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.

This is the case in California, and soon will be the case in Minnesota and New York.  For over six decades, businesses have avoided multistate income taxation relying on a federal law (P. L. 86–272) adopted in 1959.  P. L. 86–272 prohibits states from imposing income tax on income derived by an out-of-state business if the seller’s only business activity in that state is solicitation of orders for tangible personal property.  Orders must be sent outside the state for approval or rejection and filled from a point of shipment outside the state.  But if a seller accepts any orders within the state, or provides any services along with the remote sales of products, then the protections of this law do not apply.

On August 4, 2021, the Multistate Tax Commission (MTC), an intergovernmental agency that promotes uniformity across state tax codes, issued an interpretation of what types of remote interactions with a customer via website or app should be considered engaging in business activity and subjecting a seller to income taxation by the customer’s state.

California adopted that interpretation, issued guidance in 2022, and has begun enforcement via audit. [Note: this interpretation is currently being challenged in court.]  Earlier this year, the Minnesota Department of Revenue circulated a proposed notice adopting the MTC guidance. Under that guidance, activities by out-of-state businesses that would subject that business to income taxation in the state include the following:

(i) providing post-sale assistance to Minnesota customers via chat, email, or website, (ii) receiving applications via the Internet from Minnesota customers for branded credit card through its website, (iii)  inviting Minnesota residents to apply for non-sales positions via website, (iv) transferring Internet cookies onto the computers or devices of Minnesota customers for business purposes that include product development, inventory management, or market research; (v) offering and selling extended warranty plans via website to Minnesota customers; and (vi) contracting with Minnesota customers to stream digital videos and music to their devices for profit.

Bottom Line:  If your business is engaging in these activities for customers in California or New York, it is already purportedly subject to taxation. It appears that will soon be the case in Minnesota as well.

You must learn from the mistakes of others. You can’t possibly live long enough to make them all yourself. –Sam Levenson

On August 25, 2023, employers, employees and ERISA attorneys all over the nation breathed a collective sigh of relief after the IRS announced that it would provide a two-year “administrative transition” period for employers and plan administrators to coordinate and prepare for the implementation of the new Roth catch-up contribution rules expressed in SECURE Act 2.0.

By way of background, for people age 50 and older, the IRS allows additional pre-tax deferrals to their 401(k) of an annual amount in excess of the limit for those younger than 50 (“referred to as catch-up contributions”).  SECURE Act 2.0 requires catch-up contributions on an after-tax (instead of pre-tax) basis for participants who earned more than $145,000 in the prior year.

Employers began calling for a grace period almost immediately upon the rule’s announcement, which requires employees whose wages were more than $145,000 in the previous year to make catch-up contributions on a Roth (after-tax) basis . Employers were scrambling to program their payroll systems to comply with the new rule to meet the January 1, 2024 effective date. In its announcement, the IRS stated that plans that do not already provide for designated Roth contributions will continue to be deemed to satisfy the requirements of this new section during the two year transition. The IRS also stated that it intends to issue additional guidance in the future.

Bottom Line:  With the newly granted two-year administrative transition period, employers can continue to offer catch-up contributions on a pre-tax basis while they prepare their payroll systems to provide that catch-up contributions must be made on a Roth (after-tax) basis for employees with incomes higher than $145,000.

“Do things that make you happy  . . .within the confines of the legal system.”
Ellen DeGeneres

Often times when a partnership or LLC is selling a real estate investment, some partners may be ready to cash out, while others would like to defer the gain and reinvest in real estate.  If the partnership simply sells the property and uses part of the proceeds for a like- kind exchange under Section 1031 and distributes the remaining proceeds to the cash out partners, the gain on the sale that was not reinvested would be taxable to all of the partners (not just the partners receiving the cash). This obviously is undesirable to those partners who wish to defer their gain.

What if the partnership liquidated and transferred title to all of the partners individually in anticipation of the sale and then each partner sold or exchanged as desired? The problem with this approach is that the person who engages in a 1031 exchange must have held the property for investment. The IRS has challenged transactions in which someone has acquired an interest in property and immediately engaged it in a like kind exchange.  The IRS argues that the person acquired the property not for investment purposes but for the sole purpose of selling it and therefore does not qualify.

In order to address the desires of both groups of partners, a partnership could engage in what is commonly referred to as a “drop and swap” transaction.  In this transaction, the partnership distributes a fractional interest in the real estate to those partners who want to cash out. These fractional interests are generally tenancy in common interests, known as TICs. 

At the time of sale, the buyer will acquire ownership of the property from multiple sellers (i.e. the partnership and the partners holding the TIC interests).  The partners receive their cash and the partnership (as the historical owner of the property) can use its portion of the sale proceeds to engage in a Section 1031 like-kind exchange.

Bottom Line:  A drop and swap transaction can be a great way to meet the desires of partners in a real estate partnership who have different goals and tax sensitivities.

To steal ideas from one person is plagiarism; to steal from many is research. – Steven Wright