A taxpayer’s relief from indebtedness is generally a taxable event. However, where Section 351 applies to a contribution of assets to a corporation for stock, the corporation’s assumption of liabilities may or may not be taxable under Section 357.
Section 357(a) states assumptions of indebtedness pursuant to a Section 351 transaction generally do not trigger gain. However, subsections (b) and (c) have important exceptions. Subsection 357(b)(1) provides where transfers are made either to avoid Federal income tax on the exchange or with no bona fide business purpose, the taxpayer is treated as if it received cash equal to the assumed debt. Section 357(b)(2) provides the burden is on the taxpayer to prove by the clear preponderance of the evidence that Section 357(b)(1) should not apply.
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Section 1361(b)(1) provides a corporation can qualify for taxation as an S corporation only if none of its owners are nonresident aliens, foreign entities, partnerships, corporations, or ineligible trusts. An S corporation shareholder generally must be a U.S. resident individual, but there are several exceptions.
Section 1361(b)(1)(B) allows decedent’s estates, eligible trusts, and certain charitable organizations to own S corporation stock. The trusts eligible to own S corporation stock include grantor trusts under Subpart E (which are disregarded as separate from their grantor for income tax purposes), electing small business trusts (ESBTs), certain voting trusts, and qualified subchapter S trusts (QSSTs). Trusts must have specified provisions and beneficial owners to be ESBTs or QSSTs.
Subject to the origin of the claim test, most judgments or settlements paid by a business are fully deductible as ordinary and necessary business expenses under Section 162(a). However, one exception is in Section 162(f), which provides “no deduction otherwise allowable shall be allowed under this chapter for any amount paid or incurred (whether by suit, agreement, or otherwise) to, or at the direction of, a government or governmental entity in relation to the violation of any law or the investigation or inquiry by such government or entity into the potential violation of any law.” This fine or penalty exception is defined broadly to include almost any payment made to a governmental plaintiff. It prevents a subsidy in the form of tax deductions for payments to governmental entities for violations of law.
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I. Sections 453 and 1042 Deferral Provisions Can Apply in the Same ESOP Transaction; Berman vs. Commissioner, 163 TC No. 1 (2024).
In 2002, Mr. and Mrs. Berman sold their closely held C corporation stock to an ESOP for promissory notes. They did not receive any sale proceeds in 2002. They purchased qualified replacement property (“QRP”) in an amount equal to or exceeding the gain on the sale of stock to the ESOP. However, some of the QRP purchases did not occur until after the 12-month QRP replacement period. The Bermans elected pursuant to Section 1042 to defer recognition of the entire gain on the ESOP sale. They reported no taxable income from the stock sale to the ESOP.
In 2003, each of Mr. and Mrs. Berman received approximately $450,000 under the ESOP promissory notes. The Bermans used their QRP as collateral for a 90% loan, allowing the lender to keep the remaining 10% as a loan fee. The Bermans later conceded the cash-out loan they collateralized with their QRP was a disguised sale of the QRP. The IRS took the position the cash-out loan caused the Section 1042 deferred gain to be fully recognized in 2003 under the recapture rule of Section 1042(e). The Bermans took the position their 2003 gain should be limited to the $450,000 payments under the installment notes.
The Tax Court agreed with the Bermans. The court stated Sections 453 and 1042(a) are not mutually exclusive. Section 1042 acts to defer gain that otherwise would be recognized under the installment method. By not reporting any of the gain in 2002, the Bermans did not elect out of Section 453, thus allowing the deferral of gain until future note payments were received.
The doctrine of equitable recoupment applies to both assessment by the IRS (in Section 6501) and refunds by taxpayers (in Section 6511) where the IRS or taxpayer may characterize a transaction, item, or event in a different way in open tax years than it was characterized in a closed year. Inconsistencies between open and closed tax years may whipsaw either the government or the taxpayer. The courts, recognizing potential abuse, have provided a defense against this potential inconsistent treatment through the doctrine of equitable recoupment.
Pursuant to Rev. Proc. 2001-43, recipients of unvested profits interests are treated as partners on the date of grant regardless of whether they make Section 83(b) elections. Therefore, when the profits interest later vests, there is no additional income provided the parties meet the requirements of Rev. Proc. 2001-43 and Rev. Proc. 93-27. Since the owners of profits interests are treated as partners, they can be allocated income and loss prior to vesting despite the ultimate substantiality of such allocations under the Section 704(b) regulations being unclear at the time of the allocation. That creates a potential problem: What happens if the profits interest is forfeited after such allocations? That is a common occurrence, as employers often require forfeiture of unvested profits interests upon the partner’s leaving the employment of the partnership.
Rev. Proc. 2001-43 does not address forfeiture. The forfeiture of a partnership interest could be taxable to the remaining partners if they are treated as receiving a share of partnership assets from the forfeiting partner under an aggregate theory of partnership. See Treas. Reg. § 1.721-2(e) (authorizing treatment of partnerships as an aggregate of its partners where appropriate). However, the taxation of capital shifts is unsettled.
In 2005, Treasury issued proposed regulations under Section 704(b) to clarify the treatment of the forfeiture of unvested profits interests. Under the proposed regulations, a capital shift that occurs upon forfeiture is taxable to the other partners only to the extent taxable income was previously allocated to the forfeiting partner. The proposed regulations would require allocations of loss to the forfeiting partner in the year of forfeiture equal to the excess of prior non-taxed distributions over the amount paid for such interest (typically zero) minus the cumulative net income allocated to the forfeiting partner during prior years. Prop. Reg. § 1.704-1(b)(4)(xii)(c). These special allocations work to undo the prior tax treatment of the profits interest holder with offsetting allocations. Similarly, offsetting allocations to the remaining partners are required by the proposed regulations, usually income allocations that offset loss allocations made to the forfeiting partner. Thus, the proposed regulations sometimes treat the forfeiture of a nonvested profits interest as a taxable event for the remaining partners. Although the proposed regulations have not been finalized, many operating agreements incorporate their rules to resolve the treatment of a forfeiture of a nonvested profits interest.
John G. Hodnette is an attorney with Fox Rothschild, LLP in Charlotte.
I. Conservation Easement Charitable Deduction Limited to Taxpayer’s Basis in Ordinary Income Property; Oconee Landing Property vs. Commissioner, TC Memo 2024-25.
Oconee Landing Property, LLC claimed a charitable contribution deduction of almost $21 million for its donation of a conservation easement on property it owned in Georgia. The IRS disallowed the entire deduction. The Tax Court held the charitable contribution failed in its entirety for two reasons. First, the appraisers were not qualified appraisers, which meant Oconee failed to attach a qualified appraisal to its tax return. Second, because the property on which the easement was granted was ordinary income property, the amount of the charitable contribution was limited to Oconee’s basis in the donated property. Because Oconee could not prove its tax basis in the property exceeded zero, its charitable contribution was zero.
The assignment of income doctrine was established in Lucas v. Earl, 281 U.S. 111 (1930). It is a judicial doctrine that requires income earned by a taxpayer to be taxed to the taxpayer regardless of to whom it is paid. In Lucas, the taxpayer assigned to another individual his right to receive a payment for services. In Blair, 300 U.S. 5 (1937), the Supreme Court confirmed the doctrine applies to income arising from property as well as service income.
The anticipatory assignment of income doctrine is a longstanding “first principle of income taxation.” Commissioner v. Banks, 543 U.S. 426, 434 (2005) (quoting Commissioner v. Culbertson, 337 U.S. 733, 739–40 (1949)). The doctrine ensures income is taxed “to those who earn or otherwise create the right to receive it,” Helvering v. Horst, 311 U.S. 112, 119 (1940). Tax cannot be avoided “by anticipatory arrangements and contracts however skillfully devised,” Lucas v. Earl at 115.
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Section 409A addresses the taxation of nonqualified deferred compensation plans. A nonqualified deferred compensation plan is any arrangement that provides for the deferral of compensation, subject to exceptions. Section 409A is a response to executive compensation practices Congress felt were inappropriately beneficial.
Amounts deferred that do not meet the requirements of Section 409A generally are immediately includible in gross income (to the extent not subject to a substantial risk of forfeiture or previously included in income). Additionally, a 20% excise tax is imposed on the amount included in income. Interest at the federal penalty rate plus 1% is charged from the date of each failure. All such amounts are charged to the employee, rather than for the employer.
Tax practitioners are familiar with Subchapter C (C corporations), Subchapter K (partnerships), and Subchapter S (S corporations) but are generally less familiar with Subchapter T (§§ 1381-1388), which governs the taxation of cooperatives.
A cooperative is an association otherwise taxable as a C corporation that markets, purchases, or performs business functions for its patrons on a cooperative basis. The means of production and distribution are owned in common. The earnings revert to the members in proportion to their patronage (i.e., in proportion to the amount of business each member transactions with it). The predominant features of a cooperative are: (i) subordination of capital, (ii) democratic control, and (iii) proportionate allocation of profits. Cooperatives developed as a legal concept in 19th century England. In the United States, cooperatives were exempted from taxation as far back as 1916. The policy behind such exemption is cooperatives, unlike traditional corporations, are merely agents or conduits of their patrons so income should flow directly to patrons rather than being taxed to the cooperative.
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