It’s Still Pretty Bad

Depending upon what you read or, perhaps more accurately, depending upon how much you believe of what you read, you may be aware that many closely held businesses are concerned about their future.

Most of these survived the disruption caused by the pandemic lockdown only to be confronted with rising inflation, higher borrowing costs, a scarcity of available workers, the phaseout of COVID-era public support programs, and the potential for increased federal and state tax burdens.

Add to these already daunting challenges the prospect of a destabilized society and an ever more threatening world, and you can understand why many owners may be fearful for the future of their business.

Staying Alive

Owners will generally do what they can to keep their businesses viable. Although the great majority of owners will remain within the boundaries of the law, a not insignificant number may consider, and ultimately follow through with, a “strategy” that is often utilized by businesses in distress.

Specifically, such a business may intentionally fail to remit to the taxing authorities those taxes that the business has withheld or collected on their behalf – typically, an employee’s share of employment taxes on wages paid by the employer-business, as well as state and local sales taxes.

Why would a business engage in such behavior? The reasoning goes something like this: “Revenues were down. We just needed some time to recover – the tax dollars withheld were going to pay expenses and help us sustain the business until it became profitable once again. At that point, we would have paid the back taxes owing.” 

As you can imagine, it rarely works out that way, the business fails, and the owners are left holding the proverbial bag.

Bad Actors

There are times, however, in which this decision is not consciously adopted as a matter of “company policy” but, rather, is undertaken by only one well-positioned owner or officer of the business, unbeknownst to the others.

At other times, an outside service provider may divert the taxes withheld, not to benefit the business, but for their own personal gain; in other words, they embezzle the money.

A recent decision of the U.S. Tax Court[i] considered a case of embezzlement by the accountant for a closely held business that resulted in the business failing to satisfy its obligation to remit to the IRS the taxes withheld from its employees’ wages.

I suppose the case is mildly entertaining in a morbid sort of way, but before describing the circumstances presented to the Court, let’s briefly review the applicable law.

Trust Fund Recovery Penalty 
Federal law requires employers to withhold income, Social Security and Medicare tax from their employees’ wages at the time that the wages are paid to the employees.[ii] The withheld taxes are held in trust by the employer, to be remitted to the IRS at the appropriate intervals.[iii]

Because the withheld taxes are held in trust by the employer, the funds may not be used for any other purpose. If these taxes are not timely remitted to the government, the latter can pursue the company’s officers individually for the unpaid taxes, plus penalties and interest – the so-called Trust Fund Recovery Penalty (TFRP).[iv]

The Code provides:

Any person required to collect, truthfully account for, and pay over any tax imposed by this title who willfully fails to collect such tax, or truthfully account for and pay over such tax, or willfully attempts in any manner to evade or defeat any such tax or the payment thereof, shall, in addition to other penalties provided by law, be liable to a penalty equal to the total amount of the tax evaded, or not collected, or not accounted for and paid over.

A “person” within the meaning of this provision includes an officer or employee of a corporation who is under a duty to perform the act with respect to the alleged violation.[v]

To incur liability for the withheld taxes under this provision, an individual must be a responsible person – one who is under a duty to act – and must willfully fail to pay over the taxes in question. Stated differently, “[a] responsible person is someone who has the status, duty and authority to avoid the corporation’s default in collection or payment of the taxes.” 

Because “responsibility” for purposes of this rule is based upon one’s status, duty and authority within the employer organization, it is possible that more than one person may be identified as a “responsible.” However, that fact alone is immaterial to determining another responsible person’s liability.

In addition, a “responsible person” will not be relieved of their status – or absolved from their failure to collect and/or pay over a tax – merely because of the malfeasance of a subordinate.

With these basics in mind, let’s turn to the Court’s decision.

Mathematically Challenged

Taxpayer organized and incorporated Company as a management consulting and executive recruiting business.

Taxpayer was Company’s chief executive officer (CEO) and its sole shareholder. He had the authority to hire and fire employees of Company and exercise control over Company’s bank accounts.

Taxpayer claimed to suffer from a learning disability with respect to mathematics,[vi] though he was otherwise competent to conduct his personal and business affairs. Throughout his professional career, Taxpayer delegated many business, and sometimes personal, financial responsibilities to various employees and accountants, including to a particular certified public accountant (CPA).

Before the periods in dispute, Taxpayer hired CPA to manage Company’s bookkeeping and other accounting matters. Unfortunately for Company and Taxpayer, CPA embezzled between one and two million dollars from Company over an unspecified period of years.  

You Can’t Make It Up

The embezzlement scheme was discovered under very unusual circumstances.

CPA was meeting with Taxpayer and Taxpayer ‘s financial planner to go over financial records that, unbeknownst to the others, CPA had fabricated to cover up his embezzlement.

It may have been guilt or regret, or it may have been karma. Whatever the cause, CPA suffered a heart attack.[vii]

Query whether Taxpayer would have acted differently had he been aware of the losses Company incurred on account of CPA’s betrayal. In any case, Taxpayer immediately “took actions” that, according to him, saved CPA’s life.

Following this close encounter with his own demise, and while recovering at the hospital, CPA confessed to the embezzlement.[viii]

Taxpayer hired attorneys and accountants to reconstruct the amount of the losses that Taxpayer and Company sustained because of CPA’s embezzlement. Later, Taxpayer and Company sued CPA and others to recover those losses.

According to the complaint filed in one of those lawsuits, CPA embezzled and spent funds that were allocated for the payment of Company’s employment taxes.

Company and Taxpayer subsequently sued the bank that CPA used to further his embezzlement scheme.

While Taxpayer’s lawsuits were pending, Taxpayer continued to operate Company, during which time he paid himself a bonus.

Also during this time, math-challenged Taxpayer transferred funds from Company’s bank accounts to accounts maintained by a new business entity that Taxpayer had organized.

The lawsuits were eventually settled by the payment of substantial sums to Taxpayer.

Taxpayer used a portion of these settlement proceeds to pay personal expenses. None of the settlement proceeds from either lawsuit were used to pay any of Company’s outstanding employment tax liabilities.[ix]

The IRS Steps In

The IRS determined that Company had failed to collect and/or remit certain employment taxes owed for certain periods. After appropriate supervisory approval for the assessment of the TFRP, the IRS notified Taxpayer of the then-proposed TFRP assessment.

Taxpayer and his representatives subsequently met with an IRS revenue officer to discuss whether Taxpayer should be held liable for the TFRP.

The IRS assessed the TFRP and notified Taxpayer that a Notice of Federal Tax Lien (NFTL) had been filed with respect to the underlying liability. Taxpayer was advised of his right to request an administrative hearing to challenge that collection action, which he did.

On the form requesting a hearing, Taxpayer checked the box for “Offer in Compromise” and took the position that there was doubt as to the underlying liability. Taxpayer was later notified of the IRS’s determination to proceed with collection of the underlying liability.

In response to that determination, Taxpayer filed a Petition with the Tax Court challenging the IRS’s determination of the existence of that liability.[x] 

The Court’s Analysis

The issue before the Court was whether Taxpayer, as the sole shareholder and as an officer of Company at the relevant times, was a person required to collect, truthfully account for, and pay over the employment taxes in question. 

According to the IRS, when the Company failed to withhold and/or pay over certain employment taxes to the IRS, Taxpayer became liable as a responsible person for the Trust Fund Penalty in an amount equal to those employment taxes.

Of course, Taxpayer argued he was not a responsible person at the relevant times.

The Court explained that, under the Code,[xi] “[a]ny person required to collect, truthfully account for, and pay over” any federal tax “who willfully fails” to do so, shall “be liable to a penalty equal to the total amount” of that tax. The Court added that the word “person” as used above, included an officer or employee of a corporation who is under a duty to collect, account for, and pay over the tax.[xii] The Court stated that such persons are referred to as “responsible” persons. It then observed that the term is “broadly applied.”

The Court then expanded upon the foregoing definition, stating that whether someone is a responsible person is “a matter of status, duty and authority, not knowledge.” The essential question, the Court added, is whether the person had sufficient control over an employer-taxpayer’s affairs to ensure the payment of the taxpayer’s employment taxes.

According to the Court, the indicia of that control held by a responsible person include “the holding of corporate office, control over financial affairs, the authority to disburse corporate funds, stock ownership, and the ability to hire and fire employees.” In considering an individual’s status, duty, and authority, the Court continued, “the test is one of substance, and the focus of the inquiry does not involve a mechanical application of any particular list of factors.” In other words, the inquiry must focus on actual authority to control, not on “trivial duties.”

According to Taxpayer, because of his allegedly limited ability to comprehend mathematical concepts, he was not a responsible person.

According to the IRS, because of Taxpayer’s position, authority, and control over Company’s affairs, he was responsible for ensuring that Company’s withholding tax obligations were satisfied.

The Court agreed with the IRS.

Court’s Opinion

During the relevant periods, Taxpayer was Company’s CEO and sole shareholder. Taxpayer controlled the financial affairs of Company, disbursing corporate funds both to himself and to a newly formed business entity. Taxpayer also exercised authority to hire and fire employees and delegated various tasks involved in operating Company to those employees. Taxpayer apparently made the decision to sue CPA on Company’s behalf.

Therefore, the Court concluded, Taxpayer clearly had and exercised control over Company’s corporate affairs.

Responsible Person

Still, Taxpayer pointed to his difficulties comprehending mathematical concepts and noted that he hired others, including CPA, to take responsibility for Company’s bookkeeping and tax matters. As Taxpayer viewed the matter, the failure to pay Company’s employment taxes resulted from CPA’s embezzlement, not from anything Taxpayer did or failed to do.

Relying heavily on these reasons, Taxpayer argued that he should not be held liable as a “responsible person” for Company’s employment taxes.

In response to these assertions, the Court focused on Taxpayer’s authority to control Company’s obligations to pay its employment taxes, not on whether he personally took responsibility for that duty. Considering Taxpayer’s position with Company and taking into account his decisions to disburse Company funds to pay for items other than Company’s employment tax liabilities, the Court found that Taxpayer was a responsible person for purposes of Company’s outstanding employment tax liabilities.

Willfulness

Taxpayer also challenged the assessment of the TFRP because he did not “willfully” fail to pay Company’s employment taxes for the period or periods here in dispute.

The Court explained that once a person is demonstrated to be a “responsible person,” the burden is on that person to establish that the failure to pay a tax was not willful. 

“Willfulness” for this purpose, the Court continued, was indicated if a responsible person, instead of paying a taxpayer’s outstanding employment taxes, used the taxpayer’s funds for other purposes.

In the present case, Taxpayer became aware of Company’s – as well as his own – failure to pay employment taxes no later than when he filed a lawsuit alleging that CPA had “confessed to spending the funds allocated for payment of employment taxes.” Yet, after learning of the failure to pay Company’s employment taxes, Taxpayer nonetheless disbursed Company’s funds to pay obligations other than those owed to the IRS: Taxpayer transferred funds from Company to a newly formed business entity that he organized after Company’s employment taxes were assessed; he paid himself a not insignificant bonus; and he used the proceeds received from the settlement of the lawsuits for various other purposes, but not to satisfy any of Company’s outstanding employment tax liabilities.

Taxpayer blamed the failure to pay Company’s employment taxes on CPA, but the Court refused to accept that Taxpayer’s delegation of the responsibility to collect and pay over Company’s employment taxes could support a finding that Taxpayer did not willfully fail to pay those employment taxes. Taxpayer was obligated to ensure that Company’s employment taxes were collected and paid over to the IRS even though he delegated responsibility for discharging that duty to CPA. 

The Court found that Taxpayer failed to demonstrate that his failure to satisfy Company’s employment tax liabilities was not willful.

Reasonable Cause

Likewise, the Court rejected Taxpayer’s suggestion that he had reasonable cause for failing to ensure that Company’s employment tax liabilities were satisfied. The Court pointed out that, after becoming aware of Company’s outstanding employment taxes, Taxpayer used Company funds for other purposes. “No such defense may be asserted,” the Court stated, by a responsible person who knew that the withholding taxes were due, but who made a conscious decision to use corporate funds to pay creditors other than the government.” 

Importantly, the Court added, like employers who handle their own payroll duties, employers who outsource this function still are legally responsible for any and all payroll taxes due; i.e., federal income taxes withheld, as well as both the employer and employee’s share of Social Security and Medicare taxes. This remains true even if the responsible person outsourced the payroll tasks and forwarded all of the funds to a third-party provider to make the required deposits or payments.

Parting Thoughts

It isn’t easy running a business. One has to deal with often difficult customers or clients, sometimes unreliable vendors or suppliers, always determined competitors, demanding creditors, a mixed bag of employees, and at times uncooperative partners.[xiii] During their free time, the owner focuses on the core of their business, and the reason they went into business in the first place – the services they provide or the product they manufacture.

Under these circumstances, it is necessary that various administrative duties be delegated to others.

That said, it is imperative that the owner familiarize themselves with the tax obligations imposed upon their business, that they periodically check in with (and upon) those to whom they have assigned the task of satisfying these obligations, and that they immediately address any apparent errors or inconsistencies, as well as any suspicions. 

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The opinions expressed herein are solely those of the author(s) and do not necessarily represent the views of the Firm.

[i] Taylor v. Comm’r, T.C. Memo. 2024-33.

[ii] IRC Sec. 3101, 3102(a), (b), 3402, 3403. In some cases, sooner; for example, nonqualified deferred compensation may be included in income for certain withholding tax purposes when the employee becomes vested in the benefit, even though payment may not occur until a later year.

[iii] IRC Sec. 7501.

[iv] IRC Sec. 6672(a).

[v] IRC Sec. 6671(b). 

[vi] The Court didn’t elaborate on this and, frankly, my initial response was to doubt Taxpayer’s veracity. However, it turns out there are various learning disabilities that involve one’s ability to do math; for example, dyscalculia.

[vii] It’s also possible that CPA was on a Big Mac Large Fries Chocolate Shake diet. No, this isn’t about me. I prefer vanilla.

[viii] A “nearly deathbed” confession.

[ix] You know where this is going.

[x] A taxpayer who challenges an underlying liability in cases such as this one bears the burden of proof regarding the correct tax liability. TC Rule 142(a).

[xi] IRC Sec. 6672(a)

[xii] IRC Sec. 6672(a) and Sec. 6671(b).

[xiii] It’s a wonder that as many folks go into business for themselves as they do.

Last week, Sen. Warren reintroduced her “Ultra-Millionaires” wealth tax proposal to the Senate.[i] Query her timing. The measure has the proverbial snowball’s chance in Hell of being enacted by this Congress.[ii] Perhaps the Senator was inspired by the Administration’s Fiscal Year 2025 Budget, which includes its own equally ill-fated – at least for now – version of a wealth tax.[iii]   

The more likely explanation for the revival of the Senator’s tax plan is the upcoming contest for the White House, which has begun in earnest,[iv] and the Administration’s focus on what it has described as tax avoidance[v] by the “wealthy”[vi] and especially by the very wealthy.

Does that mean business owners can safely disregard the Senators’ and the Administration’s tax proposals as election year demagoguery?

Hardly. Both Chambers of Congress are up for grabs, as is the White House. The Democrats controlled the legislative process from 2021 through 2022 and, but for two outliers, they came very close to enacting some serious tax increases.[vii] At this point in the election cycle, there is no reason to discount the possibility they will have another opportunity to turn their income tax agenda into law.[viii]

For this reason, it would behoove business owners and their advisers to familiarize themselves with the changes to the federal income tax that have been proposed by the Administration, as set forth in the 2025 budget, to consider the potential consequences thereof and, to the extent feasible, to develop plans that may be implemented in response.

With that possibility in mind, what follows is a summary of several income tax proposals of which the closely held business and its owners should be made aware.[ix]

Individuals’ Ordinary Income

i. The marginal individual income tax rate applicable to the compensation,[x] interest, rents, and other items of ordinary income that are included in an individual’s gross income, would be increased from 37 percent to 39.6%.

a. Actually, the increase would be considerably greater because the new top rate would apply starting at a much lower tax bracket.[xi]

b. Specifically, the current top rate of 37 percent applies to taxable income over $731,200 for a married couple filing jointly. Under the proposal, the same couple would be subject to the top rate of 39.6 percent for taxable income over $450,000.

ii. In the case of a shareholder of an S corporation or an individual partner of a tax partnership, the owner’s share of the entity’s ordinary business income would be subject to the higher rate.

iii. Where the gain from the sale of certain property between certain related persons is treated as ordinary income, the tax on such gain would be more expensive.[xii]

iv. In the context of the sale of a business, the higher rate would apply to the seller’s depreciation recapture, inventory, covenant not to compete, and any stated or imputed interest in respect of any deferred payments of purchase price.

Individuals’ Long-Term Capital Gain

v. Long-term capital gains[xiii] of married taxpayers filing jointly would be taxed at ordinary income rates to the extent their taxable income exceeds $1 million.[xiv]

vi. It appears that the long-term capital gain arising from the sale of a business would also be subject to the increased rate.[xv]

vii. The same would be true for payments received on an installment note received in connection with the sale of property, even if the sale preceded the rate increase.

Net Investment Income Tax (NIIT)

viii. The tax rate for an individual’s net investment income (NII)[xvi] would be increased from 3.8 percent to 5 percent for those individuals with more than $400,000 of income.

ix. The NII base – which now includes (a) interest, dividends, rents, and royalties, other than such income derived in the ordinary course of a trade or business, (b) income derived from a trade or business in which the taxpayer does not materially participate, and (c) net gain from the disposition of property other than property held in a trade or business in which the taxpayer materially participates – would be expanded to ensure that all pass-through business income of high-income taxpayers is subject to either the NIIT or SECA[xvii] tax.

a. Specifically, the amount of trade or business income subject to the NIIT would be determined by adding together (a) the ordinary business income derived from S corporations for which the shareholder materially participates[xviii] in the trade or business, (b) the ordinary business income derived from either limited partnership interests or from interests in LLCs (classified as partnerships) to the extent a limited partner or LLC member materially participates in the partnership’s or LLC’s trade or business, and (c) any other trade or business income to the extent it is not currently subject to NIIT or SECA.[xix]

b. A graduated percentage of this additional income would be subject to the NIIT beginning with married taxpayers filing jointly with adjusted gross income of $400,000 and would reach 100 percent when their adjusted gross income reaches $500,000.

Medicare Tax

x. The additional Medicare tax that is imposed on the self-employment earnings and wages of individuals would be increased from 3.8 percent to 5 percent for individuals with more than $430,000 of earnings.

Individual Shareholders

xi. If a corporation makes a loan to a related corporation for the purpose of enabling the related corporation to make a distribution to its individual shareholders that is treated as a nontaxable return of stock basis, such distribution would be treated instead as a taxable dividend.[xx]

xii. In the case of individuals with taxable income of more than $1 million for a tax year, any qualified dividends qualified dividends[xxi] included in their gross income for such year would be taxed at the top ordinary rate of 39.6 percent.

a. For example, a taxpayer with $1.1 million in taxable income of which $200,000 is qualified dividends and long-term capital gain (“capital income”) would have $100,000 of capital income taxed at the preferential rate of 20 percent and $100,000 taxed at the ordinary rate of 39.6 percent.[xxii]

Minimum Income Tax

xiii. A minimum annual tax of 25 percent would be imposed on the total income[xxiii] of an individual with net wealth[xxiv] greater than $100 million.

a. The minimum tax would be phased in for taxpayers with net wealth in excess of $100 million, and would be fully phased in for taxpayers with wealth greater than $200 million.

b. Taxpayers with wealth greater than the threshold amount would be required to report to the IRS on an annual basis, separately by asset class, the total basis and total estimated value of their assets in each asset class, and the total amount of their liabilities.[xxv]

Basis Shifts in a Partnership

xiv. Members of a partnership who are related to one another would be limited in their ability to use the “inside basis” adjustment election[xxvi] to shift basis between them for the purpose of achieving tax savings.

xv. Specifically, if an in-kind distribution of partnership property results in a step-up for the basis of the partnership’s remaining property,[xxvii] a “matching rule” would be applied that would prohibit any partner that is related to the distributee-partner from benefitting from the partnership’s basis step-up until the distributee-partner disposes of the distributed property in a fully taxable transaction.[xxviii]

Excess Business Loss

xvi. The Code provision that reduces the ability of individual taxpayers to use business losses to offset unrelated income – by capping the net amount of deductible business losses at $305,000 per individual taxpayer per year and disallowing the excess – would be made permanent.[xxix]

xvii. It would also treat the excess business losses carried forward from the prior year as current-year business losses – instead of as NOL deductions, as under current law – which would subject the carryforward to the cap for that year, thereby further limiting the taxpayer’s ability to utilize such excess.

Corporate Tax Rate

xviii. The income tax rate for C corporations, including those that are closely held, would be increased from a flat 21 percent to 28 percent.[xxx]

a. The greater tax liability would leave the corporation with fewer funds to reinvest in its business, and may cause it to borrow money and/or to forego distributions.

b. The increased rate would also make the sale of the corporation’s assets more expensive.

xix. The rate used to compute the tentative minimum tax for a C corporation would be increased from 15 percent to 21 percent.

S Corporations[xxxi]

xx. S corporations would be subject to a flat income tax rate of 28 percent with respect to the net recognized built-in gain for a taxable year that is within the 5-year recognition period,[xxxii] up from the 21 percent[xxxiii] that has applied since 2018. 

xxi. Likewise, for any taxable year in which an S corporation has (a) accumulated earnings and profits from C corporation years, and (b) gross receipts more than 25 percent of which are passive investment income, the tax on the S corporation’s excess net passive income[xxxiv] would be imposed at the increased rate of 28 percent.

Deduction for Compensation

xxii. For purposes of determining its taxable income, a closely held C corporation would not be allowed to claim a deduction for compensation paid in excess of $1 million to any employee.[xxxv]

a. In general, the compensation subject to this rule includes all otherwise-deductible compensation paid to an employee for services rendered, including cash and non-cash compensation, performance-based compensation, and commissions.[xxxvi]

b. Query the interplay between the proposed increase in the tax rate for compensation, especially in connection with the sale of a business, and the proposed denial of a deduction for the payment or accrual of such compensation in that context.

xxiii. All corporate members of a “controlled group” would be treated as a single employer for purposes of applying this disallowance rule, thus making it more difficult for corporations to avoid the limitation by directing payment from another, related entity for which the employee also provides some services.

xxiv. For purposes of determining the amount of compensation paid to an individual, the disallowance rule would consider as compensation any amounts paid to the employee from an affiliated partnership rather than directly from the employer-corporation.

xxv. In addition, the Treasury would be directed to issue regulations to prevent avoidance of the rule, including through the individual’s performance of services other than as an employee.

Losses on Liquidation of Corp

xxvi. A loss recognized either by a corporation or by its shareholder(s) on a liquidating distribution of the corporation’s properties[xxxvii] would be denied where, after the liquidation, the properties of the liquidated corporation remain within the controlled group of corporations of which such corporation was a member.[xxxviii] Where applicable, this would cause losses – both on the stock of the liquidating corporation and the property it holds – to be denied.

a. The proposal would also grant the Treasury the authority to allow for the deferral, rather than the denial, of such losses.[xxxix]

Like Kind Exchanges

xxvii. The amount of gain that an individual taxpayer would be allowed to defer by engaging in a like kind exchange of real property[xl] would be limited to an aggregate amount of $500,000 per year ($1 million in the case of married individuals filing a joint return).

xxviii. Any gains from like-kind exchanges in excess of the applicable threshold in a year would be recognized and included in gross income.  

Depreciation Recapture

xxix. Any gain recognized from the sale or exchange of depreciable real property[xli] would be treated as ordinary income subject to tax at the increased 39.6 percent rate to the extent of the cumulative depreciation deductions taken after the effective date of the proposed provision.

a. Gain attributable to depreciation deductions taken on such property prior to such effective date would continue to be recaptured as ordinary income only to the extent that such depreciation exceeds the cumulative allowances determined under the straight-line method.

b. Any unrecaptured gain on such property – the amount of straight-line depreciation claimed – would continue to be taxed to noncorporate taxpayers at a maximum 25 percent rate.

c. Any remaining gain recognized would be treated as capital gain.

xxx. The above-described ordinary income treatment for post-effective date depreciation deductions would not apply to noncorporate taxpayers with adjusted gross income below $400,000 ($200,000 for married individuals filing separate returns).

Slippery Slope

The national deficit is approximately $35 trillion, and it is expected to continue growing as spending continues to outpace revenue by a significant amount.[xlii] The interest payments on the debt  may be the fastest growing item of the federal budget.[xliii]

You may recall that in August 2023 Fitch downgraded our long-term debt rating from AA+ to AAA, and last November Moody’s lowered its outlook on our credit rating from stable to negative.

Approximately $7.5 trillion of our national debt – incurred to fund the growing deficit – is held by foreign governments, with the two largest holders being Japan and China.[xliv]

I am neither an economist nor a political scientist, but I would describe the foregoing situation as critical. It also seems that the only way to get out from under such debt and its adverse consequences (both economic and geopolitical) is for the U.S. economy to grow and for American businesses and workers (i.e., taxpayers) to thrive. Such growth should naturally generate more revenue from income taxes, but query whether we can tax our away out of the deficit hole in which we find ourselves without also limiting federal spending.[xlv] Should we even try?

For one thing, can we reasonably expect that increased income taxes will foster such economic growth? By increasing the tax burden on businesses, their owners, and their key employees, will we dampen their enthusiasm to work harder and to invest their capital and efforts in the hope of achieving economic success? My visceral response is yes.

Someone who works 12 to 15 hours every day, risks their savings, and sacrifices their personal life – and often their physical well-being – in order to establish and then grow a business is not doing so as a public service. There is a reasonable expectation that they and their families will be allowed to realize the rewards stemming from whatever economic success they achieve.[xlvi]  

Enter the federal government[xlvii] with plans to increase the tax bill for all businesses and their owners by a not-insignificant amount.

What’s more, the government’s populist arguments that businesses and their owners are cheating the working public[xlviii] is laying the groundwork for the additional “tax reform” that is certain to come once the first round of tax increases fails to adequately address the deficit.

We have a rocky road ahead of us. Stay tuned.

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The opinions expressed herein are solely those of the author(s) and do not necessarily represent the views of the Firm.

*How many of you are tired of hearing this? It’s on a par with what many have described as the Veep’s word salads. That said, may the guy from Scranton survive until she can be replaced.

[i] Yes, that old chestnut of questionable constitutionality. It is clearly a direct tax, but it is not an income tax, which means it is not covered by the 16^th Amendment and has to satisfy the apportionment requirement under Article I, Sec. 2 of the Constitution. It doesn’t pass this test.

Rep. Jayapal introduced the proposal to the House. (Why is she still in Congress?)

A couple of days later, Senate Finance Committee Chair Wyden proposed a bill that would impose additional requirements on the use of GRATs. IRC Sec. 2702. Just like the White House’s budget.               

[ii] Specifically, the Republican-controlled House. But then again, with Mike Gallagher’s departure, we’re looking at 218 Republicans to 213 Dems, at least by my count. The year is still young. (I’ll just note that Gallagher was chair of the select committee investigating the CCP’s activities in the US. That probably includes the many illegally operated CCP police stations in the US, like the one the FBI and DOJ broke up in the Bronx last year.) https://www.justice.gov/opa/pr/two-arrested-operating-illegal-overseas-police-station-chinese-government .

[iii] See https://www.taxslaw.com/2024/03/estate-gift-gst-related-income-tax-proposals-what-is-the-white-house-doing/ . Among the items discussed was the proposal to treat the transfer of assets at death as a sale of such assets at fair market value. 

[iv] Election Day is on Tuesday, November 5, 2024. Of course, the date is less meaningful than it once was thanks to early voting and mail in voting.

[v] Not evasion, though that certainly occurs. The vast majority of the taxpayers at which the White House is taking aim plan within the letter of the Code, which of course has been amended time and again by Congress, and interpreted by the IRS through rulings and regulation.

[vi] Judging from the threshold at which many of the tax increases are triggered, this group includes individuals with over $400,000 of adjusted gross income.

[vii] The Republicans took advantage of their control over the White House and the 115^th Congress (basically, 2017-2018) to enact the Tax Cuts and Jobs Act.

[viii] At the same time, our nearly comatose commander-in-chief is raking in the campaign contributions as NY’s smug, over-political, and shortsighted AG prepares to seize the assets of the frontrunner.

[ix] Our last post considered the proposed changes to the income and transfer taxation of gifts, estates, and trusts. https://www.taxslaw.com/2024/03/estate-gift-gst-related-income-tax-proposals-what-is-the-white-house-doing/ .

[x] Thus, for example, the following items of compensation would be subject to the higher income tax and Medicare tax: year-end bonuses, change-in-control payments, compensatory stock transfers, the exercise of compensatory options, failed ISOs, stock appreciation rights, and payments pursuant to nonqualified deferred compensation plans (of which there are many forms). In other words, practically every incentive arrangement used by employers to retain, motivate, and reward good employees.

[xi] The current 37% rate applies to taxable income over $731,200 for a married couple filing jointly. Under the proposal, the same taxpayers would be subject to the top rate of 39.6% for taxable income over $450,000.

[xii] See IRC Sec. 1239 with respect to property that is depreciable in the hands of the buyer; see IRC Sec. 707(b) with respect to the sale of property between a partner and their partnership, or between two related partnerships, where the property sold is not a capital asset in the hands of the buyer.

[xiii] For example, gain from the sale of shares of stock and other capital assets (IRC Sec. 1221), and gain from the sale of IRC Sec. 1231 property, including real property used in a trade or business.

[xiv] The highest ordinary income rate would be 39.6%. The NIIT rate (discussed below) would be 5%. Do the math.

[xv] By contrast, the rules that would be applicable to the gain arising from the deemed sale of such assets appear to be more forgiving. See the last post.

[xvi] IRC Sec. 1411.

[xvii] Employment taxes under the Self-Employment Contributions Act (SECA).

[xviii] Material participation standards would apply to individuals who participate in a business in which they have a direct or indirect ownership interest. Taxpayers are usually considered to materially participate in a business if they are involved in it in a regular, continuous, and substantial way. Often this means they work for the business for at least 500 hours per year. The statutory exception to SECA tax for limited partners would not exempt a limited partner from the NIIT if the limited partner otherwise materially participated.

[xix] In short, the material participation exception to the NIIT would be eliminated.

[xx] Typically, the loan flows from a corporation in which the shareholders have low basis stock to a related corporation in which the shareholders have high basis stock.

[xxi] IRC Sec. 1(h). In general, a qualified dividend is one that is paid with respect to the share of stock of a domestic corporation with respect to which the shareholder has satisfied 121-day holding period.                                                                                                  

[xxii] In either case, don’t forget to add the 5% NIIT.

[xxiii] Including unrealized gains.

[xxiv] Assets minus liabilities.

[xxv] Taxpayers who are treated as “illiquid” would be allowed to defer the tax on their nontradeable assets, but would be subject to a deferral charge when such assets were sold. Think IRC Sec. 453A or IRC Sec. 1291.

[xxvi] IRC Sec. 754.

[xxvii] Under IRC Sec. 734. Say a partnership makes a current distribution of property to a partner, and the partnership’s basis for such property exceeds the distributee-partner’s basis for the property. In that case, the partnership would increase the adjusted basis of the remaining partnership property by the amount of such excess. IRC Sec. 754, Sec. 734(b) and Sec. 732(a)(2).

[xxviii] Think IRC Sec. 267(d).

[xxix] IRC 461(l). It is currently set to expire after 2028.

[xxx] The top rate before 2018 was 35%.

[xxxi] This addresses two scenarios that may apply to an S corporation that was previously a C corporation or that acquired a C corporation on a tax-free basis.

[xxxii] IRC Sec. 1374.

[xxxiii] IRC Sec. 11.

[xxxiv] IRC Sec. 1375.

[xxxv] Until now, this limitation on deduction applied only to publicly held corporations and only with respect to payments made to certain individual employees.

[xxxvi] Certain types of compensation are not subject to the deduction disallowance and are not taken into account in determining whether other compensation exceeds $1 million, including (a) payments made to a tax-favored retirement plan, and (b) amounts that are excludable from the employee’s gross income, such as employer-provided health benefits and miscellaneous fringe benefits.

[xxxvii] The corporation would recognize the loss on the deemed sale of the distributed properties under IRC Sec. 336, and the shareholder would recognize loss in respect of its shares of stock in the liquidating corporation under IRC Sec. 331.

[xxxviii] For the meaning of a “controlled group,” see IRC Sec. 1563(a) but apply a 50% ownership threshold.

[xxxix] See IRC Sec. 267(f) by analogy.

[xl] You may recall that, after 2017, only exchanges of real property could qualify for tax deferral under IRC Sec. 1031.

[xli] Basically, Section 1250 property.

[xlii] We’re expected to run a $1.6 trillion deficit for the 2024 fiscal year, ending September 30, 2024. https://www.crfb.org/papers/analysis-cbos-march-2024-long-term-budget-outlook .

[xliii] By some accounts, it is expected that interest payments will soon exceed defense spending.

[xliv] China being the principal threat to our security and one of our largest trading “partners.” Each of these countries holds approximately $1 trillion of U.S. debt.

[xlv] For example, why are we paying to fly illegal aliens all over the country? Why are we housing and feeding them?

[xlvi] This is not intended as a criticism. It is merely an observation or recognition of human nature – people are naturally selfish, and some are more so than others.

[xlvii] State and local governments are doing the same, but in those cases the business and its owners have the ability to move to a different jurisdiction.

[xlviii] Another example of how they view the world as comprised of oppressors and the oppressed. It’s neither helpful nor productive. It’s actually selfish.

Crossing the Streams[i]

It is not uncommon, in the context of a business entity in which a family owns a controlling or substantial interest, for an adviser to encounter intersecting gift and income tax issues.

This week’s post will consider one such instance in which the IRS was asked to determine the tax consequences of certain transfers of stock by an individual shareholder of the issuing corporation and by the trusts created for the benefit of the shareholder’s family.[ii]  

Before describing these transactions, it may be helpful to briefly review some of the applicable tax principles.

Passing the Torch

Many of us have encountered variations of the following scenario:  a parent owns and operates a business; one or more of their children are employed in the business; as the children mature and become more experienced and established in the business, some of them may want to assume greater managerial responsibility and to have a greater voice in strategic planning; inevitably, the children become eager to realize a greater share of the economic success enjoyed by the business which they may insist is attributable to their efforts; they want to become owners.[i]

Heads I Win, . . .

When closely held corporations that are under common control engage in any intercompany transaction, it is prudent for the corporations and their shareholders to ensure that the transaction is being undertaken for a bona fide business reason. It is also important that the form of the transaction, and the parties’ intent for engaging in such transaction, as manifested by its form or structure,  be consistent with the income tax consequences arising therefrom as reported by each of the parties.