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Deducting Pre-Acquisition Stock Compensation
In Qinetiq US Holdings, Inc. v. Commissioner, No. 15-2192 (4th Cir. 2017), the court addresses the situation where a taxpayer acquired a target corporation and then claimed a substantial tax deduction for expenses the target corporation had paid prior to the acquisition. There are rules intended to prevent taxpayers from being able to deduct pre-acquisition expenses. The stock compensation rules can be an exception to these rules, which is addressed in the case.
Facts & Procedural History
The facts and procedural history of the case are as follows:
- Thomas Hume (“Hume”) formed a corporation in 2002 and elected to have it treated as a Subchapter S corporation.
- He admitted Julian Chin (“Chin”) as a shareholder of the corporation later in 2002.
- As part of this, the corporation issued two shares of stock–Class A voting stock and Class B non-voting stock.
- The corporate records included a consent that authorized the corporation to offer to sell the shares of the Class A voting stock to Hume and Chin.
- The consent also authorized the corporation to enter into shareholder and employment agreements with Hume and Chin.
- The consent did not authorize the corporation to enter into restrictive stock agreements with Hume and Chin.
- The shareholder agreement with Hume and Chin included terms restricting the sale or transfer of stock and for returning stock to the corporation in the event of either Hume’s or Chin’s death, disability, or termination of employment with the corporation.
- The employment agreements with Hume and Chin did not have any reference to stock issued as compensation.
- Hume and Chin purchased the Class A voting stock.
- In 2008, the corporation was acquired by the Taxpayer.
- In 2009, the Taxpayer reported a $117,777,501 deduction for the stock Hume and Chin received in 2002.
- The tax court ruled that the Taxpayer had not demonstrated entitlement to the deduction on two independent bases, namely, that the stock was not property “transferred in connection with the performance of services” and was not “subject to a substantial risk of forfeiture” at the time Chin acquired the shares.
- The Taxpayer appealed the decision, which brings us to the current case.
The question for the appeals court was whether the Taxpayer was entitled to a deduction in 2009 for the stock Hume and Chin received in 2002.
Substantial Risk of Forfeiture
Compensation for services is usually deductible to the employer in the year it is paid and reported as income to the recipient in the same year. There is an exception for compensation for services that are subject to a substantial risk of forfeiture. This compensation is deductible and taxable in the year that it is no longer subject to forfeiture. The regulations include a number of rules that explain when compensation is subject to a substantial risk of forfeiture.
The appeals court cited two of these rules, namely, that there is no substantial risk of forfeiture if (1) the employer is required to pay the fair market value of such property to the employee upon the return of such property and, (2) at the time of the transfer, the facts and circumstances demonstrate that the forfeiture condition is unlikely to be enforced.
Restrictions that are Not Substantial
The appeals court noted that the shareholder agreement obligated the corporation to pay the fair market value of such property to the employee upon the return of such property upon Chin’s death, disability, or termination without cause. These restrictions failed the fair market value rule cited by the court.
The other restrictions in the shareholder agreement showed that the only circumstances in which Chin would be required to forfeit his stock at a below-market price would be if he voluntarily resigned before 20 years of employment, if he voluntarily resigned and entered into competition with the Taxpayer, or if he was terminated for cause.
The regulations say that termination for cause does not apply, so the court focused on the restriction imposed if Chin voluntarily resigned. This is the crux of the case. The tax court concluded that this risk was not “substantial” given its conclusion that Hume would have been unlikely to enforce the shareholder restrictions on the stock in the event Chin voluntary resigned. The tax court based this decision on Chin’s early role in the company and the close relationship between Hume and Chin. The appeals court accepted this conclusion.
Structuring Stock Compensation
The takeaway is that stock restrictions have to be carefully considered in determining whether it is subject to a substantial risk of forfeiture. The regulations should be reviewed as they contain detailed rules that help clarify these rules. But the regulations (and case law) cannot be relied on in isolation. For restrictions such as voluntary resignation terms, facts, such as the close relationship identified in this case, should be considered in determining whether the risk is substantial.
It should also be noted that the appeals court did not have to address the investor vs. employee compensation issue in this case. This is yet another hurdle that taxpayers seeking to deduct this type of expense from a prior year have to overcome. This is especially true where the employees pay for their stock rather than being awarded stock pursuant to an established plan or arrangement based on some pre-defined criteria.
Taxpayer Retains Right to Tax Refund Claims Despite Bankruptcy Discharge
The bankruptcy-tax rules can present a number of opportunities. In Martin v. United States, Case No. 3:13-CV-03130 (C.D. Ill 2017), the court concludes that the taxpayers retained the right to sue the IRS for substantial tax refunds for taxes that were overpaid prior to their bankruptcy, despite having discharged the their debts in bankruptcy.
Bankruptcy & Tax Refunds, Generally
Typically, a taxpayer will want to include unpaid tax debts in their bankruptcy case. With a Chapter 7 bankruptcy, this may allow the unpaid taxes to be discharged. With a Chapter 13 case, this will allow the unpaid taxes to be paid through the bankruptcy rather than surviving the bankruptcy.
The motivations for tax overpayments or refunds may be different. If the tax refund is included in the bankruptcy, it is part of the bankruptcy estate that is available to pay creditors. Pre-petition tax refunds received before the bankruptcy petition may be used to pay the secured creditors before the bankruptcy petition, with the aim of ensuring that it does to pay off the secured creditors first. Tax refunds received after the bankruptcy filing can be more problematic.
Taxpayers cannot simply fail to include a tax refund claim for taxes paid prior to the bankruptcy in their bankruptcy. To the extent the refund claim was not known at the time the bankruptcy was filed, the unreported tax refund claim remains an asset of the bankruptcy estate. The bankruptcy trustee is the party who has the ability to file the refund claim and to receive the proceeds. If the bankruptcy is already closed at the time the refund claims are discovered, the bankruptcy trustee has to re-open the bankruptcy to try to collect on the refund claims.
Martin v. United States
In Martin v. United States, the bankruptcy trustee did not file the taxpayers’ amended returns or tax refund claims. The taxpayers did. They did so before the bankruptcy case had been closed (they also filed corrected amended returns after the bankruptcy case had been closed). The IRS audited the refund claims and denied the claims (it appears that one of the tax years may have been allowed by the IRS, but this is not addressed in the court case). The IRS Office of Appeals also denied the claims. The taxpayers, not the bankruptcy trustee, then filed a lawsuit against the IRS to recoup the refunds. The bankruptcy trustee re-opened the bankruptcy case at that point. This was required given the undisclosed tax refund claims. The bankruptcy trustee then abandoned the tax refund claims (after giving creditors notice, etc.).
Can Taxpayers File Tax Returns and Bring Suit
The government moved to dismiss the taxpayers’ lawsuit, asserting that the taxpayers did not have standing to bring suit. This turned on whether the taxpayers, not the bankruptcy trustee, had the authority to file a refund claim, as the law requires taxpayers to file a refund claim prior to bringing a lawsuit to recoup the refund.
The law is not clear on this point. In reviewing this law, the court noted that once the bankruptcy trustee abandoned the refund claim, the refund claim reverted back to the taxpayers as if the bankruptcy case did not exist. Based on this, the court concluded that the taxpayers had the right to file the refund claims and to bring the lawsuit to collect on the claims.
The takeaway is that taxpayers who discover tax refunds during or after a bankruptcy case should file the refund claims, even if the bankruptcy trustee will not do so. It may help if timing wise, as in Martin, the claims are disallowed by the IRS at the administrative level. This may encourage the bankruptcy trustee to abandon the claims, rather than incur the costs to pursue them. The abandoment will cause the refund claims to revert back to the taxpayer, rather than the bankruptcy estate.
Cease-and-Desist Order Not Sufficient Evidence for Bad Debt Deduction
In Sensenig v. Commissioner,T.C. Memo. 2017-1, the court considers whether an investment fund is entitled to a bad debt deduction for cash-hungry start-up companies the fund had invested in when securities regulators barred the investment fund from raising money needed to sustain the start-up companies. The court considers whether the receipt of a cease-and-desist order from the state regulator is a triggering event that establishes that the start-up companies were worthless in the year the order was received.
The Facts & Procedural History
The facts and procedural history are as follows:
- The taxpayer operated a business that raised money to invest in start-up companies.
- In return for the money his business invested, the taxpayer would acquire an equity interest in the start-up companies and he acquired financial control over each of the companies by becoming a director, a bank account signatory, the chief financial officer, and the tax return preparer.
- The taxpayer had raised $50 million from third parties to invest in these start-up companies.
- The taxpayer’s business invested in 15-20 start-up companies.
- The Pennsylvania Securities Commission (“PSC”) determined that the practice of issuing demand notes to investors in return for receipt of borrowed funds constituted the sale of unregistered securities.
- In June of 2005, the PSC issued the taxpayer an order to cease and desist the offering and sale of unregistered securities.
- In January 2006 the PSC accepted the taxpayer’s offer of settlement and rescinded the summary order to cease and desist.
- The taxpayer and his fund were permanently barred from offering or selling securities in Pennsylvania unless he received a valid registration statement.
- The taxpayer took steps to try to register with the U.S. Securities and Exchange Commission, but it proved too costly and he abandoned the effort.
- The taxpayer claimed a $10,695,581 bad debt loss on his 2005 tax return for three of these start-up companies.
- The IRS audited the taxpayer’s return and disallowed the loss.
Debt vs. Capital Contribution
The court started by considering whether the monies advanced to the start-up companies were even a debt. The court considered the factors that indicate whether an advance is a loan or a capital investment:
(1) the intent of the parties;
(2) the identity between creditors and shareholders;
(3) the extent of participation in management by the holder of the instrument;
(4) the ability of the corporation to obtain funds from outside sources;
(5) the thinness of the capital structure in relation to debt;
(6) the risk involved;
(7) the formal indicia of the arrangement;
(8) the relative position of the obligees as to other creditors regarding the payment of interest and principal;
(9) the voting power of the holder of the instrument;
(10) the provision of a fixed rate of interest;
(11) a contingency on the obligation to repay;
(12) the source of the interest payments;
(13) the presence or absence of a fixed maturity date;
(14) a provision for redemption by the corporation;
(15) a provision for redemption at the option of the holder; and
(16) the timing of the advance with reference to the organization of the corporation.
Weighing these factors, the court concluded that the money advanced by the investment fund were capital investments. This precluded from taking a bad debt deduction.
Whether the Cease-and-Desist Order Establishes Worthlessness
The court then assumes that the advances were debt, to consider whether the loans were worthless if the advances were debt.
The taxpayer argued that the securities regulators shut down his investment activity with the June 2005 cease-and-desist order and he lacked additional funds with which he could keep the companies going. According to the taxpayer, it was obvious that the companies were therefore doomed and that the loans from the investment funds to them became worthless.
The court noted that the receipt of the cease-and-desist order was significant, but that this fact alone was not sufficient to establish that the debt was worthless. The court asked the taxpayer to provide evidence of the companies finances as of 2005. The taxpayer failed to do this, which resulted in the court concluding that the debt was not worthless.
It should be noted that the taxpayer could also be entitled to take a deduction for worthless securities for its investment in the start-up companies. It does not seem that this worthless securities deduction would have been available in 2005 either, as the start-up companies were still operating in 2005.
Bad debt and worthless securities deductions are often timing issues. The question is what year is the deduction allowable. For investment funds, the takeaway from this case is that the receipt of a cease-and-desist order from a state regulator alone is not a sufficient triggering even to establish worthlessness. The taxpayer also needs to show financial records to prove that the start-up companies were worthless in the same year that the cease-and-desist order was received.
S Corporation Owner Subject to Self-Employment Tax
Taxpayers often establish Subchapter S corporations to avoid Social Security and Medicare taxes on a portion of their earnings. This is a very common arrangement. In Fleischer v. Commissioner, T.C. Memo. 2016-238, the taxpayer was not able to avoid these taxes using a Subchapter S corporation. The case provides an example of how the Subchapter S corporation must be structured to avoid these taxes.
Facts & Procedural History
In Fleisher, the taxpayer was a financial planner. He entered into an agreement with a broker and an insurance company to sell their products to his clients. He signed the agreements in his individual capacity. The taxpayer had also formed a legal entity. He chose to have the entity be taxed as a Subchapter S corporation. The taxpayer entered into an employment agreement with the business. The taxpayer reported his earnings on the S corporation tax return (the Form 1120S) and he reported the flow through wages and distribution on his personal tax return (the Form 1040). The taxpayer did not report any self-employment tax on his personal tax return. The IRS audited the taxpayer and concluded that his income and expenses should have been reported on his personal tax return, and not on the legal entity’s tax return. If the IRS’s position was correct, this would subject a large portion of the business income to self-employment tax.
Subchapter S Corporations and Income and Self-Employment Taxes
Subchapter S corporations are not subject to income tax. Rather, they file an information return and report their income, expense, etc. which flow through to, and are reported on, the shareholder’s personal tax returns. The shareholder also reports any wages that are paid to him by the corporation.
The shareholder can classify a portion of the S corporation’s income as wages and a portion as a distribution. The wage portion is subject to self-employment tax, which includes both Social Security and Medicare taxes. The distribution portion is not.
Compare this to a sole proprietorship or single-member limited liability company. These businesses are disregarded for federal income tax purposes. The items of income, expense, etc. are reported on the taxpayer’s individual tax returns. The business income is subject to self-employment tax, which, again, includes both Social Security and Medicare taxes.
Whether the Income and Expense Belong to the Subchapter S Corporation
The question for the court was whether the taxpayer’s income and expenses should be reported by the legal entity, resulting in less self-employment tax, or reported by the taxpayer on his personal tax return.
The court noted that there are two factors to consider in answering this question:
- the individual providing the services must be an employee of the corporation whom the corporation can direct and control in a meaningful sense and
- there must exist between the corporation and the person or entity using the services a contract or similar indicium recognizing the corporation’s controlling position.
The court determined that neither element was satisfied in this case. It based this decision on the fact that the taxpayer signed the brokerage and insurance contracts in his personal capacity. He did not sign the contracts on behalf of the business. This meant that the brokerage and insurance companies were paying the taxpayer, not his legal entity. They also reported the income to the IRS in the taxpayer’s name, not in the business’ name. To the court, this meant that the business did not control the taxpayer. Accordingly, the court determined that the income and expenses should have been reported on the taxpayer’s personal tax return.
The takeaway is that business owners need to ensure that their contracts are entered into in the name of the busienss,the income is paid to the business and not the individual owner, and the income is reported to the IRS as having been paid to the business and not the individual owner.
IRA Funds to Settle a Probate Dispute
Inherited IRAs can present a number of challenges. In Ozimkoski v. Commissioner, T.C. Memo. 2016-228, the court considered the tax implications of a withdraw from an inherited IRA that was used to settle a probate dispute with the couple’s son. The case shows what not to do when using IRA funds to settle a probate dispute.
Facts & Procedural History
The facts and procedural history of the case are as follows:
- The taxpayer’s husband died and his will left all of his assets to the taxpayer.
- The couple’s son contested the husband’s will.
- The bank that held the husband’s IRA froze the account pending the outcome of the litigation.
- The taxpayer eventually entered into a settlement agreement whereby her son was to be paid $110 thousand.
- The bank transferred $235 thousand of the husband’s IRA into the taxpayer’s IRA.
- The taxpayer then took at $141 distribution from her IRA and wrote a check to her son for $110 thousand settlement payment.
- The taxpayer reported the $141 thousand distribution and paid tax on it. She did not report a 10 percent addition to tax on the $141 thousand distribution.
- The IRS assessed a 10 percent additional tax on the $141 distribution from the taxpayer’s IRA.
The Tax and Addition to Tax for Early Withdrals
Taxpayers must pay tax on distributions they receive from IRAs. Taxpayers are also subject to a 10 percent additional tax on withdraws from IRAs if the withdraws are taken before the taxpayer reaches age 59-1/2. There is an exception to the 10 percent additional tax for withdraws by a surviving spouse from the deceased spouse’s IRA if the distributions are made due to the decedent’s death. The taxpayer argued that this exception applied and that she was not subject to the 10 percent additional tax. This was the primary issue addressed by the court.
As noted in the case, the courts have previously concluded that:
once the assets in the decedent’s IRA were transferred into the taxpayer’s IRA, any subsequent distributions were no longer occasioned by the decedent’s death and were not made to the taxpayer as a beneficiary of the decedent; therefore, the exception … did not apply.
In applying this rule, the court determined that the taxpayer was liable for the 10 percent additional tax.
Avoiding the Tax and 10 Percent Addition to Tax
With a little foresight, the taxpayer could have avoided the tax and the 10 percent addition to tax altogether. Had the taxpayer not transferred the $235 thousand to her account, but had instead left it in her husband’s IRA and paid the $110 thousand to her son directly from her husband’s IRA, she would not be subject to tax on the distribtion and the 10 percent penalty would not have applied.
The taxpayer could have rolled part of her husband’s IRA into an inherited IRA for her son. With this arrangement, the son would have had to start taking distributions from the IRA immediately or within 5 years and the distributions would be subject to tax. It appears that the taxpayer’s son was aware of this rule, as the son had told the bank that he did not want an inherited IRA. With the settlement, the son was able to receive $110 thousand free of any tax, while shifting the liability for the tax and addition to tax to his mother.
Proof of Cash on Hand to Abate Failure to Pay Penalty
The failure to pay penalty is one of the most commonly assessed penalties. The penalty does not apply and can be abated or removed if the taxpayer can establish that the failure to pay is due to reasonable cause and not to willful neglect. In C1 Design Group, LLC v. United States, 1:15-cv-146-CWD (D. Ohio 2016), the court considered the taxpayer’s proof of cash on hand to establish reasonable cause for abating the failure to pay penalty.
Reasonable Cause for Failure to Pay
In the C1 Design Group court case, the IRS filed a motion for summary judgment arguing that the taxpayer could not establish that its failures to timely pay were due to reasonable cause. The court considered several prior court cases to determine whether the facts could establish reasonable cause. The court summarized these cases as follows:
- Van Camp & Bennion, P.S. v. United States, 70 F. App’x 937 (9th Cir. 2003)
The taxpayer corporation failed to timely pay its employment taxes due to a shareholder’s illness, which resulted in the taxpayer’s decrease in income—the income that was reported, the taxpayer alleged, was necessary to pay expenses to keep the business open. The United States Court of Appeals for the Ninth Circuit affirmed the district court’s finding on summary judgment that the taxpayer did not prove it exercised ordinary business care and prudence in providing for its tax liability. In support of its decision, the district court found: (1) the taxpayer was receiving large monthly deposits that were sufficient to meet its tax obligations; (2) during the relevant tax years it paid its president over $100,000 per year; and (3) the taxpayer’s tax obligation was given “very low priority in comparison to the other expenses associated with the operation of the [business].
- Fran Corp v. United States, 164 F.3d 814, 815 (2d Cir. 1999)
The taxpayer failed to make timely employment tax payments, and alleged that its payments were late because it had not been paid on two of its largest contracts. The Second Circuit affirmed the district court’s finding that the taxpayer did not prove it exercised ordinary business care and prudence during its period of financial difficulty, because the taxpayer lavishly spent its money on rent, auto leases and repairs, and entertainment in lieu of using the money to timely pay the IRS.
- E. Wind Indus., Inc. v. United States, 196 F.3d 499, 505 (3d Cir. 1999)
[T]he Third Circuit found, contrary to the district court’s conclusion when considering the same undisputed facts, that the taxpayer could prove it exercised ordinary business care and prudence based on: (1) all income received by East Wind on government contracts was used to pay either the IRS or employee wages; (2) East Wind “did not pay suppliers, rent, health and welfare premiums, employees’ union dues, and workers’ compensation insurance premiums;” (3) utility companies were not paid until the companies threatened to shut off service; (4) East Wind did not pay any of its suppliers from 1982-96, which was over $7 million owed; (5) [the president] secured a mortgage on his personal residence and sold personal assets to obtain cash to pay creditors; (6) East Wind’s bookkeeper provided a $65,000 loan of her personal funds to the business; and (7) [the president] sought legal and financial advice as to the bribery scheme and cash flow issues.
In considering the facts in C1 Design Group in light of these cases, it concluded that the taxpayer may be able to establish reasonable cause. So the IRS’s motion for summary judgment failed for this reason.
Proof of Cash on Hand
The IRS also argued that the taxpayer could not establish reasonable cause because it did not provide proof of the cash it had on hand at the time the taxes were not paid. That the argument was raised by the IRS for the first time in court shows that the IRS did not have the necessary evidence to refuse to abate the penalty in the first place. This suggests that the IRS simply denied the taxpayer’s abatement claim without any real consideration.
The court, which is not in the Ninth Circuit, cited the Ninth Circuit’s Van Camp & Bennion case cited above and other Ninth Circuit cases that followed Van Camp & Bennion for the proposition that the taxpayer has to provide this proof. It concluded that “the case law to require[s] the taxpayer to produce evidence of the cash it had on hand when its excise taxes were due toward meeting its burden of establishing reasonable cause.”
The court allowed the taxpayer to admit evidence of its cash on hand. The court accepted the taxpayer’s financial statements and the inference from the IRS’s arguments (that the taxpayer had cash on had to pay other creditors) to establish that the taxpayer had sufficient cash on hand. The court concluded that this evidence was enough to survive summary judgment.
If a business has or expects to have a significant debt, it may transfer its assets and/or operations to a new business entity to try to avoid the debt. There are a number of non-tax cases where the courts have addressed this. The courts generally apply a “continuation” theory in these cases which asks whether the subsequent business is a successor to the prior business. In Eriem Surgical, Inc. v. United States, No. 14-3540 (7th Cir. 2016), the court addressed this type of continuation theory in the context of unpaid taxes.
The Facts and Procedural History
The Eriem case involves a business that did not pay its taxes (“Business 1”). The individual owner in the case had owned 40% of Business 1. The individual’s wife formed a new business entity (“Business 2”) the day after the Business 1 went out of business. Business 2 then purchased the assets and inventory of Business 1. Business 2 took over the office space, hired the employees of, used the website and phone number for, and was in the same business as Business 1.
According to the IRS, Business 2 was a successor to Business 1. The IRS made this argument even though:
- Business 1 was owned by the husband and Business 2 was owned by his wife.
- The individual who owned Business 2 had only previously owned 40% of Business 1.
- Business 1 was not in exactly the same business as Business 2.
The IRS then levied on Business 2’s assets for the unpaid taxes owed by Business 1.
Business 2 brought a wrongful levy suit against the IRS.
The issue for the court was whether Business 2’s assets could be taken to satisfy Business 1’s tax liability. The trial court applied Illinois state law, which employs a multi-factor balancing standard to determine business successorship. In applying this standard, the trial court concluded that Business 2 was the successor of Business 1.
On appeal, the Seventh Circuit agreed with the trial court. It interpreted the prior Illinois law as saying that a complete change of ownership prevents a finding of successorship, not that complete identity of ownership is essential to successorship.
What Law Applies
Whether state or Federal law applies has been the subject of several prior cases. The Seventh Circuit summarized the cases as follows:
The Supreme Court has never decided whether state or federal law governs corporate successorship when the dispute concerns debts to the national government. One might infer from United States v. Kimbell Foods, Inc., 440 U.S. 715 (1979), that federal law controls but generally absorbs state law, unless it is hostile to national interests. But, a generation after Kimbell Foods, the Supreme Court noted a conflict among the circuits on the subject and postponed its resolution, in an opinion that did not cite Kimbell Foods. See United States v. Bestfoods, 524 U.S. 51, 63 n.9 (1998). The next year the Court held in Drye v. United States, 528 U.S. 49 (1999), that in tax cases state law determines the taxpayer’s rights in property that the IRS seeks to reach, while federal law determines which of those rights the IRS can collect on.
With respect to business succession, there are states where the law says that one business is not liable for the debts of another business absent an express agreement to assume the liability. Texas provides an example of this.
If Texas law had applied in Eriem, the IRS might not have prevailed using a continuation theory. It may have had to pursue the successor business using transferee liability or even by challenging the prior business using state or Federal fraudulent transfer laws. These options would be more difficult for the government than simply issuing an administrative levy on bank accounts or other assets as it did in this case.