By Keith A. Wood

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.

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By John G. Hodnette

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.

By John G. Hodnette

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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By John G. Hodnette

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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By Keith A. Wood

I. Thanksgiving Holiday Extends the Due Date for Filing Tax Court Petition; Sall vs. Commissioner, 161 T.C. No. 13 (2023).

Mr. Sall received a notice of deficiency dated August 25, 2022, which was sent to Mr. Sall by certified mail on August 26. The 90th day after August 26 was Thursday, November 24, Thanksgiving Day. The face of the notice of deficiency stated that “the last day to file a petition with the US Tax Court” was Friday, November 25, 2022. Although the Tax Court’s electronic filing system through Dawson was operational and accessible throughout the entire Thanksgiving week, the Tax Court was closed from Thanksgiving Day until the following Monday. Mr. Sall mailed his petition to the court on Monday, November 28, 2022. The court received Mr. Sall’s petition on Thursday, December 1, 2022.

The IRS filed a motion to dismiss on the basis that the petition was filed late, since according to the IRS, the filing deadline was November 25, 2022. The court, however, concluded the petitioner’s due date was no earlier than Monday, December 12, 2022, which was long after the court received Mr. Sall’s petition. The court navigated the rules of Section 7451 to conclude the filing deadline was extended from Friday, November 25 through Monday December 12, 2022. Even though the electronic Dawson filing system was operational throughout Thanksgiving week, the court was officially closed on Thursday, November 24 and Friday, November 25. Under Section 7451(b), the statute of limitations for filing a Tax Court petition is tolled by “the number of days within the period of inaccessibility, plus an additional fourteen days.” Section 7451(b)(1).

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