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Trends & Developments - February 2014 - From Ordinary Income Traps to Capital Gain: What Not to Do

The maximum rate of federal income tax on long-term capital gains and qualified dividends is currently 23.8%1 (including the new 3.8% tax on net investment income imposed to help fund Medicare). The maximum rate on ordinary income is 43.4% (also including the new 3.8% additional tax on net investment income). The 19.6% rate differential provides a strong incentive for taxpayers to structure their transactions and investments to produce long-term capital gains and qualified dividends.

1For long-term capital gains on "collectibles," the maximum federal rate is 31.8%.

Background

However, the Internal Revenue Code contains various provisions that convert what would otherwise be long-term capital gain into ordinary income, and the Internal Revenue Service seeks to interpret these provisions broadly.

Examples of the many statutory provisions converting long-term capital gains into ordinary income include:

  • Section 1239—Treating gain from the sale of depreciable property between related taxpayers as ordinary income.
  • Section 1245—Treating gain on the sale of depreciable personal property and certain other types of property as ordinary income to the extent of prior depreciation or amortization deductions.
  • Section 1250—Treating gain on the sale of depreciable real property as ordinary income to the extent of prior depreciation deductions that exceeded the depreciation deductions that would have been allowed under the straight-line method.
  • Section 1258—Treating a portion of the gain from certain "conversion transactions" involving financial instruments as ordinary income.
  • Section 1276—Treating gain on the sale of a market discount bond as ordinary income to the extent of the accrued market discount.

The Section 1239 Trap

A recent case illustrates how the Internal Revenue Service can utilize Section 1239 to re-characterize long-term capital gains as ordinary income. In Gary L. Fish, et ux. v. Commissioner, TC Memo 2013-270 (11/25/13), the taxpayer was liable for a $1,788,370 tax deficiency as a result of the Internal Revenue Service's successful application of that section. Section 1239(a) reads as follows:

"In the case of a sale or exchange of property, directly or indirectly, between related taxpayers,   any gain recognized on the transaction shall be treated as ordinary income if such property is, in the hands of the transferee, of a character which is subject to the allowance for depreciation provided in Section 167."

The rationale of this section is to prevent a taxpayer from selling property at a gain subject to the favorable long-term capital gain rate and then having a related taxpayer benefit from depreciation deductions on that property that would reduce ordinary income, which is taxed at a significantly higher tax rate.

The Fish Controversy

Mr. Fish was the owner of a successful corporation engaged in providing computer network security solutions. In 2004, Mr. Fish retained a financial advisor to explore either the sale of the business or finding additional capital to expand the business. In September 2004, an investor agreed to purchase convertible preferred stock in the corporation and allow the proceeds to be distributed to Mr. Fish. There were several ways this transaction could have been structured which would have provided Mr. Fish with a long-term capital gain subject to a lower federal income tax rate. The parties, presumably on the advice of their attorneys, took the following steps:

  1. On November 3, 2004, Mr. Fish incorporated Fish Holdings, Inc. ("Holdings") and that corporation elected to be a treated as a subchapter S corporation, entitled to "pass-thru" treatment.
  2. On the same day, Mr. Fish contributed all of the outstanding stock of his operating corporation, FishNet Consulting, Inc., to Holdings. FishNet Consulting properly elected to be treated as a Qualified Subchapter S Subsidiary. This election was treated as a tax-free liquidation of FishNet Consulting. As a result, Mr. Fish was the sole owner of Holdings, which for tax purposes was deemed to own the business assets.  However, the business assets were still owned and operated by FishNet Consulting, Inc. This change in corporate structure was not taxable to Holdings or Mr. Fish.
  3. On December 31, 2004, FishNet Consulting paid a $2.5 million dividend to its sole shareholder, Holdings.
  4. In January 2005, FishNet Consulting, Inc. changed its name to FishNet Security, Inc. The investor contributed $10.5 million to FishNet Security in exchange for 8,465,625 shares of a newly authorized Series A Preferred Stock. This stock had preferential rights to cumulative dividends at a rate of 7% per annum. These dividends were payable when declared by the Board of Directors, upon a liquidation event, or when the preferred stock was redeemed or voluntarily converted into common stock. The consent of the Series A Preferred shareholders was required to take major corporate action. Each share of Series A Preferred stock and each share of common stock had one vote. The Series A Preferred stockholders voted as a class to elect two out of the five directors. The common stockholders voted as a separate class to elect the remaining three directors but one of these three has to be "independent" and approved by a majority of the Series A Preferred stockholders. Such consent could not be unreasonably withheld. The issuance of the Series A Preferred stock terminated FishNet Security's status as a Qualified Subchapter S Subsidiary and, for tax purposes, the business assets were then deemed re-transferred to FishNet Security in a Section 351 transaction. In such a transaction any cash received by a transferor party is taxable "boot."
  5. As part of the transaction, FishNet Security declared and paid a dividend to Holdings in the amount of $9,687,695. This cash distribution resulted in taxable income equal to the lesser of the amount received or the amount of gain from the assets deemed transferred, which was $9,638,670. Mr. Fish expected this gain to be long-term capital gain entitled to a lower federal tax rate. FishNet Security reported a step-up in the tax basis of its assets and claimed amortization and depreciation deductions (both of which are considered as an allowance for depreciation under Section 167) based on the stepped-up amount, which reduced its ordinary income.

In November 2010, after examination, the Internal Revenue Service issued a notice of deficiency based on its position that the reported long-term capital gain was ordinary income under Sections 1239 and 1245 of the Internal Revenue Code. The taxpayer conceded the portion of the gain that was ordinary income under Section 1245 but contested the position that Section 1239 applied to the much large portion.

The Fish Decision

The Internal Revenue Service asserted that Holdings and FishNet Security were "related persons" within the scope of Section 1239(a). The relevant provisions would cause the two entities to be related for purposes of Section 1239(a) if Fish Holdings owned either (a) more than 50% of the total combined voting power of all classes of FishNet Security's stock entitled to vote or (b) more than 50% of the total value of all the outstanding shares of all classes of FishNet Security's stock.

The Tax Court first addressed the voting power issue.  Of the 22,500,000 shares outstanding (both common and Series A Preferred), Holdings owned 14,034,375 shares, or 62.375%. Nevertheless, the taxpayer argued that because of various restrictions on the power of Holdings (the common stockholder) to take certain corporate actions and elect a majority of the Board of Directors the common stock should not be treated as having more than 50% of the voting power. There is precedent that supported the position that record ownership is not the sole criteria for determining voting power, especially when there are restrictions on the ability to elect a majority of the Board of Directors. See, for example, Hermes Consol. v. United States, 14 Ct. Cl. 398 (1988). It is interesting to note that the Internal Revenue Service is usually the party advancing this type of argument, but here it was the taxpayer.

Holdings could not cause FishNet Security to engage in certain fundamental corporate actions without the consent of the Series A Preferred shareholders. However, Mr. Fish, Holdings' sole stockholder, continued to operate the corporation and its value was derived from his expertise and management. The Court recognized the limitations certain negative covenants imposed on the ability of Holdings to manage FishNet Security but did not think such limitations reduced voting power to any material degree. The Court concentrated on the ability to elect a majority of the Board of Directors. The Series A Preferred stockholders could elect two directors and so could the common stockholder (Holdings, which was owned by Mr. Fish.). However, the fifth director, which could break a tie had to be independent and approved by the Series A Preferred stockholders, which approval could not be unreasonably withheld. The Court stated that the independence requirement does not prevent Holdings from electing the controlling director "but merely reduces the pool of potential candidates, and is in fact reasonable if, as the stock purchase documents seem to portray, the company wishes to become publicly owned." Thus, the Court did not agree that the requirement that the fifth director had to be independent nor that the other limitations on the ability of the common stockholder to take certain fundamental corporate actions were significant enough to reduce the voting power of the common stockholder (Holdings) from 62.375% to 50% or less.  As a result, Holdings and FishNet Security were related persons within the scope of Section 1239 and the long-term capital gain was re-characterized as ordinary income.

Although the two tests for determining whether the two corporations were related within the meaning of Section 1239 are in the alternative, the Court went on to address the issue of whether Holdings owned over 50% of the total value of the outstanding stock of FishNet Security.  Each party had its own valuation expert. The taxpayer's expert found that the value of the FishNet Security common stock held by Holdings was $9,073,400 and the value of the Series A Preferred held by the investors was $15,426,600. The Internal Revenue Service's expert found that the value of the common stock was $14,520,000 and the value of the preferred stock was $11,260,200. The taxpayer's expert used a liquidation approach that was rejected by the Court since it did not take into account the money that was distributed to Holdings as part of the transactions.  The Court believed that the government's expert's use of the redemption value of the Series A Preferred stock was more reasonable. That approach valued the Series A Preferred stock at $11,260,000, which was clearly less than 50% of the total value of FishNet Security. Accordingly, Holdings, the common stockholder, owned more than 50% of the total value of all the stock outstanding and was a related party within the scope of Section 1239.

The Fish case illustrates the complexity of one of the sections of the Internal Revenue Code that causes gains to be re-characterized as ordinary income subject to a significantly higher federal income tax rate. Section 1239 is a "sleeper" section that is often overlooked in structuring transactions. The many other provisions that could cause ordinary income to be recognized rather than expected long-term capital gains are also complex and, sometimes, not apparent. These provisions should be on a tax practitioner's checklist for reviewing and structuring transactions. If they are not fully analyzed, the Internal Revenue Service may successfully apply one or more of them and seek a tax deficiency.


Trends & Developments - February 2014

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