After accounting for other income and deductions, Taxpayer reported on his 2008 return an NOL of almost $11.8 million. He claimed an NOL carryback of this amount from 2008 to 2005.[7] After application of this NOL carryback, his original tax liability for 2005 was reduced and the IRS issued Taxpayer a refund.

After examining Taxpayer’s 2005 and 2008 returns, however, the IRS determined that his basis in Corp-1 was only $5 million; i.e., the proceeds of the Bank loan that Taxpayer contributed to Corp-1. Accordingly, the IRS disallowed, for lack of a sufficient basis, $8 million of the $13 million flow-through loss from Corp-1 that Taxpayer claimed for 2008.

After disallowing part of the NOL for 2008, the IRS determined that Taxpayer’s NOL carryback to 2005 was a lesser amount, and the refund granted was thereby excessive; consequently the Taxpayer owed tax for that year. The IRS sent Taxpayer a timely notice of deficiency setting forth these adjustments, and he petitioned the Tax Court for redetermination.

The IRS agreed that Taxpayer was entitled to basis of $5 million in Corp-1, corresponding to funds that Taxpayer personally borrowed from Bank and contributed to Corp-1.

Taxpayer contended that he had substantial additional basis in Corp-1 by virtue of the inter-company transfers between Corp-1 and its Affiliates.

The Code

The Code generally provides that the shareholders of an S corp are taxed currently on its items of income, losses, deductions, and credits, regardless of actual distributions.

However, it also provides that the amount of losses and deductions taken into account by the shareholder may not exceed the sum of: (1) the adjusted basis of the shareholder’s stock in the S corp, and (2) the adjusted basis of any indebtedness of the S corp to the shareholder.

Any disallowed loss or deduction is treated as incurred by the corporation in the succeeding taxable year with respect to the shareholder whose losses and deductions are limited. Once the shareholder increases his basis in the S corp[8], any losses or deductions previously suspended become available to the extent of the basis increase.

The Code does not specify how a shareholder may acquire basis in an S corp’s indebtedness to him, though the courts have generally required an “actual economic outlay” by the shareholder before determining whether the shareholder has made a bona fide loan that gives rise to an actual investment in the corporation. A taxpayer makes an economic outlay sufficient to acquire basis in an S corporation’s indebtedness when he “incurs a ‘cost’ on a loan or is left poorer in a material sense after the transaction.” The taxpayer bears the burden of establishing this basis.

It does not suffice, however, for the shareholder to have made an economic outlay. The term “basis of any indebtedness of the S corporation to the shareholder” means that there must be a bona fide indebtedness of the S corp that runs directly to the shareholder.

Whether indebtedness is “bona fide indebtedness” to a shareholder is determined under general Federal tax principles and depends upon all of the facts and circumstances.

In short, the controlling test dictates that basis in an S corp’s debt requires proof of “bona fide indebtedness of the S corporation that runs directly to the shareholder.”

The Tax Court

Taxpayer argued that Corp-1’s Affiliates lent money to him and that he subsequently lent these funds to Corp-1.[9]

Taxpayer contended that transactions among the Corp-1 Affiliates should be recast as loans to the shareholders (including himself) from the creditor companies, followed by loans from the shareholders (including himself) to Corp-1. The IRS’s regulations, Taxpayer argued, recognize that back-to-back loans, if they represent bona fide indebtedness from the S corp to the shareholder – i.e., they run directly to the shareholder – can give rise to increased basis.

The Court responded that the corollary of this rule is that indebtedness of an S corp running “to an entity with passthrough characteristics which advanced the funds and is closely related to the taxpayer does not satisfy the statutory requirements.” “[T]ransfers between related parties are examined with special scrutiny,” the Court noted, and taxpayers “bear a heavy burden of demonstrating that the substance of the transactions differs from their form.”

For example, the Court continued, courts have rejected the taxpayer contention that loans from one controlled S corp (S1) to another controlled S corp (S2) were, in substance, a series of dividends to the shareholder from S1, followed by loans from the shareholder to S2, holding that the taxpayer may not “easily disavow the form of [his] transaction”. Similarly, courts have upheld the transactional form originally selected by the taxpayer and have given no weight to an end-of-year reclassification of inter-company loans as shareholder loans.

The Court rejected Taxpayer’s “back-to-back loan” argument. No loan transactions were contemporaneously documented. The funds paid by a Corp-1 Affiliate as common paymaster were booked as the payment of Corp-1’s wage expenses. And the other net inter-company transfers reflected hundreds of accounts payable and accounts receivable, which went up and down depending on the various entities’ cash needs.

These inter-company accounts were recharacterized as loans to shareholders only after the end of each year, when CPA prepared the tax returns and adjusted Corp-1’s book entries to match the “shareholder loans” shown on those returns. None of these transactions was contemporaneously booked as a loan from shareholders, and Taxpayer failed to carry the “heavy burden of demonstrating that the substance of the transaction[s] [differed] from their form.”

Even if the transactions were treated as loans, the Court pointed out, Corp-1’s indebtedness ran to its Affiliates, not directly to Taxpayer. The monies moved from one controlled company to another, without affecting Taxpayer’s economic position in any way. The was true for the Corp-1 wage expenses that an Affiliate, in its capacity as common paymaster, paid on Corp-1’s behalf; and the same was true for the net inter-company payments, which Corp-1 uniformly booked as accounts payable to its Affiliates. The Affiliates advanced these funds to Corp-1, not to Taxpayer; and to the extent Corp-1 repaid its Affiliates’ advances, it made the payments to its Affiliates, not to Taxpayer.

The Court determined that there was simply no evidence that Corp-1 and its Affiliates, when booking these transactions, intended to create loans to or from Taxpayer. CPA’s adjustments to a notional line of credit, uniformly made after the close of each relevant tax year, did not suffice to create indebtedness to Taxpayer where none in fact existed.

A taxpayer, the Court observed, may not “easily disavow the form of [the] transaction” he has chosen. The transactions at issue took the form of transfers among various Corp-1 Affiliates, and the Court found that Taxpayer did not carry his burden of proving that the substance of the transactions differed from their form. Unlike the $5 million that Taxpayer initially borrowed from Bank and contributed to Corp-1, he made no “actual economic outlay” toward any of the advances that Corp-1’s Affiliates extended to it.

Accordingly, the Court found that none of the inter-company transactions mentioned above gave rise to bona fide indebtedness from Corp-1 to Taxpayer.

Thus, the Court concluded that the IRS properly reduced Taxpayer’s allowable NOL carryback to 2005, and the Taxpayer had to return a portion of the refund received for that year.

Affiliates

How many of you have examined an entry on a corporate or partnership tax return, and have wondered what it could possibly be? The entry usually appears in the line for “other expenses,” “other assets,” or “other liabilities.”[10]

With luck, there is a notation beside the entry that directs the reader to “See Statement XYZ.”[11] You flip to the back of the return, to Statement XYZ, only to see that the entry is described as an amount owed to an unidentified “affiliate,” or as an amount owed by an unidentified “affiliate.”

Then there are the times when, as in the case described above, there are several identified affiliated companies, and they have a number of “amounts owed” and “amounts owing” among them, including situations in which one affiliate is both a lender and a borrower with respect to another affiliated entity.[12] As you try to make any sense of all the cash flows, you wish you had a chart.[13]

And, in fact, I have heard “advisers” explain that the entries are intentionally vague so as to be “flexible,” and to make it more difficult for an agent to discern what actually happened.

At that point, I tell the taxpayer, “Find yourself another tax return preparer.”

As we have said countless times on this blog, always assume that the taxing authorities will examine the return. Always treat with related parties as if they were unrelated parties. A transaction should have economic substance, and it should be memorialized accordingly. If the taxpayer or his adviser would rather not have the necessary documents prepared, they should probably not engage in the transaction.


[1] Assuming the shareholder has sufficient basis to utilize his full share of the corporation’s losses, his ability to deduct those losses on his income tax return may still be limited by the passive activity loss rules of IRC Sec. 469 and by the at-risk rules of IRC Sec. 465. For taxable years beginning on or after January 1, 2018 and ending on or before December 31, 2025, there is an additional limitation, on “excess business losses,” which is applied after the at-risk and passive loss rules.

[2] The losses that pass through to the shareholder reduce his stock basis and then his debt basis; thus, a subsequent distribution in respect of the stock, or a sale of the stock, will generate additional gain; similarly, the repayment of the debt would also result in gain recognition for the shareholder-lender. IRC Sec. 1368, 1001, 1271.

[3] For example, by making new capital contributions or loans, or by accelerating the recognition of income.

[4] During the years at issue, Corp-1’s Affiliates made payments in excess of $15 million to or on behalf of Corp-1. Corp-1 repaid its Affiliates less than $6 million of these advances.

[5] On December 31 of each year, Corp-1’s books and records showed substantial net accounts payable to its Affiliates.

[6] On Form 4797, Sales of Business Property. IRC Sec. 1231(a)(2): net Sec. 1231 gains are capital; net Sec. 1231 losses are ordinary.

[7] Prior to the Tax Cuts and Jobs Act of 2017, Pub. L. 115-97, a taxpayer could ordinarily carry an NOL back only to the two taxable years preceding the loss year. However, prompted by the financial crisis and at the direction of Congress, the IRS, for taxable years 2008 and 2009, allowed “eligible small businesses” to elect a carryback period of three, four, or five years. Taxpayer made this election for 2008. After the 2017 legislation, the carryback was eliminated, and an NOL may be carried forward indefinitely, though the carryover deduction for a taxable year is limited to 80% of the taxpayer’s taxable income for the year. Query the impact of the Act’s elimination of a struggling company’s ability to carry back its losses to recover tax dollars and badly needed cash.

[8] Debt basis is restored before stock basis.

[9] Taxpayer also advanced a second theory to support his claim to basis beyond the amount the IRS allowed. Under this argument (which the Court rejected), he lent money to the Corp-1 Affiliates and they used these funds to pay Corp-1’s expenses. Taxpayer referred to this as the “incorporated pocketbook” theory.

[10] Never in the line for “other income.” Hmm.

[11] Indeed, the form itself directs the taxpayer to attach a statement explaining what is meant by “other.”

[12] Polonius would have a fit.

[13] Of course, more often than not, the return does not reflect any actual or imputed interest expense or interest income.

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.