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

Self-employment tax (“SE Tax”) applies to “net earnings from self-employment” which includes a partner’s distributive share of income from a business conducted by a partnership.  However, an exception provides that the share of income of a “limited partner, as such” (other than guaranteed payments for services to the partnership) are excluded from the definition of self-employment earnings.

On November 28, 2022, in Soroban Capital Partners, L.P. v. Commissioner, the Tax Court considered whether the sole fact that a person is a state law limited partner was sufficient to cause the exception to SE Tax to apply. The Court determined that whether a limited partner in a state law limited partnership qualifies for the exclusion from SE Tax requires an inquiry into the activities of that partner.  The fact that the individuals are state law limited partners is not the end of the inquiry.  This is consistent with the Court’s 2011 decision in Renkemeyer

In Renkemeyer, the Court determined that the exception from SE Tax was intended to apply to individuals who were merely invested in a partnership and who were not actively participating in the partnership’s business operations. Ultimately, the Tax Court ruled in Renkemeyer that partners in the LLP in that case should not be treated as limited partners for purposes of SE Tax because their shares of partnership income arose from legal services performed on behalf of the law firm and not as a return on their investments.

The Court’s decision in Soroban was limited to whether in the case of a state law limited partner it is appropriate to make further inquiry into that partner’s functions and roles.  The Court did not (and was not asked to) examine the activities of the limited partners to determine whether they should be respected as limited partners.  Future proceedings would be necessary to make that determination.

Bottom Line: Since 2018, the IRS has been pursuing SE Tax audits for limited partnerships and LLCs, so proceed with caution in determining whether a limited partner that participates in the business of the partnership is subject to SE Tax on his or her share of partnership income.

“Anyone can do any amount of work, provided it isn’t the work he’s supposed to be doing at that moment.” — Robert Benchley

The numerous technical requirements for qualifying and maintaining status as an S corporation create many opportunities for loss of S corporation status.  In recognition of this, the law provides that taxpayers may get relief from accidental terminations of a corporation’s S election if the termination is “inadvertent,” the corporation takes action to correct the termination within a reasonable time after discovery, and consents to certain adjustments required by the IRS.

By contrast, if an S corporation files a statement of revocation, the IRS generally does not allow the revocation to be rescinded unless the corporation files a rescission statement before the effective date of the termination.  There appears to be no authority supporting the proposition that if a revocation was filed based on the mistake of fact or erroneous advice that the revocation can be considered inadvertent.

Could the corporation file a new S election? Generally, a corporation that terminates it’s S election may not file a new election until five years has lapsed.  In certain circumstances, the IRS may grant permission to make a new election before the five-year period expires. However, this generally requires a showing that termination was not within the control of the corporation or its shareholders or that there has since been change in ownership of greater than 50%.  There are a number of rulings in which the IRS refused to grant such relief where the basis for the revocation changed.  In a 1978, letter ruling, the IRS denied permission for early election where a revocation was made on advice of attorneys or accountants which advice was subsequently determined to be in error.

Bottom Line: Think carefully before revoking an S election, as it will likely be permanent (or at least for 5 years).

“The word abbreviation sure is long for what it means.” – Zach Galifianakis

S corporations provide valuable tax advantages for businesses with simple capital structures. Unfortunately, they are subject to stringent requirements creating multiple opportunities for missteps and potential loss of S corporation status. Recently, in. Rev. Proc. 2022-19, the IRS provided methods for addressing some such missteps, without the need to incur the time and expense to seek a private letter ruling.

The IRS guidance identifies six potential problems (1), non-identical governing provisions; (2) principal purpose determinations relating to the single class of stock requirement; (3) disproportionate distributions; (4) errors/omissions on Form 2553 (S Corporation election) or Form 8869 (Qsub election); (5) missing S Corporation confirmation letters; and (6) filing returns inconsistent with S corporation status.

Of those six issues, probably the most common is non-identical governing provisions that may create multiple classes of stock.  An example is an LLC that elects to be an S corporation but whose governing document contains language requiring liquidating distributions to be made in accordance with positive capital accounts, as opposed to a pro rata distribution as required for S corporations.  Additionally, S corporations may issue stock options which may also raise questions about whether multiple classes of stock have been created.

Under Rev. Proc. 2022-19, S corporations can correct this misstep through self-help if certain requirements are met, e.g., the corporation has not made disproportionate distributions, it timely filed its tax returns, and it identified and corrected the problem prior to discovery by the IRS. The corporation simply needs to prepare a statement of facts, an explanation of how the nonidentical governing provision was discovered and corrected, and the actions taken to establish that the corporation acted reasonably and in good faith. This document is not sent to the IRS but kept in the corporate records in the case of audit.

While a buyer of such a business may think “I can avoid any adverse tax result from invalid S status by requiring the seller to conduct an F reorganization and then purchasing the disregarded subsidiary.“ This is a common and effective strategy, although there may be some lingering concern over potential residual tax liability of the disregarded entity as the historic S corporation. And while this is a great strategy for a buyer, it does not reduce the risk to the S corporation shareholders.  Accordingly, this self-help mechanism could be valuable to such shareholders.

Bottom Line: If an infirmity in a corporation’s S corporation status is discovered, the self-help method described above may be a valuable remedy to keep in mind.

“You only live once, but if you do it right, once is enough.”  – Mae West

On Oct. 19, 2023, the Internal Revenue Service (IRS) announced a special withdrawal process for employers that submitted claims for Employee Retention Credit (ERC) and are concerned their claims may be inaccurate.

Under the program, employers who submitted ERC claims but have not yet received a refund may withdraw their claims and avoid future repayment obligations, interest, and penalties.

The IRS created the withdrawal program to help businesses that were pressured by aggressive marketing tactics into submitting ERC claims that the businesses now believe are or may be ineligible claims.

The ERC is a refundable tax credit intended for businesses that continued to pay employees during the COVID-19 pandemic despite experiencing a significant decline in gross receipts and/or a full or partial suspension of business activities due to governmental order.

Read more here.