The Threat of Higher Taxes, & The Sirens’ Song of Tax-Saving Schemes
September 14, 2020
What a Mess
A “perfect storm” may be defined as a critical state of affairs arising from the convergence of a number of negative factors, often after the unexpected introduction of some catalytic event.
The situation in which we find ourselves today may be described as a perfect storm from several different perspectives.
For many years, our nation has been fracturing along various socioeconomic lines. Until fairly recently, we have been able to repair some of the cracks in our social structure, and we have prevented certain identifiable fault lines from developing into fissures of any significance.[i]
The pandemic, however, has changed the environment in which these factors interact with one another, and it has influenced – in a very negative way – how their respective proponents perceive each other.
Although various and diverse “solutions” have been suggested by some hopefully-well-intentioned folks on the national stage, these proposals share a common element: the expenditure of significant funds by the federal government.
Throw Money at the Problem(s)
In order to finance the many programs being discussed, the federal government cannot simply print or borrow more money.[ii] At some point, presumably, it has to generate tax revenues.[iii]
Do voters want to pay more taxes? Probably not, regardless of the ostensible purpose for which they will be expended. So what is a group of elected officials to do without jeopardizing their livelihoods?
Collect as much tax as possible from as small a number of voters as practicable, and especially from those whom the public has identified as having benefitted the most from “the system.”[iv]
This approach to the problem is reflected in Mr. Biden’s tax proposals: increase the individual federal tax rate on ordinary income from 37% to 39.6% (43.4% when one adds the 3.8% surtax on net investment income[v] in the case of an individual investor in a business[vi] who does not materially participate in the business); increase the rate on “qualified” dividends from 20% (23.8%) to 39.6% (43.4%); increase the rate on long-term capital gains to 39.6% (43.4%); impose the 12.4% Social Security tax[vii] on all earned income in excess of $400,000;[viii] increase the corporate income tax rate from 21% to 28%; increase the tax on GILTI from 10.5% to 21%;[ix] reduce the estate, gift, and GST tax basic exclusion amounts from $10 million to $5 million;[x] eliminate the like kind exchange for real estate[xi]; etc.[xii]
The prospect of what many see as imminent, and significant, increases in federal taxes is causing members of the “targeted” population of taxpayers, especially those who reside in states or municipalities with high overall tax burdens (like New York, New Jersey and Connecticut[xiii]), to rethink their business plans, and even their way of life.
How Will Taxpayers React?
Beginning this summer, we have heard from the founding owners of many successful, closely held businesses – hardly members of the Gates, Buffet, Bezos, Hollywood, Professional Sports, or “family money” crowd[xiv] – who are concerned about the future. A sampling of their questions: Should I try to sell my business before the year-end?[xv] Does it make sense for me to utilize my gift tax exemption in 2020? How can I give up my New York residence?[xvi]
Each of these considerations involves a tax-related goal rather than a non-tax business-driven end. That’s ass-backwards, to use the vernacular, and that’s a sign of poor tax policy.
Of course, most business owners recognize – especially based on the history of recent legislation – that no tax law is “permanent.” In the meantime, they will cut costs,[xvii] try to be more efficient, try to generate more revenue, establish a line of credit, borrow money when necessary, and otherwise figure out how to sustain and strengthen their business.
There are some bad actors out there, however, who lack patience, who are less industrious, who are unwilling to make any sacrifices, and who are ready to buy into the proverbial “quick fix” for their tax problem.
Assuming the tax proposals put forth by the Democratic Party are eventually enacted into law, we are certain to encounter more unscrupulous promoters of such tax-saving schemes, along with their more-than-willing clients.
A recent decision of the U.S. Tax Court examined one such scheme.[xviii]
Taxpayer was employed as an officer of Limited Partnership (“LP”), and owned limited partnership units in LP. Taxpayer was also an officer of LP’s general partner.
During the year at issue, Taxpayer met with Adviser for the purpose of formulating a tax-planning strategy to eliminate the expected tax liability on the substantial income that Taxpayer was slated to receive later that year.
The recommended tax structure involved organizing multiple new entities owned or controlled by Taxpayer, and included an S corporation, a family limited partnership (“FLP”), and a family management trust. Under the structure, Taxpayer would contribute cash and marketable securities to the S corporation in exchange for its stock; Taxpayer would use the S corporation as a vehicle for day trading. The S corporation would then transfer those same assets to the FLP in exchange for a 98% interest as a limited partner. The trust would be the general partner of the FLP, holding the remaining 2% of the partnership interests.
Under the proposed tax strategy, Taxpayer would then liquidate and dissolve the S corporation, which would distribute the 98% limited partnership interest to Taxpayer, as its shareholder. Upon the liquidation of the S corporation, Taxpayer would own the 98% interest in the limited partnership, and the partnership would own the assets that Taxpayer had initially contributed to the S corporation.
Adviser indicated that the fair market value of the distributed limited partnership interests would reflect a reduced value, for tax purposes, because of the large discounts for lack of marketability and lack of control that would be applied in determining their value.[xix] The liquidation and dissolution of the S corporation would generate a tax loss for Taxpayer to report on their individual tax return.
Taxpayer decided to implement this strategy, organizing LLC (with Taxpayer as the sole member), S Corp, FLP, and Trust (with Taxpayer as trustee and their kids as beneficiaries). Initially, Taxpayer held the 2% general partnership interest in FLP, and S Corp held a 98% limited partnership interest, but Taxpayer then transferred the general partnership interest to Trust.
Following the formation of the entities, Taxpayer transferred their units in LP to LLC. Taxpayer also transferred cash and marketable securities from personal accounts to newly opened accounts of S Corp.
Shortly afterward, S Corp transferred most of those same, newly received assets to newly opened accounts of FLP, following which S Corp was left with very few assets other than its interest in FLP.
During the period of its existence – just over one month – S Corp executed a very small number of trades in securities.
Indeed, approximately two-and-one-half weeks after the incorporation of S Corp, Taxpayer again met with Advisor to begin taking steps to dissolve S Corp and distribute its assets. Taxpayer filed the required documents with the secretary of state to terminate S Corp, effective the last day of the calendar year.[xx] Taxpayer also signed a transfer and assignment of their interest in LLC to S Corp, retroactively effective Day One (two weeks prior). That same day, and acting in his capacity as president of S Corp, Taxpayer signed another transfer and assignment, this time of S Corp’s interest in LLC to FLP, retroactively effective Day Two. S Corp then transferred its remaining cash and marketable securities FLP. One week before the year-end, S Corp transferred its only remaining asset, the 98% limited partnership interest in FLP, in equal parts to Taxpayer and their spouse, with each receiving a 49% limited partnership interest. In addition, Taxpayer transferred a limited partnership interest in FLP to each of three trusts established for the benefit of their three sons, effective the year-end.
Taxpayer timely filed their federal individual income tax return for the year at issue. On that return Taxpayer reported, among other items, approximately $700,000 of wages, and over $1 million of nonpassive partnership income,[xxi] from LP.[xxii] Taxpayer also claimed a $2 million ordinary loss deduction on Schedule E from S Corp,[xxiii] resulting in a tax liability of zero.
S Corp filed its initial and final income tax return[xxiv] for the year at issue. On its return, S Corp reported an ordinary loss[xxv] (rather than a capital loss) in excess of $2 million, which was sufficient to offset Taxpayer’s total income from LP. The corporation reported the values of the 49% limited partnership interests in FLP distributed to each of Taxpayer and their spouse as ‘gross receipts.” To calculate the values of the distributed partnership interests, the total value of the cash, securities, and units of LP that Taxpayer had transferred to FLP through S Corp, was discounted by more than 40% for lack of control, lack of marketability, and other factors. S Corp reported as “cost of goods sold” its alleged total basis in FLP.[xxvi]
FLP also filed a federal tax return,[xxvii] on which it reported no gross receipts or sales, no deductions, and no business income or loss.
Examination and Tax Court
The IRS examined Taxpayer’s return and concluded that Taxpayer was not entitled to the claimed loss deduction on the grounds that the transactions generating the reported loss lacked economic substance; that S Corp was not a trade or business and that the transaction was not entered into for profit; that Taxpayer have failed to show that they incurred a loss on the liquidation of S Corp; and that Taxpayer understated the value of the distributed assets.
Taxpayer appealed the proposed adjustment with the IRS Appeals Office, but was unsuccessful. Taxpayer then petitioned the U.S. Tax Court.
The Court acknowledged that a taxpayer is generally free to structure their business transactions as they wish, even if motivated in part by a desire to reduce taxes. That being said, the Court then added that transactions “which do not vary control or change the flow of economic benefits” are to be “dismissed from consideration.”
The economic substance doctrine, the Court explained, allows courts to enforce the legislative purpose of the Code “by preventing taxpayers from reaping tax benefits from transactions lacking economic reality.” Thus, a court may disregard a transaction for tax purposes – even one that formally complies with the Code – if the transaction has no effect other than generating an income tax loss.
Whether a transaction has economic substance, the Court continued, is a factual determination for which the taxpayer bears the burden of proof.
According to the Court, a transaction “will be respected for tax purposes only if: (1) it has economic substance compelled by business or regulatory realities; (2) it is imbued with tax-independent considerations; and (3) it is not shaped totally by tax avoidance features.”[xxviii]
In other words, the transaction must exhibit an objective economic reality, a “subjectively genuine” business purpose, and some motivation other than tax avoidance.
Taxpayer contended that they organized S Corp as a vehicle through which to engage in day trading while still working at LP. They claimed that they transferred the cash and securities to S Corp in order to finance the day trading activities and that the transfers of assets to FLP through S Corp were for asset protection purposes.
The Court rejected Taxpayer’s argument, stating that “It is clear from the record, however, that [S Corp] existed only to generate a tax loss. Despite the time, effort, and cost of establishing the company, within 17 days of organization [Taxpayer] had begun taking steps to dissolve [S Corp] . . . before any actual significant trading had occurred.” In arriving at its conclusion, the Court considered the above-referenced factors.
The first prong of the economic substance inquiry requires that the transaction have economic substance compelled by business or regulatory realities. The Court explained,
A transaction lacks economic substance if it does not “vary control or change the flow of economic benefit[s]”. Under the objective economic inquiry, the Court examines whether the transaction affected the taxpayer’s financial position in any way, such as whether the transaction “either caused real dollars to meaningfully change hands or created a realistic possibility that they would do so.” A circular flow of funds among related entities does not indicate a substantive economic transaction for tax purposes.
The Court found that the transactions executed by Taxpayer to generate the claimed loss deduction failed to alter Taxpayer’s economic position in any way that affected objective economic reality. The asset transfers represented a circular flow of funds among related entities used to generate an artificial tax loss to offset Taxpayer’s income for the year at issue.[xxx]
Taxpayer, the Court determined, had constant control over the assets and entities at all relevant times; neither the contribution to S Corp nor its dissolution affected Taxpayer’s position or caused “real dollars to meaningfully change hands”. The form of Taxpayer’s ownership of the assets may have changed, but the substance did not. What’s more, there was no realistic possibility that the assets would change hands at any point.
Accordingly, the Court held that the transactions lacked objective economic reality and, therefore, failed to satisfy the first prong of the economic substance doctrine.[xxxi]
Subjective Business Purpose
The Court then considered whether Taxpayer had a “subjectively genuine business” purpose or some motivation other than tax avoidance.
After noting again that taxpayers are not prohibited from “seeking tax benefits in conjunction with seeking profits for their businesses,” the Court warned against a taxpayer’s entering into a transaction only for a tax-avoidance purpose.[xxxii]
In response to Taxpayer’s claim that S Corp was formed for the purpose of day trading, the Court pointed out that Taxpayer’s actions were not consistent with a profit motive.[xxxiii]
What’s more, after organizing S Corp, Taxpayer dissolved it almost immediately. Indeed, Taxpayer began taking steps to dissolve S Corp after completing a single day trade, and the majority of the day trades that S Corp transacted were executed after the process of dissolving the corporation had begun.
Before S Corp engaged in any trading, Taxpayer caused the company to transfer nearly all of its assets to FLP, a newly formed company that never engaged in any business activity and otherwise held no assets. The transfers to FLP, the Court observed, served no business purpose and offered no potential for profit. Moreover, Taxpayer could not identify a business motive or profit potential for using S Corp as a conduit for that transfer. Nor did Taxpayer identify any business purpose in transferring the LP units to FLP through S Corp. These transfers, the Court determined, served only to increase the claimed loss when S Corp dissolved shortly thereafter.
According to the Court, Taxpayer intended from the beginning to organize and dissolve S Corp within the same year in order to generate a tax loss in an effort to reduce their income tax liability arising from Taxpayer’s services for and investment in LP. Taxpayer did not have a genuine business purpose for establishing the entities, and their actions were taken solely for tax-motivated reasons. Taxpayer knew they would be receiving substantial income from LP and sought to generate a tax loss to offset it. Adviser offered Taxpayer a prepackaged tax strategy designed to create an artificial loss through a circular flow of assets, the application of substantial discounts, and the misreporting of the resulting loss as an ordinary loss, rather than a short-term capital loss.
Thus, the Court held that the transactions at issue did not have economic substance, and that Taxpayer was not entitled to the claimed loss deduction therefrom.
Let’s Be Careful Out There[xxxiv]
Most business owners work hard, rarely taking a break from their business – it is their calling, something that they enjoy and do well. Hopefully, their investment of time, effort and money leads to a successful conclusion.[xxxv]
In my experience, most successful business owners are not averse to paying taxes. They recognize that taxes are vital to maintaining our society and culture – a “necessary evil,” if you will.
That being said, too often they are portrayed as people who pay professionals to help them abuse “the system” and thereby “avoid” paying taxes, rather than as well-informed taxpayers who are merely doing what the Code allows, and even encourages, them to do.
This feeling of being put upon may result in some business owners becoming susceptible to unscrupulous promoters of schemes to “save” taxes. That’s the time to rely upon one’s instincts – that something cannot be as good as it seems – as well as upon one’s long-time advisers, who are almost certain to recognize a modern version of the snake oil salesman.
[ii] Some disagree. Have you heard of Modern Monetary Theory? https://www.newyorker.com/news/news-desk/the-economist-who-believes-the-government-should-just-print-more-money Does the government spend more than it collects in taxes? No problem. Does it have to borrow more? No problem. In that case, why collect taxes at all? To control inflation, they say.
As I have said many times before, I am no economist, but WTF?!
[iii] We’re already behind the eight ball with the trillions of dollars spent on countering the effects of COVID-19 and our response thereto.
[iv] The infamous bank robber, Willie Sutton, was once asked why he robbed banks. He is reputed to have replied, “Because that’s where the money is.” Duh?
[v] IRC Sec. 1411.
[vi] Basically, a Form 1040, Schedule E filer.
[vii] 6.2% on each of the employer and the employee.
[viii] Again, you have to ask, what about those folks who fall between the current cap of $137,700 and the proposed $400,000 threshold?
[ix] I will note that no one is suggesting that the inclusion of GILTI in gross income – a product of the 2017 tax legislation – is a bad thing.
[x] Reducing the exemption from today’s $11.58 million to $5.49 million.
[xi] It’s not far-fetched to imagine that the tax-deferred contribution of property to corporations or to partnerships may be eliminated in the not-too-distant future. The same goes for the tax-free corporate reorganization provisions. Each of these plays the same role in its respective sphere as does the like kind exchange for real estate. What about the elimination of installment reporting? It was actually repealed for accrual basis taxpayers back in 1999; it was only after intensive lobbying by the real estate industry and closely held businesses that it was reinstated the following year. Query how influential these groups would be today?
[xiii] According to the Tax Foundation, the residents of these three States have the highest state-local tax burdens – paying somewhere between 12% and 13% of their total income to state and local taxes. https://taxfoundation.org/publications/state-local-tax-burden-rankings/
[xiv] The taxes we’re talking about are, to this “funny money” crowd, what a mosquito is to an elephant.
[xv] I might also add that, almost to a person, these folks expressed their desire to reward their key employees in the event of a sale, and to ensure continued employment for the rest of their workforce.
In fact, I can probably count on one hand the number of selling owners we have represented over the years who thought differently.
[xvii] That includes employees. That’s another upshot of the pandemic. Many businesses have realized they can make due with a smaller workforce.
[xviii] Daichman, v. Commissioner, T.C. Memo. 2020-126.
[xix] See, e.g., Rev. Rul. 59-60. The Court did not make any findings as to value.
[xx] In general, S corporations are required to use the calendar year for tax purposes.
[xxi] Reported to him by LP on a Schedule K-1.
[xxii] Form 1040, Schedule E, Part II.
[xxiii] Attributable to its liquidating distribution (and deemed sale per IRC Sec. 336) of the value-discounted FLP interests, and passed through to the shareholder under IRC Sec. 1366.
Query why there was no mention of the IRS’s standard position in estate/gift tax matters that interests in a partnership funded with marketable securities did not merit much in the way of valuation discounts.
Query also why there was no discussion of the Pope & Talbot decision, 162 F.3d 1236 (9th Cir. 1999), where a corporation made a non-liquidating distribution of limited partnership interests in a single partnership to its shareholders. The corporation had valued each partnership unit as a minority interest (a discounted value). The court disagreed. The units had to be valued (for purposes of IRC Sec. 311) as if sold in their entirety, as one; otherwise, the FMV of the underlying assets would not be accurately reflected.
Finally, query why no mention was made of IRC Sec. 336(d), which denies loss recognition to a liquidating corporation on certain distributions to related persons.
[xxiv] On Form 1120S, U.S. Income Tax Return for an S Corporation.
[xxv] Because it claimed to be a day-trader?
[xxvi] Taxpayer’s accountant prepared S Corp’s return with the assistance of Adviser, who directed the accountant to report the transactions as gross receipts and cost of goods sold, and who even provided the discounts and other information used to compute those amounts.
[xxvii] On Form 1065, U.S. Return of Partnership Income.
[xxviii] The Court recognized that there is “near-total overlap between the latter two factors.”
[xxix] The year at issue preceded the effective date of IRC Sec. 7701(o), which codified the doctrine.
[xxx] Just to recap: Taxpayer transferred substantial assets to S Corp, their wholly-owned corporation, which then transferred those assets to FLP. S Corp owned a 98% limited partnership interest in FLP, while Taxpayer, as trustee of the Trust, owned the remaining 2% as general partner. Within days of the transfers to FLP, S Corp dissolved, distributing its 98% interest in FLP to Taxpayer. Taxpayer claimed a loss deduction on their tax return by calculating the values of the distributed partnership interests based on substantial discounts.
[xxxi] Although failure to satisfy any one prong of the economic substance doctrine is sufficient for a finding that the transaction lacked economic substance, the Court nevertheless addressed the remaining two prongs.
[xxxii] In other words, a taxpayer who acts with mixed motives of profit and tax benefits may nonetheless satisfy the subjective test.
[xxxiii] Taxpayer had no past experience in day trading, yet conducted no prior research into the activity, did not consult any references, and did not otherwise seek advice before expending the time and resources to establish S Corp.
[xxxiv] Hill Street Blues fans will remember Sgt. Phil Esterhaus’s catch phrase.
[xxxv] Often the sale of the business.