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Converting Stock Sales to Assets Sales (and Back Again)
S Corporation Committee ABA Section of Taxation
May 12, 2017
Washington, D.C.
John S. Harper Morrison & Foerster, LLP McLean, VA [email protected]
Edward A. Waters Dean, Mead, Egerton, Bloodworth, Capouano & Bozarth, P.A. Orlando, FL [email protected]
Mary Beth Dolan, Bryan Cave, LLP St. Louis, MO [email protected]
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There and Back Again – a Fantasy for Tax Lawyers* 1. Converting stock sales to asset sales and vice-versa (§§338(h)(10), 336(e), 453(h), and 453B(h))
2. Incorrect technical corrections (diluted installment sale benefits under §453(h) for S corporations)
3. Regulations implementing §453(h) at the shareholder level (Treas. Regs. §1.453-11)
4. Self-help remedy for distortions in the operation of §453(h) (the 100% note solution)
5. Limits on self-help: Grossed-up ADSP on less than 100% stock sales and other income recognition
6. State tax treatment of deemed assets and stock sale gains for nonresident stockholders
7. Survey of some state approaches:
• Virginia - Federal conformity, and sourcing of nonresidents’ income from deemed asset and stock sales • District of Columbia – S corporations taxed, but conformity in definition of taxable income • California – Acceleration of installment gains at corporate level only • New York – Pass-through gain and §453(h) installment gain sourced at entity level • Ohio – Sourcing stock gain based on entity level activities – constitutional limits? • New Hampshire – Disregard of basis increase or election to pay tax on or asset basis increase • Other states (audience participation)
*There are no safe paths in this part of the world. Remember you are over the Edge of the Wild now, and in for all sorts of fun wherever you go.” J.R.R. Tolkien
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Start here: Actual stock sale – §338(h)(10) or §336(e)
Target
B Buyer 1
A C
Section 338(h)(10)
80%+ purchased by single buyer
Target
B
A
C
Buyer 2
Buyer 3
Section 336(e)
80%+ disposed by shareholders to any buyers
§338 requires a single corporate purchaser of Target stock (or consolidated group acquirer) of at least 80% of Target. §336(e) permits any number and type of purchasers to be parties to stock dispositions that cumulate to at least an 80% disposition of Target stock. Overlap rule: §338(h)(10) takes priority if the transaction qualifies under both sections.
Target stock Target stock
4
Deem this: Constructive asset sale via §338(h)(10) or §336(e)
Old Target
Buyer(s)
New Target
1 Deemed assets sale
Deemed consideration, including Buyer notes
Treated for federal income tax purposes as if the sale of Old Target assets to New Target had actually occurred. Old Target treated as having received from New Target the consideration actually issued by Buyer(s) to the stockholders. Flow-through asset sale gain for state income tax purposes is generally sourced based on Old Target nexus factors.
B A C
10 80 10
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Deem this: Liquidating distribution via §338(h)(10) or §336(e)
Old Target
B A C
10 80 10 Deemed
distribution in liquidation to shareholders, including any Buyer notes
2
All consideration paid by Buyer, including installment notes, are treated as if distributed by Old Target to shareholders, including installment notes issued by Buyer(s). Old Target has no gain on actual or deemed distributions of “qualifying installment obligations” via §453B(h). Shareholders treat consideration received from Buyer as if received for stock of Old Target in redemption of Old Target stock, per §453(h). Shareholders’ stock gain is gain from the sale of intangible assets, generally treated as income sourced to each shareholder’s state of residence.
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Or do it yourself: Direct or DRE asset sale
Target
B A C
Actual asset sale
Target
B A C
DRE deemed asset sale
DRE Target assets
DRE interests
Consideration
Consideration
1
1
2
Consideration distributed in liquidation
2
Consideration distributed in liquidation
Actual or DRE asset sale is more flexible than §336(e) and §338(h)(10) qualification.
Buyer
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Back home again: Deeming a stock sale
Section 453(h)(1)(A): If, in a liquidation to which section §331 applies,
the shareholder receives (in exchange for the shareholder's stock) an installment obligation acquired [by the corporation] in respect of a sale or exchange by the corporation during the 12-month period beginning on the date a plan of complete liquidation is adopted and
the liquidation is completed during such 12-month period,
then, for purposes of this section,
the receipt of payments under such obligation (but not the receipt of such obligation) by the shareholder shall be treated as the receipt of payment for the stock.
Additional Rules • Receivables from sales of inventory – limited to bulk sales to one person in one transaction.
• Obligations allocated to depreciable property sales – if issuer of the obligation is related to the
shareholder who receives the obligation, the obligation is treated as a payment in the year of the sale.
• Stock basis must be allocated among all payments received in all years – overriding the general rule of basis recovery first in a §331 liquidating distribution.
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Living fossils: General Utilities found alive!
Section 453B(h): If—
(1) an installment obligation is distributed by an S corporation in a complete liquidation, and (2) receipt of the obligation is not treated as payment for the stock by reason of section 453(h)(1),
then,
except for purposes of any tax imposed by subchapter S, no gain or loss with respect to the distribution of the obligation shall be recognized by the distributing corporation. Under regulations prescribed by the Secretary, the character of the gain or loss to the shareholder shall be determined in accordance with the principles of section 1366(b).
Importance of lineage through General Utilities and old §337: • General Utilities and Operating Co. – no corporate income on distribution of appreciated property to
stockholders (Codified in 1954 Code §§337 and 311)
• Court Holding Co. – sale negotiated by corporation before distribution taxable
• Cumberland Public Service Corp. – asset sale by shareholders after distribution not taxable to corporation
• Old §337 eliminated inquiry of who negotiated the sale (if within the 12-month liquidation requirement)
• Form 966 – vestigial (useful to show time of adoption of the plan of liquidation)
• Plan of liquidation deemed adopted when making §338(h)(10) election
• Relevance to corporate level qualification for installment reporting on accounts receivable?
• Relevance to state law taxation of stock gain with source determined at corporate level?
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§453(h) computations: Treas. Regs. §1.453-11
• A shareholder receiving an installment note from a liquidating S corporation maximizes gain deferral by maximizing the gross profit percentage.
• Gross Profit Percentage = (Selling price – Adjusted shareholder tax basis) / Total Contract Price). This percentage is the amount of gain that is recognized on receipt of each installment payment.
• Gross Profit Percentage will be 100% when stock basis is zero. • Minimizing corporate level gain (and increasing loss) increases gross profit percentage. Corporate-
level gain (i) accelerates shareholder income on the pass-through and (ii) increases shareholder stock basis above zero.
• Deductions at the corporate level may offset income that would otherwise pass through and increase shareholder basis. Such deductions (e.g. compensation deductions, including option settlement payments) may not pass through to the shareholder anyway after basis is reduced to zero.
• Buyer’s assumption of liabilities in excess of asset basis triggers gain to the S corporation and corresponding pass-through of that gain and stock basis increase.
• A wrap-around note that is retained by the selling S corporation and shareholder(s) does not trigger gain (for actual and DYI asset sales).
• Debt assumed by a shareholder in liquidation increases the shareholder’s basis in the stock, but does not increase the amount received by the shareholder in liquidation. Treas. Reg. §1.453-11(a)(4).
• Consider whether, in light of the repeal of the General Utilities doctrine, the assumption of deductible debt by a shareholder creates a deduction at the corporate level as if paid by the corporation.
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§453B(h) – A botched 1988 “technical correction”
Dilution of installment sale deferral under §453(h) caused by cash at closing
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80% FMV $8,000 Basis $1,200
10
Target
B
Buyer A C
$10,000 purchase price 50% cash at closing and 50% note payable in 2018
100% Target stock
Assets FMV $10,000 Basis $1,500
10% each FMV $1,000 Basis $150
80
Corporate level gain computations $10,000 Deemed sale proceeds (cash and notes delivered to A, B and C) ($1,500) Less asset basis $8,500 Gross profit 85% Corporate gross profit percentage [$8,500 / $10,000] $5,000 Corporate deemed cash payment received $4,250 Corporate gain on deemed cash payment [85% x $5,000]
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§453B(h) – A botched 1988 technical correction (cont. -2)
A’s gain computations $1,200 Starting stock basis $3.400 Pass-through income [80% x $4,250] $4,600 Stock basis at liquidation $8,000 Contract price [$4,000 cash + $4,000 note] $3,400 Gross profit [$8,000 - $4,600] 43% Gross profit percentage [$3,400 / $8,000] $4,000 Closing cash payment received $1,700 Stock gain on cash payment [43% x $4,000] $1,700 Stock gain on cash payment $3.400 Pass-through income $5,100 A’s total 2017 income $8,000 A’s total amount realized $4,000 A’s closing payment received in 2017 50% A’s ratio of 2017 cash received to gain realized 75% A’s ratio of 2017 gross income to gain realized
Dilution of installment sale deferral under §453(h) caused by cash at closing
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§453B(h) self-help: 100% installment note solution
Buyer
Entire consideration in Buyer notes: $10,000 purchase price 50% payable in 2017 50% payable in 2018
100% Target stock
Target has no installment sale gain reportable in the year of sale due to receipt of notes only.
Target has no gain on deemed distribution of the notes in liquidation due to §453B(h).
Shareholders have no pass-through income from the sale.
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80% FMV $8,000 Basis $1,200
10
Target
B A C
10% each FMV $1,000 Basis $150
80
Substituting an installment obligation for proposed cash at closing
Assets FMV $10,000 Basis $1,500
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§453B(h) self-help: 100% percent note solution (cont. -2) A’s gain computations $1,200 Stock basis $8,000 Contract price [$8,000 note] $6,800 Gross profit [$8,000 - $1,200] 85% Gross profit percentage [$6,800 / $8,000] $4,000 Cash payment received in 2017 $3,400 Stock gain on cash payment [85% x $4,000] $3,400 Stock gain on cash payment $ 0 Pass-through income $3,400 A’s total 2017 income $8,000 A’s amount realized $6,800 A’s gain realized 50% A’s ratio of 2017 cash received to gain realized 50% A’s ratio of 2017 gross income to gain realized
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Limits on §453B(h) self-help: ADSP phantom cash
Less than 100% §338(h)(10) sale - phantom cash payment due to grossed-up ADSP
B and C form Buyer to purchase A’s shares for an $8,000 note.
On the same day, B and C contribute their Target stock to Buyer for Buyer stock.
Buyer’s purchase from A is a QSP and the parties agree to make a §338(h)(10) election.
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80% FMV $8,000 Basis $1,200
10
Target
B Buyer
A
C
$8,000 purchase price Entire consideration paid in one note: 50% payable in 2017 and 50% payable in 2018 10% each
FMV $1,000 Basis $150
B C
50 50
80
80% Target stock for $8,000 Buyer note to A
20% Target stock for Buyer stock issued to B and C
Target
100
1 2
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§453B(h) self-help: ADSP phantom cash (cont. -2)
Corporate level gain computations $10,000 Deemed sale proceeds (note and grossed-up ADSP [($8,000 / 80%) - $8,000] ($1,500) Less asset basis $8,500 Gross profit 85% Corporate gross profit percentage [$8,500 / $10,000] $2,000 Corporate deemed cash payment received [grossed-up ADSP] $1,700 Corporate gain on deemed cash payment [85% x $2,000] A’s gain computations $1,200 Starting stock basis $1,360 Pass-through income [80% x $1,700] $2,560 Stock basis at liquidation $8,000 Contract price [$8,000 note] $5,440 Gross profit [$8,000 - $2,560] 68% Gross profit percentage [$5,440 / $8,000] $4,000 Cash payment received in 2017 $2,720 Stock gain on cash payment [68% x $4,000] $2,720 Stock gain on cash payment $1.360 Pass-through income $4,080 A’s 2017 income $8,000 A’s amount realized $4,080 A’s 2017 income 50% A’s ratio of 2017 cash received to gain realized 60% A’s ratio of 2017 gross income to gain realized
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§453B(h) self-help: ADSP phantom cash (cont. -3)
B’s gain computations $150 Starting stock basis $170 Pass-through income [10% x $1,700] $320 Stock basis at liquidation $1,000 Payment received [deemed receipt of cash] $680 Gain on deemed cash payment $680 Stock gain on deemed cash payment $170 Pass-through income $850 B’s 2017 income $1,000 B’s amount realized $850 B’s 2017 income 85% B’s ratio of 2017 gain recognized to gain realized 85% B’s ratio of 2017 cash received to gain realized All of B’s gain in stock is recognized on closing due to combination of deemed receipt of the grossed-up portion of the ADSP at corporate level and deemed receipt of those cash proceeds as if then distributed to B in liquidation of Target. C’s gain computations are the same as B’s. Conclusion: In a sale of less than 100% of the stock with a §338(h)(10) election, it is not possible to entirely avoid the defect in §453(h) because the deemed payment to the non-selling shareholders is required to be treated as cash received by Target, and some part of the resulting corporate level gain is allocated to the shareholder who receives solely installment obligations from the buyer.
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A
Buyer’s purchase of 100% of Target stock from A for Buyer’s note
B and C each sell their 10% stock interest to A for fair market value on an installment basis for notes of A.
A sells 100% of the Target stock to Buyer, receiving a note from Buyer for 100% of the value of Target stock.
Buyer’s purchase from A is a QSP and the parties agree to make a §338(h)(10) election.
A
B
C
Target
80
10
10
A’s purchase of 20% of Target stock from B and C for A’s notes
Target
Buyer
B C
50 50
100
100% Target stock
Buyer’s note
1 2
20%Target stock
A’s notes
ADSP phantom cash solutions?
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Possible issues: • Would the initial 20% stock sale from to A be disregarded as a transitory transaction and the notes due
from A to B and C be netted against the notes from B and C to A?
• Would a sale of 20% from B and C to A, followed by 100% purchase by Buyer from A be treated as a conduit sale by B and C to Buyer?
• Purchases of Target stock from B and C for a Buyer note would not be part of the QSP, and may be treated as boot in a §351 transaction and also violate the related party prohibition of §338 purchase definition (because “50% or more” ownership by B and C of Buyer causes §318 attribution between Buyer and B or C).
• If B and C stock is not “recently purchased stock” by Buyer, the deemed cash ADSP gross-up is not avoided, because their stock in the hands of Buyer is nonrecently purchased stock.
• Would installment method reporting be available to Target if the Target assets would be depreciable in the hands of Buyer?
• Buyer would be a related person under §267(b) if it purchased the assets of Target, but in a deemed §338 asset sale between Target and New Target, it is acknowledged that §1239 does not apply to the sale between Target and New Target.
• Compare also authority given to IRS to prevent avoidance of the bar on installment sale treatment for marketable stock rules where rules of §453(k) “otherwise would be avoided through the use of related parties, pass-thru entities, or intermediaries”.
ADSP phantom cash solutions? (cont. -2)
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Holdco
B A C
DRE deemed asset sale and note distribution to A
Target (DRE)
Buyer
80 10 10
80% interest in DRE
Buyer note
1
2
A receives Buyer note in complete redemption
of stock
B C
50 50
Holdco
B C
Target (Pship)
50
3
50
Distribution of 20% interest in Pship to B
and C in redemption
A, B and C form Holdco and make an S election for Holdco. A, B and C then each contribute their shares of Target to Holdco. Holdco makes a Q-Sub election for Oldco and converts Holdco to a single-member LLC (DRE). Holdco sells 80% of its interest in DRE to Buyer (owned 50/50 by B and C) in exchange for a note payable to Holdco by Buyer. Because DRE is a disregarded entity with respect to Holdco, the sale of a DRE membership interest to Buyer is a deemed sale of 80% of the DRE assets to Buyer, followed by an asset contribution to Target as a partnership. Pursuant to a plan of liquidation, A receives the Buyer note in complete redemption of his stock under §453(h). Within the 12-month liquidation period, the remaining 20% of Target as a partnership must be distributed from Holdco to B and C (assume a closing of the books to allocate all §336 gain to B and C only if distribution is made in the same taxable year of Holdco).
80% 20%
Distribution of retained interest to B and C
ADSP phantom cash solutions? (cont. -3)
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Possible issues: • Would this enable A to get the full benefit of the installment note under §453(h)?
• Might the IRS argue that the assets of Holdco were distributed ratably to all of the shareholders and then exchanged by the shareholders at the shareholder level?
• Would seem inconsistent given Treas. Reg. §1.338(h)(10)-1(e), Ex. 10 looks at which assets are actually received by each shareholder.
• §1239 should not be implicated in the sale of 80% of the DRE assets to Buyer because B and C owned a combined 20% (not “more than 50%”) of Holdco before the sale of assets by Holdco to Buyer.
• §1239 should not be applicable to the distribution of the 20% interest in the LLC (partnership) to B and C because neither B nor C would own “more than 50%” of Holdco at the time of the distribution. Gain of Holdco on the distribution would pass through to B and C and basis in the 20% underlying property would be increased to FMV.
• If Holdco sells the 20% to Buyer directly, it seems that §1239 would apply to Holdco’s gain, because more than 50% of the stock of each of Holdco and Buyer are owned by the “same persons” per §267(b)(11). This results in immediate ordinary income and prevents use of installment sale treatment by Holdco.
• Would a transfer of the 20% interest from B and C to Buyer result in application of §1239
• Is there a potential “D” reorganization issue with respect to the sale based on overlap of ownership of Buyer and Holdco?
ADSP phantom cash solutions? (cont. -4)
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Target
A B C
80 10 10 Redemption of B and C in exchange for Target notes
1
Target
A
80 (100%)
Buyer $8,000 Buyer note
Target stock
B C
50 50 2
Target redeems all of the stock of B and C in exchange for notes in the amount of $1,000 each. See Treas. Reg. §1.338-3(b)(5). A becomes the sole owner of Target, and sells 100% of the stock of Target to Buyer for $8,000 in Buyer debt. ADSP is amount paid for A’s Target stock plus internal debt of Target = $10,000. In the installment sale, assumed debt of Target is offset against basis in Target assets, yielding an $800 deemed payment to Target in the year of sale. A recognizes pass-through gain of $800 using a closing of books allocation. Remainder of A’s gain is recognized when payments are made on Buyer’s note.
ADSP phantom cash solutions? (cont. -5)
Target
100
Redemption of B and C Purchase of 100% from A
Target notes payable to B and C
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Limits on §453B(h) self-help: Other sources of gain
Depreciation recapture (or assumed liabilities in excess of basis, cash method A/R)
10
80% FMV $8,000 Basis $1,200
10
Target
B Buyer
A
C
$8,000 purchase price in a Buyer note 50% payable in 2017, and 50% payable in 2018
Asset basis = $1,500
10% each FMV $1,000 Basis $150
B and C form Buyer to purchase A’s shares for an $8,000 note. On the same day as the purchase from A, B and C contribute their Target stock to Buyer for Buyer stock. Buyer’s purchase from A is a QSP and the parties agree to make a §338(h)(10) election. Target’s sole asset is depreciable equipment with a basis of $1,500. Target has taken $1,500 in depreciation deductions (all constitutes §1245 recapture).
B C
50 50
80
80% Target stock for $8,000 Buyer note to A 20% Target stock for Buyer stock to B and C
23
§453B(h) self-help: Other sources of gain (cont. -2) Corporate level gain computations $10,000 Deemed sale proceeds (note and grossed-up ADSP [($8,000 / 80%) - $8,000]) $1,500 Less asset basis (reduced but not below zero by assumed debt) $1,500 Less recapture income $7,000 Gross profit (installment sale gross profit is reduced by accelerated recapture income) 70% Corporate gross profit percentage [$7,000 / $10,000] $2,000 Corporate deemed cash payment received [grossed-up ADSP] $1,400 Corporate gain on deemed cash payment [70% x $2,000] $2,900 Total pass-through income [$1,400 + $1,500 from recapture] A’s gain computations $1,200 Starting stock basis $2,320 Pass-through income [80% x $2,900] $3,520 Stock basis at liquidation $8,000 Contract price [$8,000 note] $4,480 Gross profit [$8,000 - $3,520] 56% Gross profit percentage [$4,480 / $8,000] $4,000 Payment received $2,240 Gain on cash payment [56% x $4,000] $2,320 Gain on cash payment $2,240 Pass-through income $4,560 A’s 2017 income $8,000 A’s amount realized $4,080 A’s 2017 income 50% A’s ratio of 2017 cash received to gain realized 67% A’s ratio of 2017 gross income to gain realized (approximate)
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State taxation of nonresident S corp shareholders*
*Never laugh at live dragons . . . You aren't nearly through this adventure yet . . . J.R.R. Tolkien
Basic pattern of state taxation of S corporations and shareholders Pass-through entity status follows federal provisions such as S status.
• Full entity level tax in some jurisdictions as a separate taxable entity on all income (DC, NYC). • Supplemental entity level tax may be imposed (e.g., Illinois and California – 1.5% each). • Supplemental entity tax on built-in gains may be imposed (Maryland, California).
Corporate taxable income starts with federal income, subject to specified adjustments.
• Federal fictions and recast principles are generally followed (such a deemed asset sale). • Federal accounting methods are generally followed, including installment method reporting.
Corporate level income apportioned and allocated (under same rules applicable to C corporations).
• Much variation and change in apportionment principles among states (4 factor, double sales factor, sales factor only, and market source allocation etc.).
• Non-business income might be allocated to state of corporate domicile, or treated as business income.
25
State taxation of nonresident S corp shareholders (cont.)
Pass-through of apportioned income for each state is taken into account by shareholders. • Shareholders are liable for nonresident income tax on apportioned income for states in which the
shareholder is not resident. • Typically, nonresident taxes owed will be allowed as a credit against resident income taxes. • S corporations may elect to pay an entity level tax for nonresidents on a composite return that
satisfies the nonresidents’ tax liability and filing obligation. • S corporations may have a direct withholding tax obligation on income apportioned to nonresidents,
so that authority to collect tax from non-residents without presence in the jurisdiction is backed-stopped by corporate level liability.
Gain from the sale of intangible personal property (such as stock) is typically allocated to the state of residence of the owner of the property. Under these general principles, unless otherwise specified by state tax law:
• Stock sale without a §338(h)(10) election results only in shareholder level gain on stock that is allocated and taxed only in the shareholder’s state of residence.
• Asset sale by an S corporation results in apportionment of any income reportable by the corporation among the states in which the corporation conducts business.
• An S corporation is entitled to use the installment method under §453 for deferred payments to be made on the asset sale.
• An S corporation will have no gross income on distribution of installment obligations under §453B(h). • The shareholder receiving installment obligations under §453(h) is treated as having actually received
consideration for the sale of stock (but not from the note issuer but from the liquidating corporation, in a redemption of stock).
26
State taxation of nonresident shareholders - Virginia
Typical mode of analysis – No specific provisions with federal conformity Definition of a pass-through entity [Va. Code Ann. §58.1-390.1]. Tax liability of owners of pass-through entities [Va. Code Ann. §58.1-390.2]. S corporation withholding on income allocated to non-resident owners [Va. Code Ann. §58.1-486.2].
• “Income from Virginia sources” [Va. Admin. Code 10-120-20; Va. Code Ann. §§58.1-406 through 58.1-421].
• “Virginia taxable income” [Va. Code Ann. §58.1-402(A)].
• Withheld tax is creditable against the non-residents’ Virginia income tax.
• If Virginia tax is paid by the non-resident, the tax not collectible from the S corporation.
• An S corporation can also file a composite return and pay tax directly on Virginia taxable income allocable to nonresident owners [Va. Code Ann. §58.1-395].
• Result is that no gain is included in federal income at the S corporation level by reason of §453B(h). No specific Virginia authority on taxation of gain from sale of intangible personal property.
• Income from Virginia sources includes income from gains from the disposition of intangible personal property to the extent that such income is from property employed by the taxpayer in a business, trade, profession, or occupation carried on in Virginia [Va. Code Ann. §58.1-302].
• DiBelardino v. Commonwealth of Virginia, Department of Taxation and David M. M. Dutton v. Commonwealth of Virginia, Department of Taxation, Dockets CL06-5696 CL06-6291 [Va. Cir. Ct., 06/22/2007].
27
State taxation of nonresident shareholders – D.C.
Entity level tax on S corporations All corporations (including S corporation) subject to tax on “taxable income” in the form of a corporate franchise tax. [D.C. Code §47-1807.02] "Taxable income” is defined as “the amount of net income derived from sources within the District within the meaning of §§47-1810.01 to 47-1810.03.” [D.C. Code §47-1807.01(2)] “Net income" means the gross income of a taxpayer less the deductions allowed by this chapter.” [D.C. Code §47-1803.01] “Gross income" has the “same meaning as defined in §61 of the Internal Revenue Code of 1986.” [D.C. Code §47-1803.01] Installment sale conformity mandated by DC law: “If a person reports any portion of his income from installment sales for federal income tax purposes under §453 of the Internal Revenue Code of 1986 . . . he may report such income under this chapter in the same manner and upon the same basis as the same was reported by him for federal income tax purposes, if such method of reporting is accepted and approved by the Commissioner of Internal Revenue.” [D.C. Code §47-1804.04] Touchstone Consulting Group Inc. v DC Office of Tax and Revenue (Office of Administrative Hearings, 2010-OTR-00007, 4/27/2011) • Stock sold by a nonresident of DC for short-term notes delivered instead of closing cash consideration
delivered and payable directly to nonresident shareholders in a §338(h)(10) transaction • Corporation entitled to use §453 to prevent gain on the deemed receipt of installment notes, and implicitly
did not recognize gain on the deemed distribution of the notes under §453B(h) • Opinion noted specifically that no payments were made on the notes in the taxable year of the corporation
ended on the closing date.
28
State taxation of nonresident shareholders – New York
§453(h) installment gain on S corporation stock liquidation gain treated as NY source Pre-GU repeal, there was §337 conformity, so that gain on liquidation sales was not included in corporate taxable income. Letter of Deputy Commissioner for Legal Affairs, New York City Department of Revenue (August 6, 1984). 2009 – FIRPTA-like tax imposed on stock gains arising from closely-held corporations. If assets are least 50% NY real estate, the tax applies to Individuals gain on sale of interest in flow-through entities and non-publicly traded C corporations with 100 or fewer shareholders is treated as NY source based on ratio of value of NY real estate to total assets. [NYTL §631(b)(1)(A)(1); TSB-M-09(5)I (May 5, 2009)] Matter of Baum, NY Tax Appeals Tribunal, Dkt. No. 820837 (2/12/2009), affirming, New York Division of Tax Appeals (12/20/2007). (S corp pass-through gain apportioned to NY; resulting stock loss on liquidation not apportioned to NY, even though pass-through gain was apportioned to NY; on disallowance of the stock loss, taxpayers challenged the inclusion of deemed sale gain in their return by apportionment. Held no deemed corporate level gain existed for NY purposes that was available to apportion to the stockholders; thus allowance of loss not relevant.) Matter of Myron Mintz, NY Division of Tax Appeals, Dkt. No. 821807 (06/04/2009). (Shareholder’s installment gain in January 2009 per §453(h) after December 2008 sale of S corporation assets for note that distributed under §453B(h) was not NY source income; last sentence of §453B(h) referring to “character” of income does not affect “source” of income as stock gain.)
29
State taxation of nonresident shareholders – NY (cont.)
2010 amendment of NYTL §631(b)(1)(E-1) (effective for payments in or after 2010) • Installment sale notes held by an S corporation are triggered into corporate income when the S corporation
terminates taxable status in NY, and will pass-through to the shareholders sourced to NY based on corporate level apportionment factors for year of sale.
2010 amendment of NYTL §632(a)(2) (retroactive to 2007) [See also NYTL §631(b)(1)(C)] • Pass-through gain of S corporation in deemed asset sale is NY source income for nonresident shareholders
to extent determined on corporate level apportionment factors for year of sale (reversing Baum). • S corporation asset sale and distribution of installment notes – Shareholder stock gain on §453(h) notes
received is treated as NY source income based on corporate level apportionment factors for year of sale (reversing Mintz).
• Gain or loss on stock of S corporation on deemed liquidation, after stock basis step-up from corporate level gain, is allocated to shareholders state of residence, is not apportioned (consistent with Tax Dept. assertion in Baum that the stock loss was not allowable to offset the pass-through gain):
“For purposes of a section 338(h)(10) election, when a nonresident shareholder exchanges his or her S corporation stock as part of the deemed liquidation, any gain or loss recognized shall be treated as the disposition of an intangible asset and will not increase or offset any gain recognized on the deemed assets sale as a result of the section 338( h)( 10) election.”
• See New York Technical Service No. TSB-M-10(10)I (08/31/2010)
FY 2018 budget proposal – to close loophole allowing treatment of sale of partnership interest as sale of intangible personal property sourced to the state of residence of the partner: “an IRC § 1060 election allows the seller to consider the transaction to be the sale of an intangible interest, which is non-taxable, while the buyer considers the transaction to be the purchase of an asset, which is taxable.”
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State taxation of nonresident shareholders – California Acceleration of corporate level gain but not shareholder level gain on installment notes S corporations are subject to California franchise and income taxes [Ann.Cal.Rev.&T. Code § 23802]. Sections 453, 453A and 453B of the Internal Revenue Code apply except as otherwise provided [Ann.Cal.Rev.&T. Code § 24667]. Installment gain of corporation is accelerated on cessation of business in in California [Ann.Cal.Rev.&T. Code § 24672].
In the Matter of the Appeal of: West Valley Land Management Co. and Marvin Malmuth and Edwin Malmuth, California State Board of Equalization, No. 91A-0302 (8/2/1995). (Cal.Rev. & T. Code § 24667 permitting application of § 453B(h) does not preclude application of Cal.Rev.&T. Code §24672 to accelerate gain at corporate level on uncollected installment obligations.)
Appeal of Thompson K. Vodrey, California State Board of Equalization, Case No. 258566 (9/1/2005) (Distribution of installment obligations by S corporation more than 12 months after adoption of plan of liquidation resulted in inclusion in income of all installment sale gain at the corporate level upon distribution and immediate taxation to stockholders on pass-through basis.)
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State taxation of nonresident shareholders – CA (cont.) Acceleration of corporate level gain for corporate tax but not shareholder level tax In the Matter of the Appeal of: Jincan Guo and Wei Huang; and Guo Technologies Co., California State Board of Equalization, Case Nos. 511289 and 511297 (1/11/2012).
• S corporation sold assets in 2006 for cash and installment notes distributed under §453B(h) and reported by shareholder as collected under §453B(h). Resident shareholder reported no pass-through income from the corporation’s receipt of the cash at closing.
• Issues : (1) whether the company’s final taxable year occurred in 2006 triggering acceleration of installment receivables for 2006 tax under Cal.Rev.&T. Code §24672 for purposes of the 1.5% corporate level tax, and (2) whether the shareholder must include pass-through gain on cash paid at closing?
• Illustrates the acceleration of gain under Cal.Rev.&T. Code § 24672 applies only to the 1.5% California corporate level tax on gain recognized by the corporation and is not an acceleration of installment note to increase pass-through gain to the shareholder, as well as dilution of installment reporting due to cash received by corporation at closing.
California Franchise Tax Board Internal Procedures Manual Ch. 16.9(d) (2007):
• “Unlike flow-through gain, the character of gain/loss realized on deemed liquidating distributions is decided at the shareholder level, following Personal Income Tax law. Therefore, non-California resident individual shareholders report the gain/loss on deemed liquidating distributions to the state they live in, not to California.”
• “In a case where the selling S shareholders are non-residents and the installment method of income recognition was used to report income, the character of the gain/loss reportable by the non-resident shareholders on installment payments should be determined pursuant to IRC §453B(h)(1) and (2) and IRC §1366(b).”
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State taxation of nonresident shareholders – Ohio
• Statutory apportionment of stock gains on closely held pass-through entity • A taxpayer who owns at least 20% of the equity of a pass-through entity at any time during the 3-
year period prior to sale of such entity shall apportion income (including gain or loss realized from sale, exchange or other disposition of an interest in the entity) using certain property, payroll and sales factors for the current and preceding two taxable years for business income, and situs for non-business income. [Ohio R.C. 5747.212]
• Corrigan v. Testa, Ohio S. Ct., Slip Opinion No. 2016-Ohio-2805 (May 4, 2016) • Issue: whether capital gain on the sale of an interest in a pass-through entity is considered
income of the business such that it may be taxed in Ohio, even if the taxpayer subject to such tax is a nonresident, nondomiciliary of Ohio.
• “In this case, the activity at issue is a transfer of intangible property by a nonresident. Thus, Ohio’s connection is an indirect one.”
• Supreme Court of Ohio found the statute unconstitutional with respect to Corrigan for due process reasons: Ohio’s connection was to the intangible property that was being transferred, not the taxpayer, so Ohio did not have jurisdiction over the income from such sale.
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State taxation of nonresident shareholders – Ohio (cont.)
• Giddens v. Testa, Slip Opinion No. 2016-Ohio-8412 (Dec. 28, 2016) • Issue: whether a dividend distributed by an S corporation from C corporation earnings and
profits is treated as a dividend of retained earnings or a distribution of the shareholders’ distributive share of S corporation income.
• Ohio Supreme Court ruled that distributions of C corporation earnings are dividends and not distributive shares. The dividend is considered nonbusiness income that may be entirely allocated outside of Ohio.
• T. Ryan Legg Irrevocable Trust v. Testa, Slip Opinion No. 2016-Ohio-8418 (Dec. 28, 2016): • Issue: Whether the decision in Corrigan applies to a trust that sells shares of an S corporation. • The court distinguished Corrigan based on the taxpayer’s role in the business and connection to
the state. However, a concurrence argued that Corrigan should be overruled and decided based on the connection between the business assets and Ohio, and stated the taxpayer’s residency and involvement with the business were irrelevant.
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State taxation of nonresident shareholders – NH
Entity level adjustment to income • Unrecognized gain under old section 337 included in corporate income. [NH RSA 77-A:4 (VIII) – since
1981] • Tax on target entity on asset basis increase, regardless of gain recognition or denial of basis increase. • Basis increase phantom tax (1989 to 2015) -- Tax on basis step-up after sale of interest in an entity. If an
interest in a business was sold and caused the basis in the assets to increase for federal income tax purposes, the business was required to add the basis increase to gross business profits (creating a “phantom tax.”) [RSA 77-A:4, XIV before S.B. 342]
• Disallowed basis increase with option to recognize gain. [RSA 77-A:4 XIV(a) and (b), after S.B. 342 ] • Default disallowance of basis increase – depreciation or amortization due to basis increase is
added back to income and gain or loss is reported on sale of property by excluding unrecovered basis. [RSA 77-A:4 XIV(a)]
• Elective gain recognition – a business may elect to recognize the basis increase at the time of the transaction that increased the basis in the assets for federal income tax purposes. If this election is made:
• the business is required to add to gross business profits the amount of the net increase in the basis of all assets transferred or sold during the tax period in which the sale or exchange of an interest in the entity took place; and
• the entity is allowed a deduction for depreciation or amortization attributable to the increase in basis, and gain or loss upon sale or disposition of assets takes into account the basis increase. [RSA 77-A:4 XIV(b)]
New law is colloquially known as the “Planet Fitness Tax” because the change arose when Planet Fitness threatened to move its corporate headquarters from NH if an exception to prior law was not granted around its IPO.
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State taxation of nonresident shareholders – Others
In re Lambert, 1998 WL352173 (ED La 1998), affd 179 F3d 281 (5th Cir 1999) -- Sale of land located in Mississippi by S corporation owned by nonresident, in exchange for installment notes distributed under section §453B(h) and §453(h); gain reportable by shareholder on collection of the note not apportioned to Mississippi. Prince v. State Dept. of Revenue, 55 So.3d 273 (Ala. 2010) – Pass-through gain on sale of S corporation stock with a §338(h)(10) election was treated income from a sale of assets, so that gain allocable to a nonresident shareholder was apportionable based on activities of the corporation. Illinois Dept. of Rev. General Information Letter IT 07-0017-GIL (4/13/2007) -- In §338(h)(10) sale, no gain is recognized by S corporation deemed distribution of installment obligations under §453B(h) for Illinois replacement tax purposes. Illinois Dept. of Rev. General Information Letter IT 09-0033-GIL (09/28/2009) -- Nonresident stockholder’s gain from sale of stock of an S corporation doing business in Illinois not apportioned to Illinois because the stockholder was not doing business in Illinois. “It is remarkable to me that the due process clause limitations on the imposition of income tax on general partners, limited partners, and managing or non-managing limited liability company members are so poorly defined, given that more than 50 percent of all earnings in this country flow through one or more passthrough entities.” Nexus Over Nonresident Partners or Members, Clark R. Calhoun, State Tax Notes Today, Tax Notes Doc 2016-51288 (1/3/2017).
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State taxation of nonresident shareholders
“His head was swimming, and he was far from certain even of the direction they had been going in . . . He guessed as well as he could, and crawled along for a good way, till suddenly his hand met what felt like a tiny ring of cold metal lying on the floor of the tunnel. It was a turning point in his career, but he did not know it. He put the ring in his pocket almost without thinking; certainly it did not seem of any particular use at the moment.” J.R.R. Tolkien
