MANAGEMENT ENTITIES

Taxpayers who own various business entities often establish a management entity to provide management services to the entities and/or to act as a common paymaster and employer of all the various entities. The operating businesses will pay a fee to the management entity for the services provided, which fee will usually include an element for reimbursement of the hard costs of the management entity such as for employee wages and withholding taxes.

A recent Tax Court case challenged the deductions claimed by the operating entity for its payments to the management entity. The case addressed a number of the tax issues involved in these arrangements, and provides many “lessons” in structuring them. Some of the key lessons are described below.

1. WHEN WILL THE IRS ATTACK? The IRS will generally be interested in attacking these arrangements only when it perceives taxes are being deferred or avoided. Oftentimes, there are no deferral or avoidance circumstances. For instances, if the operating entities and the management entity are commonly owned, and are pass-through entities such as LLC’s, partnerships or S corporations, the deduction on the operations side is offset by the income on the management entity side. Even with C corporations, if both the operations side and the management side are profitable, then there is little chance of tax avoidance. In the instant case, the operating entity and the management entity were both S corporations. However, the management entity was owned by an ESOP. Thus, there was not common ownership on both sides. Further, the ESOP allowed for deferral or avoidance of tax on the management fees earned by the management entity, while the payor operating entity received an operating deduction. Thus, the IRS was very interested in challenging the management fees.

2. WILL THE MANAGEMENT ENTITY BE DISREGARDED AS A SHAM ENTITY? Relying on Moline Props., Inc. v. Commissioner, 319 U.S. 436 [30 AFTR 1291] (1943), in the instant case the IRS argued that the management entity should be disregarded for Federal income tax purposes because it lacked a legitimate business purpose and economic substance and was formed for the sole purpose of obtaining tax benefits. Such an attack can be successfully defended if the taxpayer can show the management entity was formed for a valid business purpose or if it actually engaged in business activity. Some business purposes that often exist in these circumstances (and that should be of assistance in defending a Moline-type attack) include:

a. Centralization of employee management;

b. Provision of management and other actual services;

c. Creditor protection (including products liability protection) by placing management in an entity without significant business assets and separating business activities in multiple entities;

d. Establishment of incentive and retirement plans for employees; and

e. Business efficiencies via centralization of services and activities.

In the instant case, while the taxpayer had difficulty factually proving a valid business purpose for the arrangement, it did conduct enough actual business activities to avoid a sham finding. In particular, the Tax Court noted that the management entity provided personnel services, maintained an investment and bank account, paid employees by check, adopted a retirement plan, followed corporate formalities and filed income and employment tax returns.

3. WILL MANAGEMENT FEES BE DEDUCTIBLE? Code §162 requires that expenses be ordinary and necessary in carrying on a trade or business to be deductible. Presumably, if the management entities provide employees to the operating entities, fees paid for such employees will be ordinary and necessary and deductible – this is what occurred in the subject case and was approved by the Tax Court. However, in the subject case, the IRS successfully challenged the management fees paid for other services. To enhance the deduction for such services, the following items are helpful:

a. Have an agreement to establish what services will be performed and what will be paid for them; and

b. Make sure the services are in fact performed by the management entity, and be able to specifically prove what was done (this was a problem in the subject case).

Overcharging or undercharging for fees can be problematic, either under Code §162 requirements of a “reasonable” amount, or Code §482 which requires amounts paid between commonly controlled entities to meet arms-length standards.

4. LOANS. If loans exist between the entities, adequate interest should be charged – if not, the IRS will typically be able to impute interest under Code §§482 and/or 7872. Code §7872 was applied in the subject case. All loans should be documented and treated as such on the books and records – failure to do so could result in deemed distributions and dividends.

On the positive side, the Tax Court had no problem with the concept of a management entity or centralized employer – so long as the parties toe the line on the above issues.

Weekend Warriors Trailers, Inc. v. Comm., TC Memo 2011-105

HOMESTEAD WAIVER CASE WITHDRAWN [FLORIDA]

On March 19, 2010, I commented on the Habeeb case. In that case, a Florida appellate court ruled that the entry of a spouse into a deed that transferred the spouse's ownership interest in a homestead to the other spouse was sufficient for that spouse to waive his remaining homestead rights in the property.

I commented that for various reasons, this appeared to be a questionable conclusion, due to Florida requirements for written waivers of homestead rights and fair disclosure of assets for a valid waiver.

The Habeeb opinion has now been withdrawn. Perhaps for the reasons I mentioned, perhaps for other reasons. Until a subsequent opinion is issued, or some other court addresses a similar issue, things are now back to where they were before the Habeeb case.

ARE YOU CHECKING FOR DOCUMENTARY STAMP TAXES ON TRANSFER OF ENTITY INTERESTS [FLORIDA]?

Florida recently issued emergency rules relating to the imposition of documentary stamp taxes on the transfer of conduit entity interests. The rules do not greatly expand on the statutory rules, but are a useful reminder of the broad reach of the conduit rules. I would wager a significant sum that there are many transactional attorneys and business persons that are not routinely reviewing the potential application of Florida documentary stamp taxes on the transfer of interests in corporations, partnerships, LLC’s, and other entities.

Florida imposes documentary stamp taxes at the rate of $0.70 per $100 of consideration paid for Florida real property. Some counties impose an additional surtax. In recent years, Florida law has developed to allow or acknowledge that oftentimes real property can be transferred to an entity without incurring the tax. This has opened the door to planning whereby taxpayers would transfer real property free of tax to an entity, and then sell the entity to a third party buyer (instead of selling the real property directly) to avoid documentary stamp taxes on that sale.

In 2009, Florida sought to close the door on this type of planning. It revised Fla.Stats. §201.02 to impose tax on transfers of interests in “conduit entities.” Generally, a tax will be imposed if (a) real property is conveyed to a conduit entity, (b) within 3 years of the conveyance, and (c) all or a portion of the grantor's direct or indirect ownership interest in the conduit entity is subsequently transferred for consideration. If the entity owns assets other than real property, then the tax will be prorated. A “conduit entity” is a legal entity to which real property is conveyed without full consideration by a grantor who owns a direct or indirect interest in the entity, or a successor entity.

Exceptions exist. Transfers of interests in a conduit entity that are in the nature of a gift (that is, they are without consideration), are not taxable. Transfers of interests in publicly traded entities are also exempt. A transfer of an interest to an irrevocable grantor trust is exempt – this appears directed at exempting sales to defective grantor trusts. A transfer of an entity interest at death generally should not be subject to tax since there is usually an absence of consideration paid.

The new emergency rules clarify that if the transfer to the entity was subject to documentary stamp taxes, then the transfer of the interest in the entity is not taxable as to that real property. They also have an example that makes clear that the buyer of an interest in the conduit entity will not be subject to tax on a subsequent resale of that interest, since the buyer was not the original “grantor.” The rules also provide that that tax is due on the earliest of the 20th day of the month following the month the ownership interest is transferred or the date that an instrument evidencing the transfer is filed or recorded in Florida.

Thus, any time there is a transfer of an interest in any nonpubicly traded entity for consideration, the question needs to be asked if Florida real property was transferred to it within 3 years by the seller (including indirect transfers through entities). This is similar to another set of tax rules that can relate to transfers of entities that is often overlooked – Code §1445 withholding on dispositions by foreign persons of interests in entities that are U.S. real property interests by reason of ownership of U.S. real property.

Florida Administrative Code §12BER11-2 (May 13, 2011)

APPLICABLE FEDERAL RATES–JUNE 2010

FUTA SURTAX EXPIRING SOON

Employers pay federal unemployment taxes on employee wages at the rate of 6.2%. 6% is the permanent rate, and 0.2% is a "temporary" surtax. Perhaps the temporary tag is a misnomer - it has been in place since 1976.

The 0.2% portion is set to expire, effective July 1, 2011. In today's political environment, it would be sheer speculation whether Congress will act to extend that portion. The President's 2012 budget seeks to make the 0.2% permanent.

PUBLIC CHARITY STATUS DENIED

Code §501(c)(3) organizations usually prefer to be classified as a public charity and not a private foundation. Private foundations are subject to excise taxes and limitations on donor charitable deductions that public charities do not have to deal with, among other disadvantages.

The usual route to public charity status is to meet certain numerical tests that show the foundation has broad funding. Organizations with a limited number of donors will not pass these tests. All is not lost for such organizations. If they can show they are operating for the benefit of one or more other specific public charities, they can qualify as Code §509(a)(3) “supporting organizations” which are treated as public charities.

One requirement (among others) under Code §509(a)(3) is the “organization test” that requires that the organization “is organized and, at all times thereafter, operated exclusively for the benefit of, to perform the functions of, or to carry out the purposes of one or more…specified organizations” that are public charities (other than by reason of being supporting organizations).  Thus the question arises whether a given organization meets this specificity requirement. The Regulations generally require the articles of incorporation to designate each of the specified organizations. Treas.Regs. §1.509(a)-4(d)(2)(i). Further refinements to the requirements are based on the “type” of qualification sought. A Type II organization need not specify by name each publicly supported organization it intends to support if its articles of incorporation “require that it be operated to support or benefit one or more beneficiary organizations which are designated by class or purpose....” Treas.Regs. § 1.509(a)-4(d)(2)(i)(b).

A recent case tested the limits of these identification and specificity requirements. The organization at issue identified the organizations it intended to support as organizations “which support, promote and/or perform public health and/or Christian objectives, including but not limited to Christian evangelism, edification and stewardship.”

The IRS argued that this identification did not meet the Type II specificity requirements. It interpreted the “designation by class or purpose” allowance as still requiring that the identification be specific enough so that the class of beneficiary organizations is “readily identifiable.” The taxpayer challenged this gloss on the regulation, but the appellate court determined that the IRS’ interpretation of its regulation was not plainly erroneous or inconsistent and thus would be respected.

The organization’s description of the organizations it would support was found to be too broad to meet this “readily identifiable” standard. The appellate court noted that there were no geographic limits imposed, nor a limit to a certain type of organization such as a church or seminary.

Note that it is not the number of organizations that are specified that is important – instead, it is whether someone can use the description to actually identify the subject organizations.  For example, the IRS and the court noted with approval the description used in Rev.Rul. 81-43. The organization in that ruling described the organizations it will support as “charitable organizations located in the Z area that are exempt under section 501(c)(3) of the Code and are public charities described in section 509(a)(1) or 509(a)(2).” Thus, this description passes muster because even though it may identify a large number of organizations, it is a precise enough standard that the organizations identified can be precisely determined.

Organizations that are not naming their supported public charities by name should take a clue from this case and undertake to include geographic limits and/or identification of the type of organization that will be supported.

Polm Family Foundation v. U.S., 107 AFTR2d Para. 2011-804 (CA DC 5/6/2011)

COMPENSATION VIA SHARE OF PROFITS DID NOT ESTABLISH A PARTNERSHIP

Parties that jointly conduct a business or venture and share the profits and losses will typically meet the definition of a “partnership” for income tax purposes and be taxed accordingly. Such partnership treatment can arise, even though the parties did not intend to create a partnership and merely have some other type of contractual arrangement between them.

This issue often arises when an individual or an entity provides services to another that is conducting a venture or business, and is paid for its efforts in whole or in part with a percentage of the profits of the venture. Since there is a sharing of “profits,” there is a reasonable risk that the IRS may find the arrangement to be a partnership, and not a non-partnership contractual arrangement.

The tax status of the relationship can have significant consequences for the parties, including whether the service provider is taxed immediately on a pass-through basis on the ventures profits, whether the provider can deduct venture losses, whether Section  1446 withholding on foreign participants may apply, and whether the service provider will be taxed on its receipts as ordinary income (nonpartner) vs. capital gain income (partner) if the shared profits are in the nature of capital gains.

It was whether such profits paid to a service provider were capital gains or ordinary income that was the issue in recent tax case.  Interestingly, the court found that the service provider was NOT a partner even though it was paid with a 20% profits interest in the venture. While the court’s examination was very fact specific, the factors looked at by the court and its view whether those facts supported a partnership or nonpartnership relationship can be useful when crafting contractual relationships when no partnership relationship is (or is not) desired. These factors included:

-the contract specifically declared that the relationship was not a partnership (this obviously was a factor against a partnership);

-the contract provider expended its own funds in performing its functions (this was considered by the court as a capital contribution and was a factor in favor of a partnership);

-the contract provider did not have authority to withdraw funds from the business, it could not increase the business owner’s capital commitment to assets, it could not enter into binding agreements in the name of the business, and it could not dispose of an asset without the owner's prior written approval. The court held that the service provider’s responsibilities, while numerous, did not extend into the key areas of acquiring and disposing of assets or drawing upon the business’  bank accounts that would indicate a partnership relationship (factor against partnership);

-the contract provider did not own title to any of the assets in the business, and apart from depositing checks did not share control with the business over the bank accounts that corresponded with the companies in the business portfolio and could only make business recommendations (factor against partnership); and

-the parties did not file partnership tax returns, and the contract provider did not hold itself out as a partner to third parties (factor against partnership).

Compensating employees or independent contractors with a profits share often makes good business sense to owners, as compared to actually making them part owners. Benefits to business owners include avoiding creating statutory rights in the recipients (such as voting rights and rights to examine books and records), and the ability to terminate the relationship without an obligation to repurchase shares or ownership interests, while gaining the incentive benefits of a profit participation. Sometimes, these interests are established as a share of gross profit instead of net profit, to avoid the partnership tax risk  -with a gross profit interest, there is no sharing of expenses or losses, thus eliminating an important factor in the establishment of a partnership relationship for tax purposes.  Thus, in addition to providing helpful factors to avoid partnership status, the case also provides some comfort that compensation via a net profit share will not, in and of itself, necessarily create a partnership relationship.

Rigas v U.S., 107 AFTR 2d ¶2011-788 (CD TX 5/2/7/2011) 

FLORIDA ACTS TO RESOLVE OLMSTEAD ISSUES [FLORIDA]

I previously discussed the Olmstead case – that discussion can be read here. This case created a stir both inside and outside of Florida, when it provided that at least in the situation of a single member LLC, a creditor’s rights are not limited to a charging order but could include a right to foreclose on the debtor’s LLC interest. The potential application of the decision to multimember LLC’s became a much-discussed issue. My partner, Jordan Klingsberg, has written the following summary relating to new LLC legislation that seeks to resolve these issues:

On Friday April 29, 2010 the Florida Senate passed CS/HB 253, Limited Liability Companies, to address some of the uncertainty surrounding Florida LLCs created by the recent Florida Supreme Court case, Olmstead v. Federal Trade Commission, 44 So.3d 76 (Fla. 2010). The bill provides that, except in one situation, a charging order is the "sole and exclusive remedy" to satisfy a judgment from a judgment debtor's interest in an LLC. The exception concerns an LLC with one member where distributions under a charging order will not satisfy the judgment in a reasonable time. In such a situation, a court may order the sale of the single member's interest in the LLC. CS/HB 253 passed both the Florida House and Senate and has been sent to the Governor to be signed into law.

In June of 2010, the Florida Supreme Court in Olmstead held that a charging order is not the exclusive remedy available to a creditor holding a judgment against the sole member of a Florida single member LLC. The court ruled that the judgment debtor had to surrender all right, title, and interest in the member's single member LLC interest in order to satisfy the outstanding judgment. The dissent in Olmstead, however, stated that the majority's holding was not limited to single member LLCs and expressed a desire that the Florida legislature clarify the law in this area.

Many practitioners believed that the Supreme Court's reasoning in Olmstead would apply to all limited liability companies. This lead many businesses to change their situs and organize in states other than Florida where a charging order is the exclusive remedy available to judgment creditors of multimember LLCs. This bill amends Fla. Stat. §608.433 to clarify that the Olmstead decision does not extend to multimember LLCs and provides procedures for applying the Olmstead decision to single member Florida LLCs.

The bill specifically states that a judgment creditor has only the rights of an assignee of the LLC interest to receive distributions to which the judgment debtor would have otherwise been entitled from the LLC. The only situation in which a court may order the sale of a member's interest is where the judgment creditor of a member's interest in a single member LLC establishes "that distributions under a charging order will not satisfy the judgment within a reasonable time." Upon such a showing, the court may order the sale of the single member's interest pursuant to a foreclosure sale and the purchaser becomes a member of the LLC and obtains the prior member's entire interest in the LLC. The foreclosure remedy is not available to a judgment creditor of a multimember LLC and cannot be ordered by a court.

Section 9 of the Bill does provide that nothing in the statute shall (i) limit the rights of a secured creditor, (ii) change the impact of a fraudulent conveyance; or (iii) change the court's right to use equitable principals such as ruling that an LLC was sham or using equitable liens or constructive trusts. These provisions, however, were likely already law in Florida.

The Bill does not contain any provisions for treating a multi-member LLC as a single member LLC and disregarding nominal interests held by minority members such as family members and grantor trusts.

This Act and the amendment to Fla. Stat. §608.433 will hopefully clarify the judgment remedies available against Florida LLCs and remove some of the ambiguity surrounding the treatment and operations of LLCs in Florida.

Special thanks to Richard Josepher of Gutter Chaves Josepher Rubin Forman Fleisher PA and other members of the special committee of the Florida Bar Tax Section who worked extremely hard and supported this legislation.

BUNDLED FIDUCIARY FEES REMAIN DEDUCTIBLE (FOR NOW)

In 2008, the U.S. Supreme Court held that costs paid to an investment advisor by a nongrantor trust or estate generally are subject to the Code §67(a) 2% floor for miscellaneous itemized deductions. Michael J. Knight, Trustee of William L. Rudkin Testamentary Trust v. Commissioner, 552 U.S. 181 (2008). What happens when the estate or trust pays a bundled fiduciary fee – that is one that does not provide a breakout on the total fee paid between investment advisory fees subject to the 2% limit and other fees that are not subject to the 2% floor? How is the taxpayer supposed to know how much is subject to the 2% floor?

After the Knight case, the IRS has issued Notices on an annual basis that relieved taxpayers of having to determine the portion of a bundled fiduciary fee that is subject to the 2% floor.

The IRS has now issued a Notice that indefinitely extends this relief, until the date that final regulations on the subject are published. Prior to that date, taxpayers may deduct the full fee without regard to the 2% floor. The Notice warns that payments by the fiduciary to third party for investment expenses are deemed to be readily identifiable and must be treated separately from the otherwise bundled fee.

Notice 2011-37, 2011-20 IRB (4/13/11)