MSCPA Federal Tax Committee C Corporations By Lorraine Travers

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1 ESOP disqualified by stock allocation to officer who drew no salary--dna Pro Ventures, Inc. Employee Stock Ownership Plan, TC Memo The Tax Court has upheld IRS's disqualification of an employee stock ownership plan (ESOP), finding that the plan's allocation of stock to a corporate officer's account exceeded the contribution limits under Code Sec. 401(a)(16) because the officer didn't receive any compensation from the corporation that year. In addition, the Court determined that the ESOP failed to obtain qualified appraisals of its assets. Background. ESOPs are qualified defined contribution plans which are designed to invest primarily in securities of the corporate employer and are subject to the requirements set out in 401(a). ESOPs provide corporate employers and their employees the tax benefits of a qualified plan, and in addition provide a financing vehicle for generating capital through their ability to borrow to acquire employer securities. In general, to be tax-qualified, a plan must meet the requirements of Code Sec. 401(a) in both form and operation meaning that the plan document must contain the requisite language or terms and that the plan must actually operate in accordance with the document and otherwise satisfy Code Sec. 401(a). Under Code Sec. 401(a)(16), a trust is not qualified if the related plan provides for benefits or contributions which exceed the limitations of Code Sec. 415 (for 2008, the lesser of $40,000 or 100% of the participant's compensation). A Code Sec. 415 failure is a continuing failure that disqualifies the plan for a future year even when there is not a separate, independent Code Sec. 415 failure in the future year. An additional requirement is that securities held by an ESOP which are not readily tradable on an established securities market be valued by an independent appraiser. (Code Sec. 401(a)(28)(C)) Facts. In 2008, Daniel J. Prohaska, an orthopedic surgeon, became involved with DNA Pro Ventures, Inc. (DNA), which was incorporated on Nov. 12, On that date, DNA issued 50 shares of class A common stock each to Dr. Prohaska and his wife in exchange for $500. At the time of DNA's incorporation, Dr. and Mrs. Prohaska were DNA's directors and its only employees, with Dr. Prohaska acting as chairman, president and treasurer, and Mrs. Prohaska serving as vice president and secretary. On 12/31/08, DNA issued 1,150 shares of class B common stock to the ESOP's trust with a par value of $10 per share. The trust then allocated the 1,150 sh. of stock to Dr. Prohaska's ESOP account that day. During 2008, DNA did not pay any salaries, wages, or other officer's compensation. Although DNA was the ESOP sponsor, it did not file any Forms 5500, Annual Return/Report of Employee Benefit Plan, for plan years 2008, 2009, and In 2011, IRS began an examination of the DNA ESOP. At several times during the course of its investigation, IRS sought documentation from DNA about the ESOP, including participant allocation schedules, employee census reports, ledgers, journals, etc., along with copies of the ESOP's bank statements, and copies of any independent appraisals, which DNA failed to provide. On June 6, 2014, IRS issued a final nonqualification letter to DNA explaining that the ESOP had failed to follow the terms set out in the plan documents and therefore the ESOP (a) was not qualified under Code Sec. 401(a) for plan years ending Dec. 31, 2008, 2009, and 2010, and (b) was not exempt from tax under Code Sec. 501(a). Any related trust was also determined not to be exempt from taxation under Code Sec. 501(a) for the same trust years. 1

2 According to IRS, the DNA ESOP had two separate failures to follow its plan document during 2008: (1) During 2008, DNA had transferred class B stock into the ESOP without consideration, and the stock accrued to the benefit of Dr. and Mrs. Prohaska. The value of the stock accruing to each participant, as reported by the ESOP, substantially exceeded 100% of each of Dr. and Mrs. Prohaska's compensation from DNA for the year Thus, the ESOP had failed to comply with Code Sec. 401(a)(16) and Code Sec. 401(a)(15) for the plan year. (2) The ESOP plan document required the ESOP to use appraisal rules substantially similar to those of Code Sec. 170(a)(1) when it obtained annual appraisals for the 2008 plan year. The ESOP, however, failed to obtain any appraisal for the 2008 plan year or for any plan year. Tax Court agrees with IRS. The Tax Court found that, since neither Dr. Prohaska nor Mrs. Prohaska had any compensation for services as a DNA officer or employee during 2008, their contribution limits with respect to the DNA ESOP were zero. Because DNA improperly transferred 1,150 shares of DNA's class B common stock to Dr. Prohaska's ESOP account in 2008, the annual addition to his account was $11,500 more than his contribution limit under Code Sec. 415(c). Accordingly, the ESOP failed to meet the requirements of Code Sec. 401(a)(16) and was not a qualified plan for 2008, and because the Code Sec. 415 failure was a continuing failure, the ESOP also was not a Code Sec. 401(a) qualified plan for all subsequent plan years. The Tax Court then determined, after reviewing the plan documents, that the DNA ESOP plan failed to satisfy the appraisal requirement under Code Sec. 401(a)(28)(C). Although the plan required a good faith valuation to determine the fair market value of the securities on each valuation date, the DNA ESOP failed to obtain any annual appraisals in 2008, 2009, and 2010, resulting in an operational failure. This failure, said the Court, made the ESOP nonqualified under Code Sec. 401(a). The Tax Court further stated that, because the failure to follow the plan language was a continuing failure, the DNA ESOP also was not qualified for the plan years ending Dec. 31, 2009 and Also, because the DNA ESOP was not a qualified trust, it was not exempt from tax under Code Sec. 501(a) for any year Thomson Reuters/Tax & Accounting. All Rights Reserved. Corporate executive not entitled to deduction for unpaid loan to bankrupt company--cooper, TC Memo The Tax Court, siding with IRS, has determined that a taxpayer couldn't deduct the amount of an unpaid loan that he made to a construction company owned by an acquaintance that later filed for bankruptcy. The Court found that the taxpayer, who was employed full-time in an executive role and had a number of other side businesses, wasn't engaged in the trade or business of lending and thus couldn't claim a business bad debt deduction. The Court further concluded that the taxpayer wasn't entitled to a deduction for non business bad debt because he failed to establish that the loan was wholly worthless in the year claimed. Background. Code Sec. 166 allows taxpayers to deduct any debt that becomes worthless within the tax year. To be entitled to a deduction, the taxpayer must show a bona fide debt based on a debtor-creditor relationship. Business debts and non business debts are treated differently under Code Sec Business debts are those created or acquired in connection with a trade or business of the taxpayer or a debt the loss from the 2

3 worthlessness of which is incurred in the taxpayer's trade or business. (Code Sec. 166(d)(2)) Non business debts are defined as debts other than business debts. Taxpayers must treat non business bad debts as losses from the sale or exchange of a short-term capital asset and can deduct the debt only for the year in which the debt becomes wholly worth-less. Business bad debts, on the other hand, give rise to deductions that can be offset against ordinary income. Whether a debt is a business or non business debt is a question of fact, and, in order to establish that a bad debt loss is a business bad debt loss, taxpayers must show that the bad debt loss is proximately related to the conduct of trade or business, or that the debt was created in the course of trade or business. Facts. Fred Cooper was a full-time employee during 2008 and 2009 at a company where he held a number of executive positions during his time there. He also owned other business interests, including rental properties, a car wash, and a pheasant farm, and he made sporadic loans to friends & acquaintances referred to him by friends. He lent money on a short-term basis to people who might otherwise have difficulty obtaining cash and charged high interest rates (up to 40%). Mr. Cooper claimed to have made at least 14 loans between 2006 and 2010, although the record only showed 12 loans to 11 borrowers from , and he produced promissory notes for only five of those loans. He knew five of the borrowers before making the loans, and the other six were referred to him. He didn't perform the sort of due diligence that would be customary in a lending business, like credit checks or verification of collateral through title searches, and he didn't keep contemporaneous, complete records. Mr. Cooper also claimed to have devoted between 120 and 150 hours per year to his lending activities during the years at issue, but the Tax Court didn't find his claimed time commitment credible in light of his other activities and lack of due diligence performed, among other things. One of Mr. Cooper's borrowers was Richard Wolper, president of Wolper Construction. In March 2006, after a prior loan had been timely repaid, Mr. Cooper made a second loan to Wolper Construction. The promissory note showed a principal amount of $750,000, a maturity date of Sept. 29, 2006, and a collateral guaranty in the form of a deed of trust on real property (although no lien was ever recorded). The loan was subsequently extended, and a second promissory note was signed, but Wolper Construction didn't pay it when due. A little over a year later, on June 23, 2008, Wolper Construction filed for bankruptcy, and Mr. Cooper didn't file a proof of claim against the bankruptcy estate. Mr. Cooper continued in 2009 to report the note as an asset. The bankruptcy proceedings were closed in August Mr. Cooper didn't report the Wolper Construction loan on his 2008 return, but in April 2010, he filed an amended return for 2008 claiming a $750,000 business bad debt deduction in April Mr. Cooper's accountant claimed that her firm had mailed a Form 1099-C, Cancellation of Debt, to Wolper Construction, and Forms 1096/1099-C to IRS reporting a $750,000 bad debt, but she didn't provide proof of mailing and IRS has no record of receiving the Form IRS disallowed the $750,000 bad debt deduction, and Mr. Cooper challenged the disallowance in Tax Court, arguing that he was in the business of lending and that the loan was therefore fully deductible as a business loan. No business of lending. The Tax Court, looking at the overall facts and circumstances, concluded that Mr. Cooper was not in the business of lending. The Court found that a number of factors indicated that lending wasn't a significant activity for him notably, the amount of time devoted to the activity, the fact that 3

4 he worked full-time in another business during the years at issue, the fact that he lent funds to friends and acquaintances, the lack of business formalities, the fact that he didn't hold himself out publicly as being in the lending business, and his inadequate recordkeeping. Accordingly, he couldn't deduct the loan as a business loan. The Court also found that, for purposes of a non business bad debt deduction, the Wolper Construction loan wasn't wholly worthless in either of the years at issue. Mr. Cooper didn't establish that he had reasonable grounds to abandon any hope of recovery in 2008 and his actions actually indicate that he thought otherwise, including his listing of the loan as an asset and his failure to report the loan as worthless when he initially filed the 2008 return. The evidence examined by the Court otherwise failed to establish that the debt was worthless in 2008 or The fact that Wolper Construction had filed for bankruptcy was insufficient to establish worthlessness Thomson Reuters/Tax & Accounting. All Rights Reserved. CA 2: taxpayer didn't qualify for small reseller's exception to UNICAP rules--city Line Candy & Tobacco Corp. v. Comm. (CA 2 9/30/2015) 116 AFTR 2d The Court of Appeals for the Second Circuit, affirming the Tax Court, has concluded that a reseller and wholesaler of cigarettes couldn't rely on the small reseller's exception to the Code Sec. 263A uniform capitalization (UNICAP) rules because it failed to show that its average annual gross receipts correctly calculated to include the entire sale price of the cigarettes it sold, including the cost of State cigarette tax stamps for the 3-tax-year periods ending with the tax years preceding each of the years at issue did not exceed $10 million. Background. Manufacturers and certain retailers and wholesalers must use the UNICAP rules to account for property they produce and for property they buy for resale. (Code Sec. 263A(a)) Under this method, the taxpayer must capitalize all direct & indirect costs properly allocable to such property. (Code Sec. 263A(b)) However, there is an exception to this general rule for resellers whose average annual gross receipts for the 3-tax-year period ending with the tax year preceding the current tax year do not exceed $10 million (small reseller exception). (Code Sec. 263A(b)(2)(B)) The term gross receipts means the total amount, as determined under the taxpayer's method of accounting, received from all trades or businesses carried on by the taxpayer (e.g., revenue derived from the sale of inventory before reduction for cost of goods sold). (Reg A-3(b)(2)(i) In determining gross receipts, certain items are excluded, e.g., receipts from any activity other than a trade or business or an activity engaged in for profit. (Reg A-3(b)(2)(ii)(F)) In Robinson Knife Manufacturing Co., Inc., (CA2 3/19/2010) 105 AFTR 2d , in a case of first impression, the Second Circuit, reversing the Tax Court, held that a corporation that manufactured kitchen knives and tools didn't have to capitalize under Code Sec. 263A the royalties it paid under trademark licensing agreements. The Court determined that the royalty costs weren't incurred by reason of, and did not directly benefit, the performance of production activities, and so weren't capitalizable under the then-appliable Code Sec. 263A regs. It held that, although the licensing agreements may have directly benefited or been incurred by reason of production activities, the regs did not require the capitalization of the royalty costs because the costs themselves did not directly benefit and were not incurred by reason of the performance of production activities. The Court allowed the payments to be currently deducted as ordinary and necessary business expenses because it determined that they weren't properly allocable to property produced under Reg A-1(e)(3)(i). 4

5 IRS amended Reg A-1 after Robinson Knife to include the capitalization of indirect costs that were determined by reference to the number of units of property sold, or are incurred only upon the sale of inventory. (New Reg A-1(e)(3)(1)(i)(A)) didn't apply to the years at issue in the taxpayer's case.) Facts. City Line Candy & Tobacco Corp. (City Line) was a corporation engaged in business as a reseller and licensed wholesale dealer of cigarettes in New York. Under New York law, all cigarettes possessed for sale must bear a stamp issued by the New York tax commissioner. (N.Y. Tax Law 471(1) (McKinney 2006 & Supp. 2013) Pursuant to this law, City Line, a licensed cigarette stamping agent for New York, purchased cigarette packs for sale, purchased and affixed cigarette tax stamps to those cigarette packs, and sold the stamped cigarette packs to subjobbers and retailers in New York City and throughout New York State. Under New York law, City Line was required to include, & did include, the cost of the cigarette tax stamps in the sale price of the cigarettes. City Line uses the accrual accounting method and a fiscal year ending Oct. 31. For all relevant years, it computed its gross receipts from cigarette sales for financial statement purposes by totaling the gross sale prices of the cigarettes sold during each year. However, for income tax reporting purposes, City Line adjusted its gross receipts from cigarette sales by subtracting the approximate cost of cigarette tax stamps purchased during the fiscal year and reporting as its gross receipts the resulting net amount. The issue. City Line contended that its average annual gross receipts as determined for income tax reporting purposes for the 3-tax year period ending with the tax year preceding each of the years in issue did not exceed $10 million. Accordingly, it argued that it was eligible for the small reseller exception under Code Sec. 263A(b)(2)(B) for each of the years in issue and so wasn't required to comply with the UNICAP rules with respect to the cigarettes that it acquired for resale. City Line maintained that New York law imposed the cigarette stamp tax on consumers, not stamping agents or wholesalers. Thus, its gross receipts did not include proceeds attributable to collection of the cigarette stamp tax. On the other hand, IRS argued that by incorrectly eliminating the cost of State cigarette tax stamps from the sale price, City Line had underreported its gross receipts for each of the years at issue and that, when properly computed, its gross receipts exceeded the $10 million threshold for the small reseller exception. IRS maintained that because New York law requires City Line to add the cost of the cigarette tax stamps to the cigarette sale price, City Line had to include in gross receipts the entire gross sale price. Tax Court's conclusion. The Tax Court concluded that IRS correctly determined City Line's gross receipts for each of the years at issue on the basis of the entire sale price of the cigarettes it sold, including that part of the sale price attributable to the cost of the cigarette tax stamps. The Court found that City Line's efforts to show that it qualified as a small reseller, by reducing its gross receipts for each tax year in an amount approximately equal to the cost of cigarette tax stamps it purchased during the year, were inconsistent with its financial statement accrual method of accounting and with applicable New York law. (City Line Candy & Tobacco Corp. (2013), 141 TC 414,) The Tax Court noted that while Reg A-3(b)(2) excludes several enumerated items in specifying how gross receipts is to be calculated for purposes of the small reseller exception, it makes no reference to taxes. 5

6 The Tax Court also concluded that the cigarette tax stamp costs were indirect costs that had to be capitalized under the UNICAP rules. The Court rejected City Line's contention that the cigarette tax stamp costs were selling expenses excepted from the UNICAP rules (i.e., marketing, selling, advertising, and distribution costs). A reseller became liable for the cigarette stamp tax when it purchased cigarettes for resale to customers and not when it actually sold the cigarettes to customers. The cigarettes could not be sold without a tax stamp affixed to the package. Accordingly, the cigarette tax stamp costs were indirect costs incurred by reason of the taxpayer's resale activities. In addition, the Tax Court determined that the cigarette tax stamp costs were handling costs that IRS properly allocated, in part, to City Line's ending inventory using the simplified resale method. Appellate Court decision. The Second Circuit concluded that the Tax Court correctly included the value of stamps in City Line's gross receipts and that the Code Sec. 263A uniform capitalization rules applied. While City Line suggested that the stamps were actually a direct cost, even if that were true, the Court found that it wouldn't change the outcome since direct costs must also be capitalized under Code Sec. 263A(a)(2)(A). The Court also rejected City Line's alternate argument that the stamps qualified as a deductible selling expense under Reg A-1(e)(3)(iii)(A), noting that Reg A-1(e)(3)(ii)(L) specifically lists taxes as an example of indirect costs that must be capitalized to the extent they are properly allocable to property acquired for resale. City Line argued that Robinson Knife allowed the deduction of indirect costs tied directly to sales. However, the Court found that Robinson Knife interpreted Code Sec A-1 as including two limitations on the requirement that indirect costs be capitalized. Only costs that were a but-for cause of the taxpayer's production or sales activity were required to be capitalized; and costs that were (1) calculated as a percentage of sales revenue from certain inventory, and (2) incurred only upon sale of such inventory, were allowed to be deducted. The Second Circuit found that the causation test was easily satisfied since City Line's cigarette sales would have been illegal but for the stamps, and the Tax Court had found that City Line's stamping activity was an integral part of its resale activity. The Court also found that City Line's situation failed (2) because under New York law, City Line became liable for the cigarette tax as soon as it offered the cigarettes for sale, not when it sold them. Observation: The Court noted that, strictly speaking, City Line also failed (1) because Robinson Knife only covered expenses calculated as a percentage of sales revenue, but N Y assessed a tax per-package. Post-Robinson Knife amendments to the regs revised Reg A-1(e)(3)(i) to apply to costs calculated per-unit or as a percentage of revenue. In addition, the Second Circuit found that even if City Line had not waived its argument that the taxes fell within Reg A-3(b)(2)(ii)(F) (excluding receipts from an activity other than a for-profit activity or trade or business) by failing to raise it before, the argument was without merit. City Line didn't just merely collect the cigarette tax as a fiduciary for the State; the cigarette stamps were an essential ingredient in City Line's wholesaling business. City Line chose to become a licensed stamping agent rather than merely a wholesaler, and it received a commission for its stamping services a source of revenue in and of itself Thomson Reuters/Tax & Accounting. All Rights Reserved. 6

7 Cost of services provided to taxpayer's joint venture was capital contribution--legal Advice Issued by Field Attorneys F In Legal Advice Issued by Field Attorneys, IRS has concluded that the cost of services that a taxpayer incurred on behalf of a joint venture in which it was a participant, was a capital contribution to the joint venture and a deductible expense of the joint venture. Background. Code Sec. 162(a) allows a deduction for ordinary and necessary business expenses, including a reasonable allowance for salaries or other compensation for personal services actually rendered. But, business expenses which satisfy the ordinary and necessary expense requirements of Code Sec. 162 are only deductible if they are proximately connected to the business of the taxpayer claiming deduction therefore. (Young & Rubicam, Inc., (Ct Fed Cl 1969) 23 AFTR 2d ) Generally, a corporation may not deduct expenses paid on behalf of a related corporation. (Interstate Transit Lines, (S Ct 1943) 30 AFTR 1310) However, there is a limited exception to this rule. A 162 deduction may be allowable by a corporation if it paid the related corporation's business expense for its own direct and proximate benefit or the expense was incurred by the corporation with the underlying motivating purpose of protecting and promoting its own business. (Young & Rubicam; Lohrke, (1967) 48 TC 679) Facts. Taxpayer was a corporation that was a participant in a joint venture. Its employees performed services on behalf of the joint venture. How to treat the cost of the services performed. IRS concluded that the expenses for the services provided to the joint venture should be treated as a contribution of capital to the joint venture by the taxpayer, accompanied by a constructive payment of the expenses by the joint venture for which it was entitled to a deduction. IRS looked to some relatively old case law and a relatively old Rev Ruling as support for its conclusion. In order for compensation and related payments to be for the taxpayer's own direct and proximate benefit, the taxpayer "must prove that the specific services performed by each of the employees involved were for its direct and proximate benefit. The general and indirect benefit which obviously inures to a parent corporation when one of its subsidiaries successfully performs its functions does not satisfy the requirements of Code Sec. 162." (Young & Rubicam) In Young & Rubicam, the parent corporation sent certain employees abroad to assist its foreign subsidiaries and paid these employees' compensation and related expenses while abroad. The court said that any benefit to the parent from these activities was not proximate and direct to its own business and, therefore, its expenses were not allowable deductions under Code Sec In Eskimo Pie Corp., (1945) 4 TC 669, the court said that payments made by a stockholder of a corporation for the purpose of protecting his interest therein must be regarded as additional cost of his stock and such sums may not be deducted as ordinary and necessary expenses Rev Rul 84-68, CB 31, holds that a parent corporation may not deduct as a business expense under Code Sec. 162 the cash bonuses that it pays to employees of its wholly owned subsidiary. Instead, the payment is treated as a contribution to the subsidiary's capital accompanied by a constructive payment by the subsidiary of the cash bonuses to its employees for which the subsidiary is entitled to a deduction. 7

8 A contribution to capital need not be made pro rata with contributions from other shareholders. (Lackey, TC Memo ) And, a contribution to capital may occur even if it "is not recorded as a contribution to capital on the corporation's balance sheet." (Fink, (S Ct 1987) 60 AFTR 2d ) IRS said that the facts here fit with those in the above cases and ruling. These facts differ slightly from those in Rev Rul in that the taxpayer paid its employees, not the joint venture's employees, and the joint venture was not wholly owned. With respect to the former, payments to the taxpayer's employees for services performed on behalf of a subsidiary should be treated the same way as payments to the subsidiary's employees. With respect to the latter, a less-than-100% shareholder may make a capital contribution even though it is not made pro rata with contributions from other shareholders and some shareholders contribute nothing at all Thomson Reuters/Tax & Accounting. All Rights Reserved. Stock issued to employee/49.75% owner wasn't subject to substantial risk of forfeiture--qinetiq U.S. Holdings Inc., TC Memo The Tax Court has held that where a corporation issued 49.75% of its stock to an employee shortly after the formation of the corporation, a successor corporation could not take a compensation deduction with respect to the stock many years later. There was some question as to whether the stock was issued in the connection with the performance of services, but, in any case, there was no substantial risk of forfeiture at the time of the stock issuance. Background. Under Code Sec. 83(a), if property is transferred to a taxpayer in connection with the performance of services, the excess of the fair market value of the property over the amount, if any, paid for the property, is included in the taxpayer's gross income in the first tax year in which the taxpayer's rights in the property are transferable or are not subject to a substantial risk of forfeiture. The rights of a person in property are subject to a substantial risk of forfeiture if the person's rights to full enjoyment of the property are conditioned upon the future performance of substantial services by any individual. (Code Sec. 83(c)(1)) The rights of a person in property are transferable only if the rights in such property of any transferee are not subject to a substantial risk of forfeiture. (Code Sec. 83(c)(2)) Whether a risk of forfeiture is substantial depends on the facts and circumstances. Property is not transferred subject to a substantial risk of forfeiture if at the time of transfer the facts and circumstances demonstrate that the forfeiture condition is unlikely to be enforced. (Reg (c)(1)) The regs provide the following five factors for determining whether the possibility of forfeiture is substantial in the case of rights in property transferred to an employee of a corporation who owns a significant amount of the stock of the employer corporation: (i) the employee's relationship to other shareholders & the extent of their control, potential control and possible loss of control of the corporation; (ii) the employee's position in the corporation & the extent to which he is subordinate to other employees; (iii) the employee's relationship to the officers and directors of the corporation; (iv) the person who must approve the employee's discharge; & (v) the employer's prior actions in enforcing the provisions of the restrictions.(reg (c)(3)) For example, if an employee would be considered as having received rights in property subject to a substantial risk of forfeiture, but for the fact that the employee owns 20% of the single class of stock in the transferor corporation, and if the remaining 80% of the class of stock is owned by an unrelated individual so 8

9 that the possibility of the corporation enforcing a restriction on such rights is substantial, then such rights are subject to a substantial risk of forfeiture. (Reg (c)(3)) Code Sec. 83(h) allows a deduction under Code Sec. 162 to the person for whom such services were performed in an amount equal to the amount included under Code Sec. 83(a) in the gross income of the person who performed such services. Facts. Mr. Hume formed TGH, an S corporation that provided government contracting services. He then engaged in discussions with Mr. Chin about joining the business enterprise. They agreed and formed DTRI, another S corporation, to perform the same contracting services. On Dec. 9, 2002, Hume received Class A voting stock for $450 and became DTRI's president. On that day, Chin received Class A stock for $445 and Class B nonvoting stock for $5 (collectively, the Chin stock) and became the vice president. A few days later, the corporation executed a document authorizing the stock issuances and authorizing it to enter into a shareholder agreement and an employment agreement with Hume and Chin. Shortly thereafter, Hume & Chin entered into shareholder agreements that provided that they could transfer the class A and class B shares of stock either as gifts or for value with prior notice and consent of DTRI and the other shareholders. The agreements also provided that if a shareholder's employment was terminated by the corporation with or without cause within 20 years of receiving the stock, he had to offer the stock back to the corporation at a price that was lower than its market value; that price increased annually up through the 20th year. At the same time, Hume and Chin entered into employment agreements which referred to the shareholder agreements and contained no additional restrictions on the stock. Between 2002 and 2004, DTRI entered into restrictive stock agreements with employees other than Hume and Chin and granted shares of restricted Class B stock. The following were contained in the agreements and/or the stock grants: five year vesting; DTRI's right to repurchase at a particular price; that the stock would be issued pursuant to an employment agreement; and that the shareholder would have no rights as a shareholder prior to vesting. In the years from 2002 through 2008, DTRI, Chin and Hume made representations, in various ways, that Chin was a shareholder of DTRI. And, Chin showed DTRI income, in proportion to the number of his shares, on his Forms 1040 for those years. Until 2008, DTRI took no deduction with respect to the Chin stock, & Chin reported no income with respect to the stock. In 2008, the taxpayer, QinetiQ, purchased all the stock of DTRI, & all of the previous shareholders received cash for their DTRI stock. QinetiQ then considered the Chin stock to no longer be subject to a substantial risk of forfeiture and deducted the 2008 value of the stock as a compensation expense. Stock issuance didn't meet the Code Sec. 83 requirements. The Court ruled that QinetiQ didn't quite prove that the Chin stock was issued in connection with the performance of services but, more clearly, didn't establish that the stock was subject to substantial risk of forfeiture until it was purchased by QinetiQ....Stock wasn't issued in connection with performance of services. The Court noted that courts, historically, have looked at the following factors in making an analysis of whether property was issued in connection with the performance of services: 9

10 (1) whether the property right is granted at the time the employee or independent contractor signs his employment contract; (2) whether the property restrictions are linked explicitly to the employee's or independent contractor's tenure with the employing company; (3) whether the consideration furnished by the employee or independent contractor in exchange for the transferred property is services; and (4) the employer's intent in transferring the property. The Court said that first and second factors were met. As to the first factor, the Chin stock was transferred near the time when DTRI entered into the shareholder agreement and the employment agreement with Chin. The stock certificates, shareholder agreement & employment agreements were all dated in December, As to the second factor, the taxpayer pointed to the shareholder agreement and argued that the Chin stock was restricted and conditioned on Chin's continued employment with DTRI. The Court said that whether the taxpayer met the third and fourth factors was less evident. As to the third factor, the taxpayer argued that Chin's services served as the consideration furnished in exchange for the Chin stock. The taxpayer argued that the $450 that Chin deposited into the bank account was a nominal amount that merely corresponded to the par value of the shares issued and was less than the intrinsic value of Chin's services to the enterprise. However, the Court said that the taxpayer failed to show that Chin's $450 deposit should not be considered an entrepreneurial investment representing the true consideration for the issuance of the Chin stock. As to the fourth factor, the taxpayer had no ownership interest in DTRI until 2008 and was not a party to either the shareholder agreements or the employment agreements upon which it relied to establish intent. Neither was the taxpayer a party to discussions between DTRI, Hume, and Chin in 2002 in connection with the organization of DTRI and the issuance of DTRI's capital stock. Therefore, the taxpayer could not speak with certainty to DTRI's intent. And, the Court noted that: 1) from 2002 through 2008, DTRI, Hume, and Chin made representations that Chin had outright unrestricted ownership of the Chin stock; 2) DTRI distributed income and losses to Chin as if he was the owner of the Chin stock as fully vested and outstanding stock; 3) Chin stock was consistently treated as outstanding stock of DTRI for corporate purposes, as evidenced by the DTRI bylaws and other corporate documents; 4) Chin voted and signed corporate documents as an outstanding owner of class A stock in DTRI from 2002 through 2008; and 5) in contrast to the issuance of the Chin stock, in all other situations where DTRI transferred stock to employees in connection with the performance of services, the relevant documents explicitly tied the stock grants to the performance of services. So, the Court, while acknowledging that there are cases suggesting that a broad reading of the applicability of Code Sec. 83 is appropriate, but also saying that the main issue in this case was whether there was substantial risk of forfeiture, concluded that the taxpayer failed to prove the Chin stock was transferred in connection with the performance of services pursuant to Code Sec Stock wasn't subject to substantial risk of forfeiture. The taxpayer contended that the first three Reg (c)(3) factors showed that Chin did not have sufficient control over DTRI to modify, cancel, or waive the restrictions on the Chin stock. The taxpayer argued that the Chin stock was subject to a substantial risk of forfeiture because the shareholder agreement contained provisions that: (1) could not be waived unilaterally by Chin; (2) required Chin to sell his stock back to DTRI at a price below fair market value if he terminated employment within 20 years of execution of the shareholder agreement; and (3) precluded Chin from transferring or selling his stock without first offering it to DTRI. The taxpayer contended that Chin was 10

11 subordinate to Hume because Hume owned 50.25% of the voting shares and served as DTRI's president, CEO, and sole director. The taxpayer argued that Chin's risk of forfeiture was governed by the above example in Reg (c)(3). IRS argued that because Chin was the executive vice president and a 49.75% shareholder in voting stock of DTRI, it was unlikely Hume would have taken any actions to terminate Chin's employment. It also argued that the taxpayer failed to demonstrate the existence of any enforcement history by DTRI of restrictions in connection with class A common voting stock. The Court ruled that the taxpayer failed to show that the Chin stock was subject to a substantial risk of forfeiture. Hume and Chin had a very close work relationship. They were DTRI's initial investors, and together they built the company from its early stages of incorporation. Along with Hume, Chin voted on all company matters and helped determine the company's overall direction. Since Chin held such a vital role within DTRI, it was unlikely that Hume would have taken any actions to terminate his employment. Chin treated the Chin stock as if he had full ownership rights and control from the initial issuance in From 2002 through 2006, Chin reported all allocations and distributions of profits and losses arising from his ownership of the Chin stock on his Federal income tax returns. In contrast, the subsequent issuances of class B common nonvoting stock were issued subject to restricted stock grants. These grants explicitly provided guidelines for the treatment of such stock both before and after vesting. Those stock grants specified that prior to vesting of the Granted Stock... you will have no rights as a shareholder of DTRI Thomson Reuters/Tax & Accounting. All Rights Reserved. Assets transferred to newly incorporated former proprietorship were capital contributions--bell, TC Memo The Tax Court has held that a couple's transfer of the assets of their sole proprietorship real estate brokerage to a newly formed corporation of which they owned all of the stock was a capital contribution, not a sale of assets, to the corporation. Background. Whether an advance to a corporation is a capital contribution or a loan depends on the facts and circumstances. In the Ninth Circuit, the following factors are considered in determining whether an advance is debt or equity: (1) the name given to the documents evidencing the indebtedness; (2) the presence of a fixed maturity date; (3) the source of the payments; (4) the right to enforce payments of principal and interest; (5) participation in management; (6) a status equal to or inferior to that of regular corporate creditors; (7) the intent of the parties; (8) thin or adequate capitalization; (9) identity of interest between creditor and stockholder; (10) payment of interest only out of dividend money; and (11) the corporation's ability to obtain loans from outside lending institutions. (Hardman, (CA ) 60 AFTR 2d ) No single factor is controlling, and the facts and circumstances of each case must be taken into consideration. (Hardman) The primary purpose of the factors is to help the Court determine the parties' intent through their objective and subjective expressions. (American Underwriters, Inc., TC Memo ) Code Sec. 351(a) provides that no gain or loss will be recognized if property is transferred to a corporation by one or more persons solely in exchange for stock in such corporation and, immediately after the exchange, such person or persons are in control of the corporation. The basis of property received by a con- 11

12 trolled corporation in a tax-free transfer, e.g. upon the incorporation of the corporation or otherwise, is equal to the basis of the property in the transferor's hands increased by any gain recognized by the transferor on the transfer. (Code Sec. 362(a)) Facts. Mr. Bell owned a real estate brokerage, Realty World MBA, that he operated as a sole proprietorship. His wife worked in the business with him. A significant part of their business was with respect to real estate owned properties (REOs). REOs were properties that were repossessed by lenders, and the Bells' business with respect to those properties involved repossessing the property, fixing it up for sale, and signing a listing contract to sell the property for the lender. In 2008, the Bells incorporated the business under the name MBA Real Estate, Inc. (MBA). The Bells held all of the MBA stock. Shortly thereafter, MBA renewed Mr. Bell's franchise license agreement with Realty World-Northern California, Inc., for a renewal fee of $250. MBA and Mr. Bell then entered into a purchase agreement. For $225,000, Mr. Bell agreed to sell MBA all of the proprietorship's work in process, customer lists, contracts, licenses, franchise rights, trade names, goodwill, and other tangible and intangible assets. No appraisal was performed. The $225,000 purchase price was determined exclusively by the Bells. The Bells allocated $25,000 of the purchase price to the 5-year franchise license agreement Mr. Bell entered into with Realty World-Northern California, Inc., in 2004 for $3,200. The remaining $200,000 of the purchase price was allocated to 40 contracts between Mr. Bell and various lenders to assist during the REO process. The purchase agreement stated that the purchase price was payable in monthly installments of $10,000 or more on the first of each month and that the unpaid principal amount was subject to 10% interest each year. MBA did not provide any security for the purchase price, and a promissory note was not executed. The purchase price was eventually paid in full. On their returns for the years at issue, , the Bells reported long-term capital gain from the sale transaction, using Form 6252, Installment Sale Income. The Bells also reported interest income from the interest payments. MBA reported substantially the same amounts as interest payments on its returns for the years at issue. MBA amortized the $225,000 purchase price over five years. IRS found deficiencies based on its determination that the transfer of the sole proprietorship's assets to MBA was a capital contribution subject to 351, not a sale. IRS argued that payments made to the Bells were in fact dividends and that the assets transferred to MBA could not be amortized or depreciated. Any appeal in this case would be to the Ninth Circuit. Tax Court says transfer was capital contribution. The Tax Court concluded that the transfer of the assets was a capital contribution governed by Code Sec. 351, and not a sale, to MBA. The Court first noted that, where a series of closely related steps are taken pursuant to a plan to achieve an intended result, the transaction must be viewed as an integrated whole for tax purposes. The sole purpose of MBA's organization was to incorporate the sole proprietorship. The inseparable relationship between MBA's organization and the transfer of the sole proprietorship's assets weighed in favor of finding 12

13 that the transfer was a capital contribution, particularly in the light of the lack of evidence of a business reason for dividing the transaction. The Court then considered each of the eleven Hardman factors and concluded that the transfer was a capital contribution. Here is how it looked at several of the factors....title of debt instrument. The issuance of a note evidences debt, and the issuance of stock indicates an equity contribution. The purchase agreement provided that the purchase price was to be paid in installments of $10,000 or more on the first of each month. The unpaid principal amount was subject to interest at the annual rate of 10%. The wording in the purchase agreement was typical of a promissory note, and it did not contain wording commonly included in a stock certificate. This factor weighed in favor of finding that the transaction was a sale....payment source. Payments that depend on earnings or come from a restricted source indicate an equity interest. The purchase agreement had no caveats regarding payment of the purchase price. On its face, the payments were due even if MBA was not profitable. This interpretation was supported by evidence presented by the Bells indicating that one of the benefits of structuring the transfer of Realty World MBA's assets to MBA as a sale was that they would receive a steady stream of income each month for several years until the purchase price was paid off without concern for the ups and downs of the business world. However, the Court said, it could not ignore common sense in making its analysis. MBA acquired essentially all of its assets, which had very little, if any, liquidation value, in exchange for the promise of repayment in the purchase agreement. Without income it would be impossible for MBA to make any payments due under the purchase agreement, and repayment was completely contingent on MBA's earnings. Consequently, this factor weighed in favor of finding that the transfer was a capital contribution....participation and management. An increase in a shareholder's interest in a corporation as the result of a transaction indicates an equity interest. MBA had no shareholders when the purchase agreement was signed, and the Bells subsequently became MBA's sole shareholders. The transaction did not affect Mr. Bell's ownership interest. This factor was neutral....identity of interest. Advances made by shareholders in proportion to their stock ownership indicate a capital contribution. A sole shareholder's advance is more likely committed to the risk of the business than an advance from a creditor who is not a shareholder. (NA General Partnership, TC Memo ) The transaction took place between MBA and Mr. Bell. The fact that Mr. and Mrs. Bell became MBA's sole shareholders indicated a capital contribution....ability to obtain loans from other sources. The corporation's ability to borrow funds from a third party indicates a debt. If no reasonable creditor would have sold property to the corporation with payments to be made in the future, an inference arises that a reasonable shareholder would not do so either. (Hardman) There was no evidence in the record as to whether MBA would have been able to obtain a loan from a third party. And, MBA was a newly organized, thinly capitalized business. The Court said that it did not believe that an arm's-length creditor would have been willing to lend MBA $225,000 on terms and conditions the same as those in the purchase agreement. This factor weighed in favor of finding that the transaction was a capital contribution. 13

14 Ramifications to corporation of transfer being a capital contribution. Under Code Sec. 362(a), MBA's initial basis in all of the property it received in connection with the Code Sec. 351 transaction was the same as the Bells' basis in the property. In addition to the amount MBA paid to renew the franchise license a- greement, MBA assumed Mr. Bell's basis in the franchise license agreement. The Bells provided no evidence that they had any basis in the transferred contracts or goodwill. Because MBA had no basis in these items, they could not be depreciated or amortized Thomson Reuters/Tax & Accounting. All Rights Reserved. State's administrative dissolution of corporation doesn't alter status for tax purposes--plr In a private letter ruling (PLR), IRS has determined that the administrative dissolution of a corporation under state law, followed by its reincorporation, did not terminate the entity's status as a corporation for federal tax purposes. Under the facts of the ruling, the corporation didn't initially know of the dissolution and continued to file federal returns and pay all corporate taxes due during the period when it was unaware of the dissolution. Facts. Taxpayer incorporated under State A law on Date 1. On Date 2, Taxpayer was administratively dissolved by State A for failure to file a Year 1 annual report and pay an annual franchise tax. During the period in which Taxpayer was unaware of this dissolution, Taxpayer continued to file Form 1120 and to pay all corporate taxes as they came due. Following discovery of the dissolution in Year 2, Taxpayer reincorporated in State A on Date 3. Background. Whether an organization is taxed as a corporation is determined under federal, not state, law. (Ochs v. U.S., (Cl Ct 1962) 10 AFTR 2d 5026) For federal tax purposes, the term corporation includes associations, insurance companies, and joint stock companies. (Code Sec. 7701(a)(3)) With limited exceptions, a corporation is required to file an income tax return regardless of whether it has taxable income or regardless of the amount of its gross income. (Reg (a)(1)) A corporation in existence during any portion of a tax year is required to make a return. (Reg (a)(2)) Further, a corporation is subject to federal corporate income tax liability as long as it continues to do business in a corporate manner, despite the fact that its recognized legal status under state law is voluntarily or involuntarily terminated. (Messer v. Comm., (CA ) 27 AFTR 2d ) For filing purposes, a corporation is not in existence after it ceases business, dissolves, and retains no assets. (Reg (a)(2)) Corporate status intact. The PLR concluded that Taxpayer's status as a corporation for federal tax purposes was not terminated by reason of the administrative dissolution and subsequent reincorporation of Taxpayer under state law Thomson Reuters/Tax & Accounting. All Rights Reserved. 14