Federal Income Tax Update: Part 4

I. Termination of S Corporation Status was Inadvertent where Shares were Owned by an IRA.

In PLR 202319003, the IRS again demonstrated its willingness to grant amnesty to inadvertent S corporation terminations. The IRS waived an S termination where shares were issued to an IRA. The corporation elected to be an S corporation, but the election was invalid because one of its shareholders was an IRA. Apparently, when the S election was filed, the officers of the S corporation and the owner of the IRA did not know an IRA is not an eligible S corporation shareholder.

After the corporation learned the IRA was an ineligible shareholder, the stock was transferred from the IRA to its owner. The IRS waived the inadvertent termination and permitted the S corporation’s status as of its original incorporation date. However, as a condition of the favorable PLR, for all open years in which the S corporation had positive income, the IRA owner had to be treated as the shareholder for all purposes. Also, for any open years in which the corporation had a net loss, the IRA had to be treated as the owner of the stock.

II. IRS Waives Other Ineffective Elections and Inadvertent Terminations.

The IRS also recently issued a number of favorable PLRs forgiving ineffective S elections and waiving inadvertent terminations.

The following are some of the rulings:

Failure to File QSST Election where Revocable Grantor Trust Ceased to be Qualifying Shareholder Two Years after Shareholder’s Death. (PLR 202305004);
Failure to File ESBT Election where Revocable Grantor Trust Ceased to be Qualifying Shareholder Two Years after Grantor’s Death. (PLR 202233001);
Failure to File QSST Election. (PLR 202303002; PLR 202315004);
Failure to File ESBT Election. (PLR 202308006; PLR 202307004; PLR 202310003; PLR 202315001);
Beneficiary Failure to Consent to QSST Election. (PLR 202315002);
Late QSSUB Election. (PLR 202325001; PLR 202325006).
Second Class of Stock Problems for an LLC Making an S Election. (PLR 202302004; also see PLR 202305002 where S Election terminated when LLC filed S corp. election and then adopted new LLC Operating Agreement); and
S Corp. Stock Transferred to Ineligible Shareholder. (PLR 202234004: S Corp. stock transferred to a Section 501(a)(4) organization, but then transferred to an eligible S Corporation shareholder upon discovering Section 501(c)(4) organization is not a qualified shareholder); (PLR 202307005: S corporation stock held by ineligible S corporation shareholder transferred to a permissible shareholder).

III. Bankruptcy Trustee Allowed to Pursue Fraudulent Conveyance Claims under Section 6502 Ten-Year Collection Period and to Reverse Pierce the Debtor’s LLC Corporate Veil; In Re: Palmieri, Bankruptcy Court IL, 131 AFTR 2d (2023).

After he faced millions of dollars in outstanding tax liabilities, Mr. Palmieri made a series of transfers of his residence, called the Byron Property, to a number of trusts for the benefit of family and friends and to his own revocable living trust. The Byron Property was Mr. Palmieri’s personal residence where he lived up to the date of the bankruptcy trial. The bankruptcy trustee sought to unwind the transfers of the Byron Property under the Delaware Uniform Fraudulent Conveyance Act (the “UFCA”). Mr. Palmieri argued because any claim under the UFCA must be brought within four years after the transfer, the trustee’s claims were time barred. The bankruptcy trustee argued Section 544(b) of the Federal Bankruptcy Code allows the bankruptcy trustee to pursue fraudulent conveyance claims under the ten-year collections statute of limitations of IRC Section 6502(a)(1).

Other courts have concluded Section 544(b) allows a bankruptcy trustee to take advantage of the longer ten-year collections period as long as the IRS is a creditor in the bankruptcy case. See, e.g., In Re Musselwhite, 128 AFTR 2d 2021-6064 (Bankr. E.D.N.C. 2021). The Illinois Bankruptcy Court allowed the bankruptcy trustee to proceed under the ten-year collection statute available to the IRS since the IRS was a creditor in Mr. Palmieri’s bankruptcy proceedings.

The court also allowed the trustee to reverse veil pierce Mr. Palmieri’s Delaware LLC to reach the Byron Property. The court noted, when considering a claim for reverse veil piercing, Delaware Courts look to the same factors considered by Delaware Courts when analyzing a traditional veil-piercing claim. These factors include alter ego aspects, insolvency of the debtor, undercapitalization, commingling of corporate and personal funds, absence of corporate formalities, and whether the property owner was merely a facade for the equitable owner. Manichaen Cap. LLC v. Exela Techs, Inc., 251 A.3d 695 (Del. Ch. 2021). The court concluded the facts surrounding Mr. Palmieri’s transfers of the Byron Property to his Delaware LLC justified a reverse veil piercing remedy.

IV. Medical Office Workers were not Independent Contractors, and Employer did not Qualify for Section 530 Relief; Cardiovascular Center, LLC v. Commissioner, TC Memo 2023-64 (2023).

In Cardiovascular Center LLC, the IRS determined the LLC failed to classify some of its workers as employees. The IRS further determined the LLC was not eligible for Section 530 safe harbor relief. The LLC therefore owed significant federal employment taxes and late filing and late payment penalties.

Dr. Frank Kresock owned 100% of Cardiovascular Center LLC, which was an Arizona limited liability company. The workers at issue included Jeanine Smith, who worked as an office manager, and four medical assistants.

Applying the twenty-factor common law test, the court determined the workers were employees and not independent contractors. The workers were paid a set hourly rate; they were subject to Dr. Kresock’s direct supervision; they were expected to follow certain office procedures set by Dr. Kresock; none of the workers could realize a profit or loss from their services; there were no formal employment contracts; the workers received training from Dr. Kresock; and he supplied their work supplies and tools. All the workers worked almost every day at the medical practice, had worked there for years, and did not freely work for other employers. Dr. Kresock controlled every aspect of the workers’ services. The work performed was a central aspect of the LLC’s regular business.

The court also found the LLC did not qualify for Section 530 safe harbor relief. First, because the practice failed to issue Forms 1099 or Forms W-2 to the workers, it did not meet the Section 530 reporting requirement. Second, the LLC did not meet the reasonable basis test because it did not prove, when making its decision to classify its workers as independent contractors, it relied on at least one of the following: (1) judicial precedent or published rulings; (2) a past IRS audit upholding independent contractor treatment; or (3) long-standing recognized industry practice.

V. Determination of Deductible Reasonable Compensation; Clary Hood, Inc. v. Commissioner, 131 A.F.T.R. 2d 2023-1875 (4th Cir. 2023).

The Fourth Circuit Court of Appeals affirmed the Tax Court’s decision in Clary Hood, Inc. to reduce substantially the amount of deductible compensation paid to the founder and primary shareholder of a construction company. The court, however, rejected the imposition of substantial understatement penalties.

Clary Hood, Inc. employed its founder and primary shareholder, Mr. Hood, as its chief executive officer. Hood, Inc. was a South Carolina C corporation. The tax issue was the amount of reasonable and deductible compensation paid to Mr. Hood in 2015 and 2016. During those years, Mr. Hood received $168,000 and $196,000 in base salary, with $5 million bonuses. After considering expert testimony from Hood and the IRS, the Tax Court reduced Mr. Hood’s deductible compensation to $3.7 million for 2015 and just under $1.4 million for 2016. The court imposed the Section 6662 substantial understatement penalty for 2016 but not for 2015.

Hood, Inc. argued Mr. Hood’s compensation was reasonable based on the independent investor test established in cases such as in Exacto Spring Corp. v. Commissioner, 196 F.3d 833, 838 (7th Cir. 1999). However, the Tax Court and Court of Appeals refused to apply the independent investor test because, unlike in other circuits, the Fourth Circuit has never adopted any iteration of that test and has always applied the multi-factor approach.

The Court of Appeals upheld the Tax Court’s decision to reduce the amount of deductible compensation paid to Mr. Hood in 2015 and 2016 based on the multifactor test. The court stated, while it may be reasonable to consider the independent investor test along with other factors, the multifactor test takes more relevant factors into account, and therefore is the better test.

The Court of Appeals, however, vacated the Tax Court’s imposition of the substantial understatement penalty for 2016. The Tax Court found Hood had reasonable cause for its 2015 position, based on the advice of its accounting firm in setting Mr. Hood’s compensation. The Court of Appeals determined, since the tax advisors approved the bonus plan for both 2015 and 2016, the company’s reliance on the advice of a professional tax advisor to establish the reasonable cause defense for 2015, also should apply to 2016.

VI. Sale of Stock did not Qualify for Section 1202 Qualified Small Business Stock Exclusion because the Company did not meet the Qualified Trade or Business Requirement; Private Letter Ruling 202319013.

Taxpayer founded a C corporation software company. The company’s employees possessed technical skill and knowledge. The IRS determined, to qualify as a Section 1202 qualified small business, the C corporation must be engaged in a qualified trade or business that is defined as a trade or business other than a trade or business involving the performance of services or where the principal asset of the trade or business is the reputation or skill of one or more of its employees. Section 1202(e)(3)(A). The company’s principal asset was the reputation or skill of its key employees, notwithstanding that the company may have possessed proprietary service delivery processes and methodologies that were unique and could not be used by employees for any other employer.

VII. Tax Court Rejects NOL Carryovers, Explains At Risk Limitation Rules for Tiered Partnerships, and Concludes Partners do not Increase Tax Basis by their Own Promissory Notes; Bryan v. Commissioner, TC Memo 2023-74.

Mr. Bryan and his wife owned all of the membership interests in LLC One. In September 2007, Mr. Bryan issued a $2.7 million promissory note payable to LLC One. LLC One acquired a 20% interest in LLC Two in exchange for issuing a $2.7 million promissory note payable by LLC One to LLC Two. LLC Two secured third-party financing that was guaranteed by another member of LLC Two. Neither Mr. and Mrs. Bryan nor LLC One was personally liable for the third-party financing owed by LLC Two. The operating agreements for both LLC One and LLC Two provided members were not personally liable for debts and obligations of the LLC. Neither operating agreement contained deficit restoration obligations or any mandatory capital call provisions. For 2010, 2011 and 2012, the Bryans had NOL carryovers from 2007, 2008 and 2009.

The IRS challenged the NOL carryovers, taking the position the Bryans had insufficient tax basis in their direct and indirect LLC interests and insufficient at-risk amounts in 2007, 2008 and 2009 to support losses in those years that could be carried forward to 2010, 2011 and 2012. The Tax Court ruled neither Mr. and Mrs. Bryan nor LLC One acquired any tax basis in the LLC interests on account of the $2.7 million promissory notes delivered to the LLCs. Citing Vision Monitor Software LLC, TC Memo 2014-182, the court stated a partner’s contribution of its own promissory note to a partnership does not increase the partner’s tax basis in its partnership interest. In addition, the court ruled LLC Two’s debt owed to a third party did not increase LLC One’s income tax basis in LLC Two. The Section 752 regulations provide in cases of tiered partnerships with recourse liabilities, the amount of liabilities of a lower-tier partnership (LLC Two) that can be allocated to the upper-tier partnership (LLC One) is equal to the amount of economic risk of loss the upper-tier partnership bears as to those liabilities. Reg. § 1.752-2(i). Neither the Bryans nor LLC One had any personal liability for the third-party debt owed by LLC Two since the third-party debt was guaranteed by another member of LLC Two.

VIII. Unpaid Lease Obligations are Bona Fide Debt for Purposes of the Section 108 Insolvency Test; White vs. Commissioner, TC Memo 2023-77.

Mrs. White’s LLC obtained a $15,000 small business loan from her local bank to fund her new business. After her business failed, the local lender cancelled her debt and sent a Form 1099C to Ms. White advising her she had $14,433 of cancellation of debt income. Mrs. White agreed the forgiven small business loan constituted cancellation of debt income. However, she contended the debt was nontaxable under the Section 108(a)(I)(B) insolvency exception because her business debts exceeded the fair market value of her assets. The most significant business debts were the small business loan of $14,433 and an unpaid lease obligation of $21,700 that she included in her insolvency calculation. Mrs. White’s lease had an acceleration clause providing upon default, the entire amounts due for the remainder of the lease term ($21,700) become immediately due and payable. However, because the landlord never sought to collect the future unpaid rent from Mrs. White, the IRS contended the unpaid rent obligations for the breached lease were not true, bona fide indebtedness.

The Tax Court agreed with Mrs. White. It ruled the unpaid lease obligations constituted a legally enforceable debt, regardless of whether the landlord intended to pursue collection against Ms. White. Since the $21,700 unpaid lease obligations was bona fide indebtedness, Ms. White could include it in her insolvency calculations.

IX. Charitable Deduction for Easement Donation Limited to Donor’s Basis where Contributing Partner Held Property as Inventory; Glade Creek Partners, LLC v. Commissioner, T.C. Memo. 2023-82.

In Glade Creek, two of the former principals of International Land Consultants, Inc. (“ILC”) formed Hawks Bluff, Inc., an S Corporation, to take over a failed residential vacation community development project from ILC. ILC’s development project involved 2,000 acres of undeveloped land in Tennessee. ILC was formed in 2006, but the 2008 economic recession and real estate development crash halted its plans to develop property into a vacation community. In April 2010, ILC transferred the undeveloped property to Hawks Bluff in exchange for Hawks Bluff’s assumption of ILC debts. Hawks Bluff assumed all of ILC’s debt in hopes that Hawks Bluff could appease ILC’s creditors. Unfortunately, plans for a vacation project did not improve. In 2012, Hawks Bluff decided to pursue a syndicated conservation easement transaction to pay its debts.

Two new entities were formed to effect the easement transaction. The first was Glade Creek, LLC, which would hold the future easement property. The second was Sequatchie, which would promote the investment transaction through issuance of a private placement memorandum to investors. Sequatchie’s PPM touted the tax advantages of a qualified easement donation.

Hawks Bluff contributed the ILC property to Glade Creek in exchange for a 98% membership interest in Glade Creek. Sequatchie purchased a 91% membership interest in Glade Creek and caused Glade Creek to grant a conservation easement in the former ILC property. Glade Creek claimed a charitable contribution deduction equal to the value of the donated easement. The IRS, however, contended the amount of the charitable contribution donation was limited to Glade Creek’s tax basis in the property.

The Tax Court found Hawks Bluff and its predecessor ILC were both real estate developers. Hawks Bluff’s tax return reported the ILC property as inventory and listed the nature of its business as a real estate developer. The IRS pointed to Section 724, which treats gain or loss on the sale of partnership property as ordinary income or loss if in the prior five years the property had been inventory in the hands of the partner who contributed it to the partnership.

The court applied some of the traditional investor versus dealer tests applied by the Eleventh Circuit Court of Appeals to determine the property was inventory in the hands of Hawks Bluff (and in the hands of ILC). That meant that Glade Creek’s charitable contribution was limited to its tax basis in the conservation easement property.

The court determined both ILC and Hawks Bluff held the property as inventory in connection with their activities as developers. That meant the property remained inventory in the hands of Glade Creek. The court determined Glade Creek was bound by Hawks Bluff’s primary tax treatment on its tax returns. The court likewise determined Glade Creek did not establish either Hawks Bluff or ILC segregated the ILC property from its other real estate or Hawks Bluff’s reason for holding the property changed due to the 2008 recession.

Keith Wood is an attorney with Carruthers & Roth, P.A. in Greensboro.

October 25, 2023/by TAX