Tax Matters

Lease Termination Costs

Taxpayers frequently enter into leases to guarantee access to a particular asset at a fixed price. Due to market changes, some leases can become financially burdensome. In such cases a taxpayer can either continue the lease or try to terminate it. If the lessor is paid a cancellation fee, the law allows the taxpayer to deduct that fee because it does not create a substantial future benefit. As an alternative, the taxpayer can buy the asset from the lessor. The correct tax treatment of the purchase price recently came before the courts.

Stated simply, Union Carbide Foreign Sales Corp. leased a vessel from a partnership. It then chose to purchase the vessel rather than continue the lease or pay a lease cancellation fee. The company paid approximately $108 million for it although the value, ignoring the lease, was only $14 million. Therefore Union Carbide capitalized $14 million of the purchase price and deducted the remainder. The government wanted it to capitalize the entire purchase price.

Result. For the IRS. The government’s main argument was that IRC section 167(c)(2) controls the taxation of the payment. This section says that if a taxpayer acquires property subject to a lease, none of the purchase price may be allocated to the leasehold interest; instead, the entire amount must be capitalized and depreciated.
Union Carbide argued that this applied only if the lease had continued. Since the lease was cancelled when the lessee acquired the property, section 167(c)(2) should not dictate the outcome. Prior case law allowed a deduction for part of the purchase price that was, in fact, a cancellation penalty.

The Tax Court acknowledged that both parties had complex but reasonable arguments to support their points. Since neither one was clearly right or wrong, the court examined the code section and congressional intent. Unfortunately, the court did not find a specific answer. However, looking at the section in the context of Congress’s overall intent when it enacted the provision and IRC section 197, the Tax Court determined that section 167(c)(2) did not require the lease to continue after the acquisition, as the taxpayer had argued.

Reviewing the cases the company cited also did not help its cause. In only one case did the court conclude that part of the price was deductible. And in a similar case, the U.S. Supreme Court later rejected the lower court’s reasoning. Therefore the Tax Court denied Union Carbide’s deduction. The entire purchase price had to be capitalized and depreciated.

The Tax Court decision follows the wording of the code exactly. It is unlikely other courts will reach a different conclusion. Therefore, a taxpayer that acquires an asset to get out from under a burdensome lease will be required to capitalize the entire payment regardless of the underlying value of the purchased property.

Union Carbide Foreign Sales Corp., 115 TC no. 32.

Supreme Court Rules on COD Income and S Corporation Stock Basis

For a number of years, taxpayers, the IRS and the courts have disagreed about the proper treatment of S corporations that have cancellation-of-debt (COD) income and are insolvent. Recently the U.S. Supreme Court ruled in a taxpayer’s favor.

David Gilitz and Philip Winn were equal shareholders in an S corporation. In 1991 the corporation realized approximately $2 million of COD income at a time when its liabilities exceeded its assets by $2.1 million. Therefore it was insolvent even after the debt cancellation. Based on IRC section 108, the corporation excluded the COD income from its gross income. Both Gilitz and Winn treated the COD income as passing through to them under IRC section 1366, resulting in an increase in the basis of their stock. Based on this increase, they deducted previously suspended losses. The IRS denied the deduction. After government victories in lower courts, Gilitz appealed to the U.S. Supreme Court.

Result. For the taxpayer. Justice Thomas delivered the Court’s opinion. He recognized there were two separate questions. First, does COD income pass through to S corporation shareholders? If the answer is yes, then the second question is, Does the attribute reduction mandated by section 108(b) occur before or after the stock basis adjustment?

Under IRC sections 61(a)(12) and 108(a), COD income is income; it simply is not included in gross income if a taxpayer is insolvent. Since section 1366(a)(1) requires all items of income to pass through to shareholders, including tax-exempt income that is excluded from gross income, COD income also passes through to shareholders. The government’s argument that COD income should be treated differently has no support in the code. Likewise, the government’s attempt to classify COD income as tax-deferred rather than tax-exempt is incorrect. Section 1366 says all income passes through to shareholders. Whether the income is exempt or deferred is irrelevant.

The second question, the order of basis increase and tax attribute reduction, is answered by section 108(b)(4) (A), which says attribute reduction takes place after the taxpayer computes his or her tax for the year. To calculate the tax, the taxpayer must calculate taxable income, which requires determining deductible losses first. Since the loss deduction depends on the stock basis, the basis adjustment must be made before the attribute reduction occurs.

In concluding his opinion, Justice Thomas said that policy issues involving double deductions and windfalls must be ignored because the “plain language” of the code dictates the outcome. The result is that COD income passes through to the shareholder, who increases his or her stock basis, claims any loss for the year or any suspended loss and then reduces any remaining loss carryover by the excluded COD income.

Gitlitz v. Commissioner, 87 AFTR2d 2001-345.

Prepared by Edward J. Schnee, CPA, PhD,
Joe Lane Professor of Accounting
and director, MTA program,
Culverhouse School of Accountancy,
University of Alabama, Tuscaloosa.

Family Limited Partnerships Funded With Personal Use Property

Historically, CPAs have dissuaded estate planning clients from funding family limited partnerships with personal use property, such as a primary or secondary residence. In the past the IRS has attacked the transfer of such property to a family limited partnership on the grounds that the entity lacked a valid or bona fide business purpose and, as a result, should have been disregarded for federal transfer tax purposes. In a recent case the Tax Court clarified an unsettled area of the law.

On December 28, 1994, Herbert and Ina Knight established a family limited partnership and two children’s trusts. The Knights also established a management trust to serve as the partnership’s general partner. They transferred certain real property and financial assets to the partnership and placed the bulk of the limited partnership interests in the children’s trusts. The IRS agreed the partnership, since its inception, satisfied all of the requirements of Texas law. The real property consisted of a 290-acre cattle ranch and two personal residences the Knights’ two children occupied rent free. The fair market value of the real property was $494,201 while the fair market value of the financial assets (municipal bond funds, Treasury notes, insurance policies and cash) was $1,587,122.

The partnership kept no records, prepared no annual reports and had no employees. In fact, the partners never corresponded or met to discuss partnership operations. The partnership never conducted any business and did not prepare annual financial statements or reports. The general partner was not compensated for its management efforts. However, the partnership did file information tax returns for 1995 through 1997, and the management trust and the children’s trusts filed fiduciary tax returns for the same period. The real property was used for personal purposes before and after the Knights formed the partnership. At no time did the children sign a lease or pay rent to the partnership on the residences. They paid all utilities while the partnership paid the property taxes and insurance. The annual cost of maintaining the residences was more than 70% of the partnership’s total expenses. After transferring the ranch to the partnership, Herbert Knight continued to raise cattle and paid no rent until after litigation began. The partnership’s only ranch-related revenue was an oral pasture lease which called for Knight to pay annual rent of $1,500.

The Knights filed a federal gift and generation-skipping transfer tax return for 1994. They reported that each had given a 22.3% interest in the partnership to both children’s trusts. The couple maintained that a 44% valuation discount should apply to the gifts as a result of portfolio, minority interest and lack-of-marketability discounts. The IRS said, in part, that the partnership lacked economic substance and should be disregarded for gift tax purposes, resulting in no valuation discounts.

Result. For the taxpayer. The Tax Court held that under Texas law the partnership should be respected because there was no reason to conclude that a hypothetical buyer or seller would disregard it. The court noted the Knights had burdened the partnership and underlying property with restrictions that were valid and enforceable under state law. It further noted that the federal estate and gift tax was based on the transferred property’s fair market value. Since fair market value is defined as “the price at which such property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and both having reasonable knowledge of relevant facts,” the Tax Court concluded that a willing buyer would take the form of the transaction—the creation of the partnership—into account and that the substance and form were not at odds for gift tax valuation purposes. The court also said IRS reliance on income tax economic substance cases was misplaced as the issue was the value of the gift. The Tax Court further held that the value of the partnership interests should be reduced by minority and lack-of-marketability discounts totaling 15%.

Justice Foley, concurring in result only, separately wrote that whether a willing buyer would take the form of the transaction into account was not relevant in determining whether the entity must be respected for transfer tax purposes. He said the willing buyer/willing seller analysis merely establishes the value of a partnership interest, not whether the economic substance doctrine applies. He concluded that the doctrine, which emphasizes business purpose, is not a good fit in a tax regime dealing with typically donative transfers. As a result, “the courts have not employed the economic substance doctrine to disregard an entity which is recognized as bona fide under state law for the purpose of disallowing a purported valuation discount.”

The Tax Court opinion seems to indicate that, if a partnership is validly created and operated under state law, its economic substance should not be disregarded for transfer tax purposes. Income tax ramifications aside, this is a welcome ruling for practitioners and their clients. It appears it is no longer necessary for clients to maintain an exhaustive list of purported business reasons or purposes for forming a partnership as long as it is formed under applicable state law. In fact, Knight indicates that traditional recordkeeping, lease or rental arrangements and management compensation for general partners are no longer essential.

CPAs, however, should understand that the income tax ramifications of the personal use of partnership property by one or more partners is still uncertain. In the corporate context, the weight of authority indicates that the personal use of corporate-owned property may result in deemed income or dividends to certain shareholders. However, the authoritative guidance on the income tax consequences of the personal use of corporate-owned property may not be entirely applicable to the personal use of partnership-owned property because, under state law, all partners have an equal right to use partnership property.

Knight v. Commissioner, 115 TC 36 (11-30-00).

Prepared by Ryan K. Crayne, CPA, JD,
senior associate with the law firm
of Winthrop & Weinstine, PA,
St. Paul, Minnesota.