Pastore & Dailey represented a mortgage servicing company in a financing transaction designed to allow the company to service a multinational bank. The transaction required expert and careful drafting and negotiation as it involved affiliates as well. Goodwin Proctor’s San Francisco office represented the lender.
Tag: Corporate
IRS Proposes to Exclude S Corporations from the New Carried Interest Exception
On March 1, 2018, IRS released Notice 2018-18 announcing that Treasury and IRS intend to issue regulations providing guidance on the application of Code §1061, enacted under P.L 115-97 to S corporations. This new statute section treats carried interests of fund managers.
Some background is important. Code Section 1061(a) states that, if one or more applicable partnership interests are held by a taxpayer at any time during the tax year, the excess (if any) of (a) the taxpayer’s net long-term capital gain with respect to such interests for such tax year, over (b) the taxpayer’s net long-term capital gain with respect to such interests for such tax year computed by applying paragraphs (3) and (4) of Section 1222 by substituting “3 years” for “1 year,” shall be treated as short-term capital gain. Such gain is taxable at the holder’s marginal income tax rate, which may be as high as 37% (plus the 3.8% net investment income tax, if applicable).
Section 1061(c)(1) defines “applicable partnership interest” as any interest in a partnership which, directly or indirectly, is transferred to (or is held by) the taxpayer in connection with the taxpayer’s performance of substantial services, or any other related person, in any applicable trade or business. An “applicable trade or business” means any activity conducted on a regular, continuous and substantial basis which, regardless of whether the activity is conducted in one or more entities, consists, in whole or in part, of: (A) raising or returning capital, and (B) either: (i) investing in (or disposing of) specified assets (or identifying specified assets for such investment or disposition), or (ii) developing specified assets. The term “specified assets” means securities, commodities, real estate held for rental or investment, cash or cash equivalents, options or derivative contracts with respect to any of the foregoing, and an interest in a partnership to the extent of the partnership’s proportionate interest in any of the foregoing.
Section 1061(c)(4)(A) provides that the term “applicable partnership interest” does not include any interest in a partnership held directly or indirectly by a corporation. (emphasis added).
Being able to continue to treat carried interest as a capital gain, at a 20% rate is an advantage to a fund manager, of course, so access to the exemption under Section 1061 has become notably important to hedge fund managers.[1] It is not clear that the increase of the holding period to qualify for capital treatment will actually have much effect, though, as the average holding period for private equity is around 6 years.[2]
So, it appears that managers are hoping that placing carried interest in a single member LLC, then electing to have the LLC treated as an S corporation, will qualify them for exemption from the three-year holding period to access capital gain treatment.
Notice 2018-18 states that regulations will be forthcoming that provide that the term “corporation,” as used in Code section 1061(c)(4)(A) does not include an S corporation, the plain language of the statute notwithstanding. While Section 1061(f) authorizes Treasury to issue regulations “as is necessary or appropriate to carry out the purposes of this section,” it offers no further guidance.
Consider that the interpretation promulgated in Notice 2018-18 proposes treatment, for this purpose, of an S corporation as an individual. This is not without precedent. In Rev. Rul. 93-36, the Service held that certain bad deduction rules, while generally not applicable to corporations, apply to S corporations because of the “same manner” device used in Code §1363(b).[3] The Tax Court has taken a slightly different approach. In Rath v. Commissioner, the court declined to allow Section 1244 loss treatment, which is applicable only to small business corporation stock sold by an individual or partnership, to stock sold by an S corporation.[4]
Also worth noting is that Notice 2018-18 is conspicuously silent on its authority to exclude S corporations from access to Code Section 1061(c)(4)(A). It may be that the Service hopes this preemptive announcement has the effect of discouraging the growing number of fund managers seeking to access treatment as a corporation for purposes of exempting carried interests from higher tax exposure.
[1] According to a report in Bloomberg, there was a 19% increase in LLC filings in Delaware during December of 2017 https://www.bloomberg.com/news/articles/2018-02-14/new-hedge-fund-tax-dodge-triggers-wild-rush-back-into-delaware
[2] The New York Times reported this figure in November of 2017. https://www.nytimes.com/2017/11/17/business/republican-tax-plan-carried-interest.html
[3] The revenue ruling states that, but for certain exceptions enumerated in §1363(b), an S corporation’s taxable income is computed in the same manner as an individual’s income. Given that §166 is not specifically listed as an exception to the general rule of §1363(b), the revenue ruling concludes that §166 applies to an S corporation in the same manner as it applies to an individual. Thus, an S corporation must claim a short-term capital loss for its wholly worthless nonbusiness debt.
[4] 101 T.C. 196 (1993)
Preserving Loan Treatment of S Corporation Payments from Shareholders
The sense of control and informality of operations experienced by shareholders of S corporations is a robust bridge for entrepreneurs, providing them an accessible connection between their personal and work lives, without the constraints of a board of directors, awkward motions and resolutions, and the pesky documentation requirements attorneys seem to impose on entrepreneurs in some other forms of business.
Among the most prevalent and cherished characteristics of S corporations is the perception by their owners that the income tax transparency of the S corporation translates into the interchangeability of the corporation with the shareholders for all tax purposes.
On August 24, 2016, the Tax Court filed a Memorandum decision providing a good review of the standards for characterization of transfers between shareholders and close corporations as either loans or capital contributions. Tax attorneys see, all too often, shareholders, partners and other principals receive large and unexpected tax bills, with penalties and interest added, resulting from incomplete or inaccurate application of the rules associated with capital contributions and loans to businesses they control. Virtually without exception, the taxpayer is caught by surprise.
In Scott Singer Installations, Inc., T.C. Memo 2016-161 (August 24, 2016), the sole shareholder and sole officer of an S corporation loaned over $1 million to his corporation over about a 5 year period. During the same period, the company paid the shareholder’s personal expenses by paying his creditors directly.
All of the cash advances by the shareholder were reported as shareholder loans on the corporation’s books of account and on the Form 1120S. There were, however, no promissory notes executed and no interest charged. (A discussion of the correct way to calculate and document interest charges under the tax rules is beyond the scope of this article.)
The IRS audited the books and records of the corporation and concluded that the payment by the corporation of its shareholder’s expenses was taxable income to the shareholder, and, further, subject to employment withholding taxes. The IRS further concluded the advances made by the shareholder were contributions to capital. While such treatment would have the effect, among other things, of increasing the shareholder’s basis in the corporation, it would also generally render the repayments of the advances as return of capital, rather than debt repayment, and the interest portion would not be recognized for tax purposes.
With regard to the advances, the Tax Court weighed the factors associated in law to determine of there was a genuine intention to create a debt, with a reasonable expectation of repayment, and whether that intention was consistent with the economic reality of creating a debtor-creditor relationship. The court found the fact that the corporation consistently carried the advances as outstanding loans on its ledger. It further found that the consistency of the corporation’s payments expense payments for its shareholder, even when the corporation was losing money, supported the conclusion that such payments were debt service and not ordinary income.
The Tax Court’s discussion calls to mind the nonexclusive 13 part test typically used in evaluating the nature of transfers to closely held corporations:
- The names given to the documents that would be evidence of the purported loans;
- The presence or absence of a fixed maturity date;
- The likely source of repayment;
- The right to enforce payments;
- Participation in management as a result of the advances;
- Subordination of the purported loans to the loans of the corporation’s creditors;
- The intent of the parties;
- The capitalization of the corporation;
- The ability of the corporation to obtain financing from outside sources;
- Thinness of capital structure in relation to debt;
- Use to which the funds were put;
- The failure of the corporation to repay; and
- The risk involved in making the transfers. (Calumet Indus., Inc., (1990) 95 TC 25795 TC 257)
These tests are, of course, factual, and weighted differently in each case. Hence, it is incumbent on shareholders of S corporations to assure, through clear, written and contemporaneous documentation, consistently prepared and maintained, that the elements of the creditor-debtor relationship are demonstrated in cases where the shareholder is lending money to the corporation.
This article is not intended as legal or tax advice and is a discussion of general principles only. The reader should consult with a qualified professional concerning his or her specific circumstances before taking any action.
Smolnik Appointed New Chair of Subcommittee by CT General Assembly
Dan Smolnik, Of Counsel with Pastore & Dailey LLC, has just been appointed by the Connecticut General Assembly to the Commission on Connecticut’s Leadership in Corporation & Business Law. He will be chairing the subcommittee on tax law and policy.
Pastore & Dailey LLC Secures Over $60 Million for Clients
Pastore & Dailey LLC is pleased to announce that the Firm has, to date, secured over $60 Million in grants and low-interest loans for Connecticut businesses through various programs with the State of Connecticut Department of Economic and Community Development.
Through the work of Attorney Susan Bysiewicz, a former Secretary of the State of Connecticut and former candidate for the United States Senate, the Firm has enabled Connecticut business owners to create over 425 private-sector jobs in manufacturing, precision engineering, green and renewable energy, and many other industries.
Pastore & Dailey LLC credits these successes to the Firm’s client-centered approach and comprehensive application process. To date, all clients that have applied for assistance through these programs have received funding. Assistance packages range from $60,000 to $48 Million. Loan packages include various levels of loan-forgiveness and carry interest rates as low as 2%.
For more information, contact Atty. Susan Bysiewicz in the Firm’s Glastonbury office: 860.266.6870 or by email, sbysiewicz@psdlaw.net.
Approved Counsel Listing
Pastore & Dailey is pleased to announce that it has been added to the approved counsel list for an International Fortune 500 Bank based out of Germany and to one of the leading banks in Fairfield County, Connecticut. We are pleased that these banks have both recognized the quality and character of our growing Firm.
DECD Small Business Express Program Financing Transaction
In April 2013, Pastore & Dailey’s transactional team successfully concluded a combination grant and loan financing transaction on behalf of a New Haven based manufacturer serving the aerospace industry. The transaction was completed in connection with the recently established State of Connecticut Department of Economic and Community Development (DECD) Small Business Express Program which seeks to provide the maximum return on investments to state taxpayers in the form of job creation and capital investment. The DECD funding will play a key role in the expansion and modernization of our client’s manufacturing facility located in New Haven, Connecticut as well as the creation of a number of new full-time jobs in Connecticut.