Category: Perspectives

Pursuant to Executive Order 13789,  IRS and Treasury have been reviewing tax regulations issued since  January 1, 2016 with an eye toward regulations that:

• Impose an undue financial burden on US taxpayers
• Add undue complexity to the US tax laws; or
• Exceed the statutory authority of the IRS

In a Notice released July 7, 2017, Treasury issued its first conclusions identifying eight regulations that they felt met the announced criteria. Now, in a second report, this one dated October 2, 2017, Treasury has announced its recommended actions on those regulations.

This note offers a brief roadmap of the October 2 report.

Of the 105 temporary, proposed, and final regulations issued between January 1, 2016 and April 21, 2017, Treasury identified eight which they believe meet at least one of the first two criteria of the Executive Order. Treasury also notes in its October report that they are also considering unstated reforms to regulations under Section 871(m) (related to payments treated as U.S. Source dividends) and under the Foreign Account Tax Compliance Act.

Treasury has identified two proposed regulations to be withdrawn, three temporary or final regulations to be revoked in substantial part, and three regulations to be substantially revised. I will summarize these proposed changes in order.

 

1.   There are two proposed regulations proposed to be withdrawn entirely. These include:
2. Proposed Regulations under Section 2704 concerning restrictions on liquidation of an interest for Estate, Gift, and Generation-Skipping Transfer Taxes. Section 2704 addresses the valuation of interests in family controlled entities, for purposes of wealth transfer tax. In some cases, Section 2704 treats lapses of voting or liquidations rights as if they were transfers for gift and estate tax purposes.

The goal of the proposed regulations was to respond to developments in state statutes and case law which had reduced the applicability of Section 2704 and enabled certain family entities to generate artificially high valuation discounts for such characteristics as lack of control and marketability.  By depressing the values of assets this way, taxpayers can depress the value of property for gift and estate tax purposes. Some comments on the regulations indicated that it is not practicable to value an interest in a closely held entity as if there were no restrictions on withdrawal or liquidation in the organization’s governing documents or state law simply because such a hypothetic environment does not exist.

Treasury now concludes that the approach of the proposed regulations to the issue of artificial valuation discounts is “unworkable” and plans to publish a withdrawal of the associated regulations in their entirety.

2. Prosed Regulations under Section 103 concerning the definition of a Political Subdivision. Section 103 of the Code excludes from a taxpayer’s gross income the interest on state or local bonds, including obligations of political subdivisions. The proposed regulations called for such a political subdivision, for this purpose, to possess not only sovereign power, but also to meet certain tests to demonstrate a governmental purpose and governmental control.

While Treasury continues to express the belief that some enhanced standards for qualifying as a governmental entity are needed to suit the purposes of Code Section 103, it expresses the conclusion that, in the context of the extensive impact on existing legal structures of Section 103, the proposed regulations are not justified.

 

1.   Regulations Treasury may consider revoking in part. These include the following three final, proposed, and temporary regulations:
2. Final Regulations under Section 7602 on the Participation of a Person Described in Section 6103(n) in a Summons Interview. The final regulations allow the IRS to use private contractors to assist the IRS in auditing taxpayers. This participation includes the authority of the Service to allow the private contractor to “participate fully” in IRS interviews of taxpayers and other witnesses, including witnesses under oath. The regulation also allows private contractors to review records received in response to a summons. These regulation were first promulgated as temporary regulation in 2014, then finalized in 2016.

Only two comments were received on these regulations. However, the regulations were not well-received by the public. One federal court observed that such a practice “may lead to further scrutiny by Congress” (U.S. v. Microsoft Corp. 154 F. Supp. 3d 1134, 1143 (W.D. Washington 2015). Thereafter, the Senate Finance Committee approved legislation that would prohibit IRS from using private contractors in a summons proceeding for any purpose.

Treasury now takes the position that it may consider amending these regulations with only prospective effect. Such an amendment would serve to prohibit the IRS from using outside legal counsel in an examination or a summons interview. Outside attorneys would not be permitted question witnesses or be involved in a back office capacity such as reviewing summoned records or consulting on IRS legal strategy. IRS will continue to use outside subject matter experts such as economists, engineers, and authorities on foreign legal matters.

2. Regulations under Sections 707 and 752 on Treatment of Partnership Liabilities. These regulations include:

• Proposed and Temporary Regulations addressing allocation of liabilities for purposes of the disguised sale rules; and
• Proposed and Temporary Regulations treating so-called “bottom dollar” guarantees and generally disallowing such guarantees for purposes of calculating a partner’s liability in the context of liability allocation

The first set of rules, dealing with liability allocation in evaluating a disguised sale, effectively renders all liabilities for these purposes as nonrecourse liabilities. Treasury acknowledges that this characterization technique is “novel” and allows that it is “considering whether the proposed and temporary regulations relating to disguised sales should be revoked and the prior regulations reinstated.”

The prior, proposed regulations were largely a codification of the IRS arguments in Canal Corporation v. Comm’r, 135 T.C. 199 (2010) where the Tax Court held that a partner’s guarantee in the context of a so-called “leveraged partnership” transaction should not be respected where the partner-guarantor was undercapitalized vis-a-vis the liability and had no contractual requirement to maintain a minimum net worth. The 2014 regulations had their own cumbersome qualities, many of which were intended to be resolved by the 2016 regulations.

Treasury indicates even less willingness to change the proposed and temporary bottom dollar regulations. After an extended recitation of the perceived problems arising from non-commercial guarantees, Treasury concludes that “the temporary regulations are needed to prevent abuses and do not meaningfully increase regulatory burdens of the taxpayers affected.”  Accordingly, Treasury does not plan to review the bottom dollar guarantee regulations.

3. Final and Temporary Regulations under Section 385 on the Treatment of Certain Interests in Corporations as Stock or Indebtedness.

These regulations generally include two categories of rules:

• Rules establishing minimum documentation requirements that must usually be satisfied before claimed debt obligations between related parties can be treated as debt for federal tax purposes (known as the “Documentation Regulations”); and
• Rules that treat as stock debt that is issued by a corporation to a controlling shareholder in a distribution or in another related party transaction that achieves an economically similar result (known as the “Distribution Regulations”).

The Documentation Regulations apply principally to domestic issuers and establish minimum characteristics of a transaction whereby its tax posture can be evaluated.

The Distribution Regulations generally affect interests issued to related parties who are non-U.S. holders and serve to limit earnings-stripping, whether by way of inversions or foreign takeovers.

Treasury now proposes to:

1. Revoke the Documentation Regulations in their entirety, followed by introduction of new regulations at a later date; and
2. Retain the Distribution Regulations in anticipation of reforms to the Internal Revenue Code.

 

III.   Regulations Treasury May Consider Substantially Revising

Treasury has identified two Final Regulations and a Temporary Regulation for consideration for revision:

1. Final Regulations under Code Section 367 on the Treatment of Certain Transfers of Property to Foreign Corporations.

Section 367 of the Code imposes a tax on transfers of property to foreign corporations, subject to certain exceptions, including an exception for property transferred for use in the active conduct of a trade or business outside of the United States.

These regulations eliminate the ability of taxpayers to transfer foreign goodwill and going concern value to a foreign corporation without incurring tax. The rules provide no exception for an active trade or business.

Treasury now argues that “an exception to the current regulations may be justified by both the structure of the statute and its legislative history.” Treasury, through the Office of Tax Policy, is proposing to expand the active trade or business exception to include relief for outbound transfers of foreign goodwill and going concern value attributable to a foreign branch under circumstances with limited potential for abuse and, curiously, administrative difficulties. The notion that making regulations controlling outbound transfers of foreign goodwill which simultaneously maximize simplicity and minimize risk of abuse, while noble in the articulation, has historically proven more aspirational than practical.

2. Temporary Regulations under Section 337(d) on Certain Transfers of Property to Regulated Investment Companies (RICs) and Real Estate Investment Trusts (REITs)

The Temporary Regulations amend existing rules on transfers of property by C corporations to RICs and REITs. The regulations also govern application of the PATH Act to spinoff transactions involving disqualification of nonrecognition treatment for C corporation property transferred to REITs. Treasury now believes that the REIT spinoff rules could result in over-inclusion of gain in some circumstances. This might be particularly problematic, Treasury says, when a large corporation acquires a small corporation that had engaged in a Section 355 spin-off and the large corporation then makes a REIT election.

Treasury now concludes that the temporary regulations may produce too much taxable gain in some cases. Hence, Treasury is considering proposing caps in situations where, because of the predecessor and successor rule in Reg. Section 1.337(d)-7T(f)(2), gain recognition is required in excess of the amount that would have been recognized if a party to a spin off had directly transferred assets to a REIT.

3. Final Regulations under Section 987 on Income and Currency Gain or Loss with Respect to a Section 987 Qualified Business Unit

These final regulations govern:

• Translation protocols forincome from branch operations conducted in a currency that differs from the owner’s functional currency;
• Calculating foreign currency gain or loss with respect to the branch’s financial assets and liabilities; and
• Recognizing foreign currency gain or loss when the branch makes certain transfers of property to its owner

The Treasury report states that these regulations “have proved difficult to apply for many taxpayers.” While this explanation meets none of the criteria advanced by the Executive Order, Treasury proposes as a solution to “defer application of Regulations Sections 1.987-1 through 1.987-10 until at least 2019.” It is unclear how delay of application of the regulations will respond either to the problem identified by Treasury or to the Executive Order.

Treasury takes its response to the subject regulations a couple of steps further. Treasury declares its intent to propose modifications to the final regulations to adopt a simplified method of translating and calculating Section 987 gains and losses, subject to unspecified timing limitations.  By way of example, the Report suggests rules that would treat all assets and liabilities of a Section 987 qualified business unit (QBU) as marked items and translate all items of income and expense at the average exchange rate for the year. Section 989 of the Code defines a QBU as “any separate and clearly identified unit of a trade or business of a taxpayer which maintains separate books and records.” The goal identified for this change is rendering Section 987 gain and loss consistent with currency translation gain and loss under applicable financial accounting rules and well as under the proposed Section 987 regulations proposed in 1991.

Treasury further proposes to limit a taxpayer’s Section 987 losses to the extent of its net Section 987 gains recognized in prior or subsequent years. The Report makes no reference to any proposed time limitation for this carryback and carryforward device.

1.   Conclusion

The October 2, 2017 Treasury Report further identifying the regulations whore removal or revision answer Executive Order 13789 appears to apply uneven and incomplete standards for those choices, and promulgate a strategy for revision and removal that may not yield, in the final analysis, a reduction in the number or complexity of  the tax regulations.

Counsel should, in any event, be aware of the changes proposed in the Report to appropriately anticipate the substantial revision in the legal landscape proposed by Treasury.

Corporations have been stockpiling cash awaiting promised tax reform. Enterprises have delayed capital investment, hiring, and cash allocation in anticipation of promised tax features such as lower rates. In February of 2017, the Secretary of the Treasury promised comprehensive tax reform before the August recess.

Because tax reform along the lines or scale articulated by some in government to date seems unlikely, I encourage businesses to consider deploying their capital more profitably than holding it in reserve.

I reviewed the circumstances generally present in the environments of each of the last eight significant tax reform acts. I found three factors present in the majority of them and offer here my view of why their presence then, and their absence now, bodes poorly for sweeping tax reform.

1. Lobbyists need to be kept at a distance or soundly aligned with the reform goals. Thus far, Congress has led with its chin by pushing such things as the Border Adjustment Tax and lower corporate tax rates. Now, K Street is already fully immersed in the process, either for or against. Neither required element of “Fair” or “Simple” is any longer possible.
2. A government more or less evenly divided, as it was in 1986, is essential so that no one party has to suffer the fallout from substantial tax reform. Division is considered not just by party within the legislative branch, but also as between the Houses of Congress and the president. See the chart below for an illustration of how this has shaped up in years when tax reform has passed. Also, recall that within 20 years after TRA 1986, over 15,000 changes to the tax law, most incrementally rolling back the changes, had already been made.
3. Revenue neutrality is a necessarily stated goal of tax reform. In 1986, Representatives took turns at the podium declaring their support for a bill that neither raised nor lowered government revenues. With a current budget deficit of about $440 billion, a tax gap of about $410 billion, and the largest income polarization in history, it’s going to be a tough sell to offer revenue neutrality. Without it, there can be no meaningful tax reform.

Given that none of the factors that have been historically required to accomplish sweeping tax reform are now present, I suspect we will not see it this year or in 2018.

This memo is intended only as an illustration of general principles. It is not intended as legal or tax advice. The reader is cautioned to discuss his or her specific circumstances with a qualified practitioner before taking any action.

Connecticut’s new Liability Company Act takes effect on July 1, 2017. It introduces numerous changes to Connecticut law and imposes several new requirements on LLCs and their members and managers. Of immediate importance to many LLCs are the several changes that the new law requires to existing operating agreements. This note will review some of those required changes.

While the new law was written to limit the impact it has on existing LLCs, it does require attention to every new and existing operating agreement so members and managers can be sure their agreements comply with the law and avail them of the opportunities within it.

At the outset, the new law changes the name of the initial LLC filing document from “Articles of Organization” to “Certificate of Organization.” The Act retroactively deems “Articles” filed under the old law to be a “Certificate” under the new law.

The new law also creates at least four statutory impositions which, if not suitably addressed by the operating agreement, control the LLC by new statutory requirements. Existing LLCs should immediately review their operating agreements (or the lack thereof) with an eye toward the effect of the new law.

One example of such impositions addresses admission of new members. Under the prior law, if the operating agreement was silent on the issue, the vote of a majority in interest was required to admit a new member. Under the new law, the default vote required is unanimity. If members want to retain the majority-in-interest vote for admission of new members, they must be sure the operating agreement affirmatively reflects this intent.

In a similar way, the old law required a two-thirds majority of votes in interest to amend the operating agreement. The new law now requires unanimous approval if the operating agreement is silent.

The new act describes in some detail the duty of care and level of loyalty required of members and managers. It also provides four areas in which the operating agreement may depart from these prescribed standards, so long as the departures are not “manifestly unreasonable.” The operating agreement may:

• Alter or eliminate certain portions of the duty of loyalty
• Identify specific behaviors that do not violate the duty of loyalty
• Alter, but not eliminate, the duty of care
• Alter, or eliminate, any other fiduciary duty

C.G.S. §34-243d(d)(3).

The notion of “manifestly unreasonable” will be refined by the courts over time. Pending that, it is imperative that LLCs preferring a less strict standard of loyalty or care for their members or managers, review and revise their operating agreements to so reflect.

It is also important to observe that the new law does not automatically recognize “sweat equity” as a valid metric for distributions. Rather, unless the operating agreement provides otherwise, the law now requires that distributions be based on their respective capital contributions rather than their percentage ownership. C.G.S. §34-255c(a). It is worth noting that federal partnership tax law has also changed to attribute losses differently under the new regulations under Section 707 of the Code.

C.G.S. §34-243d(d)(1)(B) allows for the operating agreement to provide for a more liberal definition of illiquidity than is provided by the default provision of §34-255d(a), which prohibits a LLC from making a distribution if any of the following tests for illiquidity are met: (1) The company would not be able to pay its debts as they become due in the ordinary course of the company’s activities and affairs; or (2) the company’s total assets would be less than the sum of its total liabilities plus the amount that would be needed, if the company were to be dissolved and wound up at the time of the distribution, to satisfy the preferential rights upon dissolution and winding-up of members and transferees whose preferential rights are superior to those of persons receiving the distribution.

If the members want to use the more liberal provision of § 34-243d(d)(1)(B), they may include in the operating agreement a provision that a lawful distribution requires only that the company’s total assets not be less than the sum of its total liabilities.

While the new law provides LLCs considerable discretion in formulating their operating agreements, it provides fourteen circumstances in which LLCs either may not override the statutes or limits their ability to do so.

C.G.S. §34-243d(c) now provides:

(c) An operating agreement may not:

(1) Vary the law applicable under section 34-243c;

(2) vary a limited liability company’s capacity under subsection (a) of section 34-243h, to sue and be sued in its own name;

(3) vary any requirement, procedure or other provision of sections 34-243 to 34-283d, inclusive, pertaining to: (A) Registered agents; or (B) the Secretary of the State, including provisions pertaining to records authorized or required to be delivered to the Secretary of the State for filing under sections 34-243 to 34-283d, inclusive;

(4) vary the provisions of section 34-247c [giving the Superior Court jurisdiction to compel signing, filing, or filing of unsigned records with the Secretary of the State]

(5) alter or eliminate the duty of loyalty or the duty of care, except as provided in subsection (d) of this section;

(6) eliminate the implied contractual obligation of good faith and fair dealing under subsection (d) of section 34-255h, except that the operating agreement may prescribe the standards, if not manifestly unreasonable, by which the performance of the obligation is to be measured;

(7) relieve or exonerate a person from liability for conduct involving bad faith, willful or intentional misconduct, or knowing violation of law;

(8) unreasonably restrict the duties and rights under section 34-255i [generally governing rights of members and managers, and rights for former members to information], except that the operating agreement may impose reasonable restrictions on the availability and use of information obtained under said section and may define appropriate remedies, including liquidated damages, for a breach of any reasonable restriction on use;

(9) vary the causes of dissolution specified in subdivisions (4) and (5) of subsection (a) of section 34-267 [which address the jurisdiction of the Superior Court to dissolve the LLC on application by a member for any of four reasons: i) The conduct of all or substantially all of the company’s activities and affairs is unlawful; ii) it is not reasonably practicable to carry on the company’s activities and affairs; iii) the managers have acted, are acting or will act in a manner that is illegal or fraudulent; or iv) the managers have acted or are acting in a manner that is oppressive and was, is, or will be directly harmful to the applicant]

(10) vary the requirement to wind up the company’s activities and affairs as specified in subsections (a) and (e) of section 34-267a  [articulating general and specific circumstances of the wind up of  certain LLCs] and subdivision (1) of subsection (b) of section 34-267a [describing duties of filing and debt payment for wound-up LLCs]

(11) unreasonably restrict the right of a member to maintain an action under sections 34-271 to 34-271e, inclusive;

(12) vary the provisions of section 34-271d [generally describing the duties and powers of a special litigation committee], except that the operating agreement may provide that the company may not have a special litigation committee;

(13) vary the required contents of a plan of merger under subsection (b) of section 34-279h or, a plan of interest exchange under section 34-279m; or

(14) except as provided in section 34-243e [assent to Operating Agreement] and subsection (b) of section 34-243f, [obligations of LLC and members to transferees] restrict the rights under sections 34-243 to 34-283d [addressing a broad range of rights and duties of LLCs, members, and managers], inclusive, of a person other than a member or manager.

Under the new act, an LLC operating agreement may not relieve a person from liability for conduct involving bad faith, intentional or willful misconduct, or a knowing violation of the law. C.G.S. §34-243d(c)(7). I note especially this change in law here because many existing operating agreements exempt members or managers from liability exempting from such exoneration only in cases of “fraud, gross negligence, or willful misconduct.” LLC members should review their operating agreements and reconcile their intended relief with the new statutory requirements, insofar as possible.

The new statute also addresses the rights of members to access and inspect LLC records.  In practice, we have seen access to records as a point of friction, often within LLCs experiencing dissent among members. The law now provides that an operating agreement may not impose unreasonable restrictions on access to information. It may, however, impose reasonable restrictions on the availability of use of the information. For example, the LLC may require the accessing member to execute and deliver a non-disclosure agreement. The operating agreement may also define particular remedies for breaches of reasonable restriction on the use of the information. C.G.S. §34-243d(c)(8).

While the new act explicitly articulates that “[i]t is the policy of the act to give maximum effect to the principles of freedom of contract and to enforceability of LLC agreements,” the limitations and restrictions it establishes demand careful attention to both existing and new operating agreements.

LLCs that have never had an operating agreement are not required by the new law to adopt one, but LLCs without a compliant agreement will now be subject to the default provisions of the law, whose effect may not be intended or desired by the members or managers.

This note is intended only to illustrate general principles and is not legal or tax advice. The reader should discuss his or her specific circumstances with a qualified practitioner before taking any action.