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Legal Laissez-Faire?

Few provisions of the Code have a single, clear meaning that leaves no room for interpretation. Even many of those that, on the surface, appear fairly straightforward, are usually open to alternative “understandings.”

In the absence of continuous monitoring, implementation (as in the form of regulations),[i] and enforcement, there are taxpayers that may slant a particular provision of the Code to capture a more favorable result than Congress may have intended, especially when a taxpayer is facing financial pressures, whether attributable to the broader economy, their region or industry, or something else.

Under these circumstances – i.e., in the absence of official guidance, intervention, or oversight – when enough taxpayers adopt a specific practice or approach toward one of these provisions, their “behavior” may become normalized,[ii] and the law relegated to a suggestion, for all intents and purposes.

Nonprofit organizations and the parts of the Code applicable to their tax treatment, their relationships to the communities they serve, and their interactions with the general public, are no exception to the foregoing.

Indeed, the prospect or realization of funding problems for a nonprofit may impair its ability to deliver the services for which it was founded and granted tax-exempt status, but may also lead to many of the same problems encountered by troubled private businesses, including the diversion of tax dollars.

Hopefully, Someone’s Watching

For years now, many nonprofits that are organized to engage in what  may broadly be described as “charitable” activities, and that rely on financial support from the general public, including governmental grants, have been under varying degrees of public scrutiny.[iii]

This is a positive state of affairs when it is likely to lead to the prevention or the correction of behaviors that are inconsistent with these organizations’ charitable missions, that may jeopardize the public financial support that such organizations enjoy – primarily in the form of tax-related benefits[iv] – or when it helps to restore the public’s trust in these nonprofits.  

Query the consequences when the “watchdogs” can’t afford to watch.

Public Support

The public, both directly (through their personal financial contributions) and through the laws enacted by their elected representatives, support all manner of charitable organizations.

Such an organization’s charitable status allows it to receive nontaxable gifts from members of the public, including grant-making charitable organizations, in exchange for which such donors may claim a tax-favored deduction,[v] within certain parameters, for purposes of determining their own income, gift, and estate tax liabilities.[vi]

The organization is also exempted from federal income tax[vii] if it has demonstrated it is organized and operated exclusively for one or more “exempt” charitable purposes,[viii] serves a public rather than a private interest, and does not engage in certain proscribed activities.[ix]   

Thus, the organization is exempt from income tax with respect to most of its investment income, including interest, dividends, rents, royalties, and annuities.[x] 

In addition, the income derived by a tax-exempt nonprofit charity from an activity that is substantially related to its exempt purpose is not subject to federal income tax.[xi]

Query which of these sources of revenue may be able to cover a shortfall in grants?

Public Response

Historically, the close examination of a particular behavior has, in some cases, presaged the enactment of legislation[xii] that is intended to redress some institutional, or institutionally “endorsed,” practices that Congress has determined are harmful to society or may compromise the various missions with which nonprofits have been entrusted.

Depending upon the issue, and the extent to which it captures the general public’s attention, such legislative action has often been preceded by demands for the elimination of at least some of the publicly-subsidized tax benefits that nonprofit charitable organizations have long enjoyed, including their exemption from federal income tax.

Query whether, in the absence of adequate funding, a nonprofit may engage in any questionable financial behavior.[xiii] 

Short of Revocation

However, instead of expressly providing for the revocation of the tax-favored status of any nonprofit that engages in the offensive practice in question,[xiv] Congress has generally[xv] adopted measures that are intended to curtail such practice by “punishing” the private persons involved, and to encourage the “correction” of any violation.

For example, when the nonprofit becomes involved in certain activities, the Code imposes what is basically a penalty tax upon the responsible individuals within the organization or upon the organization itself, depending upon the specific activity. In general, the tax is based upon the economic value of the triggering event; it may continue to be applied until there is a “correction.”

Recent Examples

For example, in 1996, legislation was enacted to deter and punish the transfer of a so-called “excess economic benefit” from a public charity to a so-called “disqualified person” by imposing a 25 percent tax upon the disqualified person and a 10 percent tax upon the organization’s managers.[xvi] This provision targets the direct or indirect transfer by the charity of an economic benefit that exceeds the value of the consideration (including the performance of services) received by the charity in exchange for providing such benefit.[xvii]

In 2010, Congress imposed additional requirements a hospital must satisfy[xviii] to qualify for tax exempt status as a charitable organization, including the performance of a community health needs assessment.[xix] In general, their purpose is to ensure that hospitals provide medical care to members of the community who are unable to afford it. Failure to satisfy any of these requirements may jeopardize a hospital’s tax-exemption, though failure to conduct the required health needs assessment will result in the imposition of a fixed monetary penalty.[xx] 

Beginning in 2018, a new 21 percent[xxi] excise tax was added to the Code, which would be imposed on a public charity based on the sum of (i) the amount by which the compensation paid to any of the charity’s five most highly compensated employees during the taxable year exceeded $1 million, plus (ii) any “excess parachute payment” paid by the organization to such employee.[xxii]

Also in 2018, a new tax was introduced with respect to certain private universities, equal to 1.4 percent of a covered institution’s net investment income for a taxable year when the aggregate fair market value of the university’s investment funds at the end of that year is at least $500,000 per student.[xxiii] 

Taxable Notwithstanding

It’s clear that a charitable nonprofit’s exemption from the imposition of income tax is of vital importance to the organization.

That said, there are other taxes to which such an organization, without more,[xxiv] will remain subject, and of which it may run afoul, especially under certain circumstances.

Pretty much like any other business.

Unrelated Business

Thus, the nonprofit will be taxed on its net income from an unrelated trade or business – one that is regularly carried on by the organization, but which is not substantially related to the exercise or performance by such organization of its charitable purpose or function constituting the basis for its exemption.[xxv]

A nonprofit will often engage in such an unrelated business indirectly, through a wholly owned, for-profit subsidiary corporation. The for-profit’s distribution of its earnings to its nonprofit parent will generally be exempt from income tax.[xxvi]

Query whether such an unrelated business may assume greater importance in the nonprofit’s funding and cash flow when the latter’s grant revenue falls off.[xxvii] What if the business develops into a substantial part of the organization’s activities?

Employment Taxes

If a nonprofit has employees, it must withhold federal income tax from its employees’ wages.[xxviii]  

In addition, the organization must withhold and deposit the employee’s share of Social Security and Medicare (FICA) taxes and pay a matching amount.[xxix] The Social Security tax is withheld from the employee’s gross wages until the employee’s cumulative wages for the year reach the so-called “wage base limit.” Wages above the wage base limit are not subject to Social Security tax withholding. However, there is no wage base limit for Medicare tax; all covered wages are subject to Medicare tax.[xxx]

However, an organization that is exempt from federal income tax as a charitable organization[xxxi] is also exempt from FUTA tax.

In the context of a closely held for-profit business that has fallen on hard times, it is not uncommon to encounter a situation in which the owners of the business, instead of remitting to the government the employment taxes withheld from their employees’ wages, will divert those “trust fund taxes” – which the business, acting as a fiduciary, collected on behalf of the government – toward the payment of business expenses.[xxxii]

When employment taxes have been collected but have not been paid over to the government, the Code authorizes the IRS to collect the unpaid trust fund taxes from those persons in the business who were responsible for collecting, accounting for, and remitting such taxes.[xxxiii] 

Responsible Person

Unfortunately, nonprofits are not immune from economic challenges and cash flow issues of the kind that may cause an officer to direct that the employment taxes withheld by the organization be used, instead, to fund the nonprofit’s charitable activities, which may include the purchase of necessary supplies, the payment of salaries, and the satisfaction of many other ordinary and necessary liabilities incurred by the nonprofit.  

Thus, it is not uncommon for the responsible person penalty to be imposed upon certain key employees of a struggling nonprofit.  

In fact, earlier this year, at a trial in a U.S. District Court,[xxxiv] the jury was asked to determine whether an individual taxpayer was a “responsible person” with respect to the employment tax responsibilities of a nonprofit tax-exempt charity.

The employer-charity withheld the required employment taxes from its employees’ wages but then failed to remit such taxes to the government. 

The government sought to collect the unpaid taxes from an individual taxpayer, who argued that he was not a responsible person.

The Court explained that, under the Code, any person required to collect, truthfully account for, and pay over any tax who willfully fails to collect, account for, and pay over such tax, or who willfully attempts in any manner to evade or defeat any such tax or the payment thereof, shall be liable to a penalty equal to the total amount of the tax evaded, or not collected, or not accounted for and paid over.[xxxv] 

The Court then explained that the jury must decide whether the individual taxpayer had the status, duty, and authority to avoid the charity’s “nonremittal of the withholdings” – in other words, whether he was responsible for such taxes. If the jury agreed with the IRS that the taxpayer was responsible, it would then have to determine whether the taxpayer had acted willfully and recklessly in carrying out this responsibility.[xxxvi]

The taxpayer asserted, and the judge agreed in concept, that more than one person can be responsible for the employer’s obligation to withhold and remit such taxes. “The Court will tell the jury this,” the judge stated.

The Court added, however, that “the deep and disputed question” that had to be addressed first was the extent of the taxpayer’s authority to pay the taxes. Toward the resolution of that issue, the Court continued, the taxpayer was “entitled to offer evidence about the authority of the higher-ups at” the charity in his effort to prove the limitations of his own powers and duties. Still, if the taxpayer had the power to remit the taxes, “a supervisor’s direction not to do so will not absolve [the taxpayer] of liability.”

What’s Ahead?

We’re heading into unchartered territory. Some sources of public funding have been turned off, the markets are rattled – which may temporarily deny access to other sources, and there is some uncertainty in the broader economy. Hopefully, things will work, for the most part, without serious hardships for nonprofits or the beneficiaries who depend on them.

Of course, there are going to be exceptions; some may be more severe than others. Although the great majority of organizations will remain within the law, a not insignificant number may consider, and ultimately follow through with, a “strategy” that is sometimes utilized by businesses in distress: intentionally failing to remit to the taxing authorities those taxes that the business has withheld or collected on behalf of the government – typically, the employee’s share of employment taxes on wages paid by the employer.

Why would a nonprofit engage in such inappropriate behavior? For the same reason that a business would do so – to remain viable, to continue operations and fulfilment of its mission, and to preserve employees’ jobs.

Their reasoning goes something like this: “Revenues were down. We just needed some time to recover – the tax money was going to help us sustain operations until our situation stabilized. At that point, we would have paid the taxes owing.” 

As you can imagine, it rarely works out that way; operations cease, the organization fails, and the responsible persons are left holding the proverbial bag.

There are times, however, in which this decision is not adopted as a matter of “company policy” but, rather, is undertaken – unbeknownst to the rest of the organization – by a couple of well-positioned officers of the nonprofit, who may not represent all of its responsible persons.

It is imperative for a nonprofit to implement safeguards to protect itself, as best it can, from economic disruptions that may jeopardize its ability to carry put its purpose.[xxxvii] It is also imperative that it implement measures to ensure that funds cannot be diverted from their intended use, even if for the benefit of the nonprofit. 

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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] On which reliance may not be as justified as it once was following the Supreme Court’s overruling of Chevron deference in its decision in Loper Bright Enterprises v. Raimondo, 603 U.S. 369 (2024).

[ii] So-called “custom and practice.”

[iii] Some of the more recent reasons for such scrutiny are covered here: https://www.taxslaw.com/2023/11/activities-contrary-to-public-policy-revoking-the-tax-exempt-status-of-universities/#_ednref5 and https://www.taxslaw.com/2023/10/hospitals-and-community-benefit-senators-see-a-shortfall/. 

[iv] For example, exemption from income tax under IRC Sec. 501(a), and the ability to receive gifts from donors for which the donors may claim a tax deduction under Sec. 170, Sec. 2055, or Sec. 2522.

[v] Or, in the case of most private foundations, to avoid the imposition of an excise tax for failing to make enough of its resources available to operating charities.

[vi] I should add, there is also access to tax-exempt financing through State and local governments that may issue tax-exempt bonds to finance the activities of charitable organizations described in IRC Sec. 501(c)(3). Because interest income on tax-exempt bonds is excluded from gross income, investors generally are willing to accept a lower pre-tax rate of return on such bonds than they might otherwise accept on a taxable investment. This, in turn, lowers the cost of capital for the users of such financing. 

[vii] IRC Sec. 501(a). Of course, unrelated business income is taxable. IRC Sec. 511 et seq.

[viii] Specified in IRC Sec. 501(c)(3). Among the purposes specified by the Code are religious, charitable, scientific, educational, and literary. In general, an organization is organized and operated for charitable purposes if it provides relief for the poor and distressed or the underprivileged.

For many years, the IRS has applied a ‘‘community benefit’’ standard for determining whether a hospital is charitable. Congress took the standard a step further – see IRC Sec. 501(r).  

An organization is not treated as organized or operated exclusively for one or more exempt purposes unless it serves a public rather than a private interest. Reg. Sec. 1.501(c)(3)-1.

In addition to the foregoing statutory and regulatory requirements, the purpose and activities of a charitable organization must not be so contrary to an established public policy as to undermine any public benefit that might otherwise be conferred. See Bob Jones University v. United States, 461 US 574 (1983). Although Bob Jones involved racial discrimination, the IRS seems to have extended the decision’s reasoning; see, for example, TAM 8910001:

“To warrant exemption under section 501(c)(3), an institution must fall within a category classified in that section and must demonstrably serve and be in harmony with the public interest. The institution’s purpose must not be so at odds with the common community conscience as to undermine any public benefit that might otherwise be conferred.”   

[ix] Like devoting more than an insubstantial part of its activities to attempting to influence legislation by propaganda or otherwise, or directly or indirectly participating in, or intervening in any political campaign on behalf of or in opposition to any candidate for public office.

[x] IRC Sec. 512(b).

A significant exception to this favorable rule applies to income derived from property with respect to which there is acquisition indebtedness (“debt-financed property”; for example, debt incurred to purchase rental real property), in which case the amount of such investment income that is excluded from unrelated business income is reduced. IRC Sec. 512(b)(4) and Sec. 514.

[xi] For example, tuition paid to a college or medical fees paid to a hospital.

[xii] Usually implemented by regulations.

[xiii] Fraudulent conveyances? Elder abuse? (Think life insurance or testamentary planning.)

[xiv] The IRS already has the right to revoke an individual organization’s tax exemption where the organization is operated for the benefit of private interests, where it campaigns for or against candidates for elected office, where a substantial portion of its activities includes lobbying (“attempting to influence legislation”), where it operates an unrelated trade or business as a substantial part of its activities, or where its activities are contrary to a fundamental public policy.

[xv] And predictably.

[xvi] This provision was based in part upon the private foundation self-dealing rules (IRC Sec. 4941).

[xvii] IRC Sec. 4958. Pub. L. 104-168.

[xviii] In addition to the community benefit standard and the general requirements of IRC 501(c)(3).

[xix] IRC Sec. 501(r). Hospitals must conduct a “community health needs assessment” at least once every three years and adopt an implementation strategy to meet those needs. They must have written financial assistance and emergency medical care policies. For emergency and other medically necessary care, hospitals may not charge individuals eligible under the financial assistance policy more than the amounts generally billed for care provided to those with insurance coverage. For all other medical care, hospitals must charge such patients less than the full, established prices for such care. Hospitals must also make reasonable efforts to determine whether an individual is eligible for financial assistance before beginning extraordinary collection actions.

[xx] All the relevant facts and circumstances are considered. See Reg.Sec. 1.501(r)-2. Where a tax-exempt hospital system operates more than one facility, one of which is noncompliant, the IRS may treat the income from the noncompliant facility as taxable in lieu of revoking the entire organization’s tax-exempt status for failing to comply. In addition, the IRS may levy an excise tax upon a hospital that has failed to perform the required community needs assessment. IRC Sec. 4959.

[xxi] The federal corporate income tax rate. IRC Sec. 11.

[xxii] IRC Sec. 4960. Pub. L. 115-97. Coaches – don’t get me started.

[xxiii] IRC Sec. 4968. Pub. L. 115-97. Ostensibly to encourage the expenditure of such funds.

Net investment income is determined using rules similar to those of IRC Sec. 4940(c) (relating to the net investment income of a private foundation).

This year has seen the introduction of bills to increase the tax rate imposed on such income. See, for example, Rep Lawler’s (NY) bill: https://lawler.house.gov/uploadedfiles/endowment_accountability_act.pdf .

[xxiv] For example, the use of a for-profit subsidiary.

[xxv] IRC Sec. 511, Sec. 512, Sec. 513; Reg. Sec. 1.513-1.

[xxvi] IRC Sec. 512(c). If a business regularly carried on by a partnership of which an exempt organization is a member is an unrelated trade or business with respect to such organization, such organization in computing its unrelated business taxable income shall include its share of the gross income of the partnership from such unrelated trade or business and its share of the partnership deductions directly connected with such gross income.

[xxvii] Including, perhaps, with respect to the payment of compensation to individuals also employed by the nonprofit. The excess benefit rules foresaw such a diversion of funds in determining whether compensation paid to a disqualified person was reasonable. 

[xxviii] Unlike other exempt organizations or businesses, a church isn’t required to withhold income tax from the compensation it pays to its duly ordained, commissioned or licensed ministers for performing services in the exercise of their ministry.

[xxix] Pub. L. 98-21, Social Security Amendments of 1983. Again, there is an exception for wages paid for services performed by a duly ordained, commissioned or licensed minister of a church in the exercise of their ministry.

[xxx] Wisconsin exempts from its state unemployment tax system certain religious organizations that are “operated, supervised, controlled, or principally supported by a church or convention or association of churches” and that are also “operated primarily for religious purposes.”

However, the Wisconsin Supreme Court held that Catholic Charities was not “operated primarily for religious purposes” and, thus, did not qualify for the tax exemption. Specifically, the state court held that Catholic Charities’ activities were not “typical” religious activities because Catholic Charities served and employed non-Catholics, Catholic Charities did not “attempt to imbue program participants with the Catholic faith,” and its services to the poor and needy could also be provided by secular organizations.

Catholic Charities claimed that the state violated the First Amendment’s Religion Clauses by denying a religious organization an otherwise-available tax exemption because the organization does not meet the state’s criteria for religious behavior. 

Oral arguments were held last month. The Supreme Court is expected to rule by some time in June

Catholic Charities Bureau, Inc., v. Wisconsin Labor & Industry Review Commission, et al.,  U.S. Supreme Court, Docket No. 24-154.  

[xxxi] Under IRC Sec. 501(c)(3). In general, nonprofit organizations that aren’t Sec. 501(c)(3) organizations are not exempt from withholding federal income, social security, or Medicare tax from their employees’ pay, or from paying FUTA tax.

[xxxii] The business will usually have deluded itself into thinking that it will make the government whole after the business has turned the proverbial corner. In most cases, however, there is no corner, just a downward spiral.

[xxxiii] The “responsible person” penalty.

[xxxiv] Williams v. United States, No. 4:22-cv-942-DPM, 2025 BL 9831, 2025 US Dist. Lexis 5770 (E.D. Ark. Jan. 13, 2025), Court Opinion.

[xxxv] IRC Sec. 6672(a).

[xxxvi] Whether the taxpayer acted willfully or not may be influenced by what he knew and when, including what he knew about the unpaid tax liability, when the charity planned to pay, whether it intended to pay, whether other bills were being paid instead, and whether he has received assurances from others with tax-related authority and responsibility.

[xxxvii] These may include the maintenance of emergency funds, and the preparation of plans to partner with other nonprofits or for-profits.

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Intrafamily Transfer

A parent will sometimes transfer money to a child to enable the child to make an investment that the child could not otherwise make on their own.

For example, the child may have identified an attractive business opportunity but does not have sufficient assets or liquidity with which to make an investment therein, is unwilling or unable to sell other assets to raise the funds, and has not been able to borrow the necessary amount on acceptable terms from an unrelated lender because the market rate of interest may be too high, the repayment schedule may be too short, or the collateral requirements may be difficult to satisfy.

Continue Reading “Hey Mom, Can I Have A Few Bucks?” Is It A Loan? A Gift? A Little of Each?
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Do This But Not That

Charitable organizations are dependent, in no small part, upon the financial support of many successful business owners. The generosity of these individuals and their organizations may be a manifestation of several factors including, for example, their gratitude to the communities in which they have thrived, a willingness to share their good fortune for the benefit of others, and – less altruistically – a desire for public recognition[i] and the “incidental” benefits arising therefrom.[ii]

Continue Reading Transferring the Family Business To A Private Foundation? Are You Sure About That?
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NYC Transfer Tax

According to the New York City Comptroller, the City collected approximately $1.13 billion in Real Property Transfer Tax (“RPTT”) in the FY 2024. The Comptroller’s Office has forecast that $1.21 billion of RPTT will be collected in FY 2025.[i] Impressive figures by most measures, but just a drop in the proverbial bucket compared to the City’s total tax revenue for FY 2024 of almost $75 billion,[ii] and of its estimated tax revenue of more than $77 billion for FY 2025.[iii]

Still, the RPTT is no laughing matter when one considers that the tax is imposed at a rate of 2.625% of the purchase price for the “transfer” of commercial “real property,” or of an “economic interest” in such property,[iv] located within the City, where the value of the property is more than $500,000.[v]

Continue Reading NYC Transfer Tax, Charities, and Single Purpose LLCs – Are Lenders Beneficiaries?
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Tax Receipts

Late last year, the Office of the State Comptroller (the “OSC”) estimated that sales and use tax receipts would increase by 2.3% in the SFY 2024-2025.[i]

The OSC also projected that collections from sales and use taxes would increase by 3.5 percent for SFY 2025-2026.[ii]

Part of this increase is undoubtedly attributable to the efforts of the Department of Taxation and Finance to identify taxpayers who failed to collect and/or remit the correct amount of sales tax.[iii]

Continue Reading New York Sales Tax: When a Responsible Person Acts Irresponsibly
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Good Intentions

Many successful business owners attribute some part of their success to their community. For some of these owners, it is not enough to simply acknowledge this “debt”; they feel an obligation to share some of their financial success with the community. For example, the owner or business may contribute funds to a local charity. Another may solicit the voluntary assistance of their workforce to support a local charitable organization or event.

Although these endeavors are commendable, they are of an ad hoc nature, meaning they are of limited duration and are dependent, in no small part, upon the business owner, who acts as the catalyst for the charitable activities of the business.

Recognizing these practical limitations, some business owners may seek to “institutionalize” the charitable activity of the business by establishing a private foundation.[i]Along the way, as we will see shortly, a very small number of owners may be tempted to use the foundation’s assets for other than their originally intended purpose.

Establish a Foundation

Typically, the foundation will be organized as a not-for-profit corporation, separate from the owner and the business; it may be named for the owner or the business; and it will be funded by the owner or the business, with an initial contribution of cash or property.[ii] In later years, the owner may contribute additional amounts to the foundation, often culminating with a significant bequest to the foundation upon the death of the owner.

With this funding, the foundation – which will not be financially dependent upon contributions from the general public (thus, a “private” foundation, as distinguished from a “public” charity[iii]) – will have the financial wherewithal to conduct its charitable activities.

In most cases, the foundation’s only activity will be to make grants of money to tax-exempt, publicly supported, not-for-profit organizations that are directly and actively engaged in charitable activities, provided these grants and activities are in furtherance of the foundation’s stated purposes.[iv]

Whatever the objects of the foundation’s activities, the Code prescribes a number of rules with which the founding business and its owner(s) must become familiar, and with which they and the foundation must comply, if they hope to secure and maintain tax-exempt status for the foundation, and also avoid the imposition of certain penalty (excise) taxes.

Know the Rules

Unfortunately, many business owners embark upon the establishment of a private foundation without first educating themselves as to the operation of such a tax-exempt organization; in particular, with the activities in which it is prohibited from engaging.

Of paramount importance is the requirement that the foundation be operated in furtherance of, and in accordance with, its charitable purposes as set forth in its organizational documents and described in its tax-exemption application[v] filed with the IRS. It must further a public interest, and no part of its net earnings may inure to the benefit of any private individual. 

If the foundation’s activities result in any prohibited[vi] private benefit or inurement, its tax-exempt status could be revoked by the IRS, as was

illustrated by a recent ruling from the IRS’s Office of Chief Counsel.[vii]

Foundation As . . . Lender?

Foundation was incorporated under State law, was recognized[viii] by the IRS as a tax-exempt private nonoperating foundation – i.e., as a grant-making organization – and was initially funded with shares of stock[ix] by spouses, Husband and Wife (collectively, the “Managers”).[x]

The ruling does not tell us what motivated the Managers to organize Foundation, nor does it describe the organization’s charitable activities in any meaningful way.

Since its organization, the Managers served as the sole members of Foundation’s board and as its only officers,[xi] though it appeared that during the years at issue all investment decisions on behalf of Foundation – including, as we’ll soon see, whether, to whom, and on what terms to issue loans – were made at the sole discretion of Husband. What’s more, Foundation did not keep minutes of board meeting reflecting approval of such loans.

The Borrowing Business Entities

Between Year 3 and Year 14, Foundation made several, presumably not insignificant, unsecured balloon loans to two business entities: Corp and LLC.

Corp

Corp was formed by Husband, who also served as its [president].[xii] In Year 7, Husband owned more than 35 percent of Corp’s voting stock. After Year 7, Husband ‘s interest in Corp decreased below 35 percent.

In Year 15, Corp was acquired by an unrelated company.

LLC

Husband formed LLC as a State limited liability company in Year 2. Prior to Year 13, Husband owned C percent of the profits interest in LLC and served as [an officer] of the LLC. Wife was also active in LLC’s operations and managed its day-to-day operations.

In Year 13, the Managers acquired 100 percent of LLC by buying out the membership interest held by Husband’s [business partner]. Following the Managers’ acquisition of all the membership interests in LLC, it appeared that the Managers elected to treat LLC as a disregarded entity; thus, LLC’s activities,[xiii] would have been treated as activities of the Managers beginning in Year 13.

The Managers reported LLC’s income in Year 13 and Year 14 on their Form 1040 Schedule C, and LLC did not file partnership returns for those tax years. Thus, it appeared that LLC elected to be disregarded as an entity separate from its owners in Year 13, and that the Managers continued to treat LLC as a disregarded entity in Year 14.[xiv] 

Lending History

The loans from Foundation to Corp and LLC were generally term loans of several years, which provided for quarterly payments of interest at  fixed rate, with all the principal coming due at the maturity date.

Corp received several loans from Foundation, with the largest loans occurring in Year 6 and Year 7, well before Corp was sold.[xv] Corp paid interest quarterly and, in Year 15 (the year of its sale), had a significant outstanding principal balance owing to Foundation.

LLC also received loans from Foundation; in fact, during every year between Year 3 and Year 12. LLC failed to make interest payments on these loans in Year 4, Year 5, Year 7, Year 12, and Year 13.

By the end of Year 12, the aggregate face value of Foundation’s loans to Corp and LLC comprised substantially all of its assets.[xvi]

Hide the Loans

In Year 10, Year 12, and Year 14, Foundation agreed to extend the due dates of the loans to Corp through letters signed by Husband as Corp’s [officer]. Extensions were also granted on the LLC loans in Year 9 and Year 10. The extension letter in Year 10 was signed by Husband as LLC’s [officer].

In Year 13, Husband approached Foundation’s tax return preparer (Return Preparer) regarding his plan to purchase all of the remaining equity in LLC. Husband was concerned that purchasing additional LLC equity might cause LLC to become a disqualified person[xvii] with respect to Foundation and might violate the prohibition on self-dealing due to the outstanding loans between Foundation and LLC.

In order to remove the LLC loans from Foundation’s books, Return Preparer proposed that Foundation grant the LLC notes to public charities at a zero-dollar value.[xviii] In preparation for these transfers, Foundation and LLC agreed to modify the notes by extending the repayment periods by [several] years, and by reducing the interest rate.[xix]

Husband signed the modification agreement on behalf of both Foundation and LLC, and directed Return Preparer to assign the LLC notes to various public charities. Husband also requested that the assignments be dated as of a date [a few] months earlier.

Although Return Preparer reported the transfers on Foundation’s annual federal tax return for Year 13 as if they had occurred, the notes were never transferred. Consequently, Foundation continued to hold the LLC notes after the Managers acquired 100 percent of the equity interests in LLC, and neither Foundation nor the Managers discovered the failed transfers until the IRS initiated an examination of Foundation’s returns.

The IRS Steps In

During the course of the examination. Foundation conceded that an act of self-dealing[xx] occurred with respect to the LLC notes as of Year 13. Foundation also proposed that this act of self-dealing could be “corrected”[xxi] by having Foundation transfer the LLC notes to public charities as initially planned.

At that point, it appears the IRS examiner requested the assistance of the Office of Chief Counsel.[xxii] Specifically, the examiner asked whether Foundation’s unsecured balloon loans (collectively constituting substantially all of Foundation’s assets) to business entities founded, partially owned, and operated by a foundation manager (Husband), and the repeated extension of those loans, caused Foundation to be operated for the private benefit of the Managers and their business entities.[xxiii]

Chief Counsel’s Analysis

Chief Counsel began by discussing the statutory and regulatory framework within which organizations that have been recognized by the IRS as exempt from federal income tax are expected to operate.

Organized and Operated Exclusively

The Code exempts from federal income tax[xxiv] organizations that are organized and operated exclusively for one or more exempt purposes within the meaning of Section 501(c)(3) of the Code (e.g., religious, charitable, or educational).[xxv] Whether an organization is organized and operated exclusively for exempt purposes is determined based on the facts and circumstances of each case.   

The regulations promulgated under Section 501(c)(3) elaborate on what it means to be acting “exclusively” for a charitable purpose.[xxvi] According to these regulations, an organization will be regarded as operated exclusively for one or more exempt purposes only if it engages primarily in activities which accomplish one or more of such exempt purposes specified in Section 501(c)(3).[xxvii]

An organization will not be so regarded if more than an insubstantial part of its activities is not in furtherance of an exempt purpose.[xxviii] Thus, the presence of a single nonexempt purpose, if it is substantial in nature, will preclude tax exemption regardless of the number or importance of truly exempt purposes for which the organization is operated.

Private Interests

In addition, an organization will not be regarded as organized and operated exclusively for exempt purposes unless it serves public rather than private interests.[xxix] To satisfy this requirement, an organization must establish that it is not organized or operated for the benefit of private interests[xxx] including, for example, a substantial contributor to the organization, a member of the contributor’s family, an officer or director of the organization, or any business controlled by any of the preceding. In other words, an organization is not operated exclusively for an exempt purpose if its net earnings inure in whole or in part to the benefit of private individuals.[xxxi]

To illustrate this point, Chief Counsel gave the example of a private foundation that was controlled by its creator’s family and operated to enable the creator and his family to engage in financial activities beneficial to them but detrimental to the foundation. This organization was operated for a substantial nonexempt purpose and served the private interests of the creator and his family. The foundation, therefore, was not entitled to exemption under Section 501(c)(3).[xxxii]

Chief Counsel then described several instances in which an organization was not entitled to tax exemption under Section 501(c)(3) because the organization had issued loans to its founder and his family, or had based its investments upon the needs of private interests, or had acted as “an incorporated pocketbook” into which the founder could transfer excess personal funds and claim tax deductions while still retaining control of the funds and using them for nonexempt purposes.

In each of the foregoing scenarios, the organization was not operated exclusively for the public benefit; instead, it served as a private source of credit for its founder and its activities resulted in the inurement of its net earnings to private individuals.

What About Foundation?

Turning to the matter of Foundation, Chief Counsel reviewed the many unsecured loans Foundation made to Corp and LLC, two companies founded, partially owned, and operated by a Foundation officer and board member – Husband.

Husband’s Control

Through his control of Foundation’s investment decisions, Chief Counsel, stated, Husband was able to direct significant amounts of capital from Foundation to his two businesses. Thus, Corp received significant loans from Foundation during its early years of existence, and LLC received regular cash infusions for almost every year of its existence. 

Incorporated Pocketbook

By the end of Year 12, Foundation’s loans to Corp and LLC comprised substantially all of its assets. Therefore, it appeared that Foundation was operated by Husband as an “incorporated pocketbook” into which he could transfer assets while still retaining control over those assets and directing them toward his private business interests when he deemed necessary or advantageous.

Convenience and Cost Savings

Chief Counsel then noted that the benefits to Corp, LLC, and Husband went beyond the dollar amounts received from Foundation. By obtaining loans from Foundation rather than from a commercial lender, Corp and LLC avoided the delays, inconveniences, and formalities – not to mention the costs – of applying for commercial loans.

“Lax” Enforcement

In addition, due to Husband ‘s position on both sides of the loan transactions, it was unlikely that Foundation would take steps to enforce the loan terms if either Corp or LLC failed to honor the terms of the loan agreements. Indeed, Foundation did not seek to enforce the terms of the loan agreements when LLC failed to make interest payments. In fact, despite LLC’s failure to consistently pay interest on its existing loans, Foundation continued to make additional loans to LLC.

No Collateral

Finally, Chief Counsel observed that the Corp and LLC loans were unsecured; by leaving the business assets unencumbered, Foundation provided a further benefit to Husband and his business interests.

Unreasonable Investments

Although Husband stated that the loans to Corp and LLC were reasonable investment decisions, Husband’s significant involvement in both business entities as a founder, officer, and partial owner called into question whether the loans were reasonable investments.

The lack of any contemporaneous records or board minutes reflecting review of the loans or discussion of alternative investments further undercut the assertion that the loans to Corp and LLC, repeated loan extensions, and subsequent modifications of the loans were made in the best interests of Foundation or reflected reasonable investment decisions.

Private Interests

Under these circumstances, Chief Counsel stated, it was reasonable to conclude that Foundation’s decisions to make those loans to Corp and LLC were motivated more by the private entities’ need for funds rather than for any return on investment realized by Foundation.

When a foundation is used as a vehicle for activities advantageous to its creator and his family, and as a source of funds to finance those activities, Chief Counsel continued, that foundation is not operated exclusively for the public benefit; rather, it is operated for a substantial nonexempt purpose: serving the private financial interests of its creator. Chief Counsel stated that such an organization served private interests and did not qualify for exemption under Section 501(c)(3) of the Code.

In this case, Foundation’s board was fully controlled by the Managers, and they used this control to direct Foundation assets toward business entities in which they held interests, thereby serving the private interests of the Managers, Corp, and LLC more than insubstantially.

Taking the facts of the case as a whole, Foundation’s loans to Corp and LLC served the private interests of Foundation Managers by providing a private source of credit for their business interests. The loans, therefore, caused Foundation to be operated for a substantial nonexempt purpose and the revocation of Foundation’s tax-exempt status was appropriate.

More Than Insubstantial

Foundation asserted that the revocation of its tax-exempt status would be inappropriate because it had carried out a charitable program commensurate in scope with its resources and had made significant grants to charitable organizations during its existence.

In response, Chief Counsel pointed out that, in order for an organization to be described in Section 501(c)(3) of the Code, no more than an insubstantial part of its activities may be in furtherance of a nonexempt purpose. 

Foundation’s making of unsecured balloon loans, collectively constituting substantially all of the Foundation’s assets, to business entities founded, partially owned, and operated by a foundation manager, and the repeated extension of those loans, served the private interests of the foundation manager and the associated business entities, resulting in Foundation operating more than insubstantially in furtherance of a nonexempt purpose.

Chief Counsel added that the presence of even a single nonexempt purpose, if substantial in nature, would preclude exemption under Section 501(c)(3) regardless of the number or importance of “truly exempt” activities conducted by the organization. 

Therefore, revocation of Foundation’s tax-exempt status was appropriate regardless of Foundation’s other activities.

Observations

Chief Counsel was right to revoke Foundation’s tax exemption from federal income taxes – I’d be shocked if anyone thought otherwise based on these facts. 

The unanswered question is why did Foundation’s Managers engage in such blatantly inappropriate conduct?

It certainly was not out of ignorance – as indicated above, Husband was concerned about the LLC’s being treated as a disqualified person for purposes of the excise tax rules applicable to private foundations, about triggering the self-dealing rules, and about correcting the offending act. After all, the Code states clearly that any lending of money or other extension of credit between a private foundation and a disqualified person is an act of self-dealing,[xxxiii]  

Perhaps the businesses were unable to obtain capital elsewhere, at least not on terms that were acceptable to Husband and the businesses. We sometimes encounter closely held businesses that have diverted, toward the payment of business expenses and other expenditures, the taxes the businesses were required to collect and should have instead remitted to the government. Unfortunately for these businesses and their owners, the government is not in the business of making loans to struggling ventures.[xxxiv]

However, it may also have been the case that the Managers intended all along to abuse their private foundation by using it, in Chief Counsel’s words, as an incorporated pocketbook. They contributed shares of stock to Foundation. Assuming these were appreciated, they avoided recognition of the gain inherent in such shares, but were still able to claim a charitable contribution deduction in an amount equal to their fair market value. Foundation likely sold the shares without incurring any income tax liability. It then held the sale proceeds, and any tax-free investment return thereon, at the ready to fund Husband’s businesses.[xxxv]

Regardless of the Managers’ circumstances, or the condition of their businesses, I hope that somewhere along the way, some professionals read them the riot act.[xxxvi] It is unfortunate that others seem to have facilitated their misconduct.

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[i] Many owners and their businesses have been going a different route. For example, some are utilizing a Delaware Public Benefit LLC, which is a for profit entity “that is intended to produce a public benefit or public benefits and to operate in a responsible and sustainable manner.” See Chap. 18 of the LLCA – that’s a subject for another day.

Others are foregoing the formalities and the oftentimes complex rules of private foundations and, instead, are engaging in more direct and strategic philanthropic activities.

[ii] Usually marketable securities. The gain inherent in such securities is not recognized at the time of the contribution but the contributor is entitled to claim a FMV tax deduction. IRC Sec. 170.

[iii] IRC Sec. 509.

[iv] In some cases, the foundation may, itself, be directly and actively engaged in conducting a charitable activity. Such a foundation may qualify to be treated as an “operating foundation.” IRC Sec. 4942(j)(3).

[v] IRS Form 1023, Application for Recognition of Exemption Under Section 501(c)(3).

[vi] Not all private benefit is prohibited. The classic example is reasonable compensation for services actually rendered to the foundation.

[vii] PLR 202504014 (January 24, 2025).

[viii] Under IRC Sec. 508, an organization will not be treated as one described in IRC Sec. 501(c)(3) unless it applies to the IRS for recognition of such status.

[ix] Presumably, publicly traded.

[x] Described in IRC Sec. 501(c)(3) and Sec. 509(a). 

[xi] IRC Sec. 4946(b)(1) provides that the term “foundation manager” means, with respect to any private foundation, an officer, director, or trustee of the foundation (or an individual having similar powers or responsibilities). Therefore, the Managers were “foundation managers.”

[xii] Much of the information in the ruling was redacted, though enough may be gleaned from the context to surmise most of the relevant facts. Where this was done, the information has been bracketed.

[xiii] Including any “indirect” acts of self-dealing between LLC and Foundation.

[xiv] See Rev. Proc. 2002-69, 2002-2 C.B. 831, which provides that if a husband and wife as community property owners treat a limited liability company as a disregarded entity (or, alternatively, as a partnership) for federal tax purposes, the IRS will accept that position for federal tax purposes. If the LLC is treated as a partnership, appropriate partnership returns must be filed. A change in reporting position will be treated for federal tax purposes as a conversion of the entity. LLC filed partnership returns for Year 15 and Year 16; however, it did not appear that an IRS Form 8832, Entity Classification Election, was filed to change LLC’s entity classification to that of a partnership, and the ruling did not mention the admission of another member. See Reg. Sec. 301.7701-3(c)(1)(i).

[xv] Query whether Corp needed the funds at that point in its existence to fund the expansion of its business.

[xvi] As reported on its Form 990-PF, Return of Private Foundation.

[xvii] IRC Sec. 4946.

[xviii] I guess he did not expect them to be repaid. Query what public charity would have accepted the notes.

[xix] In an arm’s length setting, one would have expected the interest rate to be increased to compensate the lender for the additional period during which the lender would remain at risk. One might also have expected a payment of some principal in exchange for the extension.

[xx] Under IRC Sec. 4941(d)(1)(B). In addition to self-dealing (of both the direct and indirect variety), the IRS identified violations of the prohibition on jeopardy investments. IRC Sec. 4944. The agency also determined that the proposed method of correction was unacceptable.

[xxi] IRC Sec. 4941(e)(3). The terms “correction” and “correct” mean, with respect to any act of self-dealing, undoing the transaction to the extent possible, but in any case placing the private foundation in a financial position not worse than that in which it would be if the disqualified person were dealing under the highest fiduciary standards.

[xxii] Taxpayers under examination may request that the IRS examiner refer an issue to Chief Counsel for technical advice. IRM 4.46.5.4.2.1 (12-13-2018). I suspect that the threatened revocation of Foundation’s exemption was the reason the Office of Chief Counsel was contacted.

[xxiii] IRC Sec. 4941(d)(1)(E). 

[xxiv] Under IRC Sec. 501(a).

[xxv] Reg. Sec. 1.501(c)(3)-1(c)(1).

[xxvi] Reg. Sec. 1.501(c)(3)-1(c)(1).

[xxvii] Reg. Sec. 1.501(c)(3)-1(c)(1).

[xxviii] Reg. Sec. 1.501(c)(3)-1(c)(1).

[xxix] Reg. Sec. 1.501(c)(3)-1(d)(1)(ii).

[xxx] Reg. Sec. 1.501(c)(3)-1(d)(1)(ii). An organization claiming IRC Sec. 501(c)(3) status bears the burden of proof. 

[xxxi] Reg. Sec. 1.501(c)(3)-1(c)(2).

[xxxii] Citing Rev. Rul. 67-5.

[xxxiii] The only exception is the lending of money by a disqualified person to a private foundation if the loan is without interest or other charge, and if the proceeds of the loan are used exclusively for purposes specified in IRC Sec. 501(c)(3). IRC Sec. 4941(d)(2)(B).

[xxxiv] It would be better for all concerned if a business in such circumstances just shuts its doors.

[xxxv] Conjecture or not, just writing this paragraph got my dander up.

[xxxvi] For those who practice in New York, Sec. 716 of the N-PCL reads as follows:

No loans, other than through the purchase of bonds, debentures, or similar obligations of the type customarily sold in public offerings, or through ordinary deposit of funds in a bank, shall be made by a corporation to its directors, officers or key persons, or to any other corporation, firm, association or other entity in which one or more of its directors, officers or key persons are directors, officers or key persons or hold a substantial financial interest, except a loan by one charitable corporation to another charitable corporation. A loan made in violation of this section shall be a violation of the duty to the corporation of the directors or officers authorizing it or participating in it, but the obligation of the borrower with respect to the loan shall not be affected thereby.

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My Steadfast Partner, The IRS

If you’ve worked with the owners of closely held businesses for even just a few years, you have realized they are only half joking when they complain about having the government as a partner. Consider how much federal, state, and local tax[i] a business and its owners may pay over to the tax authority of each jurisdiction during the course of a taxable year.

If the business is treated as a partnership for tax purposes,[ii] the IRS is generally authorized to collect from the partnership any income tax deficiency arising out of the partnership’s operations for a taxable year, even if the persons who were partners in the year to which the deficiency relates are no longer partners in the year that the deficiency is assessed.[iii] Stated differently, the partnership’s current-year partners will bear the economic burden of the tax liability even though the tax adjustments relate to a prior year in which the composition of the partnership may have been different, and even though they themselves have satisfied their own tax liabilities.

In some cases, a business owner who may have reasonably delegated certain tax withholding and payment responsibilities to another owner or key employee (an officer, for example) of the business may still be held personally liable[iv] for a failure by the other owner or employee to collect and/or remit such taxes to the appropriate tax authorities.

Finally, and perhaps to the surprise of some, a co-owner of a business who has been diligent in satisfying their own tax liabilities may suffer an economic detriment as a result of government tax collection efforts against their less than tax-compliant co-owner. What follows is a description of one dentist’s (“Doc’s”) efforts to avert the forced sale of their practice and of the related real property that the dentist owned jointly with a tax-deficient fellow dentist and co-owner (“Taxpayer”).[v]

Paying Taxes Is Like Going To The Dentist, Except You Do All The Drilling

Taxpayer failed to pay federal income taxes for ten consecutive years.[vi] Taxes were assessed against Taxpayer but were never paid. In order to collect on the overdue taxes, the Government placed liens on Taxpayer’s property and rights to property,[vii] including Taxpayer’s 50% co-ownership interests in a dental office suite (the “Real Property”), and in a dental practice (the “LLC”) that operated from the Real Property.[viii] For each property, the other 50% interest was owned by Taxpayer’s fellow dentist and business partner, Doc.[ix]  

The Government sought to collect the delinquent income taxes owed by Taxpayer. It petitioned the Court to force a sale[x] of the two properties, notwithstanding that Taxpayer owned only a partial interest therein,[xi] only Taxpayer owed back taxes to the Government, and the Government had placed liens only on Taxpayer’s interests in the properties.[xii]

Indeed, Doc did not owe taxes, was not responsible for his business partner’s (Taxpayer’s) delinquencies, and did not have liens placed on his property interests. Still, Doc was joined as a defendant because he could claim an interest in the properties involved in the action.[xiii] 

Doc opposed the Government’s petition, objecting to the sale of the entirety of both properties and arguing instead for the Government to foreclose on Taxpayer’s interests alone. The Court gave the two partners time to sell both the properties and avoid a foreclosure. Months later, the parties represented to the Court that they were not able to reach any agreement of sale.[xiv]

The Court’s Analysis

The only issue before it, the Court stated, was whether the Government was permitted to conduct a forced sale of the entire Real Property and LLC, despite the fact that only Taxpayer – and not Doc – was delinquent on taxes.

According to the Court, while Doc owed no debts to the Government, the plain language of the Code[xv] contemplated “not merely the sale of the delinquent taxpayer’s own interest, but the sale of the entire property (as long as the United States has any ‘claim or interest’ in it).”[xvi] 

It was clear, the Court stated, that “tak[ing] into account both the Government’s interest in prompt and certain collection of delinquent taxes and the possibilities that innocent third parties will be unduly harmed by that effort[,]” the Government was “entitled to a complete sale of both the Real Property and the LLC,” and judgment in its favor was appropriate.

Doc’s Position

The Court began by considering Doc’s argument regarding why his interest in the LLC could not be foreclosed upon; specifically, because the only appropriate remedy, according to Doc, was for the Government to file a charging order,[xvii] not a forced sale.[xviii]

The Court responded that although state law allowed a charging order as the “sole remedy of a judgment creditor,” the Government was not bound by the state laws of an ordinary creditor when it sought to foreclose pursuant to the Code.[xix] Furthermore, the Court continued, even if the Government were an ordinary creditor, state law would still not apply because the Court was dealing with “the effectuation of the underlying property interest.”[xx] 

Therefore, the Court concluded that it may, in its discretion, order a forced sale of the entire LLC pursuant to the Code[xxi] so long as the so-called “Rodgers factors” (described below) were satisfied.

Foreclosure by the Government

The Court stated that the U.S. Supreme Court has recognized that the Government’s “power to enforce the obligations of the delinquent taxpayer” was “grounded in the constitutional mandate to lay and collect taxes.’”[xxii]  Indeed, the Government “has the right to pursue the property of the delinquent taxpayer with all the force and fury at its command.”  This power, the Court asserted, extends beyond the privileges of an ordinary creditor, and it is instead borne “out of the express terms of [the Code].”[xxiii]

The Court then explained that the Code contemplates a two-step process for the foreclosure of property to satisfy a tax debt. First, the Government can place a lien on any of the delinquent taxpayer’s pieces of property.[xxiv] Although a physical piece of real estate might be the most obvious target for a government lien, “the statutory language is broad and reveals on its face that Congress meant to reach every interest in property that a taxpayer might have. Stronger language could hardly have been selected to reveal a purpose to assure the collection of taxes.” 

Once the lien is attached, the Court continued, the Government may file an action in district court to enforce the lien.[xxv] The district court is directed to adjudicate the merits of the potential foreclosure and, if the interest of the U.S. is established, the court “may decree a sale of such property.”[xxvi] As part of this adjudication, the district court was required to make party to the action “all persons having liens upon or claiming any interest in the property” at issue.[xxvii] 

The Rodgers Factors

Having clarified the Government’s extensive ability to impose a lien and ultimately foreclose on a wide variety of properties, the Court added that the Government’s power was not limitless. “In the seminal case of United States v. Rodgers, the Supreme Court marked the contours of the Government’s power under [the Code] to force a judicial sale of a property when that sale might negatively affect an innocent third-party with no tax delinquency.” 

In Rodgers, the Government sought foreclosure of an individual’s interest in the home he shared with his spouse.  Under state law, however, the spouse was also entitled to an interest in the home, and therefore a sale of the entire home would deprive her of her property interest, despite the fact that she had no tax delinquency herself.  The Court held that it must “read the statute to contemplate, not merely the sale of the delinquent taxpayer’s own interest, but the sale of the entire property.” 

Nonetheless, the Court also held that Congress did not intend for a “district court to authorize a forced sale under absolutely all circumstances,” but that there is “limited room” in the statute for “the exercise of the [district court’s] reasoned discretion.”[xxviii] 

The Rodgers court introduced a four-factor balancing test that was designed to “take into account both the Government’s interest in prompt and certain collection of delinquent taxes and the possibility that innocent third parties will be unduly harmed by that effort.”  In determining whether a forced sale would cause undue hardship to an innocent third party, a court must consider:

(1) the extent to which the Government’s financial interests would be prejudiced it if were relegated to a forced sale of the partial interest actually liable for the delinquent taxes;

(2) whether the third party with a non-liable separate interest in the property would, in the normal course of events, have a legally recognized expectation that separate property would not be subject to forced sale by the delinquent taxpayer or his or her creditors;

(3) the likely prejudice to the third party, both in personal dislocation costs and in practical “undercompensation”; and

(4) the relative character and value of the non-liable and liable interests held in the property.

These factors are “not an exhaustive list,” the Court added, and observed that district courts are encouraged to rely on “common sense and consideration of special circumstances.” Still, despite the many considerations allowed on behalf of the non-liable third party, the “limited discretion accorded by [the Code] should be exercised rigorously and sparingly, keeping in mind the Government’s paramount interest in prompt and certain collection of delinquent taxes.” 

The Rodgers Factors Applied

The Government exercised its authority under the Code to foreclose on two separate properties related to Taxpayer’s dental practice: the Real Property and the LLC. For each property, the Court applied the Rodgers factors to determine whether Doc’s interests outweighed the Government’s “paramount interest in prompt and certain collection” of taxes. 

Taxpayer and Doc each owned a 50% stake of the Real Property as tenants in common; they each owned 50% of the LLC. In order to recover Taxpayer’s unpaid taxes, the Government imposed liens on Taxpayer’s 50% interest. The plain language of the Code permitted the Government to foreclose only on Taxpayer’s share of the Real Property and LLC, particularly since Taxpayer did not contest his delinquency and Doc would not object to such a sale. Rather, Doc only objected to the sale of his own 50% share in these properties. The Government wanted to sell the entire Real Property and LLC in order to best recoup what it was owed and “end this inefficient and wasteful use of taxpayer money.”

Doc argued that, applying the Rodgers test, the remedy of a complete forced sale was not justified because he would lose his investments, incur significant tax obligations, and be forced to displace his employees and patients.

Court’s Decision

The Court considered the forced sale of each property, as well as Doc’s arguments, and applied the Rodgers factor with respect to each property. But the Court also heeded the Rodgers Court’s warning against using the four factors as a “mechanical checklist,” and followed its direction to employ “common sense and consideration of special circumstances.”

According to the Court, the most salient additional considerations with regard to the Real Property were the impact of a forced sale on Taxpayer’s and Doc’s employees and patients, who were non-liable third parties. Doc asserted that he employed five people and cared for 5,000 patients. Each of these people – including Doc himself – might be inconvenienced, the Court stated, by a sale of the Real Property, or by having to work or go to the dentist in a new place that might not be as close by or as easily accessible. Alternatively, the Court opined, that a new location might be more advantageous for both Doc and his employees, and more convenient for his patients. Regardless, the Court did not find that the common-sense considerations discussed by the Rodgers Court underlying a forced sale of the Real Property weighed sufficiently in favor of halting the forced sale.

Next, the Court considered the impact that the sale of the dental practice (the LLC) may have on its patients and employees. The Court found that these considerations did not weigh against the forced sale. Aside from what the Court described as the “unsubstantiated, dire predictions” set forth in his brief and affidavit, Doc did not provide the Court with any expert report or analysis demonstrating his “doomsday speculations.” Those individuals were free to continue to associate with the LLC after the sale, or to find another dentist or place of employment. The Rodgers Court explicitly highlighted the “limited discretion accorded by [the Code]” and how such discretion “should be exercised rigorously and sparingly, keeping in mind the Government’s paramount interest in prompt and certain collection of delinquent taxes.”  Given these restrictions, and the fact that the circumstances presented did not outweigh the Government’s “paramount interest in prompt and certain collection of delinquent taxes[,]” the Court determined that any equitable balancing weighed in favor of the forced sale of the LLC.

Having considered the four Rodgers factors and the above additional common-sense consideration of special circumstances, the Court concluded that the Government was entitled to foreclose on both the Real Property and the LLC in their entirety.

Partners Beware?

As we saw above, if a taxpayer is delinquent in satisfying a Federal tax liability, the Code authorizes the U.S. to initiate a civil action in the appropriate U.S. District Court to enforce its tax lien over the liability or to subject any of the delinquent taxpayer’s property or interest in property to the payment of that liability. As we also saw, when the U.S. files a complaint in District Court to enforce a lien, it is required to name all parties having liens on, or otherwise claiming an interest in, the relevant property as parties to the action.

As in the case of Taxpayer and Doc, these collection efforts may result – after the Court’s consideration of the Rodgers factors – in the forced sale of a business or investment in its entirety, rather than a sale of just the portion thereof owned by the delinquent taxpayer, notwithstanding the remaining interest in the property is owned by a non-liable third party; for example, the delinquent taxpayer’s business partner (like Doc).

How may an innocent partner protect themselves from the risk of such a forced sale? How may they retain control of their business and its assets? Can they remove the tax-delinquent partner?

Much will depend upon the presence of a carefully drafted partnership or operating agreement; for example, one that requires prompt disclosure of an audit or other tax proceeding by the delinquent partner – that’s a good start.

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[i] For example, income taxes on the taxable income of the business and of the owners; employment taxes on the compensation paid to employees (including owners); sales and use taxes on the purchase or sale of certain properties and services; transfer taxes on the disposition of real property; capital gain tax on the sale of the business; etc. It adds up pretty quickly.

[ii] Which generally includes an LLC with at least two members. Reg. Sec. 301.7701-3.

[iii] According to the governor’s latest budget proposal, New York State may soon be adopting the Federal partnership audit rules.

[iv] As a “responsible person,” usually with respect to employment taxes, or sales and use taxes.

[v] U,S. v. Thomas Driscoll, 2025 WL 30092 (U.S. District Court, D. New Jersey) Civil Action No. 18-11762 (RK) (RLS), Signed January 6, 2025.

[vi] You might say there was a substantial “gap” in his compliance.

[vii] IRC 6321 (allowing for a lien to be placed on “all property and rights to property” belonging to “any person liable to pay any tax neglects”). “Property” here refers not only to real property, but “all property and rights to property, whether real or personal.” See IRC Sec. 6321.

[viii] These were the only assets from which the entire tax deficiency may be satisfied.

[ix] Taxpayer and Doc owned Real Property as tenants in common.

[x] Pursuant to IRC Sec. 7403, which reads as follows:

  • Filing

In any case where there has been a refusal or neglect to pay any tax, or to discharge any liability in respect thereof, whether or not levy has been made, the Attorney General or his delegate, at the request of the Secretary, may direct a civil action to be filed in a district court of the United States to enforce the lien of the United States under this title with respect to such tax or liability or to subject any property, of whatever nature, of the delinquent, or in which he has any right, title, or interest, to the payment of such tax or liability. For purposes of the preceding sentence, any acceleration of payment under section 6166(g) shall be treated as a neglect to pay tax.

  • Parties

All persons having liens upon or claiming any interest in the property involved in such action shall be made parties thereto.

  • Adjudication and decree

The court shall, after the parties have been duly notified of the action, proceed to adjudicate all matters involved therein and finally determine the merits of all claims to and liens upon the property, and, in all cases where a claim or interest of the United States therein is established, may decree a sale of such property, by the proper officer of the court, and a distribution of the proceeds of such sale according to the findings of the court in respect to the interests of the parties and of the United States. If the property is sold to satisfy a first lien held by the United States, the United States may bid at the sale such sum, not exceeding the amount of such lien with expenses of sale, as the Secretary directs.

  • Receivership

In any such proceeding, at the instance of the United States, the court may appoint a receiver to enforce the lien, or, upon certification by the Secretary during the pendency of such proceedings that it is in the public interest, may appoint a receiver with all the powers of a receiver in equity.

[xi] Taxpayer did not dispute the tax liability and did not argue against the foreclosure of the property.

[xii] 7403(c) (allowing a district court to “decree a sale” and “distribute the proceeds of such sale” to satisfy the interests of the parties and of the United States).

[xiii] IRC Sec. 7403(b).

[xiv] During discussions of a possible sale, the Court had administratively terminated the Government’s pending Motion, and agreed not to consider it until contract negotiations concluded.  The Motion was reinstated in November 2024.

[xv] IRC Sec. 7403.  

[xvi] Citing, United States v. Rodgers, 461 U.S. 677 (1983).

[xvii] Basically, a court order pursuant to which the debt owed to a creditor is satisfied by allowing the creditor to seize the debtor’s share of any distributions made by a business entity in which the debtor has an interest.

[xviii] Doc also argued that, because the LLC was not a named party to the action, allowing a forced sale would violate the LLC’s due process rights. Doc relied on the fact that, under state law, LLCs were separate entities that did not take on the identities of their owners or shareholders. However, the LLC did not need to be joined, the Court responded, because both Taxpayer and Doc were joined in this action, they were the only people with decision-making power over the LLC’s activities, and they adequately represented the LLC’s interests in the case. Accordingly, the Court rejected this argument.

[xix] Citing Rodgers (“The Government’s right to seek a forced sale of the entire property in which the taxpayer has an interest does not arise out of its privileges as an ordinary creditor, but out of the express terms of §7403.”).

[xx] “Although the definition of the underlying property interests is left to state law, the consequences that attach to those interests is a matter left to federal law.”

[xxi] IRC Sec. 7403.

[xxii] Rodgers (quoting U.S. Const. art. I, sec. 8, cl. 1).

[xxiii] Citing IRC Sec. 7403.

[xxiv] IRC Sec. 6321.

[xxv] IRC Sec. 7403(a).

[xxvi] IRC Sec. 7403(c).

[xxvii] IRC Sec. 7403(b).

[xxviii] The Court relied in part on the term “may decree a sale of such property” in IRC Sec. 7403(c). (Emph. added)

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Back to the Office

You are probably aware that many employers are discarding the fully flexible, remote work policies that were forced upon them – as “nonessential” businesses – during the COVID-19 pandemic[i] and which they retained as an accommodation to employees after the pandemic ended. Indeed, there is now a steadily increasing percentage of employers that are requiring their employees to return to the office or place of business.

Some employers are mandating that employees work in the office full-time.[ii] Many other businesses expect employees to be physically present at least three days per week.[iii] Often, employers are “taking attendance” to ensure compliance with their in-office policies.

Whatever the justification for the uptick in return-to-office policies – for example, firm culture, collaboration, mentoring – it appears that the fully flexible model is fading away.  

The Great Lockdown

Unfortunately for some employees who telecommuted during the pandemic, the legacy of the “great lockdown” continues to haunt them as certain states assess additional income taxes against nonresident employees who started working remotely in March 2020.

Specifically, a telecommuting employee who resided in, and worked from, a state (their “State of Residence”) other than the state in which their primary office or place of business was located (their “State of Business”), may be facing the prospect of owing additional income tax to their State of Business in respect of the days worked remotely from their State of Residence.[iv]

A recent decision out of New York’s Division of Tax Appeals illustrated the plight of one such employee (“Taxpayer”).

The Office is Closed

Taxpayer was a longtime Pennsylvania resident who never resided in New York. During the 2020 tax year, Taxpayer was employed by Bank, which was part of a financial group of companies operating in Canada and the U.S. From January 1 through March 13, 2020, Taxpayer worked in Bank’s office in New York City, where he was responsible for managing traders within one of Bank’s divisions.

On January 30, 2020, the WHO designated the COVID-19 outbreak as a Public Health Emergency, and on January 31, 2020, the U.S. Dept. of Health and Human Services declared a public health emergency for the entire U.S. Thereafter, travel-related and community contact transmission cases of COVID-19 were documented in New York State, and more expected to occur. In response, then-Governor Cuomo declared a state of emergency for the entire State of New York.

Executive Order

Effective March 20, 2020, the Governor mandated (the “New York State on PAUSE” order) that:

“[a]ll businesses . . .  in the state shall utilize, to the maximum extent possible, any telecommuting or work from home procedures that they can safely utilize . . . Any essential business . . . providing essential services or functions shall not be subject to the in-person restrictions. This includes . . . banks and related financial institutions . . . Empire State Development Corporation shall issue guidance as to which businesses are determined to be essential.”[v]

Essential Business

In response to the Pause Act, the Empire State Development Corporation[vi] issued “Guidance for Determining Whether a Business Enterprise is Subject to a Workforce Reduction Under Recent Executive Orders,”[vii] which provided: “ESSENTIAL BUSINESSES OR ENTITIES . . . are not subject to the in-person restriction [imposed under the Executive Order quoted from above],” and identified essential businesses as including “Financial [i]nstitutions including banks or lending institution[s], insurance, payroll, accounting, [and] services related to financial markets, except debt collection[.]”

Bank was an essential business not subject to the in-person restrictions imposed by the Governor’s Executive Order as it was a bank and/or related financial institution. However, commencing on March 16, 2020[viii] – prior to the order but on the same day the Canadian government called on its citizens to restrict their movements[ix] – Bank temporarily closed its New York City office.

Alternative Arrangements

Bank required Taxpayer to find alternative working arrangements – it did not offer Taxpayer an alternative office location in New York for conducting his work after the New York office temporarily closed. However, Bank established a “disaster recovery site” in New Jersey that was provided with the equipment necessary to work remotely.  

Taxpayer worked at Bank’s New Jersey site on March 16 and March 17, 2020, though it does not appear that this location became Taxpayer’s assigned or primary office.  Indeed, from March 18 through December 31, 2020, Taxpayer worked for Bank exclusively from Taxpayer’s home in Pennsylvania and never physically came into New York to work.[x]

Taxpayer had 242 total workdays for Bank during the 2020 tax year:  49 workdays from January 1 through March 15, 2020 (20.25% of his 2020 workdays), plus 193 workdays from March 16 through December 31, 2020 (79.75% of his 2020 workdays).

New York Audit

Taxpayer timely filed a New York State form IT-203, Nonresident and Part-Year Resident Income Tax Return, for the 2020 tax year with the Division, on which Taxpayer reported wages of $1,378,389.00 in the federal amount column and $285,664.00 in the New York State amount column. Taxpayer claimed a refund of $104,182.00 on the return which arose solely with respect to Taxpayer’s income from employment.

The Division of Taxation selected Taxpayer’s return for audit and sent Taxpayer a request for information (RFI)[xi] to verify the income allocation reported on the return. Taxpayer responded to the RFI, and included a completed income allocation questionnaire.[xii]

The Adjustment

The Division increased the total New York State taxes owed by Taxpayer from $19,347.00 to $93,372.60, based on a recalculation of the return whereby the Division allocated $1,378,389.00 in wages from Bank to New York State for tax year 2020 based on the application of the “convenience of the employer test,”[xiii] whereby all of Taxpayer’s workdays in 2020 were considered New York workdays.

After applying Taxpayer’s total payments and refundable credits of $123,529.00 against the increased amount of income tax owed, the Division computed an overpayment of $30,156.40, which was paid to Taxpayer, and disallowed the remainder of the refund originally requested.

In response to the Division’s proposed adjustments and notice of disallowance, Taxpayer petitioned the Division of Tax Appeals for a redetermination of the deficiency for, and of the refund of, New York State personal income tax for the year 2020.[xiv]

Division of Tax Appeals

The issue before the ALJ was whether Taxpayer had established that the Division improperly applied the convenience of the employer test to allocate to New York all of Taxpayer’s wages from Bank in 2020.

Taxpayer’s “Concession”

After some preliminary adjustments to Taxpayer’s income,[xv] Taxpayer asserted (i) that the New York State column of his state tax return should have reflected $636,917.00, and (ii) that he was entitled to a refund of $80,385.00 (of which $30,156.00 had already been paid), based on 193 days worked in New Jersey and Pennsylvania for Bank during tax year 2020.[xvi]  

The Divisions Holds Fast

The Division asserted that Taxpayer was not entitled to an additional refund beyond the $30,156.00 calculated in the adjustment notice and already paid, because Taxpayer should have allocated to New York State the entire amount of wages, in the amount of $1,378,389.00, paid by Bank to Taxpayer in tax year 2020, including the days worked in New Jersey and Pennsylvania as a nonresident employed by a New York employer, assigned to a primary work location in New York, for Taxpayer’s convenience rather than necessity of the employer based on the application of the convenience of the employer test.[xvii]

The ALJ’s Analysis

The ALJ explained that the Tax Law imposes tax on a nonresident individual based on their income from New York sources.[xviii] The tax imposed on the nonresident is equal to the tax imposed on a New York resident for the full year, reduced by certain credits, and then multiplied by the New York source fraction.[xix]

The New York source fraction, in turn, is equal to the nonresident individual’s New York source income divided by the individual’s New York adjusted gross income from all sources for the entire year.[xx] A nonresident individual’s New York source income consists of the sum of the items of income, gain, loss and deduction entering into Federal adjusted gross income derived from or connected with New York sources.[xxi] The tax is determined by applying the appropriate graduated rate[xxii] to the nonresident’s total income from all sources less any statutory deductions, exemptions or credits.[xxiii] The taxpayer’s total income is derived from “New York adjusted gross income,”[xxiv] which is determined by reference to the taxpayer’s “federal adjusted gross income as defined in the laws of the United States for the taxable year.”[xxv]

In the case of a nonresident individual who works partly within and partly without New York, the ALJ stated, New York’s Tax Law provides that “[i]f a business, trade, profession or occupation is carried on partly within and partly without this state, as determined under regulations of the tax commission, the items of income, gain, loss and deduction derived from or connected with New York sources shall be determined by apportionment and allocation under such regulations.”[xxvi]

Convenience of the Employer

The Division’s applicable regulation[xxvii] provides that:

“[i]f a nonresident employee . . . performs services for his employer both within and without New York State, his income derived from New York State sources includes that proportion of his total compensation for services rendered as an employee which the total number of working days employed within New York State bears to the total number of working days employed both within and without New York State. The items of gain, loss and deduction . . . of the employee attributable to his employment, derived from or connected with New York State sources, are similarly determined. However, any allowance claimed for days worked outside New York State must be based upon the performance of services which of necessity, as distinguished from convenience, obligate the employee to out-of-state duties in the service of his employer.”

The last sentence of the above-quoted provision is commonly referred to as the “convenience of the employer test,” the application of which was at the center of the Taxpayer’s dispute with the Division.

According to the ALJ, “the convenience of the employer test provides that any allowance claimed for days worked outside New York must be based on the performance of services that, “of necessity, as distinguished from convenience, obligates the employee to out-of-state duties in the service of the employer.”[xxviii] If work performed at the nonresident employee’s out-of-State home, the ALJ continued, could just as easily have been performed at the employer’s New York office, the work is performed for the employee’s convenience and not for the employer’s necessity.   

It was the Division’s position that because Bank was exempt from the Pause Act, the convenience of the employer test applied to Taxpayer because the nature of his employment was such that it could have been performed at the employer’s New York office if such accommodations had been made available.

The Division alleged that it was irrelevant that Bank temporarily closed its New York office and required Taxpayer to find alternative working arrangements because that requirement did not constitute necessity on Bank’s part. Specifically, the Division asserted that although Bank temporarily chose to close its office and did not provide a New York sitused accommodation for Taxpayer, that did not constitute necessity on Bank’s part because Bank, in its status as a bank and/or financial institution, was exempt from the Pause Act.

Conversely, Taxpayer asserted that working from Bank’s New York City office was an impossibility, therefore, Taxpayer was required to work from home in Pennsylvania[xxix] absent any other suitable location.   

The ALJ’s Decision

As noted, the Pause Act, required that all “non-essential” businesses in New York reduced their in-person workforce at all work locations by 100% by March 22, 2020. However, as a financial institution, Bank was exempt from the Pause Act. Thus, Bank was not legally mandated to close its New York office and the record provided no evidence or explanation from Bank as to why it closed its offices. Contrary to Taxpayer’s argument, although it may have been necessary for Taxpayer to find alternative working arrangements, what was lacking is evidence as to why it was necessary for Bank to close its offices. When an employer deems telecommuting a necessity, it means the job cannot be effectively performed from the employer’s New York office due to factors such as specialized equipment needs or the nature of the work itself. The record was “utterly silent” as to Bank’s necessity in this matter.  

The ALJ explained that “[i]t is well settled that a nonresident employed by a New York employer is not subject to the convenience of the employer test . . . when [he] works outside of New York, performs no work within New York, and has no office or place of business in New York (i.e., where suitable facilities to carry out [his] employment duties are not maintained for or available to [him] in New York).”

Taxpayer “physically worked in New York until March 16, 2020 and there [was] no evidence to suggest that the nature of his job changed, only where it was performed.” Based on this failure of proof, the ALJ concluded, Taxpayer did not sustain “their burden of proving that the Division improperly allocated [Taxpayer’s] wages from Bank to New York State in 2020 pursuant to the convenience of the employer test.”

The Taxpayer’s petition was denied, and the notice of disallowance was sustained.

Parting Thoughts

The ALJ seems to have focused on the fact that Bank, as an essential business, was not legally ordered to close its New York office. That the business nonetheless closed the office, thereby forcing Taxpayer to work elsewhere, was of no import in the absence of any evidence as to why Bank closed the office.[xxx]

In other words, Taxpayer failed to demonstrate (i) that it was necessary for Bank to close its New York location, and (ii) that Bank had determined telecommuting was necessary.  

Talk about a move only a contortionist can perform.

I will assume that, if Bank’s New York office had been available, Taxpayer would have continued to work there and not from elsewhere.

Because Bank closed its New York office and, presumably, did not allow its employees to work from there, Taxpayer had to work from elsewhere.

Although Bank provided a location in New Jersey, there was no indication in the ALJ’s opinion that this site became Taxpayer’s assigned or primary office. If it had been, the fact that Taxpayer chose to work from Pennsylvania instead should have had no bearing upon his status vis-à-vis New York.[xxxi]

After all, days worked at home are considered New York workdays only if the employee’s assigned or primary work location is at an established office or other bona fide place of business of the employer in New York State. If the employee’s assigned or primary work location is at an established office or other bona fide place of business of the employer outside New York State, then any normal workday worked at home would be treated as a day worked outside New York State.[xxxii]

What’s Next?

The foregoing decision considered the extraordinary circumstances in which businesses and their employees unexpectedly found themselves during the pandemic and the resulting lockdown. Hopefully, we will not be revisiting the issue of remote work in that context ever again.

Moreover, the pendulum on remote work appears to swinging toward less flexible arrangements, at least for now.

The fact remains, however, that many New York businesses will continue to employ individuals from other states, and among these employees will be several who are allowed to work remotely from their homes.

We can only hope that, one day, the Supreme Court will accept a challenge to the convenience of the employer rule and will be receptive to the taxpayer’s position.

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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] On the advice of various experts, to prevent the spread of the virus. Thankfully, many of these businesses were able to continue operations with relatively little interruption as their employees continued to work remotely from home; i.e., telecommuting.

[ii] On January 20, Pres. Trump signed an executive order requiring all federal employees to come back to the office five days a week.

[iii] Several large law firms have introduced a four days per week minimum.

[iv] Inn October 2020, New Hampshire requested that the U.S. Supreme Court enjoin enforcement of the imposition of Massachusetts income tax on those residents of the Granite State who were forced to work remotely during the pandemic while their employer’s place of business in Massachusetts was closed. The Supreme Court denied the request in June 2021. See https://www.taxslaw.com/2023/02/new-yorks-convenience-of-the-employer-rule-new-jersey-and-connecticut-respond/.

[v] (Executive Order [A. Cuomo] No. 202.6 [9 NYCRR 202.6]; see also Executive Order [A. Cuomo] No. 202.8 [9 NYCRR 202.8] [amending Executive Order No. 202.6 to provide that, “[e]ach employer shall reduce the in-person workforce at any work location by 100% no later than March 22 at 8 p.m.”]; Public Health Law § 12 [1] [prescribing a penalty for violating public health orders]) (Pause Act).

[vi] The New York State Department of Economic Development.

[vii] https://esd.ny.gov/guidance-executive-order-2026 (last updated October 23, 2020).

[viii] Before the Executive Order was issued.                                                                                         

[ix] “Bank” was the Bank of Montreal.

[x] Bank re-opened the New York City office in September of 2021.

[xi] Form DTF-948.

[xii] Form AU-262.55. https://www.tax.ny.gov/pdf/questionnaires/au-262.55.pdf.

[xiii] As set forth in the Division’s regulations at 20 NYCRR 132.18 (a).

[xiv] In the Matter of the Petition of Richard S. Myers and Erin Langan, Determination DTA NO. 850197.

[xv] During the course of this proceeding, Taxpayer asserted that the original reporting of the New York State amount on the return was understated because it did not properly reflect that, in 2020, Taxpayer received a deferred bonus in the amount of $442,191.00 that was based on work performed or deemed performed in New York prior to 2020 and should have been completely allocated to New York in 2020. 

In addition, Taxpayer asserted that the return should have reported Taxpayer’s wages of $1,378,389.00 in the federal amount column and $636,917.00 in the New York State amount column.

Taxpayer further asserted that, consequently, the total New York State taxes due should have been increased from $19,347.00 to $43,144.00. After a recalculation based on the above-described increase in the New York State amount, the New York State tax increased from $19,347.00 to $43,144.00, and Taxpayer asserted that the amount of overpayment claimed for 2020 should have been reported as $80,385.00 instead of the original $104,182.00 claimed by Taxpayer on the return as a refund. 

[xvi] When the Division issues a notice of disallowance, the petitioner bears the burden of proof in a case before the Division of Tax Appeals, except where that burden has been specifically allocated to the Division (see NY Tax Law Sec. 689 [e]; 20 NYCRR 3000.15 [d] [5]). The burden of proof is on the taxpayer to show by clear and convincing evidence that the notice of disallowance was erroneous (see Matter of Leogrande v Tax Appeals Trib., 187 AD2d 768, 769 [3d Dept 1992], lv denied 81 NY2d 704 [1993]).

[xvii] If Taxpayer prevailed on his assertion that Taxpayer was not required to allocate wages to New York during the 193 days that Taxpayer worked in New Jersey and Pennsylvania, the Division agreed that the amount of the refund that would have been due was $50,229.00, plus applicable interest. 

[xviii] NY Tax Law Sec. 601 (e) (1).

[xix] NY Tax Law Sec.  601 [e] [2], [3].

[xx] NY Tax Law Sec. 601 [e] [3].

[xxi] Defined by NY Tax Law Sec. 631 (a) (1) and (2).

[xxii] NY Tax Law Sec. 601 (a) through (c).

[xxiii] NY Tax Law Sec. 606; Sec. 611 [a].

[xxiv] NY Tax Law Sec. 611 [a].

[xxv] NY Tax Law Sec. 612 [a].

[xxvi] NY Tax Law Sec. 631 (c).

[xxvii] 20 NYCRR 132.18 (a).

[xxviii] One policy justification for the convenience of the employee test, the ALJ stated, “lies in the fact that since a New York State resident would not be entitled to special tax benefits for work done at home, neither should a nonresident who performs services or maintains an office in New York State.”

[xxix] Interestingly, PA has its own version of the convenience of the employer rule.

[xxx] This line of “reasoning” should sound familiar. It’s almost the same language the ALJ used in In the Matter of the Petition of Zelinsky, Determination DTA NOS. 830517 and 830681 (Nov. 30, 2023).

“The fact that petitioner’s employer did not provide accommodations but instead allowed petitioner to work out-of-state at home does not constitute necessity or requirement by Cardozo . . . Petitioner has failed to meet his burden that he worked out-of-state due to his employer’s necessity.”

[xxxi] At that point, New York would not have been the location to which Bank had assigned Taxpayer.

[xxxii] TSB-M-06(5)I.

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Expiring Provisions

Just a few weeks ago, many individual taxpayers, driven by what they viewed as the relatively imminent expiration of the enhanced federal transfer tax[i] exemptions, sought advice on how to leverage their remaining exemption and thereby optimize the transfer of value to their beneficiaries while limiting the amount of tax incurred.

Even following the results of the November elections, and regardless of the President-Elect’s recent statements about further curbing the federal transfer taxes, many individuals continue to be concerned about the reduction of the “basic exclusion amount”[ii] that is scheduled to occur at the end of this year.[iii]

Are these folks unreasonably anxious?  

Divided GOP?

Stated differently, is it far-fetched to contemplate a scenario in which the GOP leadership in the House is unable to keep all of its members in line,[iv] resulting in the failure to win a majority vote and extend – let alone expand – the expiring provisions of the 2017 legislation,[v] including the enhanced transfer tax exemptions?

Not necessarily.  

Reconciliation

Or is it possible that any extension of the 2017 legislation’s expiring transfer tax benefits will itself be temporary?

Yes.

Under the Senate’s budget reconciliation rules, a bill may be passed with a simple majority vote[vi] – the GOP holds 53 seats in the Senate – but if the bill increases the deficit because, for example, it includes tax cuts that are not offset by other, revenue-generating provisions, those tax cuts will have to expire.[vii]

Watch Your Step

For that reason, it will behoove taxpayers who undertake any estate planning for the tax efficient inter vivos or testamentary disposition of their assets to be cautious and to familiarize themselves with those strategies and structures that have passed muster with Congress, the IRS or the federal courts.

Perhaps just as importantly, taxpayers should be aware of those other strategies that the government has found wanting. As someone once said, those who are ignorant of history are doomed to repeat it.

The truth of this cautionary proverb was borne out by a recent decision of the U.S. Tax Court that considered the estate tax consequences of one ill-conceived plan.[viii]

The Beloved Nephew

Decedent inherited her late spouse’s business and ran it very successfully. She had no children but “took a particular interest” in her Nephew. In her later years she relied on Nephew to take care of her and manage her assets.

In fact, when Decedent prepared her last will and testament (the “Will”), she named Nephew the executor of her estate.

She also executed a power of attorney (POA), and a health care proxy.

Nephew Takes Charge

The POA appointed Nephew to act as Decedent’s agent and attorney-in-fact upon her disability or incapacity.[ix] Decedent did not restrict any of the powers provided for in the POA.[x]

Likewise, the health care proxy designated Nephew as Decedent’s agent to make healthcare decisions for her should she be unable to do so.[xi] There were no restrictions on the health care proxy.

Decedent was diagnosed with Alzheimer’s. Several months later, she required surgery, which was followed by a stay at a rehabilitation center,[xii] and then at a long-term care facility. Shortly thereafter, however, Nephew moved Decedent into a house that he purchased as her agent, and using her assets. He also hired caregivers to provide Decedent round-the-clock care under his supervision.[xiii]

Nephew then approached Lawyer about certain investments that he wanted to make using Decedent’s assets. On the advice of Lawyer, Nephew formed two LLCs: Investment LLC and Real Estate LLC. Decedent, who was identified as the sole member of both these LLCs, did not personally sign the operating agreements; instead, Nephew signed those agreements for Decedent as her agent. He also signed each agreement on his own behalf as the LLC manager.[xiv]

“Decedent’s” Estate Plan

Nephew subsequently met with Lawyer’s partner, Estate Planner, to discuss the disposition of Decedent’s future estate. Following a meeting with Nephew, Estate Planner organized Limited Partnership and Management LLC in accordance with State law, and prepared partnership and operating agreements[xv] for these newly formed entities.

Operating Agreement

Nephew executed the operating agreement for Management LLC in his individual, nonfiduciary capacity.

Under that agreement, Nephew was the company’s sole member and its sole manager; he signed the agreement in both capacities. The agreement also provided that Nephew would contribute $1,000 to Management LLC in exchange for all of its membership interest.   

Partnership Agreement

Nephew also executed the partnership agreement for Limited Partnership. Under the partnership agreement, Management LLC was the limited partnership’s general partner and Decedent was its sole limited partner.

The partnership agreement provided that, subject to certain restrictions, the general partner “shall have the sole and exclusive right to manage the business of [the partnership].” 

The agreement also provided that: profits for each fiscal year “shall be allocated to the Partners in proportion to their respective Percentage Interests”; the general partner had absolute discretion to distribute cash “to the Partners in proportion to their respective Percentage Interests”; the partnership would dissolve and wind up upon (among other things) “[t]he affirmative vote of all the Partners” (i.e., Management LLC and Decedent); and, in the event the partnership was wound up, partnership property would be liquidated and the proceeds first used to pay the partnership’s debts and liabilities to third parties, then used to pay the partnership’s debts and liabilities to the partners, and finally distributed to the partners in accordance with their respective capital accounts.

Capital Contributions

The partnership agreement further provided that Management LLC (i.e., Nephew, individually) would contribute $1,000.00 to Limited Partnership[xvi] in exchange for a “0.0059%” equity interest and that Decedent would contribute assets with an aggregate value of $16.97 million to the partnership in exchange for a 99.9941% interest.

Nephew signed the limited partnership agreement both in his individual role as manager of Management LLC and on Decedent’s behalf, as her agent under the POA. Further, as manager of Management LLC,[xvii] Nephew executed the certificate of formation for Limited Partnership. 

Immediately following the formation of Limited Partnership and Management LLC, the latter contributed $1,000 to Limited Partnership in exchange for its general partner interest. The next day, Nephew executed an assignment that identified Decedent as the transferor of certain assets, and Limited Partnership as the transferee of such assets. Nephew signed the other necessary transfer forms,[xviii] both for the transferor (as Decedent’s agent) and for the transferee (as manager of Management LLC).[xix]

Decedent received a 99.9941% limited partner interest in Limited Partnership in exchange for the above assets. Following the transfers, Decedent’s assets remaining outside the limited partnership totaled approximately $2.15 million, consisting of $1.53 million in liquid assets, $495,000 in real estate (illiquid), and $127,000 in other illiquid assets.

Decedent’s Demise

Decedent, who was hospitalized during most of the above-described planning activities, died just a few days after the last of the transfers were completed.[xx] 

Decedent’s Will provided for ten specific cash bequests (three of which were to charities) totaling $1,450,000, and one noncash bequest of shares of Corp stock. The rest of Decedent’s estate passed to Nephew.

Because Decedent’s Estate did not have enough cash to pay all the cash bequests, Nephew distributed $600,000 of cash and 1,200 shares of Corp stock from Limited Partnership to the Estate. Then, as the executor of the Estate, Nephew wrote out the necessary checks.

The 706

Nephew retained CPA to prepare the Estate’s federal estate tax return, on IRS Form 706. On that return, the Estate included in the Decedent’s gross estate her limited partner interest in Limited Partnership, at a discounted (by approximately 36%) value of $10.88 million.[xxi]

The Estate did not include, independently of the limited partner interest, any value of Decedent’s assets that were earlier transferred to Limited Partnership.

The estate tax return reported a federal estate tax liability of about $4.62 million. Nephew signed the estate tax return as executor of the Estate.

Off to Court

Because the Estate did not have enough cash to pay the reported estate tax liability, Nephew sold some of Limited Partnership’s marketable securities and distributed the cash proceeds from Limited Partnership to the Estate (as the limited partner), which then paid the tax.

IRS Exam

The IRS audited Decedent’s estate tax return and determined, based on the facts and circumstances surrounding the organization of Limited Partnership, that Decedent’s gross estate should have included the full (undiscounted) date-of-death value of those assets that Decedent had previously contributed to Limited Partnership.

Consequently, the IRS issued a notice of deficiency in which it asserted that the Estate owed additional estate tax.

The Estate disagreed with the IRS’s assertion and timely petitioned the U.S. Tax Court.

The Issue

The issue before the Court was whether the value of Decedent’s gross estate should be increased by an amount equal to (1) the aggregate date-of-death value of the assets Decedent contributed to Limited Partnership, over (2) the reported value of Decedent’s limited partner interest in the partnership. In other words, should the Decedent be treated as still owning the contributed assets?[xxii] 

The Court’s Analysis

The Court explained that the value of a decedent’s gross estate generally includes the fair market value of all property that the decedent owned on the date of death.

Inclusion of Retained Interests

However, the Court added that a decedent’s gross estate will also include the fair market value of property that was transferred by the decedent during their lifetime, and which was not owned by the decedent at the time of death, but is nevertheless required to be included in the decedent’s estate for tax purposes because the transfer was “testamentary in nature.”[xxiii] 

For example, if a decedent made a lifetime transfer of property (other than through a bona fide sale for adequate and full consideration) and retained specific rights or interests in such property – like the right to all income from the property – that were not relinquished until the decedent’s death, the full value of the transferred property generally is included in the decedent’s gross estate.[xxiv] 

According to the Court, there are three requirements that must be satisfied for property to be included in a decedent’s gross estate under the above-described “retained interest” rule:

  1. first, the decedent must have made a lifetime transfer of the property;
  2. second, the decedent must have retained a statutorily enumerated interest or right in the transferred property, which they did not relinquish until death; and
  3. finally, the transfer must not have been a bona fide sale in exchange for which the decedent received adequate and full consideration.[xxv] 

Transfer

The Court noted there was a lifetime transfer of property when Nephew, on Decedent’s behalf, contributed most of Decedent’s assets to Limited Partnership while Decedent was still alive.

Retention

Next, the Court considered whether Decedent retained any rights or interests in the property “she transferred” that may properly cause such property to be included in her gross estate.[xxvi]

The Court explained that property transferred by a decedent may be included in their gross estate if the decedent retained possession or enjoyment of, or the right to income from, the property.[xxvii]  For these purposes, a transferor retains “possession or enjoyment” if they retain a “substantial present economic benefit” from the property, as opposed to “a speculative contingent benefit which may or may not be realized.” Possession or enjoyment is “retained” for these purposes, the Court continued, if there is an express or implied agreement among the parties to that effect at the time of the transfer, whether or not the agreement is legally enforceable.[xxviii] 

Although the partnership agreement gave Management LLC some rights to the income and underlying property of Limited Partnership, it acquired those rights in exchange for a $1,000 contribution that represented a de minimis interest that was “hardly more than a token in nature,” the Court stated.

Decedent’s Agent

What’s more, Management LLC was the general partner of Limited Partnership at all times, with absolute discretion to make proportionate distributions; Nephew was the LLC’s sole member and manager; and both before and throughout his tenure as manager, Nephew acted as Decedent’s agent under the POA.

Therefore, at all times Decedent effectively held the right to virtually all the income from the transferred assets, and the Limited Partnership’s agreement constituted an express agreement to that effect.[xxix] Although Decedent did not actually receive any income distributions from Limited Partnership during her life.[xxx]  the right to possession or enjoyment of, or the right to income from, the property “does not require that the transferor pull the ‘string’ or even intend to pull the string on the transferred property; it only requires that the string exist.”

Continued Reliance on Transferred Assets

The Court also concluded that Decedent retained enjoyment (i.e., substantial present economic benefit) of the transferred assets themselves.[xxxi]

The transfers to Limited Partnership left Decedent with only $2.15 million of assets outside the partnership,[xxxii] while her Will provided cash bequests of $1.45 million, and a substantial estate tax liability was foreseeable. On this basis, the Court found an implicit agreement between Nephew and Decedent that Nephew, as manager of the general partner of Limited Partnership, would make distributions from the partnership to satisfy Decedent’s final expenses, debts, and bequests if and when necessary.[xxxiii] Nephew did in fact make distributions to satisfy Decedent’s bequests and the Estate’s estate tax liability. The use of a significant portion of the partnership’s assets to discharge obligations of the Estate was evidence of a retained interest in the assets transferred to the partnership. “As we remarked in an analogous case,” the Court continued, “virtually nothing beyond formal title changed in decedent’s relationship to [her] assets.”[xxxiv]

Right to Determine Enjoyment

In addition to retaining enjoyment and rights,[xxxv] Decedent also retained “the right, either alone or in conjunction with any person, to designate the persons who shall possess or enjoy the [transferred] property or the income therefrom.”[xxxvi] 

Specifically, the Limited Partnership agreement provided that Decedent had the right, in conjunction with Nephew, to dissolve the partnership, at which time Nephew would be obligated to liquidate all partnership property, pay off partnership debts, and distribute the remaining cash to the partners in accordance with their capital accounts. Accordingly, Decedent retained the right – “in conjunction with” Nephew – at any time to acquire outright all income from the transferred assets and then designate its disposition. 

With that, the Court determined there was no pooling of assets in the partnership similar to what one would find in a joint venture vehicle; rather, the partnership functioned essentially as a vehicle to reduce the value of Decedent’s contributed assets and to thereby reduce the estate tax.

Having found that Decedent retained the enjoyment of the transferred assets, as well as the right to the income from those assets, and the right to designate who should possess or enjoy that income, the Court was prepared to require the inclusion of such assets in Decedent’s gross estate.

Bona Fide Sale?

Before it could do so, however, the Court considered an exception to the above rule for transfers constituting a “bona fide sale for an adequate and full consideration in money or money’s worth.”

According to the Court,[xxxvii] whether a transfer is a bona fide sale is a question of motive, and whether a transfer is for adequate and full consideration is a question of value.[xxxviii] 

Whether a transfer to a partnership in exchange for a partnership interest was made for adequate and full consideration depends on whether:

  1. the interests credited to each of the partners was proportionate to the fair market value of the assets each partner contributed to the partnership,
  2. the assets contributed by each partner to the partnership were properly credited to the respective capital accounts of the partners, and
  3. on termination or dissolution of the partnership the partners were entitled to distributions from the partnership in amounts equal to their respective capital accounts.

All three of these requirements were met here: Management LLC and Decedent received Limited Partnership interests proportionate to their contributions to the partnership; the contributions of both partners were properly credited to their respective capital accounts; and the  partnership agreement provided that upon termination or dissolution of the partnership, and after payment of partnership debts, the partners would receive distributions in accordance with their respective capital accounts.[xxxix]

The Court therefore concluded that Decedent received adequate and full consideration for her contribution to Limited Partnership.

Still, the question remained whether there was a bona fide sale.

Non-Tax Purpose

As to whether Decedent’s transfer of assets to Limited Partnership was bona fide, the Court began by stating that “the proper inquiry is whether the transfer in question was objectively likely to serve a substantial nontax purpose.” This requires an objective determination as to what, if any, nontax business purposes the transfer was reasonably likely to serve at its inception.”[xl]

The Court explained that “the objective evidence must indicate that the nontax reason was a significant factor that motivated” the partnership’s creation. A significant purpose, the Court stated, must be an actual motivation, “not a theoretical justification.”[xli] 

The Estate (i.e., Nephew) alleged there were four significant and legitimate nontax purposes for Decedent’s[xlii] contributions to Limited Partnership:

  1. The partnership protected Decedent from further instances of financial elder abuse;[xliii]
  2. It allowed for “succession management of assets,” i.e., Nephew would be able to choose his successor to manage Limited Partnership (whereas he could not choose his successor under the POA);
  3. Limited Partnership resolved the problem of third parties, such as banks, refusing to honor the POA;
  4. The limited partnership allowed for consolidated and streamlined management of assets.

In support of the foregoing reasons, the Estate relied largely on Nephew’s testimony. Unfortunately for the Estate, the Court did not find credible Nephew ‘s testimony that he was motivated to contribute Decedent’s assets to Limited Partnership in order to achieve the above goals, especially given ‘s Decedent’s age and health at the time of the contributions.

The Court was not convinced that Nephew was actually motivated to undertake the Limited Partnership transactions for any reason other than reducing estate tax (by virtue of obtaining a discount on Decedent’s partnership interest for lack of control and lack of marketability).

In reaching its conclusion, the Court found it troublesome there was no evidence of any discussion of transferring Decedent’s assets into a partnership until Decedent’s health appeared to be in “precipitous decline”; yet thereafter “the transfers proceeded rapidly.”

The Court also observed that: 

  1. Leading up to the formation of Limited Partnership, there were no significant changes in the amount or composition of Decedent’s wealth that might reasonably have triggered a nontax concern for asset management that did not exist before.
  2. The record contained no contemporaneous documentary evidence of Nephew’s motivations for effecting the Limited Partnership transactions other than the email from Estate Planner to the appraiser about “obtaining a deeper discount” of Decedent’s partnership interest for tax purposes.
  3. The assets transferred to Limited Partnership were of a disparate character, promised no obvious synergies with each other, and came almost exclusively from Decedent – there was no prospect of realizing the intangible benefits “stemming from a pooling [of assets] for joint enterprise.” 
  4. The assets transferred to Limited Partnership were not “working” interests in any business requiring active management. 
  5. Decedent was not herself involved in any of the partnership planning or management; instead, Nephew represented both her interests (as Decedent’s agent) and his own.
  6. The asset transfers depleted Decedent’s liquidity to the point that the Estate could not pay Decedent’s bequests or its reported estate tax liability.

In view of the above-listed factors, the Court found it more likely that the nontax purposes given by Nephew were offered after the fact as “theoretical justification[s]” rather than “actual motivation[s].”[xliv] 

Court’s Conclusion

Thus, the Court concluded that the transfers to Limited Partnership were not bona fide.

Because the transfer of Decedent’s assets to Limited Partnership was not a bona fide sale, and because Decedent retained applicable rights and interests with respect to those assets up until her death, her gross estate should have included the date-of-death fair market value of the transferred assets.

However, because the transfer was made in exchange for consideration in money or money’s worth, but was not a bona fide sale, there was included in the gross estate only the excess of the fair market value at the time of death of the property otherwise to be included, over the value of the consideration received therefor by the Decedent.

Looking Ahead

An elderly, incapacitated taxpayer who happened to be wealthy; a beneficiary who was also taxpayer’s agent; a partnership that was organized by the beneficiary-agent without taxpayer’s involvement; an insignificant capital contribution by the agent individually in exchange for which he became the general partner; a transfer by the agent to the partnership, on behalf of the taxpayer, of almost 90% of taxpayer’s assets, consisting mostly of marketable securities, in exchange for a limited partnership interest; taxpayer’s demise shortly after completion of the foregoing transactions; a substantially discounted estate tax value for taxpayer’s limited partnership interests; an estate with insufficient liquidity to satisfy its obligations.

Any individual taxpayer and their estate planner or adviser should cringe at the thought of finding themselves in the above-described position. The beginning of a new administration that promises to be friendlier to business owners, and the anticipated partial defanging of the IRS’s enforcement capabilities, do not present an opportunity for pursuing “strategies” that the federal courts have clearly rejected,[xlv] nor do they grant a license for what may be described as reckless planning.[xlvi]

The consequences of ignoring this cautionary note may be more severe if the new Congress is unable to extend the expiring federal transfer tax benefits, and the “cushion” they may otherwise provide, beyond the end of this year.

Stay tuned.

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[i] I.e., the estate, gift, and generation-skipping transfer taxes.

[ii] IRC Sec. 2010.

[iii] Last week, the Joint Committee of Taxation released a list of federal tax provisions that will be expiring over the next few years. JCX-1-25, January 9, 2025.

[iv] Consider the very narrow 219 to 215 breakdown between the GOP and the Dems in the House. Is it far-fetched to posit a situation in which some of the more conservative members of the GOP may decide not to toe the party line? The internal divisions were not wiped away by the first-round re-election of Speaker Johnson. Is it impossible to imagine a New York Republican (yes, there are some of those) voting against a bill that does not eliminate the SALT cap? Is it difficult to foresee a circumstance in which a strong Republican (say, Rep. Roy) votes against a bill on principle?

Coming at it from another perspective, how likely is it that a Democrat will cross the aisle to support a bill originating from the other side?

[v] Tax Cuts and Jobs Act, Pub. L. 115-97.

[vi] Thereby avoiding the Senate’s filibuster rule, which requires 60 votes to pass a bill.

[vii] The so-called “Byrd Rule.”

[viii] Estate of Fields v. Comm’r, T.C. Memo. 2024-90 (2024).

[ix] The POA stated that Decedent would be considered disabled or incapacitated for purposes of the POA if a physician certified in writing that, based on the physician’s medical examination, she was mentally incapable of managing her financial affairs.

[x] She also gave Nephew the power to make gifts, provided they did not exceed “the amount of annual exclusions allowed from the federal gift tax for the calendar year of the gift.”

[xi] And should a physician certify in writing that she was so unable.

[xii] Taxpayer was a victim of financial elder abuse while she was recovering at the rehabilitation center. A second instance occurred after she left the center.

[xiii] While the property was in escrow, it became unclear whether Nephew had the authority to act on Taxpayer’s behalf in the home purchase and other financial matters. Thus, Nephew obtained letters from two of Taxpayer’s physicians, each of which stated that, in the physician’s medical opinion, Taxpayer had the requisite mental capacity to understand the meaning and significance of the general POA when she signed it a few years earlier. One of the letters stated that, in the physician’s medical opinion, Taxpayer was “not capable of appreciating the meaning or significance of the [purchase of the property], or of handling her legal and financial affairs,” thereby satisfying the condition precedent for the general POA to take effect.

[xiv] At the time of Decedent’s death, Investment LLC held cash, notes receivable (consisting of loans that Investment LLC made to Nephew), and some collectibles.

[xv] Interestingly, Estate Planner sent copies of the draft agreements to an appraiser, asking him for “any comments [he might have] … regarding the terms that might be useful in obtaining a deeper discount.”

[xvi] The same amount that Nephew contributed to Management LLC in exchange for all of its membership interests.

[xvii] The general partner.

[xviii] The bill of sale purported to transfer the following:

1) $10 Million of the assets Decedent held at a brokerage account

2) All her shares of Corp stock, having an approximate value of $5.34 million

3) All her interest in a farm, having an approximate value of $1.1 million

4) All her interest in Investment LLC

5) All her interest in Real Estate LLC.

[xix] Assuming it was proper to treat Limited Partnership as a partnership for purposes of the federal income tax, the contribution of assets by Decedent in exchange for partnership interests was tax-deferred under IRC Sec. 721.

[xx] After Decedent died, Nephew initiated a probate action with the Probate Court. That court subsequently admitted Taxpayer’s Will to probate, appointed Nephew as executor of Decedent’s estate (the “Estate”), and authorized the issuance of letters testamentary.

[xxi] Recall that shortly before her death, Decedent transferred $16.97 million of assets to Limited Partnership in exchange for all the limited partnership interests.

[xxii] Stated differently, should Limited Partnership be disregarded?

[xxiii] IRC Sec. 2031, 2033–2046; Reg. Sec. 20.2031-1.

The federal estate tax is imposed on the transfer of a decedent’s taxable estate. IRC Sec. 2001(a). The taxable estate’s value is the value of the gross estate after applicable deductions. IRC Sec. 2051

[xxiv] IRC Sec. 2036(a). The purpose of IRC Sec. 2036(a) is to include in the gross estate inter vivos transfers that were basically testamentary in nature.

[xxv] Citing Estate of Bongard v. Commissioner, 124 T.C. 95 (2005).

[xxvi] If she did, we then must consider whether her transfers meet the exception for bona fide sales for adequate and full consideration.

[xxvii] IRC Sec. 2036(a)(1).

[xxviii] Citing Strangi v. Commissioner, 417 F.3d 468 (5th Cir. 2005), aff’g Estate of Strangi v. Comm’r, T.C. Memo 2003-145; see also Reg. Sec. 20.2036-1(c)(1)(i).

[xxix] Citing Estate of Strangi v. Commissioner, T.C. Memo. 2003-145 (holding that the decedent retained the right to income from property transferred to a family limited partnership in exchange for a 99% partnership interest, where the general partner was managed by the decedent’s attorney-in-fact).

[xxx] Having died shortly after the partnership was organized and funded.

[xxxi] As distinct from the income therefrom.

[xxxii] About 11% of her total assets prior to the transfer.

[xxxiii]Citing Estate of Bongard (“The existence of an implied agreement is a question of fact that can be inferred from the circumstances surrounding a transfer of property and the subsequent use of the transferred property.”).

[xxxiv] Citing Estate of Strangi.

[xxxv] Within the meaning of IRC Sec. 2036(a)(1).

[xxxvi] Within the meaning of IRC Sec. 2036(a)(2).

[xxxvii] And contrary to what many may conclude that receipt of adequate and full consideration indicates a bona fide sale.

[xxxviii] Citing Estate of Bongard.

[xxxix] See Reg. Sec. 1.704-1(b)(2)(iv).

[xl]  Citing Strangi v. Commissioner.

[xli] Citing Estate of Bongard.

[xlii] In fact, the contributions directed by Nephew as Decedent’s agent while Decedent was incapacitated.

[xliii] There had been two instances of financial elder abuse by others that had occurred years before the formation of Limited Partnership.

[xliv] Citing Estate of Bongard.

[xlv] Although the heyday of the family limited partnership (the “FLP”) as a “valuation discounting” vehicle may be behind us – as it should be – the FLP remains a viable alternative for addressing many family investment and family business challenges.

[xlvi] After all, by the time the IRS examines the plan implemented by the taxpayer, the government’s enforcement posture may be very different.

Listen to this post

Legitimate Interest

Few would argue that the federal government does not have a legitimate interest in preventing, detecting, and punishing tax fraud, money laundering, and other financial crimes. Likewise, I imagine few would disagree with the precept that the means by which the federal government chooses to perform these functions must not exceed its constitutionally enumerated powers.[i] Among Congress’s enumerated powers is the power to “regulate Commerce with foreign nations, and among the several States, . . .”[ii]

Limits – Enumerated Powers

As you may recall from your studies of Constitutional Law, the Commerce Clause is among the most debated and broadly construed provisions of the Constitution. Thus, it should come as no surprise that those federal courts[iii] that have considered challenges to the Corporate Transparency Act (the “Act”) over the last year or so have been inconsistent in their assessment of whether Congress exceeded its enumerated powers under the Constitution when it passed the Act.

Stop-Go-Stop-Go-Wait

Indeed, events over the last month alone have taken enough twists and turns to qualify the anxious owners of many closely held businesses – not to mention their advisers – for a spot in a Pepto-Bismol commercial.[iv]

Given the degree of uncertainty surrounding the legal status of the Act – and of the obligations imposed on businesses and their owners thereunder – it may be helpful to provide a scorecard, of sorts, that traces the development of opposition to enforcement of the Act and provides a status update. Here it goes.[v]

A Snapshot

  • The House passed its version of the Corporate Transparency Act in late 2019;[vi]
  • After several months of negotiations and changes, the Senate passed the Anti-Money Laundering Act;
  • The bill was added to the National Defense Authorization Act for FY 2021;
  • After more negotiation and editing, the bill was passed by Congress in December 2020 and then sent to the President, whose veto of the bill was overridden;[vii]
  • The bill was enacted January 1, 2021;
  • Relevant to this post was the addition of a new section to the Bank Secrecy Act, which required “reporting companies” to submit specified beneficial ownership information (“BOI”) to the Financial Crimes Enforcement Network (“FinCEN”);[viii]
  • The statutory requirement for reporting companies to submit BOI was to take effect “on the effective date of the regulations” implementing the reporting obligations;[ix]
  • Under the Act, reporting companies created or registered to do business after the effective date were required to submit the requisite information to FinCEN at the time of creation or registration, while reporting companies in existence before the effective date would have a specified period in which to report;[x]
  • FinCEN issued final BOI reporting rules on September 30, 2022, with an effective date of January 1, 2024;[xi]
  • As issued, the rules required (a) companies formed before January 1 to file a BOI report with FinCEN by December 31, 2024, and (b) companies created on or after the rule’s effective date (of January 1, 2024) and before January 1, 2025, to file within 30 calendar days of notice of their creation;
  • In November 2022, National Small Business United challenged the Act in the U.S. District Court for the Northern District of Alabama claiming the Act exceeded Congress’s enumerated powers and was unconstitutional (the “NSBU case”);
  • The reporting rules were amended in November 2023 to provide an extended filing deadline of 90 calendar days for reporting companies created on or after January 1, 2024 and before January 1, 2025; entities created on or after January 1, 2025 will continue to have 30 calendar days from notice of their creation to file their BOI reports with FinCEN;[xii]
  • December 29, 2023, a lawsuit was filed with the U.S. District Court for the Northern District of Ohio[xiii] alleging that the Act exceeded Congress’s constitutional authority;
  • The reporting rules became effective January 1, 2024;
  • March 1, the U.S. District Court in the NSBU case[xiv] concluded that the Act was “unconstitutional because it cannot be justified as an exercise of Congress’s enumerated powers” – it did not regulate commercial or economic activity but only the act of incorporation – and enjoined FinCEN from enforcing the Act against the plaintiffs;[xv]
  • March 11, the Justice Department filed a Notice of Appeal to the Eleventh Circuit Court of Appeals on behalf of the Treasury[xvi] – the Circuit Court granted expedited review and scheduled oral Arguments for September 27, 2024;
  • March 11, FinCEN issued a notice in which it stated that, while the NSBU litigation was ongoing, FinCEN would continue to implement the Act as required by Congress, while complying with the District Court’s order; thus, other than the individuals and entities subject to the District Court’s injunction, reporting companies would still be required to comply with the Act and file BOI reports as provided in FinCEN’s regulations;[xvii]
  • March 15, a plaintiff filed a complaint in the U.S. District Court for the District of Maine in which they argued that the Act was unconstitutional because it exceeded Congress’s power to regulate interstate commerce, and asked that the Court enjoin FinCEN from enforcing the Act against the plaintiff;[xviii]
  • March 26, the Small Business Association of Michigan filed suit with the U.S. District Court for the Western District of Michigan challenging the constitutionality of the Act,[xix] and asking that the Court enjoin FinCEN from enforcing the Act against the plaintiff while the case was pending – the Court denied the motion for an injunction;[xx]
  • April 17, the proceedings in the District Court for Northern District of Ohio were stayed pending the decision of the Eleventh Circuit;[xxi]
  • April 29, a bill was introduced in the House to repeal the Act;[xxii] a similar bill was introduced into the Senate on May 9;[xxiii]
  • May 20, twenty-two States joined in filing an amicus brief with the Eleventh Circuit in which they urged the Court to affirm the above March 1 decision by the District Court in Alabama, based largely on principles of federalism[xxiv]
  • May 28, the National Federation of Independent Business filed a suit in the District Court for the Eastern District of Texas challenging the Act (the Texas Top Cop Shop case) in which it sought a declaratory judgment that the Act was unconstitutional on the grounds that it exceeded Congress’s enumerated powers, including its power to regulate interstate commerce, and asking that the Court grant a permanent injunction prohibiting enforcement of the Act, including the reporting rule;
  • May 29, the Black Economic Council of Massachusetts sued the Treasury over the Act, asserting it was unconstitutional;[xxv]
  • June 3, the plaintiffs in the Texas Top Cop Shop case sought a preliminary injunction against the Act and reporting rule; 
  • July 18, the Eleventh Circuit scheduled oral argument in the NSBU case for September 27;  
  • August 14, the Eleventh Circuit requested that the parties submit supplemental briefs regarding whether the District Court erred “in not holding the plaintiffs to their burden of showing that there are no constitutional applications of the Corporate Transparency Act”;[xxvi]
  • September 20, the U.S. District Court for the District of Oregon ruled[xxvii] that the plaintiff businesses were not likely to succeed on the merits of their suit alleging the Act exceeded Congress’s power to regulate interstate commerce, concluded that the Act was a legitimate exercise of Congress’s broad authority to regulate interstate commerce, and declined to enjoin enforcement of the Act;
  • September 27, a three-judge panel of the Eleventh Circuit heard oral arguments in the NSBU case;
  • October 9, 2024, the District Court in the Texas Top Cop Shop case held a hearing on the matter of the injunction;
  • October 24, the U.S. District Court for the Eastern District of Virginia denied the plaintiff’s request for injunctive and declaratory relief to prevent enforcement of the Act, finding that the plaintiff was unlikely to be able to show that Congress overstepped “the outer bounds of its commerce power” when it enacted the Act;[xxviii]
  • November 5, the Midwest Association of Housing Cooperatives filed a complaint in the U.S. District Court for the Eastern District of Michigan in which it asserted that the Act exceeded Congress’s constitutional authority;[xxix]
  • December 3, the District Court in the Texas Top Cop Shop case[xxx] determined that the Act was likely unconstitutional as outside of Congress’s power, and granted the plaintiff’s motion for a preliminary injunction, as a result of which enforcement of the reporting rule was enjoined nationwide, and compliance with the January 1, 2025 BOI reporting deadline was stayed pending any further order of the Court;
  • December 4-5, supplemental authorities were filed in the Eleventh Circuit’s NSBU case;
  • December 5, the government appealed the District Court’s preliminary injunction in the Texas Top Cop Shop case to the Fifth Circuit Court of Appeals;[xxxi]
  • December 9, FinCEN stated on its website “In light of a recent federal court order, reporting companies are not currently required to file beneficial ownership information with FinCEN and are not subject to liability if they fail to do so while the order remains in force,” but added that “reporting companies may continue to voluntarily submit beneficial ownership information reports” while the government appeals the injunction;
  • December 11, the government filed a motion with the Fifth Circuit to stay the Court’s order enjoining enforcement of the Act and the reporting rule;
  • December 13, the government filed an emergency stay motion in the Fifth Circuit requesting relief no later than December 27 in order to reinstate the January 1, 2025 deadline, and the Circuit Court entered an expedited briefing schedule;
  • December 17, House Speaker Johnson unveiled a continuing resolution that would have extended by one year the deadline for existing companies to report their beneficial ownership information to FinCEN, as required under the Act;[xxxii]
  • December 19, the U.S. District Court for the District of Utah stayed a case to block the Act and denied the plaintiff’s request for a preliminary injunction against enforcement of the Act,[xxxiii] stating that the “parties agreed to a 90-day stay, pending the new presidential administration”;[xxxiv]
  • December 23, 2024, a split motions panel[xxxv] of the Fifth Circuit granted a stay of the district court’s preliminary injunction against enforcement of the Act, entered in the Texas Top Cop Shop case, pending the outcome of the Department of the Treasury’s ongoing appeal of the district court’s order, and reinstated the January 1, 2025 reporting deadline;
  • December 23, FinCEN issued an alert notifying the public of the Fifth Circuit ruling, and recognizing that reporting companies may have needed additional time to comply with beneficial ownership reporting requirements, FinCEN extended the reporting deadline as follows for reporting companies created: before Jan. 1, 2024, have until Jan. 13, 2025 to file BOI reports with FinCEN; on or after Sept. 4, 2024, that had a filing deadline between Dec. 3, 2024, and Dec. 23, 2024, have until Jan. 13, 2025, to file; on or after Dec. 3, 2024, and on or before Dec. 23, 2024, have an additional 21 days from their original filing deadline; on or after Jan. 1, 2025, have 30 days after receiving notice that their creation;
  • December 24, the plaintiff in the Texas Top Cop Shop case asked the Fifth Circuit for an expedited rehearing by the entire Court to determine whether the injunction against enforcement of the Act should be reinstated, and asked that the Court rule on its petition no later than January 6, 2025;
  • December 26, a different panel of the Fifth Circuit issued an order vacating the earlier panel’s December 23 order that had granted a stay of the preliminary injunction in the Texas Top Cop Shop case, thereby restoring the injunction issued by the District Court and relieving reporting companies from the requirement to file BOI with FinCEN;[xxxvi]
  • December 27, the Fifth Circuit issued an expedited schedule for briefing (the government’s opening brief is due February 7, 2025) and oral argument (March 25);[xxxvii]
  • December 27, FinCEN issued an alert stating: “In light of a recent federal court order, reporting companies are not currently required to file beneficial ownership information with FinCEN and are not subject to liability if they fail to do so while the order remains in force. However, reporting companies may continue to voluntarily submit beneficial ownership information reports.”[xxxviii] 
  • December 31, the DOJ asked the U.S. Supreme Court[xxxix] to issue a stay of the preliminary injunction issued by the District Court in the Texas Top Cop Shop case, pending the consideration and disposition of the government’s appeal to the Fifth Circuit and, if the Circuit affirms the District Court in whole or in part, pending the timely filing and disposition of a petition for a writ of certiorari and any further proceedings in the Supreme Court.

What’s Next?

Over the last few weeks, the Texas Top Cop Shop case has been front and center among the many lawsuits initiated by businesses and business organizations to challenge the Act as unconstitutional.

Although this is understandable – especially so after the DOJ brought the Supreme Court into the mix on New Year’s Eve – we must not lose sight of the fact that any day now the Eleventh Circuit may render an opinion in the NSBU case.[xl]

One has to wonder what effect that Circuit’s opinion would have upon the Supreme Court’s response to the DOJ’s request for a stay of the nationwide preliminary injunction issued by the District Court in the Texas Top Cop Shop case, or upon the Fifth Circuit’s ultimate disposition of that case.    

One also has to wonder whether the new Trump Administration and this Congress will try to repeal the Act. As indicated above, the District Curt in Utah seems to have adopted this not unreasonable approach.

Hear Me Out

Setting the foregoing litigation aside for a moment, let’s consider why Congress thought the Act was a good idea just a few years ago.

Congress found that more “anonymous” legal entities,[xli] including corporations and LLCs, are formed in the U.S. than in any other national jurisdiction. It also determined that such legal entities are often being used by domestic and foreign criminals to engage in various illicit activities, to launder the proceeds from such activities, and to otherwise access and transact business in the U.S. economy to their benefit with relative impunity.

Congress observed that such activities are facilitated by the fact that the U.S. did not have a centralized or complete store of information about who owns and operates legal entities within the U.S.[xlii] Moreover, the information about such entities that was already available to law enforcement was generally limited to the information required to be reported when the entity was formed at the state level. Even then, however, most states do not require the identification of an entity’s individual beneficial owners at the time of formation, and the vast majority of states require disclosure of little to no contact information or information about an entity’s officers.[xliii]

Congress believed that bad actors, being aware of the dearth of information regarding beneficial ownership, have exploited state entity formation procedures to conceal their identities when forming corporations or LLCs in the U.S., and have then used the newly created entities to commit crimes affecting commerce, including tax fraud.

Likewise, according to Congress, the lack of available beneficial ownership information impeded the efforts of law enforcement to investigate corporations and LLCs suspected of committing such crimes.

Having concluded that the identities of the beneficial owners of legal entities are of interest to the federal government because of their economic status as the persons who own or control a company that operates, at least in part, within the U.S., the federal government enacted the Act, with bipartisan support, and delegated authority to the Treasury to establish an effective date for filing and updating beneficial ownership information reports and to promulgate regulations regarding these reports.[xliv]

Although the means selected to remedy what Congress believed to be a defect in the law may ultimately itself be found wanting, the federal government continues to have a legitimate interest in accomplishing the intended goal.

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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] I would add that the federal government must balance its obligation to enforce, say, the federal tax laws against its obligation to protect the equally legitimate interests of its constituents in maintaining their privacy. Of course, I am referring to the members of society from whom the government derives its authority, and whom the government serves, at least in theory.

[ii] U.S. CONST. Art. I, Sec. 8, Cl. 3.

[iii] As you’ll see below, there have been several.

[iv] You know the one: The Pepto-Bismol 5-Symptom Song & Dance, with its famous line – nausea, heartburn, indigestion, upset stomach, diarrhea. Please don’t shoot the messenger.

[v] All dates are in 2024 except as otherwise indicated.

[vi] Earlier versions were introduced in 2017.

[vii] The Senate voted 81-13 to override President Trump’s veto. The House had previously approved the bill by a vote of 322-87.

[viii] 31 U.S.C. 5336.

[ix] 31 U.S.C. 5336(b)(5).

‘‘(5) EFFECTIVE DATE — The requirements of this subsection shall take effect on the effective date of the regulations prescribed by the Secretary of the Treasury under this subsection, which shall be promulgated not later than 1 year after the date of enactment of this section.”

[x] 31 U.S.C. 5336(b)(1)(B), (C).

[xi] Published Document: 2022-21020 (87 FR 59498).

[xii] Published Document: 2023-26399 (88 FR 83499).

[xiii] Robert J. Gargasz Co. LPA v. Janet Yellen, Case No. 1:23-cv-02468 (N.D. Ohio filed Dec. 29, 2023).

[xiv] The suit was filed in November 2022.

[xv] National Small Business United, d/b/a National Small Business Association, et al., v. Janet Yellen, in her official capacity as Secretary of the Treasury, et al., No. 5:22-cv-01448 (N.D. Ala.).

[xvi] National Small Business United et al. v. U.S. Department of the Treasury et al., case number 24-10736, in the U.S. Court of Appeals for the Eleventh Circuit.

[xvii] https://www.fincen.gov/news/news-releases/updated-notice-regarding-national-small-business-united-v-yellen-no-522-cv-01448

[xviii] Boyle v. Yellen , D. Me., No. 2:24-cv-00081 (D. Me. Mar. 15, 2024).

[xix] Small Business Association of Michigan, et al v. Yellen.

[xx] Small Business Ass’n of Mich. v. Yellen, No. 1:24-cv-00314-RJJ-SJB (W.D. Mich. Apr. 26, 2024).

[xxi] https://www.pacermonitor.com/public/case/51852710/Robert_J_Gargasz_Co,_LPA_et_al_v_Secretary_of_the_Treasury_et_al

[xxii] H.R.8147, the “Repealing Big Brother Overreach Act”. 

[xxiii] S.4297, Among other things, the sponsors cited the severe penalties for noncompliance.

[xxiv] https://assets.law360news.com/1839000/1839407/https-ecf-ca11-uscourts-gov-n-beam-servlet-transportroom-servlet-showdoc-011013344879.pdf,: Alabama, Arkansas, Florida, Georgia, Idaho, Iowa, Kansas, Kentucky, Louisiana, Mississippi, Missouri, Montana, Nebraska, Ohio, South Carolina, South Dakota, Tennessee, Texas, Utah, Virginia, West Virginia, and Wyoming.

Twenty-Five States have filed in the Texas Top Cop Shop case.

[xxv] Black Economic Council of Mass., Inc. v. Yellen, D. Mass., No. 1:24-cv-11411, 5/29/24.

[xxvi] https://www.courtlistener.com/docket/68332749/national-small-business-united-v-us-department-of-the-treasury/  

[xxvii] Firestone v. Yellen, D. Or., No. 3:24-cv-01034, 9/20/24.

[xxviii] Community Associations Institute v. Yellen, U.S. District Court for the Eastern District of Virginia, No. 1:24-cv-1597 (MSN/LRV).

[xxix] Midwest Ass’n of Hous. Coop. v. Yellen, E.D. Mich., No. 2:24-cv-12949, complaint filed 11/5/24.

[xxx] Texas Top Cop Shop, Inc. v. Garland, E.D. Tex., No. 4:24-cv-00478, 12/3/24.

[xxxi] Texas Top Cop Shop, Inc. v. Garland, U.S. Court of Appeals (5th Cir.), No. 24-40792 (12/26).

[xxxii] You may recall that President-elect Trump opposed this Continuing Resolution.

Sec. 122 of the Continuing Resolution: 

Section 5336(b)(1)(B) of title 31, United States Code, is amended by striking ‘‘before the effective date of the regulations prescribed under this subsection shall, in a timely manner, and not later than 2 years after the effective date of the regulations prescribed under this subsection,’’ and inserting ‘‘before January 1, 2024, shall, not later than January 1, 2026,’’.

[xxxiii] Phillip Taylor et al. v. Yellen et al., case number 2:24-cv-00527, in the U.S. District Court for the District of Utah.

[xxxiv] Interesting that the Court wanted to see what the incoming Administration would do with respect to the Act. A very practical approach.

[xxxv] One Judge would have kept the injunction in place for the plaintiff.

[xxxvi] According to this panel, it vacated the earlier order “In order to preserve the constitutional status quo while the merits panel considers the parties’ weighty substantive arguments, that part of the motions-panel.”

[xxxvii] The panel also allowed the plaintiff’s earlier petition for an en banc hearing to be withdrawn.

[xxxviii] Query whether another extension is likely.

[xxxix] Garland v. Texas Top Cop Shop Inc., U.S., No. 24A653, application 12/31/24.

[xl] Or will that Circuit wait on the Supreme Court’s decision regarding the Texas District Court’s nationwide preliminary injunction?  

[xli] Anonymous in the sense that the ownership of such entities is not a matter of public record.

[xlii] In contrast to the U.S., member countries of the European Union are required to have corporate registries that include beneficial ownership information.

[xliii] H. Rept. 116-227 – Corporate Transparency Act of 2019;

https://www.congress.gov/congressional-report/116th-congress/house-report/227/1;. As the Committee Report put it:

“A person forming a corporation or limited liability company within the United States typically provides less information at the time of incorporation than is needed to obtain a bank account or driver’s license and typically does not name a single beneficial owner.”

[xliv] Id. § 5336(b)(1).

In general, the CTA requires each reporting company to submit to FinCEN a report identifying each beneficial owner of the reporting company and each applicant with respect to that company by: (1) full legal name, (2) date of birth, (3) current residential or business street address, and (4) unique identifying number from an acceptable identification document.

The applicant is the individual who files the document that forms a domestic corporation or LLC under state law. They are required to file a list of a reporting company’s beneficial owners, along with certain identifying information, with FinCEN at the time the company is formed.

In general, a reporting company includes a corporation, LLC, or “other similar entity” that is created under state law by filing a document with the secretary of state (or a similar office) of the governing jurisdiction.

However, certain entities are not treated as reporting companies. Significantly, from the perspective of many closely held businesses, the term “reporting company” does not include any U.S. company that:

i. has more than 20 employees on a full-time basis in the U.S.,

ii. filed Federal income tax returns in the U.S. in the previous year demonstrating more than $5 million in gross receipts or sales in the aggregate (including the receipts and sales of other entities it owns or through which it operates), and

iii. has an operating presence at a physical office within the U.S.

The term “beneficial owner” means a natural person who, directly or indirectly, through any contract, arrangement, understanding, relationship, or otherwise:

i. Exercises substantial control over a company; or

ii. Owns or controls 25 percent or more of the equity interests of a company.