Archive for April, 2011

In purchase agreements, it is common to see part of the purchase price placed into an escrow account, to be released to the seller at a future date upon the occurrence of some contingency. Buyers often choose to place funds in escrow to guarantee the performance of the seller or to protect themselves from unknown liabilities. For the seller, a properly structured escrow may defer some of the gain on the sale until the escrowed funds are released.

However, a cash basis taxpayer need not actually receive the purchase price for it to be taxable. In fact, the regulations under Section 446 require that a cash basis taxpayer pay tax on income in the year it is actively or constructively received.

The concept of constructive receipts becomes tricky when dealing with escrowed amounts. Generally, when cash or property is placed in escrow and the taxpayer receives no right to control the assets, the courts and the Service have held that the amounts are not taxed until the contingency is met and the funds are released. However, if the taxpayer exercises a considerable degree of domination and control over the assets in escrow, the amounts in escrow have generally been treated as having been constructively received by the seller and taxed accordingly.

This creates a problem for two reasons. First, if the seller is deemed to have constructively received escrowed amounts, he will recognize gain without having the ability to liquidate the escrowed assets and pay the tax. In addition, if the escrowed amounts are not cash, but rather an asset with a fluctuating value like stock, the seller may recognize gain based on the FMV of the stock at the date of the closing, even though the value may be considerably less when subsequently released from escrow.

Last week, the Eleventh Circuit decided U.S. v. Fort, 107 AFTR 2d 2011-739 (Eleventh Circuit, 2011)  a case that illustrates the factors the IRS and courts will consider in determining if stock placed in escrow will be treated as having been constructively received by the seller.

In Fort, the taxpayer was a partner in Ernst & Young’s IT consulting business. The partners sold the business to Cap Gemini, a French corporation, in exchange for Cap Gemini stock, and signed an employment agreement to work for a new entity owned by Cap Gemini. Important details relative to the stock proceeds include:

  1. The stock was placed into an individual account in Fort’s name at Merrill Lynch, effectively acting as an escrow.
  2. The stock could not be withdrawn from the Merrill account and sold by Fort for four years and 300 days following closing. This was done to prevent all of the E&Y partners from selling the Cap Gemini stock at once and diluting its value.
  3. During the time the stock was restricted, Fort had full dividend and voting rights.
  4. The restricted shares would be forfeited upon three conditions: If Fort terminated his employment, violated his employment agreement, or was fired for cause.
  5. In the event Fort was terminated for “poor performance”, he could forfeit 50% of the restricted shares, but could also receive all of the shares pending a review.

Fort initially reported the value of the stock as having been constructively received in 2000, the year of the sale. After later discovering that some of his former E&Y partners had filed amended returns to remove the escrowed value from the 2000 return, however, Fort followed suit.

The Eleventh Circuit agreed with the District Court that Fort had constructively received the escrowed stock in 2000. Referenced a string of similar cases featuring other selling partners of the E&Y IT consulting group, the Eleventh Circuit cited the following factors in its decision:

  1. As the stock was paid into a Merrill Lynch account in Fort’s name, Fort was merely postponing unrestricted access to the shares. According to the courts, “a taxpayer’s willingness to defer consumption does not defer taxation…The fact that the partners risked having to return some of their shares at a later time does not mean that they did not constructively receive the shares in the first place.”
  2. Fort bore the risk that the restricted shares would increase or decrease in value. This was an indiciationof control over the escrowed stock.
  3. Fort had both dividend and voting rights over the restricted stock.
  4. Since the shares would only be forfeited if Fort quit, violated his contract, or was fired for cause, Fort ultimately had complete control over whether he’d receive the stock.

The Eleventh Circuit dismissed Fort’s argument that he did not have “control” over the restricted stock because he would forfeit them if fired for poor performance. Fort argued that “poor performance” meant “any reason at all,” meaning Fort ultimately had no control over whether he’d get the stock, as Cap Gemini could fire him at their will.

The court saw things differently, arguing that “poor performance” was just that. Since Fort was in control of his performance, he was in control over whether he would be terminated and forfeit the shares.

The lesson here is obvious. The E&Y guys were bright and tax-savvy. They clearly amended their 2000 returns on sound advice that the restricted stock was not constructively received until the restrictions were lifted. The fact that they were wrong reflects just how uncertain the constructive receipt doctrine remains when dealing with escrowed funds. Careful consideration should be given to any escrow arrangement if the goal of the parties is to defer taxation on the escrowed amounts. A seller will obviously want some degree of control over the escrowed funds to protect their proceeds; too much control, however, will accelerate income recognition.

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It’s only April 20th, so unless your scribbled “NO HABLO INGLES” in crayon across the front page of your Form 1040, you probably haven’t heard from the IRS regarding your 2010 tax return.

Should you one day wake to find a missive from the Service in your mailbox, however, USA Today has some helpful tips on how to handle it. For obvious reason, I’m partial to the suggestion “Get Help.”

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OK, technically that may not be accurate, but statistically speaking, it’s true. According to the nonpartisan Tax Policy Center and via CNN.com, 45% of all households will not pay income tax in 2010. So feel free to shake an angry fist towards Old Man Jensen’s house today; in all likelihood he’s resting easy while your feverishly packaging up your loose change to send to Uncle Sam.

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As the saying goes, no good deed goes unpunished.

Congress enacted the first-time homebuyer credit — which has ranged in value from $6,500 to $8,000 since its inception in 2008 — to kick-start a sluggish real estate market. While they did their best to keep the qualifications relatively simple, one basic requirement has always been that the taxpayer, you know…actually own a home. 

Despite this rather intuitive prerequisite, a recent report by a government investigator revealed that the IRS has been ripped off to the tune of $513 million in improper homebuyer credits, with many of the tax benefits finding their way to prisoners, children under 18, and other taxpayers who never actually purchased a home.

Keep in mind, this same report indicated that the IRS was successful in denying hundreds of thousands of improper claims and managed to identify 200 criminal schemes along the way, which begs the question: Did anyone in America actually deserve the homebuyer credit?

No word on how many improper credits were awarded to members of the notoriously deceitful Farming, Fishing, and Forestry industries.

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If you’re a shiftless layabout couch potato  fan of cable news, you’ve inevitably stumbled upon an advertisement for Tax Masters, featuring this fetching gentleman offering to help settle your unpaid federal tax liability.

Well, buyer beware, because ABC News recently did an expose on Tax Masters, citing accusations in two states that the company is engaging in “false, misleading, and decptive acts and practices.” If you’d like to watch the ABC News video or just continue to revel in Patrick Cox’ bearded masculinity, click here.

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President Obama seems like a nice enough guy, but he’s certainly got room for improvement on his soft skills. You’re supposed to offer the good news before you hit ’em with the bad, not the other way around.

Just days after causing a collective heart attack in America’s country clubs by proposing a $1 trillion tax increase targeting the wealthy, the President gave one back by signing into law a repeal of onerous 1099 reporting requirements added by the Small Business Jobs Act of 2010.

Long story short, it’s like the 2010 law — which would have added 1099 requirements for payments to corporations and payments for goods while greatly increasing the reporting burden for rental property owners —  never happened. 

So in general, reporting on Form 1099 is again only required when the payor is considered to be engaged in a trade or business. The most common transaction requiring reporting will be payment for services. Payments to corporations continue to be exempt.

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In CCA 201114017, the IRS addressed the question as to whether a qualified subchapter S subsidiary (” QSub”) election and subsequent deemed liquidation results in an increase in the shareholder’s basis in the parent corporation’s stock. 

Putting some numbers to the situation, assume P Co. is owned 100% by A, who has a basis in the P stock of $200. P owns 100% of S Co., a C corporation. P elects to treat S Co. as a QSub when S has assets with a basis of $10 and a FMV of $100. Can A increase his basis in P stock from $200 to $290 for the $90 gain inherent in S’s assets at the time of the QSub election?

To understand how the IRS approached this issue, and why it’s an important analysis, we have to understand some concepts that span Subchapters C and S:

1. In general, S corporations do not pay entity level tax. Instead, under Section 1366(a)(1), each shareholder reports their pro rata share of income or loss on their individual income tax return. To prevent double taxation (product placement!), shareholders are required to increase their basis in the S corporation stock by income and decrease it by losses, distributions, and nondeductible expenses.

3. Included in the positive adjustment to stock basis is an increase for tax-exempt income realized by the S corporation. Why is this? To preserve the tax-exempt nature of the income. Assume you put $100 into S Co. which S Co. invested in muni bonds, generating $2o of tax-exempt interest under Section 103. If someone wanted to buy your stock, they would likely pay $120 for it. If you did not increase your stock basis from $100 to $120 upon pass-through of the $20 of tax-exempt income, the $20 of tax-exempt interest would effectively be taxed upon the sale of the stock.

4. Under Section 1361(b)(3), an S corporation may elect to treat a 100% owned subsidiary meeting certain requirements as a QSub, in which case the subsidiary’s tax existence is disregarded and the assets and liabilities of the subsidiary are deemed to be owned by the parent.

5. The regulations provide that when a QSub election is made, it results in a deemed liquidation of the subsidiary under Sections 332 and 337.

6. Under these two code sections, the liquidation of a 100% subsidiary is not a taxable event. The parent corporation merely takes a basis in the assets of the subsidiary equal to the subsidiary’s basis prior to liquidation. The subsidiary does not recognize gain on the distribution of any appreciated assets to the parent, which is an exclusion to the general rule of Section 311(b) that treats a corporate distribution of appreciated assets as a sale. Likewise, the parent recognizes no gain upon receipt of the subsidiary’s assets.

Got all that? Good.

In CCA 201114017, the taxpayer argued that when the parent made the QSub election (#4 above) and liquidated the subsidiary (#5), since the subsidiary did not recognize gain on the appreciation inherent in its assets under Section 337 (#6), the unrecognized gain should be treated as tax-exempt income earned by the subsidiary, passed through to the parent corporation, and in turn passed through to the shareholders. As a result, the shareholders should increase their basis in the parent corporation’s stock (#3). 

The IRS disagreed. It reasoned that Section 337 is not an exemption from income, but rather a nonrecognition provision that simply effects a change in the form of a taxpayer’s property. In this case, the parent S corporation continued its investment in the subsidiary corporation, but in a different form by holding the assets directly rather than through stock ownership.

The IRS differentiates this situation from one in which an S corporation recognizes cancellation of indebtedness income that is excluded under Section 108, which was held by the Supreme Court in Gitlitz to increase the shareholder’s basis in the S corporation. In the COD context, the taxpayer has realized a clear accession of wealth by being relieved of a debt that is then being excluded under a statutory provision.

When a corporation liquidates its subsidiary, however, the combined companies are no wealthier than they were before. The IRS concluded that “tax-exempt income” for purposes of increasing a shareholder’s basis should be reserved for those items that provide a formal exclusion from an economic benefit.

So going back to our number example, A is not entitled to increase its stock basis in P from $200 to $290, because the nonrecognitoin of S’s $90 gain under Section 337 does not constitute tax-exempt income.

This ruling has important planning implications as well, as it confirms that S corporations may want to think twice before buying the stock of a corporation and then making a QSub election. In purchasing the stock, you will be paying for the net FMV of the underlying assets. If you then make the QSub election, the deemed liquidation of the newly purchased subsidiary will require the parent to take a basis in the subsidiary’s assets equal to their historical cost. With this CCA, it is clear that the Service’s position is that no step-up will be afforded to parent’s shareholders for the unrecognized gain on the subsidiary’s liquidation.

To illustrate, if a corporation acquires the stock of a company with assets having a basis of $100 and a FMV of $1,000 by paying $1,000 and then immediately makes a QSub election, all the parent corporation will have to show for its $1,000 payment is assets with a depreciable basis of $100. The $1,000 it paid for the stock “disappears.”


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