IRS Wins Debt vs. Equity Case

A frequent area of dispute between taxpayers and the IRS is whether an indebtedness obligation should be treated as debt, or an equity investment, for income tax purposes. Taxpayers often seek debt treatment to obtain interest deductions, defer gain to a seller, or avoid gift treatment. Sometimes the underlying transaction is a straight loan - other times it involves a financed purchased of property.

The latter is what occurred in the subject case - a U.S. corporation purchased partnership units from a foreign corporation for a debt obligation. The debt was helpful since it provided an interest deduction to the U.S. obligor, deferred gain on the sale to the selling foreign corporation, and no taxable interest income to the foreign corporation obligee per qualification of the debt as tax-exempt portfolio interest debt.

There were factual aspects of the transaction that prompted the IRS to assert that the debt obligation was not debt, but an equity investment by the foreign corporation in the U.S. corporation.

In distinguishing debt from equity, the ultimate question is whether there was a genuine intention to create a debt, a reasonable expectation of repayment, and a finding that the intent comports with the economic reality of creating a debtor-creditor relationship.

There are a number of factors that courts will examine, including: (1) the names given to the certificate evidencing the indebtedness; (2) the presence or absence of a fixed maturity date; (3) the source of the funds used to pay interest and repay the creditor; (4) the right to enforce the payment of principal and interest; (5) the extent of a creditor's participation in management; (6) the status of the advance in relation to other corporate creditors; (7) the intent of the parties; (8) thinness of capital structure in relation to the debt; (9) identity of interest between creditor and stockholder; (10) the debtor's ability to obtain loans from outside lending institutions; (11) the extent to which the advance was used to acquire capital assets; and (12) the failure of the debtor to pay on the due date or to seek a postponement.

The court sided with the IRS and found the debt was actually an equity investment. Some of the key aspects that supported the finding included:

a. No real negotiation of the terms of the debt between the parties;

b. The purported borrower obtains significant rights over debtor operations such that it effectively managed the debtor;

c. The principal source of repayment of the debt was the purchased asset;

d. There was no down payment;

e. The notes were not paid timely, with extensions to pay being granted in lieu of the lender declaring a default. A reduction in the interest rate was also granted;

f. On the sale transaction, an independent valuation of the purchase price/value was not undertaken - the taxpayers instead adopted the suggestion for a price of the tax advisor;

g. Suggestions of non-arms length aspects of the transactions

Now some of these factors are often found in lending transactions. I would speculate that it was the structured nature of the transaction by a tax advisor so as to obtain tax deductions, no U.S. income tax on the interest payments, branch profits tax problems of the selling entity, and the ability of the U.S. corporation to benefit from an NOL in regard to income from the purchased partnership interest, that may have swayed the court against the taxpayer. The appeals court itself noted this when it declared “[m]any cases demonstrate the difference between arranging a contemplated business transaction in a tax-advantaged manner, which is legitimate, and entering into a prearranged transaction designed solely to use preserved NOLs and create a tax benefit, which is not.”

Not only did the court find against the existence of a debt obligation, but it further found that the debtor did not have reasonable cause for its position and thus was subject to substantial understatement penalty on the interest deductions it took.

Note that related party sales and debt are often undertaken for estate planning purposes. The foregoing concepts could be applied by the IRS to treat such arrangements as taxable gifts in lieu of debt transactions.

Proposed 2016 regulations under Code §385 were not applicable here, but could impact similar fact patterns in the future if the regulations are adopted. Under those proposed regulations, debt between related corporations will not be treated as debt if not in writing, and a written analysis of ability to repay is not undertaken, all within a short time of period of the establishment of the debt. However, even if one clears the hurdle of these potential new requirements, the IRS will still be able to challenge the arrangement under the above factor analysis.

A cautionary tale.

American Metallurgical Coal Co., TC Memo 2016-139

Treasury Removes a Reporting Trap for Section 83(b) Elections

Taxpayers who receive property as payment for performing services are generally taxable on the value of the property received in the year of receipt. Section 83 may allow such taxation to be deferred when the property received is subject to a substantial risk of forfeiture (e.g., an employee is issued stock, but will forfeit it if he quits or is fired) until the risk of forfeiture is removed.

Such a delay can hurt the employee, since the value of the property may increase before the risk of forfeiture is removed – the employee is required to include the value of property in income based on the value at the time such forfeiture risk goes away.

Section 83(b) provides relief to the employee – the employee can file an election with the IRS within 30 days of receiving the property to include it in income in the year of receipt even if there is a substantial risk of forfeiture. An employee may want to do this if he or she believes the current value is low, and the value later when the risk of forfeiture disappears may be materially higher.

To make a valid election, the regulations also require that a copy of the election be filed with the employee’s income tax return for the year of the election. This is a trap for an employee who forgets to do this.

This last requirement to file a copy with the tax return has now been removed in newly adopted Treas. Regs. § 1.83-2(c). To make the election, all that is needed now is the filing of the election within 30 days of receiving the property.

This change does not appear to be motivated by a desire to remove a trap for taxpayers – instead, it is in acknowledgment of the difficulty of filing a copy of an election if the tax return is filed electronically.

T.D. 9779, 07/25/2016, Reg. § 1.83-2

Save the Date – September 28, 2016!

If you are in South Florida, and are interested hearing Jonathan Blattmachr present at the 3rd annual Palm Beach County Wealth & Estate Planning Seminar, click here to learn more and register (scroll down to the bottom of the list on that page for “Individual” sign ups). Space is limited, so don’t delay!

Jonathan will be speaking on two topics - The Critical Importance of Significant Tax Free Returns and How to Achieve Them, and The New Regulations Under Section 2704(b). If those new regulations are not released by then, the alternate topic will be The Charitable Deduction for Estates and Trusts–Something You Need to Know Cold. The presentation is given at the Boca Raton campus of Florida Atlantic University in the late afternoon, and is followed by a cocktail reception.

It is not too late to sign up as a sponsor either – so if you would like to get your name or your business name placed prominently before 250 or so of the best and brightest attorneys, accountants, financial advisers, insurance agents, and others in the South Florida estate planning community, click here for what you received with each level of sponsorship, click here to sign up to be a sponsor, or send me an email at crubin@floridatax.com and I can help and answer any questions. Again, the sooner you sign up, the quicker we can get you added to the list of sponsors on the event website and on event mailings.

I hope to see many of you there on September 28!

Safe Harbor Acquisition of Control for Spin-Offs

Code Section 355, and related Code provisions, when applicable, will allow a corporation to spin-off or split-off a subsidiary corporation to its shareholders without triggering gain to the corporation or its stockholders. One of the requirements for this treatment is that the distributing corporation “control” the distributed corporation (i.e., own 80% or more of the voting power and number of shares of the distributed corporation) immediately before distributing it to its shareholders.

To come under Section 355, the distributing corporation may intentionally acquire control before the spin-off or split-off, and then transactions are undertaken after the distribution that reverse in whole or in part such acquired control as to the shareholders that succeed to ownership of the distributed corporation. Determining whether the IRS will respect such acquisition and subsequent disposition of control and the application of Section 355 can be difficult to determine.

The IRS has now issued a Revenue Procedure describing some safe harbor circumstances when such an acquisition and divestiture of control will not be the basis of a challenge by the IRS to Section 355 applying.

Generally, under the safe harbor, if the distributing corporation is issued shares of the distributed corporation to give the distributing corporation control, and if no action is taken to unwind the acquired control within the first 24 months after the distribution, then the IRS will allow Section 355 treatment. If the unwind occurs via an unanticipated third party transaction with other persons, such as a merger, the safe harbor applies if there is no agreement, negotiations or discussions within the first 24 month period (even if the transaction itself occurs within that 24 month period), and there is not more than a 20% overlap of ownership between the other person in the transaction (e.g., the other corporation in the merger) and the distributed corporation.

Rev.Proc. 2016-40

State Court Retroactive Change to IRA Beneficiary Not Given Tax Effect by IRS

A decedent had 2 IRAs. The death beneficiaries of the IRAs were trusts that qualified as "look through" trusts, such that the payout period for the IRAs after the decedent died could be computed using the life expectancy of the trust beneficiaries.

However, before he died, the decedent moved the IRAs to another firm, and entered into new paperwork that  erroneously designated his estate as the death beneficiary. With the estate as beneficiary, the payout period for the IRAs could not be "stretched" under IRS regulations The decedent thereafter died.

The trustees of the trusts petitioned a state court for a declaratory judgment to change the beneficiary designations back to the trusts. The court agreed and ordered the change, retroactive to the date the new beneficiary designation forms were signed.

A private letter ruling was then sought to give effect to the state court order, such that the IRA payouts could be calculated based on the life expectancy of the trust beneficiaries. The IRS declined, and ruled that the state court order could NOT retroactively change the tax consequences of the decedent having died with his IRA beneficiaries being designated to be his estate.

The IRS relied on Estate of La Meres v. Comm., 98 TC 294 (T.C. 1992). In that case, a state probate court order approved a post-death amendment of a trust to eliminate a provision that caused adverse estate tax results, and held that such amendment was retroactive to the date of the decedents death. The Tax Court held such reformation ineffective for tax purposes, explaining that courts generally disregard the retroactive effect of state court decrees for Federal tax purposes.

This is not the first time the IRS has ruled against giving tax effect for IRA stretch purposes of a retroactive reformation See PLR 201021038 for example. Interestingly, the IRS had previously given effect to such reformations - see PLRs 200235038 and 200620026.

Private Letter Ruling 201628004, July 8, 2016

Napkin Theory Saves the Day [Florida]

Renee established and funded a  revocable trust, with charitable residuary beneficiaries at her death. The trust was revocable, but it did not provide a method for revocation.

Four years later, Renee prepared a will that left all of her estate to a caretaker. The will included language that "I...declare this to be my Last Will and Testament, revoking all other wills, trust and codicils previously made by me." There was no more specific reference to the prior revocable trust. Was this revocation sufficient to revoke the revocable trust and have its assets pass under the will after Renee died?

Florida has a statute dealing with revoking revocable trusts. It provides:

736.0602(3): Subject to s. 736.0403(2), the settlor may revoke or amend a revocable trust:

     (a) By substantial compliance with a method provided in the terms of the trust; or

     (b) If the terms of the trust do not provide a method, by:

          1. A later will or codicil that expressly refers to the trust or specifically devises the property that would otherwise have passed according to the terms of the trust; or

          2. Any other method manifesting clear and convincing evidence of the settlor's intent.

(3)(a) did not apply, since there was no method of revocation provided in the trust. (3)(b)1. did not either, since the revocable trust was not referenced with any specificity. This leaves (3)(b)(2) - was the will "any other method manifesting clear and convincing evidence of the settlor's intent [to revoke]?"

The trial court ruled that a will cannot be used under (3)(b)2. - that is, the will can only be used to revoke using (3)(a) or (3)(b)1. "Any other method" means a method other than by will. But does the statute say this? Perhaps - "any other" could mean excluding use of a later will or codicil since those terms are described in (3)(b)1.

A will can be a method used to meet (3)(b)2, says the appellate court. (3)(a) and (3)(b)1. provide two mechanisms to revoke a trust. If those are not followed, then (3)(b)(2) can be used - albeit with a higher standard of proof (clear and convincing evidence) than otherwise applicable. There is nothing in the statute that prohibits the will from being the method of revocation. To do otherwise would be to absurdly interpret the law such that a will revocation would be ineffective while if the settlor "scribbled the exact same thing on a napkin or a piece of paper and left it in her dresser drawer" that could be effective - i.e., giving more validity to a napkin scribble than a last will.

Note, however, that the appellate court appears to provide that a will revocation under 3(b)(2) will not be sufficient by the will language alone to meet the clear and convincing evidence burden standard. Some other evidence of intent will be needed to meet that burden - in the subject case there was other evidence of the decedent's intent to revoke the revocable trust.

(3)(b)(2) derives from Section 330(1) and the comments thereto in the Restatement of Trusts (Second). While such items do not impose a clear and convincing standard unlike the Florida provision, the findings in this case may also be relevant in other states that do not have law contrary to the Restatement.

Bernal v. Marin, 3rd DCA (Case No. 3D15-171, June 15, 2016)

Anatomy of a Busted Tax Rescue Transaction

For many years, there were companies out there that marketed a service to tax professionals to help their corporate clients with large tax liabilities. I remember receiving solicitations to think of them if I came across companies that could benefit from their services. The bare bones of a typical transaction involved a C corporation that had sold assets for a gain or otherwise incurred a large amount of income (or expected this to happen in the near future). The rescue company would purchase the sale of the stock of the company, either with rescue company funds, funds from a lender, or possibly from the target company itself.

Stockholders would do this because they were promised more in funds than if the corporation paid the tax liability and liquidated. How? The rescue company asserted that it had companies available with large tax losses, or had other arrangements that could generate a tax loss, that the target company could use. Thus, the large tax bill to the IRS of the C corporation would never have to be paid, and the rescue company and the shareholders of the target company would split that tax savings between them.

These were the facts before the Tax Court in a recent case. The facts are pretty lengthy, but in essence the target company had a large tax liability to the IRS due to a litigation award. The rescue company arranged for the purchase of the shareholders’ stock via a loan from a third party lender, which loan was secured by and was to be repaid from the cash of the rescue company. After the acquisition, Treasury bills of low value were contributed to the target company, and the target company asserted a carryover basis in those bills of over $50M. The target company claimed a loss on the Treasury bills which eliminated the corporate income tax on the litigation award.

The IRS disallowed the loss, and turned its eye on the shareholders as transferees of corporate funds to pay the taxes.

Ultimately, the IRS won on its transferee liability claim. It did this first by finding that the transaction was a fraudulent conveyance under state law - here, Oregon. Recasting the transaction as a corporate redemption of the shareholders, the shareholders were found to be liable for the unpaid taxes of the target corporation under Oregon law.

The court then applied Section 6901 to find federal transferee liability for the shareholders, since the transaction had no practical effects other than the creation of tax losses.

An important fact was that the shareholders had been warned that the contemplated transaction could be a “listed transaction” and that there could be transferee liability for the shareholders - indeed, PriceWaterhouse Coopers refused to become involved with the transaction due to these issues. So the shareholders were forewarned there were problems with the transaction, and that assisted the court in making the appropriate findings for transferee liability under state and federal law.

I’m not sure if any of these rescue companies are still out there. If approached, taxpayers and their advisors should use extreme caution in entering into these rescue transactions.

Estate of Richard L. Marshall v. Comm., TC Memo 2016-119