TaxProf Blog

Monday, April 26, 2004

Susan Kalinka (LSU) has posted Individuals and Passthrough Entities – Fifth Circuit’s Opinion in St. David’s Raises More Questions than it Answers on SSRN. Here is the abstract:

On November 7, 2003, the United States Court of Appeals for the Fifth Circuit published its opinion in St. David’s Health Care System, Inc., reversing a grant of summary judgment in favor of the plaintiff, a nonprofit hospital, by the District Court for the Western District of Texas. The issue in St. David’s concerned whether the IRS had abused its discretion in revoking the tax-exempt status of the nonprofit hospital when it entered into a limited partnership with a for-profit hospital. This article discusses the opinions of both the district court and the Fifth Circuit in St. David’s and the standards that the Fifth Circuit set forth for purposes of determining whether forming a partnership or other entity classified as a partnership with a for-profit organization will cause a nonprofit organization to lose its tax-exempt status.

Monday, April 26, 2004

Howard Abrams (Emory) has posted The Section 734(b) Basis Adjustment Needs Repair on SSRN. Here is the abstract:

The partnership tax provisions – Subchapter K of the Internal Revenue Code – work pretty well. Those provisions have a difficult job of providing a reasonable mechanism for taxing arrangements between parties that can be far from off-the-rack. It should not be difficult to figure out how to tax two individuals who contribute equal amounts of cash to start a joint business in which each will own a one-half interest. It quickly becomes problematic, however, when one of the two partners wants a greater share of early receipts in exchange for a lower share of back-end gains. If the amounts the partners contribute are unequal, they will have some arrangement to account for that difference which the taxing structure must digest. A partnership is the most flexible form of business organization, and the rules of Subchapter K capture that flexibility surprisingly well.

The basic paradigm upon which Subchapter K is best described is tax transparency; that is, that a partnership should be all but invisible to the taxing system. In particular, transactions between a partner and the partnership should be tax-free as much as possible, with the taxable events being dealings between the partnership (or the partners) and third parties. Thus, most contributions and distributions are tax-free, but transfers of partnership assets or interests to non-partners generally are taxable.

A corollary of tax transparency is the general equality of aggregate inside and outside bases. “Inside basis” is the partnership’s adjusted basis in its assets, while outside basis is a partner’s adjusted basis in his partnership interest. Because aggregate inside basis and aggregate outside basis each represent the after-tax (and debt-financed) investment in partnership assets, they should equal each other. They start equal by reason of the basis rules applicable to contributions of property (including the debt allocation rules of section 752), and will in general remain equal throughout the life of the partnership. The examples presented in this Article do not consider the case of partnership indebtedness, although adding debt to the transaction should not create any change to the analysis.

When inside and outside basis are not equal, astute taxpayers can exploit the difference. Suppose, for example, that aggregate outside basis is higher than aggregate inside basis. A sale of all the partnership interests would transfer the partnership’s assets just as would a direct asset sale, but by selling the higher-basis interests, aggregate gain is reduced. Conversely, if inside basis were higher, the assets rather than the interests would be sold.

Nonetheless, there are transactions that can break the equality of aggregate inside and aggregate outside basis. An election is provided by section 754 which ensures, by adjusting inside basis, that this equality is in fact always maintained so long as the election is made early enough. Indeed, the basis adjustments provided by the section 754 election are so well designed – and the equality between aggregate inside and aggregate outside basis so important – that commentators have called for making these basis adjustments mandatory rather than optional.

When an election under section 754 is made, the electing partnership becomes subject to two basis adjustment provisions: (1) section 734(b), providing for certain inside basis adjustments upon the occurrence of specified triggering distributions of cash or property from the partnership; and (2) section 743(b), providing for certain inside basis adjustments upon the sale or exchange of a partnership interest. The regulations specifying the manner of making these adjustments have recently undergone major revisions, with the greatest attention focused on the section 743(b) adjustments. Now, despite the lack of any real statutory support, an incoming partner will in effect take a share of inside basis in each of the partnership’s assets equal to that partner’s share of each asset’s fair market value, an outcome so reasonable that one could only have wished Congress rather than the Treasury had seen fit to specify it.

Unfortunately, the regulations applicable to section 734(b) adjustments were not much changed, and that is indeed unfortunate. While the amount of the section 734(b) adjustment is computed properly, the allocation of that adjustment is not right. Absent a correction, the statute as written offers significant tax reduction strategies.

Saturday, April 24, 2004

Christopher House (Michigan) & Matthew Shapiro (Michigan) have posted Phased-In Tax Cuts and Economic Activity on SSRN. Here is the abstract:

Phased-in tax reductions are a common feature of tax legislation. This paper uses a dynamic general equilibrium model to quantify the effects of delaying tax cuts. According to the analysis of the model, the phased-in tax cuts of the 2001 tax law substantially reduced employment, output, and investment during the phase-in period. In contrast, the immediate tax cuts of the 2003 tax law provided significant incentives for immediate production and investment. The paper argues that the rules and accounting procedures used by Congress for formulating tax policy have a significant impact in shaping the details of tax policy and led to the phase-ins, sunsets, and temporary tax changes in both the 2001 and 2003 tax laws.

Friday, April 23, 2004

David Mayo (Gibson, Dunn & Crutcher) has posted Restricted Stock Notes on SSRN. Here is the abstract:

The 1990s saw an increasing use of equity-based compensation, most notably among dot com and other technology companies where stock options were seen as the path to quick riches at no cash cost to the issuer. Along with the increased use of equity-based compensation came increased efforts to avoid the principal downside of stock options, the realization of ordinary income on exercise, through the use of restricted stock. Restricted stock, however, requires the outlay of cash, either to the issuing corporation as a payment for the stock or to the government in payment of the taxes due on its vesting (or issuance, if a section 83(b) election, discussed below, is made). Sufficient cash for either purpose often would not be available to an employee who is to receive equity-based compensation, and in the start-up context the employer often would be unable to lend the employee cash to pay the taxes.

A transaction using a restricted stock note, which provides for the payment for restricted stock with a note issued by the employee, if properly structured, was thought to solve all of these problems. The restricted stock note provided payment for the restricted stock without the immediate outlay of cash by the employee to the employer, and because full fair market value would be paid for the restricted stock, no taxes would be due if the recipient were to make a section 83(b) election. As a result of the section 83(b) election the ordinary income that would arise on the exercise of a stock option would be avoided.

The problems that were not foreseen, however, were those caused by a falling stock market or, more specifically, a drop in the price of the stock of the employer. Most significant to the employee are the problems of repayment and of default on the restricted stock note if the market value of the restricted stock were to fall below the amount of the note. Inability to repay leads to issues regarding the characterization of full or partial forgiveness of the notes for both the employee and the employer.

Part I of this article discusses the structure and treatment of the issuance of restricted stock for restricted stock notes. Part II considers the potential consequences to employees of restructuring a restricted stock note, including partial and complete forgiveness and conversion of recourse notes to nonrecourse notes. Part III deals with the consequences to an employer of the restructuring of a restricted stock note.