The Struggling Business

When things start to go badly in a business, its owners may feel compelled to take certain extraordinary, and usually ill-conceived, measures “to keep the doors open and the lights on.”

For instance, when faced with a reduction in positive cashflow,[i] the owner may decide to forgo the remittance of sales taxes or employment taxes properly withheld by the business,[ii] or the payment of other taxes owed by the business, and instead divert such funds toward the payment of business expenses.

It’s an old story. The owner of the business acknowledges their failure to satisfy its tax obligations, and recognizes that serious consequences may result therefrom. Still, the owner will rationalize their decision to forgo payment by convincing themselves that once the business has turned the proverbial corner, it will discharge whatever taxes may be owing at that time (plus interest and any penalties).

The Tax Court has previously held that a partner who contributes his own note to a partnership in exchange for a partnership interest takes no basis in the interest and their capital account is not credited for the value of the contribution. 

In the case discussed below, an entity that was disregarded for purposes of the income tax received a promissory note from its sole owner, which it then contributed to a newly formed partnership in exchange for an interest in that partnership.[i]

What followed was not intended by the parties.

LLCs Run Through It

What do you think of when someone mentions Montana? Is it the seemingly boundless landscape from which the largest land-locked state[i] derived its nickname, Big Sky Country?[ii] What about its Rocky Mountain national parks, like Glacier or Yellowstone?[iii]

Until recently, I had always equated Montana with rugged landscapes, honest outdoor living,[iv] flyfishing,[v] and my grandfather.[vi]

Of late, however, Montana, or more accurately, the use of Montana LLCs, has become synonymous with sales tax avoidance (or worse).

Tax Deficiency

Over their career, every tax practitioner has had many client-taxpayers against whom a government’s taxing authority – be it federal, state, or local – has asserted and then assessed a tax deficiency.

There are many reasons why a taxpayer – whether an individual, corporation, partnership, estate or trust – has unpaid tax liabilities. For example, the taxpayer has: miscalculated the amount of tax owed, carelessly omitted an item of income, mistakenly deducted a non-deductible expense, or claimed a tax treatment for an item on their tax return with which the government disagreed.

Non-Recognition Exchanges

Under the Code and the Regulations issued thereunder, the gain or loss arising from the conversion of property into cash is treated as income realized or as loss sustained by the owner of the converted property,[i] which the owner must generally account for in determining their federal income tax liability for the year of the conversion.[ii]

Likewise, the gain or loss arising from a property owner’s exchange of such property for other property that differs “materially in kind” from the property exchanged should, as in the case of a sale for cash, be treated as a taxable event, the gain or loss from which must be accounted for in determining the owner’s gross income for the year of the exchange.[iii]