I am excited to announce that my June 18, 2018 blog post “S Corps, CFCs & The Tax Cuts & Jobs Act” has been published as Chapter 6 in The Tax Cuts and Jobs Act: A Guide for Practitioners e-book. The chapter discusses the Tax Cuts & Jobs Act’s changes to the taxation of business income arising from the foreign activities of U.S. persons – and what that means for the increasing number of closely-held U.S. businesses who have established operations overseas.

The e-book was produced by the National Association of Enrolled Agents (NAEA). If you are interested in purchasing a copy, please click here.

In General

It is a basic principle of federal tax law that a taxpayer cannot, for purposes of determining the taxpayer’s taxable income, claim a loss with respect to an investment in excess of the taxpayer’s unrecovered economic cost for such investment. If the taxpayer invested $X to acquire a non-depreciable asset – for example, a capital contribution in exchange for shares of stock in a C corporation, or a loan to a corporation in exchange for an interest-bearing note – the amount of loss realized by the taxpayer upon the disposition or worthlessness of the asset will be based upon the amount invested by the taxpayer in acquiring the asset. Where the asset is depreciable by the taxpayer, the loss realized is determined by reference to the taxpayer’s cost basis, reduced by the depreciation deductions claimed by the taxpayer (which represent a recovery of the taxpayer’s cost), i.e., the taxpayer’s adjusted basis.

Application to S-Corps

In the case of an S corporation, a shareholder’s ability to utilize his pro rata share of any deductions or losses realized by the S corporation is limited in accordance with this principle; specifically, for any taxable year, the aggregate amount of losses and deductions that may be taken into account by a shareholder cannot exceed the sum of the adjusted basis of the shareholder’s stock in the S corporation, and the shareholder’s adjusted basis for any bona fide loans made by the shareholder to the S corporation.

Stock Basis

Because an S corporation is treated as a pass-through for tax purposes, its income is generally not subject to corporate-level tax; rather, it is taxed to its shareholders (whether or not it is distributed to them).

In order to preserve this single level of tax, a shareholder’s initial basis for his shares of S corporation stock – which may be the amount he paid to acquire the shares from another shareholder or the adjusted basis of any property he contributed to the corporation in a tax-free exchange for such shares – is adjusted upward by the amount of income that is allocated and taxed to the shareholder; in this way, the already-taxed income may later be distributed to the shareholder without causing him to realize a gain (as where the amount distributed exceeds the stock basis).

By the same token, where already-taxed income has not been distributed to the shareholder, it remains subject to the risks of the business, and the shareholder is effectively treated as having made an “economic outlay” which may be lost in the operation of the business; this is reflected in his stock basis.

Debt Basis

In general, a shareholder’s basis for a cash loan from the shareholder to the corporation is equal to the face amount of the loan.

If the corporation’s indebtedness to the shareholder arose out of a transfer of property by the shareholder to the corporation – basically, a sale of the property in exchange for the corporation’s obligation to pay the purchase price some time in the future – the basis is equal to the face amount of the obligation less the amount of the deferred gain.

As the corporate indebtedness is satisfied, and the amount at economic risk is reduced, the shareholder’s basis in the debt is reduced.

“Necessity” as the Mother of Invention?

Because of this basis-limitation rule, S corporation shareholders, over the years, have proffered many arguments to support their ability to claim their share of S corporation losses – i.e., to increase their stock or debt basis – without having made an economic outlay. A recent decision by the U.S. Tax Court illustrates one such argument.

The Personal Guarantee

The sole issue in this case was whether Taxpayer had a sufficient basis in S-Corp., on account of his obligation with respect to S-Corp’s debt to a third party, to permit Taxpayer to deduct $X, which represented a portion of his distributive share of the corporation’s flow-through losses, on his personal income tax return.

Taxpayer was the sole shareholder of S-Corp. S-Corp. borrowed $Y from Bank, and Taxpayer personally guaranteed the loan. S-Corp. was later liquidated. At the time of liquidation, S-Corp. still owed Bank $X. S-Corp. filed its Form 1120S, U.S. Income Tax Return for an S corporation, on which it reported an ordinary business loss of $X. Taxpayer had no stock or debt basis in S-Corp. when it was liquidated.

According to the record before the Court, after S-Corp. was liquidated, the operations of the business somehow continued under its former name, S-Corp.’s loan with Bank was somehow renewed, and S-Corp. remained the named borrower of the renewed loan. Taxpayer signed the renewal note as president of S-Corp. and was the guarantor of the loan.

Also according to the record, Taxpayer made all loan payments following the liquidation of S-Corp., but the record did not indicate whether he made the payments from his personal funds or merely signed checks drawn on the account of S-Corp.

The IRS examined Taxpayer’s tax return and disallowed the $X loss deduction related to S-Corp., explaining that, because Taxpayer’s share of S-Corp.’s loss was limited to the extent of his adjusted basis for his stock, the amount of loss in excess of such basis was disallowed and was not was not currently deductible.

The Court’s Analysis

The Court began by explaining that an S corporation shareholder may take into account his or her pro rata share of the corporation’s losses, deductions, or credits. It then explained how the Code limits the aggregate amount of losses and deductions the shareholder may take into account to the sum of (A) the adjusted basis of the shareholder’s stock in the S corporation, and (B) the shareholder’s adjusted basis in any indebtedness of the S corporation

Taxpayer conceded that he had no stock or debt basis in S-Corp. at the time of its liquidation. However, he contended that upon the liquidation, he assumed the balance due on the note as guarantor and, because he was the sole remaining obligor, this assumption was effectively a contribution to capital, allowing him to deduct the amount of S-Corp.’s losses. Further, he asserted that, following S-Corp.’s liquidation, the Bank expected him, as guarantor, to repay the loan and that the Bank’s expectation was sufficient to generate basis for Taxpayer in S-Corp.

The Court rejected Taxpayer’s arguments. Merely guaranteeing an S corporation’s debt, it stated, was not sufficient to generate basis. The Court pointed out that, on many prior occasions, it had held that no form of indirect borrowing, be it by guaranty, surety or otherwise, gives rise to indebtedness from an S corporation to its shareholders until and unless the shareholders pay part or all of the obligation. “Prior to that crucial act, ‘liability’ may exist, but not debt to the shareholders.” The Court also stated that a shareholder may obtain an increase in basis in an S corporation only if there was an economic outlay on the part of the shareholder that leaves the shareholder “poorer in a material sense.” In other words, the shareholder must make an actual “investment” in the corporation.

The Court recognized, however, that a shareholder who has guaranteed a loan to an S corporation may increase his or her basis where, in substance, the shareholder has borrowed funds and subsequently advanced them to the corporation. Although, as a general rule, an economic outlay is required before a shareholder in an S corporation may increase his or her basis, this rule does not require a shareholder, in all cases, to “absolve a corporation’s debt before [he or she] may recognize an increased basis as a guarantor of a loan to a corporation.” Observing that “where the nature of a taxpayer’s interest in a corporation is in issue, courts may look beyond the form of the interest and investigate the substance of the transaction.” The Court indicated that a shareholder’s guaranty of a loan to an S corporation “may be treated for tax purposes as an equity investment in the corporation where the lender looks to the shareholder as the primary obligor.”

This determination, the Court stated, was an “inquiry focused on highly complex issues of fact and that similar inquiries must be carefully evaluated on their own facts.” (For example, the testimony of a loan officer stating that the lender-bank looked primarily to the taxpayer, and not the corporation, for repayment of the loan, as well as evidence that the S corporation was thinly capitalized.)

The Court then turned to the facts in the case to determine whether Taxpayer had established that the Bank looked to Taxpayer for repayment and Taxpayer had made economic outlays in making those payments.

The Court found that Taxpayer presented no evidence to support a finding that the Bank looked primarily to him, as opposed to S-Corp., for repayment of the loan, especially given the fact that, even after the corporate liquidation, S-Corp. remained an ongoing business enterprise.

It acknowledged that, according to the stipulation of facts, “[t]he [Taxpayer] continues to make payments on the loan”, but there was no indication, it pointed out, that the loan payments were made from Taxpayer’s personal funds rather than S-Corp.’s funds with Taxpayer signing payment checks as president. Moreover, under the terms of the renewal note, the renewed loan was to S-Corp. and Taxpayer’s obligation was that of a guarantor, not the maker of the loan.

The Court next considered Taxpayer’s assertion that the renewal of the loan to S-Corp. did not affect his position that he became the primary obligor of the loan upon S-Corp.’s liquidation. Taxpayer posited that he assumed the debt at the time of S-Corp.’s liquidation and that “his status as the sole remaining obligor”, for tax purposes, caused the repayments of the loan to be treated as contributions to the capital of S-Corp. The IRS disagreed, arguing that “upon the corporation’s liquidation, the debt remained undisturbed: the corporation did not default on the debt, the terms of the debt were not altered, and payments on the debt continued.”

The Court determined that there was insufficient evidence in the record to support a finding that the loan was made to Taxpayer personally, as opposed to S-Corp., and that Taxpayer, as the borrower, advanced the loan proceeds to S-Corp. Because Taxpayer failed to establish that the Bank looked primarily to Taxpayer to satisfy the debt obligation or that Taxpayer made an economic outlay with respect to the loan, Taxpayer failed to prove he had a basis in S-Corp. sufficient for him to deduct the reported business losses.

Advice to S Corporation Shareholders

What is an S corporation shareholder to do when corporate losses have been allocated to him, but he has no basis in his shares, and he either has no outstanding loan to the corporation or at least not one in which he has any basis? What happens to these excess losses, and how can they be utilized?

The excess losses allocated to a shareholder for a tax year cannot be used by the shareholder to offset ordinary income reported on the shareholder’s tax return for that year. That being said, the shareholder must realize that the excess losses are not lost (sorry for the pun) – they are merely suspended until such time as the shareholder has sufficient basis in his stock, or in a loan made by him to the corporation, to allow the losses to flow through to him. (Even then, however, the losses have to pass muster under the “at risk” and “passive loss” rules before the shareholder can realize their full benefit.)

So, how can a shareholder facilitate or expedite the use of his suspended losses? There are some options to consider:

  • Make a capital contribution to the corporation (using the shareholder’s own funds, or using funds borrowed from a third party; paying off a corporate debt)
  • Forego distributions by the corporation in profitable years (loan the distributed funds back to the corporation)
  • Accelerate the recognition of income by the corporation
  • Defer the deduction of corporate expenses
  • Make a loan to the corporation (using the shareholder’s own funds, or using funds borrowed from a third party; substituting the shareholder’s note for the corporation’s)

Each of these options presents its own risks and issues. For example, what if the shareholder does not receive additional stock in the corporation in exchange for his capital contribution? Has he made a gift to the other shareholders? He has certainly put more of his money at risk.

Of course, the shareholder can wait until the corporation sells its business. The gain from the sale may generate sufficient basis so as to allow the use of the suspended losses for the year of the sale (though the shareholder will thereby likely realize more gain on a subsequent liquidation of his shares).

However, if the disposition of the business is effected through a sale of stock by the shareholders (without an election to treat it as an asset sale), the suspended losses will disappear. They will also be lost if all of the shares are gifted to another (other than the shareholder’s spouse or to a grantor trust) prior to any sale. The suspended losses will also be lost if the shareholder dies before having used the losses – the step-up in basis for the stock that occurs at death does not benefit the deceased shareholder.

Thus, it may behoove the shareholder to find a way to “consume” the suspended losses before it is too late, provided as always, of course, that the means chosen makes sense from a business perspective.

Roll-Over: Tax Issue

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Before the LOI

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

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

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

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

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

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

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

Roll-Over: PEF’s Perspective

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

Roll-Over: Seller’s Perspective

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

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

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

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

Acquisition Mechanics

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

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

Roll-Over: Mechanics

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

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

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

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

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

The owners of closely-held businesses are among the greatest benefactors of charitable organizations in this country. Although their contributions to charity are usually effectuated through the transfer of cash or marketable securities, it is often the case that the only asset available to satisfy an owner’s charitable inclinations is his or her interest in the closely-held business that the owner founded and/or operated.

Of course, the owner, or the owner’s estate (in the case of a testamentary transfer) will realize a tax benefit by virtue of making a charitable transfer, provided the transfer is completed in accordance with various statutory and regulatory requirements. Thus, where the interest in the closely held business is included in the owner’s gross estate, the bequest of such interest to a qualifying organization will generate a charitable contribution deduction for purposes of determining the owner’s estate tax.

Most charitable organizations, however, have no interest in owning equity in a closely-held business because it is not easily convertible into cash, at least not without some advance planning. Thus, many donors “arrange” for the purchase of such equity from the organization.

This strategy presents many challenges and risks, as illustrated in a recent decision.

Mom’s Testamentary Plan

Decedent and some family members owned DPI, a closely-held real property management corporation that managed a combination of commercial and residential rental properties.

DPI was a C corporation. Decedent owned 81%, and Son E owned 19%, of DPI’s voting shares. Decedent also owned 84% of DPI’s nonvoting shares, and her Sons  owned the remaining 16%.

Decedent and her Sons were officers and directors of DPI at the time of Decedent’s death.

During her life, Decedent had created an irrevocable life insurance trust that distributed the insurance proceeds to her children upon her death, and had established Trust and Foundation. Son E was the sole trustee of Trust and Foundation.

Decedent’s will left her entire estate to Trust. Under the terms of Trust, some cash passed to various charitable organizations. The remainder of Decedent’s estate, consisting primarily of DPI stock, was to pass to Foundation.

The Estate Tax Appraisal

The Estate obtained an appraisal to determine the date-of-death fair market value (FMV) of Decedent’s DPI shares. The appraisal explained that it would be used for estate administration purposes.

The appraisal valued the voting stock at $1,824 per share with no discount because the voting shares represented a controlling interest. It valued the nonvoting stock at $1,733 per share, which included a 5% discount to reflect the lack of voting power.

On its estate tax return, the Estate reported no estate tax liability, claiming a charitable contribution deduction for the date-of-death value of Decedent’s DPI shares.

Post-Death Events

Numerous events occurred after Decedent’s death, but before Decedent’s bequeathed property was transferred to Foundation.

S Corp. Election

Seven months after her death, DPI elected S corporation status in order to accomplish long-term corporate tax planning; specifically, the corporation’s board wanted DPI to avoid the built-in gains tax on corporate assets. The board also wanted Foundation, as an owner of shares in an S corporation, to avoid being subject to the unrelated business income tax (“UBIT”).

Redemption

In addition, DPI’s board realized that, pursuant to the Code, Foundation would be required to make annual minimum distributions of at least 5% of the value of its assets. Son E, as trustee of Foundation, was concerned that merely owning Decedent’s bequeathed DPI shares would not provide Foundation sufficient cash-flow necessary to make the requisite annual distribution.  Son E was also concerned that Foundation could be subject to excise tax on the value of any “excess business holdings” in DPI held by Foundation.

As a result, DPI agreed to redeem all of Decedent’s bequeathed voting shares, and approximately 72% of  her bequeathed nonvoting shares, from Trust in exchange for cash and promissory notes.

Son E then obtained local court approval for the redemption, to confirm that the redemption would not be a violation of the “self-dealing” rules.

At the same time as the redemption, pursuant to subscription agreements, Decedent’s Sons purchased additional shares in DPI in order to infuse the corporation with cash to assist in paying off the promissory notes DPI gave the Trust as a result of the redemption transaction.

An appraisal of Decedent’s DPI stock for purposes of the redemption and subscription agreements determined that her DPI voting shares had a FMV of $916 per share, and the nonvoting shares of $870 per share. The appraisal of the voting stock included discounts of 15% for lack of control and 35% for lack of marketability. The appraisal of the nonvoting stock included the lack of control and marketability discounts plus an additional 5% discount for the lack of voting power.

The IRS Challenge

The IRS disputed the amount of the Estate’s charitable contribution, arguing that the amount of the charitable contribution should be determined by the post-death events. The Estate argued that the charitable contribution should not be measured by the value of the property received by Foundation.

Because the IRS found that the value of Estate’s charitable contribution was lower than reported on its Estate Tax Return, the IRS also determined that additional estate tax was due. The Estate challenged the asserted deficiency in the Tax Court.

The Court considered whether the Estate was entitled to a charitable contribution deduction equal to the date-of-death FMV of DPI stock bequeathed to Foundation.

The Estate’s lawyer, who also served as DPI’s and Foundation’s lawyer, hired an appraisal firm to appraise the DPI stock. The appraisal specified that it provided a valuation of a minority interest in DPI as of the date of the redemption agreement. His understanding was that the appraisal would be used as support for the redemption. The appraisal treated DPI as a C corporation. The appraisal valued the DPI shares at $916 per voting share and at $870 per nonvoting share, reflecting discounts for lack of control and lack of marketability.

The date-of-death valuation had not included these discounts.

Foundation Tax Return

On its Form 990-PF, Foundation reported that it had received the following contributions from Trust:

  • Approximately 28% of Decedent’s nonvoting DPI shares;
  • A long-term note receivable; and
  • A short-term note receivable (the notes having been received by the Trust from DPI in the redemption transaction).

Trust Tax Return

On its Form 1041 for the taxable year of the redemption, Trust reported a capital loss for the sale of its shares of DPI voting stock, and a capital loss for the sale of its shares of DPI nonvoting stock (the redemption appraisal having been lower than the date-of-death appraisal from which the Trust’s adjusted basis for the shares was derived).

The Court’s Analysis

In general, the value of a decedent’s gross estate includes the FMV of all property that she owned, or in which she had an interest, at the time of her death. The value of stocks is the FMV per share at that time. “Fair market value” is defined as the price that a willing buyer would pay a willing seller, both persons having reasonable knowledge of all the relevant facts and neither person being under compulsion to buy or sell. The “willing buyer” and “willing seller” are hypothetical persons, rather than specific individuals or entities, and all relevant facts and elements of value as of the valuation date must be considered.

Charitable Deduction

In calculating a decedent’s taxable estate, a charitable deduction is generally allowed for bequests made to charities. The deduction from the gross estate generally is allowed for the value of property included in the decedent’s gross estate and transferred by the decedent at her death to a qualified, charitable organization. In general, the courts have held that the amount of the charitable contribution deduction is based on the amount that passes to the charity.

In the case at hand, the Estate contended that the applicable valuation date for determining the value of the charitable contribution was the date of death.

The Estate also argued that the charitable contribution deduction should not depend upon or be measured by the value received by Foundation. The Estate contended that consideration of post-death events that may alter the valuation of property would not truly reflect the FMV of Decedent’s assets. The Estate further contended that there was neither a plan of redemption nor any other precondition or contingency affecting the value of Decedent’s charitable bequest.

The IRS argued that the value of the charitable contribution should be determined by post-death events. It argued that the Sons thwarted Decedent’s intent to bequeath all of her majority interest in DPI or the equivalent value of the stock to Foundation, contending that the manner in which the two appraisals were solicited, as well as the redemption of Decedent’s controlling interest at a minority interest discount, indicated that the Sons never intended to effect Decedent’s testamentary plan.

The Valuations

The Court acknowledged that, normally, the date-of-death value determines the amount of the charitable contribution deduction, which is based on the value of property transferred to the charitable organization. There are circumstances, however, where the appropriate amount of a charitable contribution deduction does not equal the contributed property’s date-of-death value.

The Court noted that numerous events occurred after Decedent’s death, but before Decedent’s property was transferred to Foundation, that changed the nature and reduced the value of Decedent’s charitable contribution. DPI elected S corporation status. On the same date, DPI agreed to redeem all of Decedent’s voting shares and most of her nonvoting shares from the Trust, in exchange for promissory notes from DPI. Additionally, using the appraisal for the date of the redemption agreement, the Sons signed subscription agreements purchasing additional shares in DPI for $916 per voting share and $870 per nonvoting share.

The Estate contended that the foregoing subsequent events occurred for business purposes and should not affect the amount of Decedent’s charitable contribution.

The subsequent events did appear to have been done for valid business purposes. DPI elected S corporation status in order to avoid the section 1374 built-in gains tax on corporate assets. Additionally, DPI believed that the redemption would allow it to freeze the value of its shares (that would pass to Foundation) into a promissory note, which would mitigate the risk of a decline in stock value. The redemption also made Foundation a preferred creditor of DPI so that, for purposes of cash-flow, it had a priority position over DPI’s shareholders. The Sons purchased additional shares in DPI in order to infuse the corporation with cash to pay off the promissory notes that DPI gave the Trust as a result of the redemption.

The same firm that had completed the date of death appraisal was hired to perform an appraisal of Decedent’s bequeathed shares for purposes of the redemption. This appraisal included a 15% discount for lack of control and a 35% discount for lack of marketability, plus an additional 5% discount for the lack of voting power in the case of the nonvoting stock. The appraisal did not explain why these discounts were included.

Decedent’s bequeathed majority interest in DPI therefore was appraised at a significantly higher value only seven months before the redemption transactions without explanation.

Even though there were valid business reasons for the redemption and subscription transactions, the record did not support a substantial decline in DPI’s per share value. The reported decline in per share value was primarily due to the specific instruction to value Decedent’s interest as a minority interest with a significant discount.

Given that intra-family transactions in a close corporation receive a heightened level of scrutiny, Sons’ roles (especially Son E’s) needed to be examined, the Court said. Son E, as executor of the Estate and President, director, and a shareholder of DPI, instructed DPI’s attorney to inform the appraiser that Decedent’s bequeathed shares should be valued as a minority interest. He was also sole trustee of Trust and of Foundation. Decedent’s majority interest, therefore, was redeemed for a fraction of its value without any independent and outside accountability. The Sons thereby altered Decedent’s testamentary plan by reducing the value of the assets eventually transferred to Foundation without significant restraints.

Accordingly, the Tax Court held that the Estate was not entitled to the full amount of its claimed charitable contribution deduction.

Still A Good Idea

Notwithstanding the Court’s decision, the Decedent and her Sons had the right idea. The family was charitably inclined, and Foundation provided an effective vehicle through which to engage in charitable giving.

The bequest to Foundation would have enabled the Estate to escape estate tax if the Sons had not gotten greedy by “depressing” the value of the DPI shares.

The redemption would have removed the Foundation from the reach of the UBIT and some of the excise taxes (mentioned above) that apply to private foundations.

Importantly, the redemption would have removed from Foundation, and shifted to the Sons, the future appreciation in the value of decedent’s DPI shares.

Finally, if the Foundation and DPI were ever controlled by different persons in the future, the redemption would have removed the potential for shareholder disputes.

When A Business Fails

It goes without saying that no one goes into business in order to realize a loss. Unfortunately, not all businesses succeed, and many owners suffer significant losses. The challenge presented for the tax adviser to the business is how to best utilize those losses for income tax purposes and, thereby, to ease the resulting economic blow to the owners of the business.

Although the solution to this problem will necessarily depend upon the facts and circumstances of the particular business and its owners, it is probably safe to say that most taxpayers would prefer to treat the loss as an ordinary, as opposed to a capital, loss. In trying to accommodate this preference, advisers must tread carefully.

A Loss Subsidiary

Consider the case of an S corporation that owns a qualified subchapter S subsidiary (or “Qsub”) that has become worthless. The S corporation parent has several obstacles to overcome in order to pass an ordinary deduction through to its shareholders. A Qsub is a disregarded entity; that is, it is not treated as a separate corporation for federal income tax purposes, even though it remains a separate legal entity under state law. Instead, all of a Qsub’s assets, liabilities, items of income, deduction and credit are treated as items of the parent S corporation.

The shareholders of the S corporation parent primarily have three ways to recognize a loss, none of which results in an ordinary loss:

Take a worthless stock deduction on their S corporation shares, resulting in a capital loss (assuming qualification under the Code);

Revoke the “S” Election?

The IRS recently considered a somewhat aggressive approach attempted by one taxpayer to secure an ordinary loss.

Taxpayer was an S corporation that owned Subsidiary, a Qsub that operated a regulated Business. In Year 1, Subsidiary’s Business operations were depressed and, based on this downturn, Taxpayer and its shareholders sought to maximize and pass through Subsidiary’s losses in Year 1, before Agency placed Subsidiary in receivership. Specifically, Taxpayer wanted to recognize a loss realized by Subsidiary and have that loss flow through to its shareholders as an ordinary loss.

In an attempt to qualify its shareholders for ordinary loss treatment for the full amount of their investment, Taxpayer affirmatively terminated its S corporation status. As a result, Subsidiary’s Qsub status also terminated and, under IRS regulations, Subsidiary (the former Qsub) was treated as a new corporation acquiring all of its assets (and assuming all of its liabilities) from Taxpayer (its S corporation parent) in exchange for stock of the new corporation.

Thus, immediately before Taxpayer’s “S” election terminated, Subsidiary’s Qsub election terminated and it became a C corporation.

Ordinary Loss – On Subsidiary Stock?

A taxpayer may realize an ordinary loss from the worthlessness of the stock of a subsidiary corporation, notwithstanding that the stock otherwise is a capital asset, if certain “affiliation” and “gross receipts” tests are satisfied.  A corporation is treated as affiliated with a taxpayer if: (1) the taxpayer owns stock in that corporation representing at least 80% of both the total voting power and total value of the stock of such corporation; and (2) generally, more than 90 percent of the aggregate of its gross receipts for all tax years has been from sources other than passive investments (e.g., rents, dividends, interest, and gains from sales of securities).

Taxpayer argued that when it was still an S corporation, but after Subsidiary became a C corporation, Subsidiary became worthless – i.e., at the moment that Subsidiary was deemed to have acquired its assets from the Taxpayer.

Based upon this analysis, Taxpayer asserted that it was entitled to an ordinary deduction, provided that its “new” subsidiary C corporation was affiliated and worthless. Once that deduction was recognized, Taxpayer passed through the ordinary deduction to its shareholders.

The IRS Disagrees

The IRS rejected the Taxpayer’s position on several grounds.

According to the IRS, when a Qsub election terminates, the former QSub is treated as a new corporation acquiring all of its assets (and assuming all of its liabilities), immediately before the termination, from the S corporation parent in exchange for stock of the new corporation.

In such a case, the deemed creation of a new corporation may qualify as a tax-free transaction. Alternatively, the transaction may be taxable and, if any of the transferred assets has a basis in excess of its fair market value, the recognition of the loss may be deferred under the “related party” rules.

In order to qualify as a tax-free transaction, a contribution of property to a corporation must be made solely in exchange for stock of such corporation and, immediately after the exchange, the contributor must be in control of the corporation.

An Insolvent QSub

However, insolvency can destroy an otherwise tax-free contribution to a corporation in two ways. First, significantly encumbered property may not be considered “property”; thus, there can be no contribution of property. Second, the “in exchange for stock” requirement is not met when the transferor receives stock in an insolvent corporation. (A similar “net value” rule applies to corporate reorganizations).

Specifically, “property” must have value, and something of value must be exchanged between the contributing shareholder and corporation. The IRS stated that because worthless subsidiary stock does not have value, the deemed contribution transaction incorporating liabilities in excess of the value of the transferred assets were taxable, and would be deferred under the related party rules.

 Worthless Stock

A taxpayer may realize an ordinary loss from the worthlessness of the stock of a subsidiary corporation if certain “affiliation” and “gross receipts” tests are satisfied.

A corporation is treated as affiliated only if none of the stock of the corporation was acquired by the taxpayer solely for the purpose of converting a capital loss sustained by reason of the worthlessness of any such stock into an ordinary loss.

Thus, according to the IRS, Taxpayer had to explain why it “acquired” the C corporation stock for reasons other than to obtain an ordinary deduction.

In determining whether this anti-abuse rule applies, the IRS noted that Taxpayer had many options to create a deduction from Subsidiary’s alleged worthlessness. Of the options available to Taxpayer, terminating the QSub election, resulting in acquiring C corporation stock, was the only option that arguably generated an ordinary loss. This stock acquisition coupled with an immediate claim of an ordinary loss deduction was evidence, the IRS said, that the sole purpose of converting the Qsub into a C corporation was to attempt to qualify for an ordinary deduction.

Indeed, though there are a few benefits bestowed on taxpayers that terminate their QSub election, none of these benefits are relevant in the context of an S corporation running a defunct business. Some of the usual reasons a taxpayer may convert from QSub-to-C status are:

  • Federal income tax rates are sometimes lower for C corporations than individuals;
  • Employee-owners of C corporations do not have to include certain fringe benefits as income;
  • C corporations may carryback capital losses two years; and
  • C corporations have greater flexibility to choose when their fiscal year ends.

An S corporation in the process of receivership would not be engaged in tax planning about future tax brackets, shareholder-employee fringe benefits, carrying back of losses, or changing to a fiscal year. With an ordinary loss at stake, Taxpayer’s purpose was clear. This is exactly the type of acquisition of stock with the intent to convert a capital loss into an ordinary loss that the anti-abuse rule was designed to prevent.

Thus, the newly created C corporation was not treated as affiliated with Taxpayer and the ordinary deduction was disallowed.

 Sometimes, You Have to Settle

Although tax advisers like to believe that no tax challenge is too daunting, or incapable of being addressed, the truth is that, quite often, there is no entirely satisfactory solution to every tax problem.

The sooner the adviser realizes this, the better he or she will manage the client-taxpayer’s expectations, and the more likely the adviser will stay clear of aggressive or “too good to be true” fixes that, in the end, will only harm the taxpayer and the adviser’s reputation.

No, I don’t mean the yellow-brick road, or any train, or anything like that. I am referring, of course, to the Protecting Americans from Tax Hikes Act of 2015 (the “PATH” or the “Act”). The recently enacted legislation provides a number of tax benefits, a few of which will be of particular interest to the owners of certain closely-held corporations who may be considering the sale of their business. PATH-Act3

 First, Some Basics

Most business owners who operate their closely-held business through a corporation know that the deal structure by which the business is sold may have a significant impact on their tax liability and, thus, on the net economic result of the sale.

 A sale of stock will generate long-term capital gain for the selling shareholders, taxable at a federal rate of 20%, provided they have held the shares for more than 12 months. If the target corporation is a C corporation, an additional 3.8% surtax (on net investment income) may be imposed on the gain realized. If the target is an S corporation and the selling shareholder has been active in its business, this surtax may not apply.

A sale of assets may yield very different results, depending upon the composition of the corporation’s assets and the corporation’s tax status.

 A sale of assets by a C corporation will generate gain that will be subject to corporate level tax, at a maximum federal rate of 35% (regardless of the nature of the assets sold); the distribution of the remaining proceeds to the shareholders in liquidation of the corporation will generate a second level of tax – to the shareholders – at the federal long-term capital gain rate of 20% and, perhaps, the 3.8% surtax.

 A sale of assets by an S corporation is generally not taxable at the corporate level; rather, the gain realized will flow through and be taxed to the shareholders. The nature of the gain, as ordinary or capital, will depend upon the nature of the assets being sold (e.g., inventory, depreciation recapture property like equipment, real estate, goodwill, etc.); this will determine the rate of tax imposed upon the shareholders, with ordinary income items being taxed at a maximum federal rate of 39.6% and capital gain items at 20%. If the business was “passive” as to a particular shareholder, these rates would be increased to include the 3.8% surtax.

 If the S corporation was previously a C corporation, and its assets were appreciated (had built-in gain, or “BIG”) at the effective date of the “S” election, then the sale of such assets within the corporation’s “recognition period” will generate a corporate level tax liability (at the maximum corporate rate), based upon the amount of the built-in gain.

 Planning for the Sale?

Oh, to have a crystal ball.

 Business owners have many things to think about when they start, or acquire, a business, and I daresay that taxes and the ultimate disposition of that business may not be at the forefront of their concerns.

 Moreover, business realities may force certain tax “decisions” upon the owners. For example, the need for an infusion of capital from an unrelated investor group (an “angel” investor in the form of a partnership), whether as equity or convertible debt, may preclude an S corporation election for the business.

However, business owners who do not consider taxes at the inception of the business, and throughout their ownership of the business, do so at their peril.

Insofar as the PATH in concerned, business owners should familiarize themselves with the changes affecting the sale of small business stock and the recognition period for S corporations that were formerly taxable as C corporations.

 Small Business Stock Exclusion

In general, a taxpayer other than a corporation may exclude 50% of the gain from the sale of certain “small business stock.” This is stock in a domestic C corporation that was acquired at original issue from the corporation (in exchange for cash, services, or property other than stock) and held for at least five years.

The amount of gain eligible for the exclusion by an individual with respect to the stock of any corporation is the greater of (1) ten times the taxpayer’s basis in the stock or (2) $10 million (reduced by the amount of gain eligible for exclusion in prior years).

To qualify as a “small business,” when the stock is issued, the aggregate gross assets (i.e., cash plus aggregate adjusted basis of other property) held by the corporation may not exceed $50 million, and the corporation must satisfy certain active trade or business requirements. The portion of the gain that is not excluded from taxable income under this rule is taxed at a maximum rate of 28% under the regular tax (not the 20% usually applicable to capital gain); 7% of the excluded gain is an alternative minimum tax preference.

 Pre-PATH History and the PATH

Prior to the passage of the Act, for stock acquired after February 17, 2009 and before September 28, 2010, the percentage exclusion for qualified small business stock sold by an individual was increased from 50% to 75%.  For stock acquired after September 27, 2010 and before January 1, 2015, the percentage exclusion was increased to 100% and the minimum tax preference does not apply.

The Act made both the post-September 27, 2010, 100% exclusion and the exception from minimum tax preference treatment permanent effective for stock acquired after December 31, 2014.

 S Corporation Recognition Period

For taxable years beginning in 2009 and 2010, no tax was imposed on the net recognized BIG of an S corporation under section 1374 if the seventh taxable year in the corporation’s recognition period preceded such taxable year. Thus, with respect to gain that arose prior to the conversion of a C corporation to an S corporation (the “BIG”), no corporate-level tax was imposed if the seventh taxable year that the S corporation election was in effect preceded the taxable year beginning in 2009 or 2010.

 For any taxable year beginning in 2011, no tax was imposed on the net recognized BIG of an S corporation if the fifth year in the corporation’s recognition period preceded such taxable year. Thus, with respect to the BIG, no corporate tax was imposed if the fifth taxable year that the S corporation election was in effect preceded the taxable year beginning in 2011.

For taxable years beginning in 2012, 2013, and 2014, the term “recognition period” was also the five-year period beginning with the first day of the first taxable year for which the corporation was an S corporation (or beginning with the date of acquisition of assets if the rules applicable to assets acquired from a C corporation applied). If an S corporation with assets subject to the BIG tax disposed of such assets in a taxable year beginning in 2012, 2013, or 2014 and the disposition occurred more than five years after the first day of the relevant recognition period, gain or loss on the disposition was not taken into account in determining the net recognized built-in gain.

 The PATH

The Act made the rules applicable to taxable years beginning in 2012, 2013, and 2014 permanent, effective for taxable years beginning after December 31, 2014.

Thus, if the fifth year of an S corporation’s recognition period ended in 2015, the gain from an asset sale (or a deemed asset sale under IRC Sec. 338(h)(10) or Sec. 336(e)) in 2016 will not be subject to the BIG tax.

 Planning for the Sale

With apologies to The Godfather, business owners never know when a potential buyer will make an offer that cannot be refused. Nor do they know when they will find themselves in circumstances under which the sale of their business, though not ideal, will make the most economic sense.

 Preparing for the sale of the business is an ongoing process, not a matter of just a few months. For this reason, business owners should stay abreast of changes in the tax laws, such as the PATH provisions described above, and should keep their tax advisers informed of changes in the business and its ownership. This will afford business owners the opportunity to avoid costly mistakes and to tailor the structure of the business so as to reduce their tax liabilities on its disposition.

It Was the Worst of Times, Except . . .

It happens in most closely-held businesses: so long as the business is profitable and cash keeps flowing into the hands of the owners, everyone is happy. When the spigot slows, or is just plain turned off, however, the investor-owners (as distinguished from the management-owners) will have questions that they want answered, and quickly. When responses are not forthcoming, or are viewed as evasive, a lawsuit may not be far behind. iStock_000000181896XSmall11

In any litigation, there are few real winners. A lawsuit arises in the first place because someone was wronged, or believes to have been wronged, and there has certainly been an economic loss. Enter the attorneys, the accountants, perhaps, the “experts,” and rapidly-mounting costs.  Years may pass, and who knows what becomes of the business in the interim.

Sounds awful, right? But what if someone told you that, under the right circumstances, the costs may be cut by at least forty percent? You may say, “Tauric defecation.” (Any readers from Bronx Science out there?) “No,” I would reply, “it’s called tax savings.”

The Facts of a Recent PLR

Taxpayer was a shareholder in several closely-held corporations that owned and operated Business for many years. Taxpayer personally or jointly managed the finances of all the closely-held corporations that operated Business.

Taxpayer, E and F formed a closely-held corporation (“Corp.”), an S corporation, to operate Business in a new location. The shareholders agreed that Taxpayer was to manage Corp. and receive a management fee. The distribution of the remaining net profits was allocated among the shareholders based on their ownership percentages. For several years, E consistently received monthly distribution checks from Taxpayer. However, at some point the checks became less regular. After not receiving checks for several months, E made several inquiries of Taxpayer. There were several meetings and many letters and e-mails in which E asked Taxpayer for Corp.’s financial records. E eventually received some of the records, but they did not explain why Corp. was losing money. E filed a lawsuit against Taxpayer asserting causes of action that included fraud, breach of fiduciary duty, and breach of contract.

The jury found Taxpayer liable for breach of fiduciary duty and fraud. It also awarded E punitive damages. The court awarded costs to E. The final judgment against Taxpayer consisted of compensatory and punitive damages, prejudgment interest, costs, and post-judgment interest.

Taxpayer paid E the amounts ordered by the judgment of the trial court. In addition, Taxpayer paid legal fees to his accounting consultants and expert at trial, as well as to the attorneys he retained to defend him in the lawsuit at the trial court.

The Law

Section 162 of the Code provides a deduction for all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business. The regulations promulgated under Sec. 162 provide that deductible expenses include the ordinary and necessary expenditures directly connected with or pertaining to the taxpayer’s trade or business. The regulations under Section 263 of the Code provide that a taxpayer must capitalize an amount paid to another party to acquire any intangible from that party in a purchase or similar transaction. To qualify as a deduction  allowable under Sec. 162, an expenditure must satisfy a five part test: it must

(1) be paid or incurred during the taxable year,

(2) be for carrying on a trade or business,

(3) be an expense,

(4) be necessary, and

(5) be ordinary.

Thus, personal expenditures incurred outside of a taxpayer’s trade or business are not deductible under Sec. 162. In addition, capital expenditures under Sec. 263 are not deductible.

Once In A Lifetime

Even though a particular taxpayer may incur an expense only once in the lifetime of its business, the expense may qualify as ordinary and necessary if it is appropriate and helpful in carrying on that business, is commonly and frequently incurred in the type of business conducted by the taxpayer, and is not a capital expenditure. “Ordinary” in this context does not mean that the payments must be habitual or normal in the sense that the same taxpayer will have to make them often. A lawsuit affecting the “safety” of a business may happen only once in a lifetime. Nonetheless, the expense is an ordinary one because we know from experience that payments for such a purpose, whether the amount is large or small, are the common and accepted means of defense against attack. The term “necessary,” under Sec. 162, imposes the requirement that the expense be appropriate and helpful for the taxpayer’s business. However, if litigation arises from a capital transaction (e.g., the sale of property) then the costs and legal fees associated with the litigation are characterized as acquisition costs and must be capitalized under Sec. 263.

The Origin of the Claim

A payment will be deductible under Sec. 162 as a trade or business expense only if it is not a personal expenditure or a capital expenditure. The controlling test to distinguish business expenses from personal or capital expenditures is the “origin of the claim.” Under this test, the origin and character of the claim with respect to which an expense was incurred – rather than its potential consequences upon the fortunes of the taxpayer – is the controlling test of whether the expense was “business” or “personal” and, hence, whether it is deductible or not. Similarly, the origin and character of the claim with respect to which a settlement is made, rather than its potential consequences on the business operation of the taxpayer, is the controlling test of whether a settlement payment constitutes a deductible expense or  a nondeductible capital outlay. It should be noted that the “origin-of-the-claim” test does not contemplate a mechanical search for the first in the chain of events that led to the litigation but, rather, requires an examination of all the facts. The inquiry is directed to ascertaining the “kind of transaction” out of which the litigation arose. One must consider the issues involved, the nature and objectives of the litigation, the defenses asserted, the purpose for which the claimed deductions were expended, and all the facts pertaining to the controversy. Generally, amounts paid in settlement of lawsuits are currently deductible if the acts that gave rise to the litigation were performed in the ordinary conduct of a taxpayer’s business.

Similarly, amounts paid for legal expenses in connection with litigation are allowed as business expenses where such litigation is directly connected to, or proximately results from, the conduct of a taxpayer’s business.

The IRS Rules

The IRS determined that Taxpayer’s payments to satisfy the judgment awarded against him were ordinary and necessary expenditures. Under the origin of the claim test, E’s claims against Taxpayer had their origin in the conduct of Taxpayer’s trade or business – the management of Corp. Taxpayer’s activities that gave rise to the lawsuit did not result in the acquisition of a capital asset, did not perfect or defend title to an existing asset, and did not create a separate and distinct asset. Taxpayer did not receive a long-term benefit from the payments. An examination of all the facts indicated that the litigation payments were business expenses, and not personal or capital expenditures. Thus, the IRS concluded that the expenditures that Taxpayer paid, that resulted from the lawsuit by E against Taxpayer as the managing shareholder of Corp., were deductible under Sec. 162, provided that Taxpayer was not reimbursed for any of the payments by insurance or similar compensation.

Be Aware

In some cases, the deductibility of litigation-related expenses may not be relevant, as where the taxpayer’s costs are reimbursed by insurance.

In many other cases, however, the taxpayer and his or her attorneys ought to be aware of the opportunity for tax savings.

Although there is little that can be done about the facts when litigation has begun, a taxpayer should determine the kind of transaction out of which the litigation arose. He or she must consider the background of the litigation, its nature and its objectives. In turn, the defenses asserted may be framed in order to support the treatment of the litigation and settlement expenditures, as ordinary and necessary expenditures incurred in the conduct of the taxpayer‘s trade or business.

The goal in defending any litigation is damage-control, which includes the reduction of the economic cost of conducting and settling the litigation. The ability to reduce such cost through tax deductions can go a long way in making the economics of a deal easier to swallow.

Oops

During the course of my career, I have sometimes gone months, if not years, without encountering a particular tax issue. I am aware of the issue and I am familiar with the relevant authorities, but it was not a concern for the clients whom I was then representing. Then, all of a sudden, the issue appears with a frequency that is simply uncanny. I am sure that many of you have had the same experience.

One such issue is the ownership by a nonresident alien (“NRA”) of shares of stock in an S corporation. Specifically, if such an individual owns shares of stock in a domestic corporation, the corporation is not eligible to elect to be treated as an S corporation for tax purposes. Rather, it will be treated as a C corporation, the taxable income of which is taxed at the corporate level and, then again, at the shareholder level when the after-corporate-tax income is distributed to such shareholders.

The prohibition, under the S corporation rules, against stock ownership by an NRA is so basic that you may ask, how can a corporation have knowingly issued shares to an NRA, or how can a shareholder have knowingly transferred his or her S corporation shares to such an individual?

The answer is, “pretty easily,” much to the regret of the other shareholders.

The context in which I recently confronted the issue was the proposed sale of assets by an S corporation, which proposed sale was preceded by the testamentary transfer of a deceased shareholder’s shares of S corporation stock to a trust for the benefit of individuals that included one or more NRAs.

Estates

The estate of a deceased shareholder who was a U.S. citizen or resident may own S corporation shares, even where an NRA is a beneficiary of the estate, but only for a reasonable period of administration. If the administration of the estate is unduly or unreasonably prolonged, the estate may, instead, be treated as a trust for income tax purposes. In that case, the rules described immediately below must be considered.

 Section 645 Electing Trust

In the case of a qualified revocable trust for which a timely election is made to treat the trust as part of the decedent’s estate for income tax purposes,  the trust may continue to own the deceased grantor’s S corporation shares for the duration of the so-called “section 645 election period” (generally, the date on which both the related estate and the trust have distributed all of their assets, though the trust’s qualification may end sooner ), even where an NRA is a beneficiary of the trust. At the end of such period, if the trust continues to hold the stock, it may be treated as a testamentary trust for a two-year period (see immediately below).

Testamentary Trusts

A domestic trust to which S corporation stock is transferred pursuant to the terms of a decedent’s will may hold the S corporation stock, but only for the 2-year period beginning on the day the stock is transferred to the trust, even where an NRA is a beneficiary of the trust. After the termination of the two-year period, the trust must determine how it may otherwise qualify as an S corporation shareholder.

Former Grantor Trusts

A domestic grantor trust is a trust, all of which is treated, for tax purposes, as owned by an individual (typically the grantor) who is a citizen or resident of the United States.

Upon the death of the deemed owner of the grantor trust, if the trust was a grantor trust immediately before the death, and it continues in existence after the death, the trust may continue to hold S corporation stock, even where an NRA is a beneficiary of the trust, but only for the 2-year period beginning on the day of the deemed owner’s death. In general, a trust is considered to continue in existence if the trust continues to hold the stock pursuant to the terms of the decedent’s will or of the trust agreement.  After the termination of the two-year period, the trust must determine how it may otherwise qualify as an S corporation shareholder.

QSST

A QSST is a permitted S corporation shareholder. It is defined as a trust that, among other things,  distributes or is required to distribute  all of its income to a citizen or resident of the United States. Thus, a QSST cannot have an NRA as its income beneficiary.  Of course, the NRA cannot be the remainderman.

ESBT

An ESBT is a permitted S corporation shareholder if it satisfies various requirements, including the requirement that an NRA cannot be a “potential current beneficiary” of the trust.  Thus, an NRA cannot be a beneficiary who is entitled to, or in the discretion of the trustee may, receive, a distribution of principal or income of the trust.

What To Do? Consequences?

OK, an S corporation shareholder has died and his or her shares of stock in the corporation are set to pass to or for the benefit of an NRA under the terms of the decedent’s will or trust.

In the case of (i) an estate, (ii) a testamentary trust, (iii) a former grantor trust, or (iv) a Section 645 trust, the corporation will have some time to consider its options. There aren’t many. At the end of the day, if the corporation is to retain its status as an S corporation, the NRA’s interest will have to be eliminated.

Of course, the foregoing assumes that the corporation and the other shareholders are aware of the NRA’s beneficial interest. What if they become aware of this interest only after the offending transfer has occurred?

At that point, the S corporation will have lost its tax-favored status, becoming a C corporation, the income of which is subject to so-called “double taxation.”  If the corporation desires to re-elect S corporation status, it will generally have to wait five years before doing so. When the “new” S election is made, the corporation will begin a new built-in gain recognition period.

IRS Ruling?

Alternatively, depending on the facts and circumstances, the corporation may be able to request a determination from the IRS that the termination of its election was inadvertent. The request is made in the form of a ruling request and should set forth all relevant facts pertaining to the event or circumstance, including a detailed explanation of the event or circumstance causing the termination, when and how the event or circumstance was discovered, and the steps taken after discovery of the terminating event so as to “correct” the terminating event in order that the corporation may again qualify as a small business corporation.

The corporation has the burden of establishing that, under the relevant facts and circumstances, the termination was inadvertent. The fact that the terminating event was not reasonably within the control of the corporation and was not part of a plan to terminate the election, or the fact that the terminating event or circumstance took place without the knowledge of the corporation, notwithstanding its due diligence to safeguard itself against such an event or circumstance, tends to establish that the termination of the election was inadvertent.

The status of the corporation after the terminating event and before the determination of inadvertence is determined by the IRS. Inadvertent termination relief may be granted retroactively for all years for which the terminating event is effective, in which case the corporation is treated as if its election had not terminated. The IRS may require any adjustments that are appropriate. In general, the adjustments required should be consistent with the treatment of the corporation as an S corporation during the period specified by the IRS. In the case of stock held by an ineligible shareholder (for example, an NRA) that causes an inadvertent termination, the IRS may require the ineligible shareholder to be treated as a shareholder of the S corporation during the period the ineligible shareholder actually held stock in the corporation. Moreover, the IRS may require protective adjustments that prevent the loss of any revenue due to the holding of stock by an ineligible shareholder (for example, an NRA).

Although the IRS may ultimately issue a favorable ruling, including retroactive relief, to redress the inadvertent termination of an S corporation’s election, it would behoove the corporation and its eligible shareholders to avoid finding themselves in the position where such action is required. The best way to do that is to adopt a shareholders agreement that, among other things, prohibits the transfer of stock to an ineligible shareholder, requires shareholders (and their transferees) to make whatever elections are necessary to preserve the Corporation’s status as an S corporation, requires shareholders to cooperate in restoring the corporation’s “S” election, requires shareholders to make their estate plans known to the corporation, and imposes economic penalties upon any shareholder who violates the foregoing provisions, including the cost of any IRS ruling request that become necessary as a result of such violation.

Why, Oh Why?

We’ve heard it before: “Why would you choose to operate as an S corporation?”

Underlying this question are a number of other business-related questions, among which are the following:

  • Why would you limit the types of investors from whom you could accept equity capital contributions? Non-U.S. individuals, partnerships and other corporations cannot own equity in the S corporation without causing it to lose its tax-favored status. In addition, only certain kinds of trusts can own shares in an S corporation; in many cases, the trust, or its beneficiary, must make a special election in order to qualify the trust as a shareholder.
  • Why would you limit the type of equity interests that you can issue to an investor? S corporations can only have one class of common stock issued and outstanding –all of its shares must have identical economic rights. Preferred shares of stock are not permitted; special allocations of income and loss are not permitted. Many potential investors, however, will require a special return on and/or of their investment to compensate them for the use of their capital or for the risk they are assuming.
  • Why would you limit the number of shareholders? An S corporation cannot have more than 100 shareholders. Although special counting rules have alleviated this limitation in the case of family-owned corporations, other S corporations, with growing businesses, may have to confront this ceiling.

These are valid concerns that, in the case of a newly-formed business enterprise, may cause the owners to operate, at least initially, through an LLC that is treated as a partnership for tax purposes, rather than through an S corporation.

Caught Between Scylla and Charybdis?

The fact remains, however, that there are many S corporations in existence. Although an S corporation may “convert” into a partnership, the conversion, regardless of the form by which it is effected, will be treated as a liquidation for tax purposes. Thus, its shareholders will be taxed as though the corporation’s assets (including goodwill) had been distributed to them, as part of a taxable sale and liquidation, in exchange for their shares. If the corporation is subject to the built-in gains tax, it will incur a corporate level tax. s

Alternatively, the S corporation can free itself of the above limitations by revoking its election to be taxed as an S corporation. Of course, this will cause the corporation to be taxed as a C corporation: its profits will be subject to a corporate level tax and, when these after-tax profits are distributed to its shareholders, the shareholders will also be subject to tax.

What’s An S Corp. to Do?

Thankfully, there are situations where the choices are not as bleak, as a recent IRS letter ruling illustrated.

X Corp. was an S corporation. Y Corp. and Z Corp. were also S corporations. X Corp. had close to 100 shareholders.

The shareholders of X Corp. planned to restructure its business by undertaking several steps, the result of which would be that X would become a general partnership under State law, and Y and Z together would own all of the interests in X (the “Restructuring”). The shareholders of X would become shareholders in either Y Corp. or Z Corp., and Y and Z would be governed by identical boards of directors pursuant to a voting agreement entered into by their shareholders.

Following the Restructuring, the parties anticipated that both Y Corp. and Z Corp. would issue additional shares to new shareholders over time, so that the total number of shareholders in Y and Z together may exceed 100. However, neither Y nor Z would separately have more than 100 shareholders.

The Ruling

The IRS reviewed one of its published rulings in which unrelated individuals entered into the joint operation of a single business. The individuals divided into three equal groups and each group formed a separate S corporation. The three corporations then organized a partnership for the joint operation of the business. The principal purpose for forming three separate corporations, instead of one corporation, was to avoid the shareholder limitation for qualification as an S corporation and thereby allow the corporations to elect to be treated as S corporations.

In an earlier published ruling, the IRS had concluded, based on the same facts, that the three corporations should be considered to be a single corporation for purposes of making the election, because the principal purpose for organizing the separate corporations was to make the election. Under this approach, the election made by this “single” corporation would not be valid because the shareholder limitation would be violated. In reconsidering the prior ruling, the IRS concluded that the election of the separate  corporations should be respected. The purpose of the “number of shareholders” requirement, it said, was to restrict S corporation status to corporations with a limited number of shareholders so as to obtain administrative simplicity in the administration of the corporation’s tax affairs. In this context, administrative simplicity was not affected by the corporation’s participation in a partnership with other S corporation partners; nor should a shareholder of one S corporation be considered a shareholder of another S corporation simply because the S corporations are partners in a partnership.

Thus, the fact that several S corporations were partners in a single partnership did not increase the administrative complexity at the S corporation level. As a result, the purpose of the “number of shareholders” requirement was not avoided by the partnership structure and, therefore, the S elections of the corporations should be respected.

Accordingly, the IRS concluded in the letter ruling that Y and Z would continue to meet the S corporation requirements subsequent to the Restructuring, so long as neither Y nor Z exceeded 100 shareholders each.

Other Applications?

The above ruling indicates that the 100 shareholder limit may not be insurmountable if the business of the S corporations is conducted through a partnership.

Would the same strategy apply with respect to the single class of stock requirement? What about the restriction as to who may be a shareholder? The answer in most cases should be “yes.”

For example, A Corp. and B form partnership PRS to conduct a bona fide business. A contributes business assets to PRS, and B contributes cash, in a tax-free exchange for partnership interests in PRS.  A is an S corporation. B is a nonresident alien. Because the S corporation rules prohibit B from being a shareholder in A Corp., A and B chose the partnership form, rather than admit B as a shareholder in A, as a means to retain the benefits of S corporation treatment for A Corp. and its shareholders. According to the IRS, the partnership tax rules are intended to permit taxpayers to conduct joint business activity through a flexible economic arrangement without incurring an entity-level tax. The decision to organize and conduct business through PRS is consistent with this intent.

It is important to note, however, that the form of the partnership transaction may not be respected if it does not reflect its substance – application of the substance over form doctrine arguably could, depending on the facts, result in B being treated as a shareholder of A Corp., thereby invalidating A’s S corporation election. Thus, the form in which the arrangement is cast must accurately reflect its substance as a separate partnership and a separate S corporation. At the very least, there should be a bona fide business purpose for forming the partnership.