Fish Bites Section 1239 Trap

 

Let’s talk about how a business purchase transaction can blow up.

The pepper in this stew is that the seller and buyer have different tax goals:

• The buyer wants to deduct as much as possible. In general, this means that the other side (the seller) will be recognizing ordinary income to offset those ordinary deductions.

• The seller wants as much capital gains as possible. In general, this means that the other side (the buyer) may have to amortize or depreciate assets over time rather than deducting them immediately.

M&A tax planning at heart comes down to the above tension.

Sometimes reading M&A cases can be difficult: numerous entities, mind-numbing detail, this move, that move, everyone come down and bust a move. Let’s take one case that caught my attention. As we have (sometimes) done before, we will modify the names to make the story easier to follow.

In 1996 Vernon started a one-man technology company in Kansas City. By 2004 it was one of the largest network security companies in the nation.

Let’s call his company Harry.

Vernon wanted cash for his troubles and travails. He would keep majority control of the company, but he would also have cash for little things - like expensive cars and multiple houses. I am with Vernon here.

Petunia was looking to invest in Harry.

Dial-in the tension between the seller and the buyer. Here is what they came up with

• Vernon owned 100% of Harry, an S corporation.
• Vernon transferred 100% of his stock in Harry to Hermione, a newly-formed S corporation.

COMMENT: There is a problem here: S corporations generally have to be owned by individuals, estates and certain trusts. A corporation cannot own an S corporation, except for …

• Harry immediately elected to be a Qualified Subchapter S Subsidiary (QSSS), an exception to that corporation-owning-an-S thing. Hermione owned Harry and it was all okay.

• Petunia dropped $10.5 million into Hermione in exchange for 43% of newly-issued preferred stock.

COMMENT: The money is now in play. The issue is getting it out to Vernon.

• We have a problem with Hermione. First, an S corporation must have only one class of stock, and Hermione now had two: common and preferred. Second, a QSSS can have only one shareholder: a parent who owns 100% of the QSSS stock. Hermione now had two shareholders. No surprise …

• Hermione’s S election blew up.

COMMENT: This was intentional. Harry was deemed to have transferred its interest in Hermione to a new corporation in exchange for 57% of the new stock. Petunia was deemed to have transferred $10.5 million for the remaining 43% interest. We will call the new corporation Ron.

COMMENT: There is a Code section (Section 351) that normally prevents incorporations from being taxable. There are ways to make it taxable, but most planners stay far away from them. One way? Pay money back to an incorporator (in this case, Harry via Hermione). The geek term for this money is “boot.”

• Ron paid $9.7 million in boot to Harry/Hermione upon reincorporation.

COMMENT: There you go: the planners deliberately sprung the trap. I do not recall ever doing this in my career. Why did they do it? To move the money to Vernon, of course, but also to have a chance at capital gains treatment by rinsing it through a Section 351 transaction.

• Let’s take stock of where we are.

a.     Petunia wanted ordinary deductions. She now has it in the way of amortization and depreciation. She put money into Hermione/Ron – and that money was buying assets; tangible, intangible, whatever. Petunia never bought stock.

b.    Vernon wanted capital gains. The easiest way would have been to sell Harry/Hermione stock, but Petunia wasn’t interested. All this ambulation was to mimic the sale of stock.

I admit: the tax work up to this point is clever.

But someone overlooked this interloper:

26 U.S. Code § 1239 - Gain from sale of depreciable property between certain related taxpayers

(a) Treatment of gain as ordinary income

In the case of a sale or exchange of property, directly or indirectly, between related persons, any gain recognized to the transferor 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 idea here is simple: Congress did not want related parties to depreciate assets and then sell them to a related party to start the depreciation over again.

Tax being tax, the words have a loaded meaning. For example, does “depreciation” under Section 167 include amortization, which is the equivalent of depreciation but for intangible assets? “Related persons” also has multiple definitions, depending upon where you are in the Code.

Let’s continue.

Remember that we are dealing with a technology consulting company in Kansas City. This is a not a manufacturing plant in Pennsylvania with all kinds of real estate and machinery and equipment. Most of what Petunia bought for $10.5 million was intangible assets, amortizable under Section 197 over 15 years.

At which point I presume the tax planners stopped, reasoning that Section 197 is not Section 167 and therefore Section 1239 was not an issue.

Except for Reg 1.197-2(g)(8):

Also, an amortizable Section 197 intangible is section 1245 property and Section 1239 applies to any gain recognized upon its sale or exchange between related persons (as defined in Section 1239(b)).”

Buried deep, but there it is. Section 1239 slipped its first noose on the transaction.

But were the parties related? Could Harry/Hermione/Ron avoid the second noose?

Here is Section 267(f):

Think of Section 1563 as applying to consolidated corporations (where corporations own other corporations). Section 267 addresses individuals owning corporations (what we would call brother-sisters). Section 267 is taking a consolidation definition and changing it for brother-sisters. It is changing the definition to make it less stringent.

Section 1239 wants related parties, and Section 267 says you have related with more than 50% common ownership.

Vernon owned 100% of Harry and 100% of Hermione. He also owned 57% of Ron.

Yep, related.

Section 1239 applied.

Vernon got ordinary income, not capital gain, treatment on the $9-plus million dollars.

Petunia got her ordinary deductions - over time and not right away.

It is very tough to accommodate both sides.

But Vernon did get his $9-plus million dollars.

Our case this time, modified a spot for ease of writing and readability, was Fish v Commissioner, T.C. Memo 2013 - 270.

A Paycheck As A Treasure Trove

 

I am looking at a case where the taxpayer was using Cesarini to argue her position.

COMMENT: Cesarini is one of my favorite tax decisions and a big reason this case caught my eye. The family purchased a piano at auction for $15. Seven years later – while cleaning the piano – they discovered approximately $4,500 in currency. The tax case addressed when the $4,500 was taxable – when they bought the piano, when they found the money, or some other date. It also introduced us to the “treasure trove” doctrine, addressing – not surprisingly – when finding a treasure is taxable.

COMMENT: $4,500 does not strike as that much money in 2025. Cesarini however was decided in 1964, when median U.S. household income was about $6,000. We probably would agree that finding 75% of your annual household income by fluke could be described as a treasure trove.

Let’s introduce Corri Fiege, who worked in Alaska for a U.S. subsidiary of an Australian corporation. She participated in a performance rights plan and was granted 60,000 unvested rights in parent company stock. The rights vested over three years, and she received 20,000 shares on each of July 31, 2011, 2012 and 2013.

There of course was tax involved. She had the company sell 1/3 of the stock and send the cash as federal tax withholding. She owed tax. She paid tax. There was no problem with these years.

In 2013 she received a fresh tranche of rights - 400,000 rights vesting over the four-years ending December 21, 2013, 2014, 2015 and 2016.

This time the grant was a handcuff. The parent company was in financial distress and was firing people left and right. However, they wanted to keep Corri - that is, until they let her go on November 24, 2014.

Vesting did not happen until December 21. She wasn’t going to make it.

But the company did something unexpected: it transferred 100,000 shares of stock into her Charles Schwab account. She assumed they made a mistake, and she was required by plan terms to report if there was a mistake. She called someone in Brisbane, Australia; that person had left. She called another in Houston, Texas. That person had left too. She gave up trying to report the matter to the company.

She received a W-2 showing an additional $75,660 from the stock.

But this time there was no selling 1/3 of the shares for tax withholding. She would be writing a check to Uncle Sam.

What to do?

She did not file a joint income tax return for 2014.

COMMENT: Worst. Possible. Decision.

This was easy picking for the IRS computers.

Off to Tax Court they went.

Corri and the IRS had two very different arguments.

She argued that the treasure trove doctrine applied.

Corri argued that the shares were transferred contrary to the performance rights plan, making the money subject to an ongoing claim by her employer under Alaska law.

I get it: she argued treasure trove because it would delay taxation until the taxpayer had undisputed possession.

This of course put a lot of pressure on her argument that she had disputed possession.

The IRS came from an altogether different angle.

·       Corri had an employment relationship.

·       She was compensated both in cash and property.

·       Under the tax Code, both cash and property are taxable.

·       The Code does have a specific provision (Section 83) for property transferred with restrictions on its further transfer or with a risk of forfeiture. This is what happened here. Corri was awarded rights, exercisable in the future. If she remained employed, the rights were exchangeable for actual shares, which she was free to keep or sell without further restriction. The rights were not taxable when awarded, as Corri had to remain employed until the exercise date. Once she reached that date, the restrictions came off and she had taxable compensation.

The IRS argument proved formidable against Corri. She had no further obligations to the company after she left. In addition, she was not required to refrain from acting (think a covenant not to compete). There was no risk of forfeiture from her acting or not acting. She was also free to sell or otherwise transfer the shares.

And it was there that she lost the argument of disputed possession. In Cesarini nobody knew who the cash had belonged to, and the matter of its possession had to be sorted out under state law. In this case all parties knew who the shares belonged to, and there remained nothing to be sorted out under Alaska law.

There was no treasure trove.

There was no delay.

The IRS won.

There are two things in this case that bother me. Neither are tax driven. I would describe them instead as common sense.

1. The Company had the right to overrule the terms of the performance rights plan and award shares even if plan terms were not met. To rephrase, the company was not allowed to remove a benefit already granted but it was allowed to grant a benefit an employee would otherwise not receive. I believe that is what happened here: Corri was a diligent and valued employee, and the company wanted to show appreciation, even if they had to release her.
2. If an employer gives me free money, why wouldn’t I pay tax? It seems to me that I am still better off than without the free money.

Our case this time was Corri Feige v Commissioner, T.C. Memo 2025-88.

A Call From Chuck

I was speaking with a client this week. He told me that he recently retired and his financial advisor recommended he discuss a matter with me.

Me:              So, what are we going to talk about?”

Chuck:         I worked for Costco for many years.”

Me:              OK.”

Chuck:         I bought their stock all along.”

Me:              Not sure where this is going. Are you diversifying?”

Chuck:         Have you heard of Net Unrealized Appreciation?”

Me:              Sure have, but how does that apply to you?”

That was not my finest moment. I did not immediately register that Chuck had – for many years – bought Costco stock inside of his 401(k).

Take a look at this stock chart: 

Costco stock was at $313 on February 7, 2020. Five years later it is at $1,043.

It has appreciated – a lot.

I missed the boat on that one.

The appreciation is unrealized because Chuck has not sold the stock.

The difference between the total value of the Costco stock in his 401(k) and his cost in the stock (that is, the amount he paid over the years buying Costco) is the net unrealized appreciation, abbreviated “NUA” and commonly pronounced (NEW-AHH).

And Chuck has a tax option that I was not expecting. His financial advisor did a good job of spotting it.

Let’s make up a few numbers as we talk about the opportunity here.

Say Chuck has 800 shares. At a price of $1,043, the stock is worth $834,400.

Say his average cost is 20 cents on the dollar: $834,400 times 20% = cost of $166,880.

Chuck also owns stocks other than Costco in his 401(k). We will say those stocks are worth $165,600, bring the total value of his 401(k) to an even $1 million.

Chuck retires. What is the likely thing he will do with that 401(k)?

He will rollover the 401(k) to an IRA with Fidelity, T Rowe, Vanguard, or someone like that.

He may wait or not, but eventually he will start taking distributions from the IRA. If he delays long enough the government will force him via required minimum distributions (RMDs).

How is the money taxed when distributed from the IRA?

It is taxed as ordinary income, meaning one can potentially run through all the ordinary tax rates.

It was not that long ago (1980) that the maximum tax rate was 70%. Granted, one would need a lot of income to climb through the rates and get to 70%. But people did. Can you imagine the government forcing you to take a distribution and then taking seventy cents on the dollar as its cut?

Hey, you say. What about those capital gains in the 401(k)?  Is there no tax pop there?

Think of a 401(k) as Las Vegas. What happens in Las Vegas stays in Las Vegas. What leaves Las Vegas is ordinary income.

And that gets us to net unrealized appreciation. Congress saw the possible unfairness of someone owning stock in a regular, ordinary taxable brokerage account rather than a tax-deferred retirement account. The ordinary taxable account can have long-term capital gains. The retirement account cannot.

Back to NEW-AHH.

How much is in that 401(k)?

A million dollars.

How much of that is Costco?

$834,400.

Let’s roll the Costco stock to a taxable brokerage account. Let’s roll the balance ($165,600) to an IRA.

This would normally be financial suicide, as stock going to a taxable account is considered a distribution. Distributions from an IRA are ordinary income. How much is ordinary income tax on $834,400? I can assure you it exceeds my ATM withdrawal limit.

Here is the NUA option:

You pay ordinary tax on your cost - not the value - in that Costco stock.

OK, that knocks it down to tax on $166,880.

It still a lot, but it is substantially less than the general rule.

Does that mean you never pay tax on the appreciation – the $667,520?

Please. Of course you will, eventually. But you now have two potentially huge tax planning options.

First, hold the stock for at least a year and a day and you will pay long-term capital gains (rather than ordinary income tax) rates on the gain.

QUIZ: Let’s say that the above numbers stayed static for a year and a day. You then sold all the stock. How much is your gain? It is $667,520 (that is, $834,400 minus $166,880). You get credit (called “basis” in this context) for the income you previously reported.

What is the second option?

You control when you sell the stock. If you want to sell a bit every year, you can delay paying taxes for years, maybe decades. Contrast this with MRDs, where the government forces you to distribute money from the account.

So why wouldn’t everybody go NUA?

Well, one reason is that (in our example) you pony up cash equal to the tax on the $166,880. I suppose you could sell some of the Costco stock to provide the cash, but that would create another gain triggering another round of tax.

A second reason is your specific tax situation. If you just leave it alone, distributions from a normal retirement account would be taxable as ordinary income. If you NUA, you are paying tax now for the possibility of paying reduced tax in the future. Take two people with differing incomes and taxes and whatnot and you might arrive at two different answers.

Here are high-profile points to remember about net unrealized appreciation:

(1)  There must exist a retirement account at work.

(2)  There must be company stock in that retirement account.

(3)  There is a qualified triggering event. The likely one is that you retired.

(4)  There must be a lump-sum distribution out of that retirement account. At the end of the day, the retirement account must be empty.

(5)  The stock part of the retirement account goes one way (to a taxable account), and the balance goes another way (probably to an IRA).

(6)  The stock must be distributed in kind. Selling the stock and rolling the cash will not work.

BTW taking advantage of NUA does not have to be all or nothing. We used $834,400 as the value of the Costco stock in the above example. You can NUA all of that – or just a portion. Let’s say that you want to NUA $400,000 of the $834,400. Can you do that? Of course you can.

Chuck has a tax decision that I will never have.

Why is that?

CPA firms do not have traded stock.

An S Corporation Nightmare

Over my career the preferred entities for small and entrepreneurial businesses have been either an S corporation or a limited liability company (LLC). The C corporation has become a rarity in this space. A principal reason is the double taxation of a C corporation. The C pays its own taxes, but there is a second tax when those profits are returned to its shareholders. A common example is dividends. The corporation has already paid taxes on its profits, but when it shares its profits via dividends (with some exception if the shareholder is another corporation) there is another round of taxation for its shareholders. This might make sense if the corporation is a Fortune 500 with broad ownership and itself near immortal, but it makes less sense with a corporation founded, funded, and  grown by the efforts of a select few individuals – or perhaps just one person.

The advantage to an S corporation or LLC is one (usually - this is tax, after all) level of tax. The shareholder/owner can withdraw accumulated profits without being taxed again.

Today let’s talk about the S corporation.

Not every corporation can be an S. There are requirements, such as:

·       It cannot be a foreign corporation.

·       Only certain types of shareholders are allowed.

·       Even then, there can be no more than 100 shareholders.

·       There can be only one class of stock.

Practitioners used to be spooked about that last one.

Here is an example:

The S corporation has two 50% shareholders. One shareholder has a life event coming up and receives a distribution to help with expenses. The other shareholder is not in that situation and does not take a distribution.

Question: does this create a second class of stock?

It is not an academic question. A stock is a bundle of rights, one of which is the right to a distribution. If we own the same number of shares, do we each own the same class of stock if you receive $500 while I receive $10? If not, have we blown the S corporation election?

These situations happen repetitively in practice: maybe it is insurance premiums or a car or a personal tax. The issue was heightened when the states moved almost in concert to something called “passthrough taxes.” The states were frustrated in their tax collection efforts, so they mandated passthroughs (such as an S) to withhold state taxes on profits attributable to their state. It is common to exempt state residents from withholding, so the tax is withheld and remitted solely for nonresidents. This means that one shareholder might have passthrough withholding (because he/she is a nonresident) while another has no withholding (because he/she is a resident).

Yeah, unequal distributions by an S corporation were about to explode.

Let’s look at the Maggard case.

James Maggard was a 50% owner of a Silicon Valley company (Schricker). Schricker elected S corporation status in 2002 and maintained it up to the years in question.

Maggard bought out his 50% partner (making him 100%) and then sold 60% to two other individuals (leaving him at 40%). Maggard wanted to work primarily on the engineering side, and the other two owners would assume the executive and administrative functions.

The goodwill dissipated almost immediately.

One of the new owners started inflating his expense accounts. The two joined forces to take disproportionate distributions. Apparently emboldened and picking up momentum, the two also stopped filing S corporation tax returns with the IRS.

Maggard realized that something was up when he stopped receiving Schedules K-1 to prepare his personal taxes.

He hired a CPA. The CPA found stuff.

The two did not like this, and they froze out Maggard. They cut him off from the company’s books, left him out of meetings, and made his life miserable. To highlight their magnanimity, though, they increased their own salaries, expanded their vacation time, and authorized retroactive pay to themselves for being such swell people.

You know this went to state court.

The court noted that Maggard received no profit distributions for years, although the other two were treating the company as an ATM. The Court ordered the two to pay restitution to Maggard. The two refused. They instead offered to buy Maggard’s interest in Schricker for $1.26 million. Maggard accepted. He wanted out.

The two then filed S corporation returns for the 2011 – 2017 tax years.

They of course did not send Maggard Schedules K-1 so he could prepare his personal return.

Why would they?

Maggard’s attorney contacted the two. They verbally gave the attorney – piecemeal and over time – a single number for each year.

Which numbers had nothing to do with the return and its Schedules K-1 filed with the IRS.

The IRS took no time flagging Maggard’s personal returns.

Off to Tax Court Maggard and the IRS went.

Maggard’s argument was straightforward: Schricker had long ago ceased operating as an S corporation. The two had bent the concept of proportionate anything past the breaking point. You can forget the one class of stock matter; they had treated him as owning no class of  stock, a pariah in the company he himself had founded years before.

Let’s introduce the law of unintended consequences:

Reg 1.1361-1(l)(2):

Although a corporation is not treated as having more than one class of stock so long as the governing provisions provide for identical distribution and liquidation rights, any distributions (including actual, constructive, or deemed distributions) that differ in timing or amount are to be given appropriate tax effect in accordance with the facts and circumstances.

Here is the Tax Court:

… the regulation tells the IRS to focus on shareholder rights under a corporation’s governing documents, not what the shareholders actually do.”

That makes sense if we were talking about insurance premiums or a car, but here … really?

We recognize that thus can create a serious problem for a taxpayer who winds up on the hook for taxes owed on an S corporation’s income without actually receiving his just share of distributions.”

You think?

This especially problematic when the taxpayer relies on the S corporation distributions to pay these taxes.”

Most do, in my experience.

Worse yet is when a shareholder fails to receive information from the corporation to accurately report his income.”

The Court decided that Maggard was a shareholder in an S corporation and thereby taxable on his share of company profits.

Back to the Court:

The unauthorized distributions in this case were hidden from Maggard, but they were certainly not memorialized by … formal amendments to Schricker’s governing documents. Without that formal memorialization there was no formal change to Schricker’s having only class of stock.”

I get it, but I don’t get it. This reasoning seems soap, smoke, and sophistry to me. Is the Court saying that – if you don’t write it down – you can get away with anything?      

Our case this time was Haggard and Szu-Yi Chang v Commissioner, T.C. Memo 2024-77.