Oftentimes when a partnership plans to sell real estate, some partners want to cash out while other want to roll over into other real estate tax-free.  The challenge is that if the partnership receives cash in part to pay to the partners cashing out, then all the partners would be taxed on their percentage of that cash. 

As discussed in a prior “Did You Know,” one way to do address this is through a “drop and swap.”  Another alternative is to use a partnership installment note (“PIN”) transaction.  In a PIN transaction, the partnership sells its property to a buyer in exchange for cash (which a qualified intermediary will use to buy replacement property) and an installment note in the amount necessary to cash out the departing partners. The note could provide for payment of most of the note shortly after the sale and a small payment shortly after the end of the year.  The partnership then transfers the note to the departing partners in complete redemption of their partnership interests.

As long as at least one payment under the note is due after the end of the tax year, the gain on the note will be taxed only when the payments are received.  As a result, neither receipt nor distribution of the note by the partnership triggers tax to the partnership or the partner. The partner is taxed when he or she receives the payments from the buyer.  (Note this strategy can result in a portion of the departing partner’s gain being taxed at a 25% rate rather than 20% rate.)

Bottom Line: When some partners want to cash out while others want to defer tax, a PIN transaction may be the answer.  It may be a particularly effective solution when distribution of an interest in the property would violate loan covenants.

Intaxication: Euphoria at getting a refund from the IRS, which lasts until you realize it was your money to start with. ~From a Washington Post word contest

When an S corp seeks to wind up its affairs by selling assets in an installment sale and then liquidating, the distribution of the note along with other property (e.g., cash retained or downpayment) can trigger unintentional acceleration of tax on the deferred gain.

The Internal Revenue Code provides that an S corp may distribute an installment note to its shareholders in liquidation without triggering tax on the deferred gain from the note. However, for those seeking to take advantage of this provision, there is a trap for the unwary. The trap results from a requirement that the shareholders’ basis in their stock be allocated among the assets received pro rata based on relative value. 

For example, consider an installment sale without liquidation. Assume an S corp has one shareholder with a tax basis in her stock of $1 million, and the S corp’s only asset is land with a basis of $1 million, which it sells for $2 million consisting of $1 million cash plus a $1 million note. Under the installment sale rules, the S corp would be taxable on $500,000 of gain. The gain increases the shareholder’s basis to $1.5 million. The S corp could distribute the $1 million to the shareholder with no additional tax (since the cash distributed does not exceed the shareholder’s tax basis). 

By contrast, if the S corp distributed the cash and the note to the shareholder in liquidation, only ½ of the shareholder’s basis is allocated to the cash, and she would have taxable gain to the extent the cash exceeded ½ of her basis (i.e., $750,000). Thereby triggering tax on an additional $250,000 gain.

This unpleasant result can often be avoided using a “one-day” note. This structure pays 100% of the price with an installment note. The portion of the purchase price that otherwise would have been paid in cash at closing is paid “one day“ after (or shortly after) the S corp liquidates. The deferred gain in the note is not taxable on the distribution, and when the first payment is made, only $500,000 (rather than $750,000) of gain is subject to tax.

Bottom Line: If an S corp will receive an installment note in the asset sale and then liquidate, using a ” one-day” note can avoid accelerating tax upon liquidation.

“The trick is to stop thinking of it as ‘your’ money.” – IRS auditor

Generally, buyers of businesses want to buy assets so they can take a step up on a tax basis. Sellers prefer to sell stock, so their gain will be taxable at favorable capital gains rates. Some gain is usually taxable at higher ordinary income tax rates in an asset sale. Accordingly, S corporation owners who have been asked to sell assets typically request, and buyers typically agree to, an increase in the purchase price to account for the additional tax costs – a “tax gross-up.”

Since 2018, the federal income tax deductibility of state taxes for individuals has been limited to $10,000, but 36 states have now adopted a workaround known as pass-through entity tax elections (PTE election). A PTE election enables owners of S corporations and partnerships to have the company pay the owner’s state income tax on the income from the company. That state income tax paid by the entity is fully deductible for federal income tax purposes. The IRS approved such planning, which avoids the $10,000 limit (Ruling 2020-75). In a sale of stock, the PTE election is not available.

So, for instance, in a sale of stock with a gain of $1 million subject to 20% federal capital gains tax and 10% income tax (e.g., Minnesota’s rate), the state income tax would only be deductible up to $10,000 so the total federal and state income tax liability would be $298,000 (a savings from the state tax deduction of $2000). By contrast, if the S corporation had that same $1 million gain and 20% of that gain was taxable at ordinary income tax rates (37%), the additional tax would be 17% of $200,000 (i.e., $34,000).  If the S corporation made a PTE election and deducted the full $100,000 of state taxes paid, its tax savings of $37,000 (37% of $100,000) more than offsets the additional income tax from selling assets. Obviously, the amount of ordinary income and state income tax rates in a particular case will impact this calculation.

Bottom line. When considering an asset sale versus a stock sale and the need for a tax gross-up, don’t forget to consider the impact of a PTE election.

“When in doubt, look intelligent.” — Garrison Keillor

Earlier this year, Indiana instituted new successor liability notice requirements for sellers and buyers involved in bulk transactions of businesses and business assets in Indiana. For deals closing on or after Feb. 14, 2024, and involving transfers of more than 50% of the tangible personal property of a business, transferees may be liable for the past due Indiana taxes of transferors, including penalties, and interest, up to the amount of the purchase price or value of the tangible personal property transferred. The Indiana tax liabilities included are sales, use, county innkeepers, and food and beverage taxes. The test for determining whether a transferee is a successor in liability is measured by the value of tangible personal property, including inventory, transferred over the total value of tangible personal property owned by the transferor legal entity at the time of the transaction, regardless of location.

A Notice of Transfer in Bulk must be filed with the Indiana Department of Revenue (DOR) at least 45 days before taking possession or paying the purchase price in a transfer or sale of tangible personal property of the business. The notice may be filed by the transferor or transferee and must include all required information and documentation.

If a completed Notice of Transfer in Bulk is filed with the DOR and the transferor has outstanding tax liabilities or past due returns, the DOR will provide a summary of sales, use, food and beverage and county innkeeper’s tax liabilities, including missing or estimated periods. If the transferor has no outstanding tax liabilities or past due returns, the DOR will mail a tax clearance letter to the transferor and transferee within 20 days after DOR’s receipt of the Notice of Transfer in Bulk. If the DOR fails to mail a tax liability summary within 20 days, then the potential successor in liability will not be liable for the transferor’s tax liabilities, unless the transfer was not at arm’s length or was a gift. The transferee will be liable for transferor taxes if the parties complete the transfer or payment before receiving a tax clearance letter. A tax clearance letter is valid for 60 days, and if the parties do not complete the transfer within 60 days, a new notice must be submitted.

A transferee may become a successor in liability even if the transferor does not receive any consideration up to the value of the assets transferred, in which case the DOR may require that the successor in liability provide a third-party valuation for the assets. Moreover, successor in liability status is determined by statute and may not be altered by agreements and contracts between a buyer and seller.

Bottom Line: Beware of Indiana successor liability issues for state taxes for failure to comply with advance notice filing requirements for transfers of business assets.

“If you’re not part of the future, then get out of the way!” John Mellencamp

Beginning in 2022, businesses are now required to capitalize specified research and experimental expenditures  (“SRE expenditures“) and amortize (deduct) them over time.  Expenditures attributable to domestic research are amortized over five years and expenditures attributable to foreign research are amortized over 15 years.   SRE expenditures are generally research and development costs in an experimental or laboratory sense for product development or improvement and include software development costs.

If the property with respect to which the SRE expenditures are being amortized is sold, the business is not allowed to deduct the unamortized expenditures or use them to offset gain on the sale but must continue to deduct the amortization over the relevant period (i.e., 5 or 15 years).  For companies that have substantial unamortized SRE expenditures this could result in the practical loss of meaningful deductions if the company sells its business in an asset sale.  If, for example, the company is in its second year of a five-year amortization period, it will be required to deduct that amortization over the following three years.  Having sold its business, it may not have any income against which to apply the deductions.

Guidance released earlier this year in Notice 2023–63 provides some relief, allowing corporations that cease to exist i.e., dissolve (in a taxable transaction) to deduct the unamortized expenditures in its final tax year.  Accordingly, if the selling corporation can be liquidated in year of sale, it will be able to use the unamortized expenditures to offset sale gain.  If liquidation in the year of sale is not an option or the selling company is not a corporation, deferring payment of a portion of the purchase price might allow a seller to use unamortized expenditures more fully.  In addition, a seller’s receipt of equity of the buyer or an earnout may provide an opportunity to utilize the unamortized losses depending upon the timing and amount of the future income or gain.

Bottom Line:  For companies with substantial unamortized SRE expenditures, careful planning may be required to prevent the loss of those deductions.

“Every day I get up and look through the Forbes list of the richest people in America. If I’m not there, I go to work.” —Robert Orben

As you probably know, in a like-kind exchange, any sale proceeds that you do not apply to purchasing a new investment property will be taxable (up to the total gain on the property). The challenge with making a like-kind exchange of property in a seller-financed sale is that the seller doesn’t receive any (or very little) cash at closing.  As a result, even if the seller rolls that cash over into a new property, subsequent payments received on the note will be taxable (to the extent of gain). The question is, how can a seller get cash (instead of the seller’s note) to the qualified intermediary (QI) so the QI can fully reinvest the sale proceeds into the new property.

One approach may be for the seller to purchase the note from the QI for cash. For example, if a seller sold a property for $100,000 with $20,000 cash at closing plus a note for $80,000, the seller could buy the note from the QI for $80,000, leaving the QI with $100,000 cash to use to purchase the replacement property. (The buyer of the note would have a tax basis in the note equal to the amount paid for it, so the receipt of subsequent payments on the note would not be taxable except to the extent of interest received).

Coming up with cash to buy the note may, of course, be easier said than done.  Does the seller have the cash? Will a lender be willing to loan the seller that cash? Is there a third party that would be willing to purchase the note? As the numbers get larger, this may become more challenging. 

If the property sold is subject to existing debt, and the replacement property is purchased in part with seller financing, this complicates the analysis somewhat but doesn’t change the ultimate result. On the positive side, the third-party debt may reduce the amount of the buyer note payable to the seller and, therefore, reduce the amount of cash that would be needed to buy the note.

Bottom Line:  While the need for cash may make this a challenging structure, there may be an opportunity to defer gain on seller-financed property in a Section 1031 exchange.

 “When you’re in jail, a good friend will be trying to bail you out. A best friend will be in the cell next to you saying, ‘Damn, that was fun.’” —Groucho Marx

A common investment structure presented to domestic tax-exempt entities involves investing in flow-through operating businesses through a “blocker corporation.” Avoiding unrelated business taxable income (“UBTI”) is a key focus for many tax-exempt entities. By investing through a blocker corporation, the blocker corporation pays any applicable income tax and then passes on the remaining profits to the tax-exempt entity as a dividend. Corporate dividends are considered passive income and as such, are not subject to the UBIT tax, except in limited situations.

Fund sponsors often are quick to offer up a “blocker corporation” when courting investment dollars from tax-exempt entities, but sometimes little thought is put into the question of whether the blocker should be located within or without the United States.  For example, some fund sponsors will establish offshore blockers in a no-tax jurisdiction, such as the Cayman Islands or the British Virgin Islands.  The use of such jurisdictions is generally based on the absence of an income tax and the relative low cost of administration. However, the choice between a domestic or foreign blocker can have material implications for the tax-exempt investor’s overall return.

Specifically, tax-exempt entities generally should avoid the use of a foreign blocker corporation if the intended underlying investment (e.g., the investment strategy of a private equity or venture capital fund) is targeted at domestic flow-through businesses.  This is because even though the foreign blocker will be taxed at the same corporate rate as a domestic blocker, the foreign blocker will also be subject to the full U.S. branch profits tax in the absence of an applicable tax treaty.  The combined income and branch profits tax results in an overall effective U.S. federal tax rate of 44.7 percent. By contrast, if a domestic blocker is utilized for such an investment, the effective tax rate would equal the federal corporate tax rate of 21 percent.

By contrast, if the fund’s investment strategy is aimed at non-U.S. flow-through businesses, a foreign blocker can be highly advantageous.  None of the blocker’s income would be subject to U.S. tax and the dividends the tax-exempt investor receives generally would not constitute UBTI.  If such investment were made through a domestic blocker, U.S. corporate tax would be owed on such income.

As in all things involving investment structures, the devil remains in the details.  For example, the generic results above can change dramatically, depending on the use of leverage (by the tax-exempt investor or the fund), the type (or types) of underlying investments the fund intends to make, the potential availability of foreign tax credits, and the making or omission of certain “elections” that are often left to the full discretion of the fund’s sponsor. 

Bottom Line: Professionals directing investments for tax-exempt entities should consider their options carefully when presented with a blocker structure and should thoroughly review the investment fund’s intended underlying investment strategy

“This is too difficult for a mathematician. It takes a philosopher.” – Albert Einstein, on filing tax returns.

A common structure in the acquisition of the assets of a business is for the seller to receive equity from the acquirer in addition to cash. Receipt of a partnership or LLC interest in exchange for property is generally non-taxable. A seller can obtain substantial tax savings by deferring gain on the low-basis assets by specifying in the agreement that specific high-basis assets will be sold for cash and that certain low-basis assets will be exchanged for partnership interests. 

To take a very simple example, assume a seller has two pieces of real estate that it agreed to sell for $1 million each ($1 million cash and $1 million of LLC units), and the seller’s basis in one parcel is $800k and its basis in the other parcel is $400k. By selling the high-basis parcel for cash and exchanging the low-basis parcel, the seller’s taxable gain would be $200k. If the cash and units were allocated to the two properties equally, the total taxable gain would be $400k. For computing the gain, the basis of each property is allocated in proportion to the value of the property exchanged for cash and for equity. The gain on the high basis property would be $100k (i.e., $500k cash -$400k basis), and the gain on the low basis property would be $300k (i.e., $500k cash -$200k basis).  

However, the same may not be true for the acquisition of seller LLC units which is treated as an asset sale.  While no cases or rulings are on point, the IRS has indicated that associating certain considerations with certain assets may not be respected where a purchase of LLC interests is treated as a purchase of assets (e.g., Rev. Rul. 99–5).

Bottom Line:  By negotiating the identification of which assets are to be exchanged directly for equity and which for cash, sellers may be able to defer substantial tax liability.

“There are few things in life harder to find and more important to keep than love. Well, love and a birth certificate.” —Barack Obama

The Infrastructure Investment and Jobs Act (2021) and the Inflation Reduction Act (2022) provide ample opportunity for construction industry employers to win government contracts. For some employers, one hindrance to competing for government construction contracts is that under the Davis-Bacon Act, all government construction-related contracts require employers to pay their laborers and mechanics not less than the prevailing wage and fringe benefits. Often, employers who have chosen to provide self-funded benefits struggle to have such benefits credited toward the fringe benefit requirement.

However, for those employers offering self-funded health and welfare benefits, there are options to credit such benefits toward the prevailing wage requirements by qualifying the plan as a “bone fide” fringe benefit plan. One way to qualify as a bone fide fringe benefit plan under 29 C.F.R. 4.171 is for the employer to make an irrevocable contribution to cover potential benefits under the plan to a trust controlled by either a voluntary employees’ beneficiary association (VEBA) or an independent trustee.  However, making such contributions is irreversible and forces the employer sponsoring the plan to give up the flexibility to pay claims out of their general assets as they arise, which is often one of the attractions of a self-funded plan. Another option is to submit to the U.S. Department of Labor (DOL) an application requesting a determination that the plan is a bona fide fringe benefit plan under the Davis-Bacon Act.  The process is straightforward and efficient, requiring the employer to gather and provide information showing that the plan satisfies the usual requirements for a welfare plan under ERISA.  In most cases, the required information is readily available to the employer.  Upon approval by the DOL, payments under the approved plan can be credited toward prevailing wage requirements.

If you or your organization would like to explore the possibility of having a self-funded plan qualified and credited toward prevailing wage requirements through either a trust or formal approval, we can help. 

For more information or any questions regarding plan compliance and operations, please contact Matt Secrist, Jeff Mullins or Amelia Trefz.

In the recent case of ES NPA Holding LLC v. Commissioner, the IRS argued that a profits interest can only be received tax-free by a service provider when the service is rendered directly to or for the benefit of the entity issuing the interest. The facts of the case are complicated, but in short, in the ES NPA case, the person that received the profits interest had rendered services to a corporation which was a member in the LLC (taxed as a partnership) that issued the profits interest. Moreover, the profits interest in the operating LLC was held indirectly through an upper tier partnership. 

Under the relevant guidance (Rev. Proc. 93-27), a profits interest is not treated as income upon its acquisition if a person receives it “for the provision of services to or for the benefit of a partnership in a partner capacity or in anticipation of being a partner.”  The Tax Court rejected the argument of the IRS as being too narrow a reading of Rev. Proc. 93-27. The Court found that the services provided to the corporation were part of the transaction that caused the formation the LLC. It further found that it is of no material consequence that the profits interest in the LLC was held indirectly through an upper tier LLC which it said was a mere conduit since the economic rights in the profits interest units in both the upper tier and lower tier LLCs were identical.

By this holding, the Tax Court has effectively approved what has in effect become relatively common practice, i.e., the practice of issuing profits interests to a service provider in circumstance in which the services are rendered to an entity other than the partnership issuing the profits interest as long as the services benefit the issuing partnership.

Bottom Line: This decision will not likely result in a significant change in practice with respect to issuing profits interests but provides additional comfort for continued use of structures already determined to be permissible by tax practitioners.

This post uses all-natural intelligence. No added artificial intelligence or flavors . . . it is also gluten free.