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.

On February 7, 2024, the IRS announced it would continue its Pre-Examination Retirement Plan Compliance Program pilot with the Pre-Examination Compliance Pilot 2.0. The pilot program aims to enhance tax compliance for retirement plans by allowing plan sponsors to identify and address issues before their retirement plans are subject to a full-scale examination.

If selected for the pilot program, plan sponsors will receive a notice from the IRS that their retirement plan has been chosen for an examination and that, if they choose to respond, they have 90 days to perform an internal review to determine whether the retirement plan’s documents and operations meet current tax requirements. The plan sponsor will then present their findings in response to the IRS and the IRS will determine whether a full-scale or limited examination is still warranted. The initial Pre-Examination Compliance Program resulted in a 72% response rate from plan sponsors.

In the event a plan sponsor’s internal review reveals an issue in the retirement plan’s documents or operations that is eligible for correction through the Employee Plans Compliance Resolution System (EPCRS), the plan sponsor may make such corrections through either the self-correction program of the EPCRS, which does not incur fees from the IRS, or the voluntary compliance program of the EPCRS, which is subject to the voluntary correction program fee structure. Additionally, if an issue is revealed that is not eligible for correction through the EPCRS, the plan sponsor may still submit a request for a closing agreement to the IRS, and the IRS will use the voluntary correction program’s fee structure to determine the amount owed under the closing agreement, which may result in considerable cost savings when compared to fees and penalties assessed in a full-scale examination that reveals the same issue.

With the continued rollout of the Pre-Examination Retirement Plan Compliance Program, the IRS aims to collaborate with plan sponsors to address discrepancies early, streamline the examination process, and reduce the taxpayer burden resulting from full-scale examinations of retirement plans.

Bottom Line: If you or your organization receives notice of an audit of your retirement plan by the IRS and is provided the opportunity to participate in the Pre-Examination Retirement Plan Compliance Program, expediently conducting an internal review and replying to the notice within the 90-day window could save your organization both time and money.

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

In a sale of the assets of a business (or a sale of stock that is treated as a sale of assets), the buyer and the seller must allocate the consideration paid among the business’s assets, including goodwill, and report it to the IRS on Form 8594. This allocation must be made using the residual method. Under the residual method, the business assets are allocated among seven classes in order of priority from Class I to Class VII. 

Consideration is allocated to the value of the assets of a class. Any residual purchase price is allocated to the next class in order and so on, beginning with Class I -cash and cash equivalents, then Class II – actively traded personal property, Class III – mark to market assets, Class IV – inventory, Class V – all assets not in included in any other class, Class VI – all Code section 197 intangibles (other than goodwill or going concern value), and Class VII – goodwill and going concern value.  In recent years, bonus depreciation has increased the stakes concerning the classification of assets since buyers have greater motivation to allocate to personal property, which is generally adverse to sellers’ interests.   A seller prefers to allocate the purchase price to goodwill, which is taxable at a capital gains rate, but goodwill must be amortized over 15 years. By comparison, a buyer prefers to allocate to Class V assets, which may be 60% deductible in the sale year but taxable to the seller at ordinary income rates to the extent of depreciation recapture.

However, there is no requirement that a buyer and seller agree on the purchase price allocation. If the parties agree in writing on the allocation, their agreement will generally be binding on them but not on the IRS. Parties typically agree on an allocation of purchase price in the purchase agreement. This agreement is ideal given the concern that inconsistency in reporting may attract scrutiny in an IRS audit. However, that concern should be mitigated if you are confident in your numbers.

Bottom Line: In situations where the buyer and seller cannot agree on a purchase price allocation, each party has the option of allocating and reporting as they deem appropriate.

“Here is a test to find whether your mission on earth is finished— If you’re alive it isn’t.” — Richard Bach.

By making a Section “83(b) election,” an employee can defer until sale the tax associated with the receipt of restricted stock as well as convert ordinary income on the stock to capital gain. Consequently, the consequences of missing the deadline for the election are fairly dramatic. The Section 83(b) election must be filed with the IRS within 30 days of receipt of the stock. With such a short timeline, as you might expect, these elections sometimes are missed.

Simply canceling and re-issuing the restricted stock would likely not be respected by the IRS absent some change in terms and circumstances with respect to such stock. See CCA 199910010. However, depending on the circumstances, there may be ways to mitigate the adverse tax consequences of a missed 83(b) election.

  1. The restricted stock grant could be canceled and stock options (in particular
    incentive options), or a profits interest (maybe with a catch up) in the case of a partnership, could be issued in substitution. Assuming that the employee makes a qualifying disposition of the incentive stock options, it may be possible to achieve economic and tax results substantially identical to that of the restricted stock with the 83(b) election.
  2. The terms of the restricted stock grant could be amended to make the restricted
    stock transferable (free from vesting restrictions). This would cause the stock grant to be taxable to the recipient at the time of that amendment. Limiting the permitted transferees to a few key shareholders may reduce the loss of retention incentive.
  3. Another alternative would be to eliminate the vesting restrictions. While this
    addresses the tax concerns of the missed election, it does not address loss of the retention incentive. It may be possible to impose vesting restrictions at some later date however, that would require the cooperation of the employee and a business reason for imposing those restrictions that the IRS would respect.
    Bottom Line: All may not be lost if an 83(b) election is missed. There are some potential actions that could be taken to mitigate the tax consequences without loss of the retention incentive.

Bottom Line: All may not be lost if an 83(b) election is missed. There are some potential actions that could be taken to mitigate the tax consequences without loss of the retention incentive.

“Remember, today is the tomorrow you worried about yesterday.” – Dale Carnegie

Section 1202 of the Code provides special benefits to certain stock in C corporations that meet the requirements. The gain from the sale of 1202 stock (acquired after September 27, 2010) is excluded from a non-corporate owner’s taxable income up to the greater of $10 million or 10 times their tax basis in the stock. With the reduction in corporate income tax rates in 2017, conducting business through a C corporation that qualifies as a qualified small business has gained popularity. It is easy to see why when a shareholder could save tax of $2 million or more on the sale of stock!

There are numerous requirements that must be met in order for stock to qualify as 1202 stock. The corporation must be a C corporation, the stock must be acquired at original issuance, the corporation must engage in a “qualified business” (e.g., no legal or medical services businesses, no finance, etc.), its gross assets must not exceed $50 million prior to or at the time of the stock issuance, and the stock must be held for 5 years prior to sale.

The ability to exclude gain on sale of 1202 stock is highly desirable but as might be expected is not without its challenges and traps for the unwary. One such potential trap is that the transfer of 1202 stock to a partnership will cause the stock to lose its status as 1202 stock and a subsequent sale of that stock will be fully taxable. Unfortunately, the statutory language on this point (Section 1202(g)(2)(A)) is not particularly clear. That section provides that gain on the sale by a partnership of stock which is 1202 stock in the hands of that partnership is not included in income. Since 1202 stock must be acquired at original issue, a partnership that receives a contribution of 1202 stock fails that original issue requirement and the stock is no longer 1202 stock. This consequence is more clear in the legislative history than the language of the Code section.

Bottom Line: Don’t transfer 1202 stock to a partnership. If 1202 stock is to be held by a partnership, transfer money or property to the partnership and have the partnership acquire the stock at original issue.

“The difference between try and triumph is just a little umph!” — Marvin Phillips

Occasionally, parties to a transaction may determine after closing that they would have been better off not completing the transaction. This may result from a misunderstanding of the facts or the law, the failure of anticipated events to occur, or the occurrence of unanticipated events.

Under what has come to be known as the “rescission doctrine,“ parties to a completed transaction may be able to unwind that transaction and have it be disregarded for tax purposes. This principle was originally adopted in case law in 1940 and ultimately accepted by the IRS in 1980. Pursuant to IRS guidance (Rev. Rul. 80-58), the IRS will disregard the tax consequences of a transaction that has been rescinded where the following two prerequisites are met:

(1) the parties have each been returned to the positions they were in prior to the transaction; and

(2) the rescission is completed within the same tax year as the original transaction.

In Rev. Rul. 80-58, the IRS approved rescission where a real estate sale that had closed was unwound during the same year pursuant to the terms of the original sale agreement. The IRS has demonstrated flexibility in subsequent private letter rulings and approved rescissions that were not authorized in the original agreement between the parties. It has also authorized rescission where the parties are related. The IRS has even approved rescission of only portions of a transaction. The rulings suggest that at least in the context of a private letter ruling request, the IRS may permit the rescission and reformation remedy not only in those situations where it is applied to correct a problem in the original transaction, but also to achieve more favorable tax consequences or to reengineer the underlying transaction using the benefit of hindsight.

While the IRS adopted a no ruling policy with respect to rescission transactions in 2014, this appears to be more a function of budgetary considerations than opposition to the doctrine of rescission.

Bottom Line: When parties discover that a transaction did not have the tax or business consequences that they were trying to achieve, the doctrine of rescission may give them the opportunity to turn back the clock and unwind the transaction, and perhaps even to modify it to some degree as long as it is within the same year.

“All you need in this life is ignorance and confidence; then success is sure.” ― Mark Twain