Visiting the Committees

• Jurisdiction: United States,Federal
• Citation: Vol. 28 No. 3
• Publication year: 2020

Visiting the Committees

Commentary and Updates by the Committees

CORPORATE AND PASS-THROUGH ENTITIES COMMITTEE

The Corporate and Pass-Through Entities Committee focuses on issues faced by corporate taxpayers and provides opportunities for practitioners and corporate tax counsel to maintain a level of expertise in the field of corporate tax law, expand their professional contacts, and serve the profession, the public and the legal system. Membership in the Committee offers practitioners information on developments with respect to corporate and business tax and a greater voice on developments in such legislation.

Committee Activities

Normally, the Committee holds monthly meetings via teleconference and interested members of the Tax Section are welcome to participate. The Committee is also planning to have three webinars later this year involving various partnership tax topics. In addition, members and other interested parties are welcome to submit articles for Quick Points on Corporate and/or Pass-through topics of general interest to the members of the Taxation Section. For more information regarding upcoming meetings and events should contact the Committee Co-Chairs, Cameron Hess at (916) 920-5286 or chess@ wkblaw.com or Erin Fraser at EFraser@fbm.com.

Quick Points

A New Era of Executive Compensation, Part I: Elimination of the Qualified Compensation Tax Deduction

The Tax Cuts and Jobs Act's (the "TCJA") impact on executive compensation-related matters has been monumental. Rather than condense the changes in a single article, this is the first in a series of Quick Point articles meant to highlight the TCJA's impact on executive compensation.

The TCJA caused a major transformation to the executive compensation landscape with the elimination of the performance-based compensation exception. Generally, section 162(m) disallows the deduction by a publicly held corporation for compensation in excess of $1 million paid to "covered employees." Under pre-amended section 162(m), a "qualified performance-based compensation" exception meant the $1 million deduction limitation did not apply to performance-based compensation. The TCJA eliminated this exception in tax years beginning after December 31, 2017.

Performance-based compensation plans had to meet a variety of requirements to qualify for deduction under preamended section 162(m). For example, shareholders had to approve performance metrics and eligibility criteria by vote at least once every five years. Violating the requirements of pre-amended section 162(m) could have caused inadvertent non-deductibility. The repeal of the performance-based compensation exception eliminates such requirements and uncertainty and thus reduces administrative costs and burdens.

The TCJA's repeal of the performance-based exception also increases companies' flexibility in determining incentive awards. Under pre-amended section 162(m), individual performance criteria to compensation were not common since the subjective assessment of employee performance did not meet the performance-based exception of pre-amended section 162(m) (unless the subjective criteria were used only to exercise negative discretion). Pre-amended section 162(m) required employee compensation plans to use objective, quantifiable criteria (e.g., stock price, market share, sales, and earnings per share). Further providing flexibility, companies can now modify performance criteria during the performance period to reflect unanticipated events, and compensation committees may exercise positive discretion in determining final bonus amounts.

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By removing the tax penalty (i.e., the non-deductibility of non-qualified compensation over $1 million), companies have more freedom to incorporate nontraditional, nonfinancial measures and goals in their compensation plans, which may help alleviate executives' myopic focus on short-term financial goals.

The next installment in this series will cover the expanded definitions under section 162(m), and requirements for the grandfathering of previously granted qualified compensation plans.

—Afshin Michael Khazaeli
PwC
San Francisco

S-Corps & ESBTs: TCJA Provides New Opportunity for Non-Resident Aliens

Under the Subchapter S Corporation ("S-Corp") restrictive ownership rules of IRC § 1361(b), an S-Corp must: (i) not have more than 100 shareholders; (ii) have only individual shareholders (except certain trusts and tax-exempt organizations); (iii) not have more than one class of stock; and (iv) not have non-resident alien ("NRA") shareholders.

Trusts are allowed to be shareholders of S-Corps in limited circumstances under IRC § 1361(c)(2), one being an Electing Small Business Trust ("ESBT") defined in IRC § 1361(e). The ESBT and all its Potential Current Beneficiaries (defined under IRC § 1361(e)(2) generally as persons who have a present, remainder, or reversionary interest in the trust) are treated as shareholders of the underlying S-Corp.

Historically, if the NRA became a Potential Current Beneficiary of the ESBT, the S-Corp would lose S-Corp status because the NRA was considered to be a shareholder in violation of IRC § 1361(b)(1)(C) and Treas. Reg. § 1.1361-1(m).

The Tax Cuts and Jobs Act ("TCJA") amended IRC § 1361(c)(2)(B)(v) to specifically allow a NRA to be the beneficiary of an ESBT that holds S-Corp stock without terminating the S-election. Effectively, the TCJA allowed NRAs to be S-Corp shareholders (albeit, indirectly).

Planning Point: If a practitioner's NRA client is interested in either utilizing an S-Corp, or investing in an S-Corp, the practitioner can now use an ESBT, but should draft the ESBT as a grantor trust. Under Treas. Reg. § 1.641(c)-1, an ESBT is treated as two separate trusts for tax purposes (or three if it is a grantor trust): the grantor portion, the S-portion and the non-S portion. According to Treas. Reg. § 1.641(c)-1(c), the grantor portion is taxed under IRC § 671. Negatively, the S portion is generally taxed at the highest individual tax rate under Treas. Reg. § 1.641(c)-1(e). Importantly, however, the S portion of an ESBT is the portion of the trust that consists of S-Corp stock, and is not treated as owned by the grantor. Consequently, if the grantor is also the sole beneficiary of the grantor ESBT, there is only a grantor portion and no portion of the ESBT is the S-portion subject to the highest individual tax rate. Thus, a grantor ESBT provides the NRA an ability to be an S-Corp shareholder without the negative consequence of being taxed at the highest individual tax rate.

—Spencer T. Higgins
Teeple Hall, LLP
San Diego

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ESTATE AND GIFT TAX COMMITTEE

The Estate and Gift Tax Committee is comprised of attorneys throughout the State of California who devote a significant portion of their practice to understanding the evolving areas of estate and gift tax planning, drafting, compliance, and controversy work. One of the primary functions of the Committee is to provide valuable, informative, high quality continuing education programs on behalf of the Taxation Section.

If you are interested in becoming involved with the Committee, please contact Eric Baggett, at (619) 515-5645.

Quick PointValuation of Closely-Held S-Corporation Shares Determined: Kress V. United States, 123 AFTR 2d 2019-XXXX (E.D. Wisconsin, March 26, 2019)

The Kress family members were shareholders of a closely-held S-corporation (the "Company"). The Company's bylaws contained a Family Transfer Restriction restricting transfers to Kress family members. From 2006-08, the Kresses' gifted minority shares in the Company. The taxpayers' appraiser used the guideline public company approach and applied a lack of marketability discounted between 25% and 28% for the gifted interests (including a discount for the Family Transfer Restriction). The appraiser thoroughly considered the Company's financial position, the 2008 recession, non-operating assets to the extent the assets contributed to the overall earnings, payment of dividends, the Company's management, possibility of any future public offerings, and its status as an S Corporation.

IRS issued notices of deficiency challenging the valuation. The IRS' appraiser also valued the company using the guideline public company as a C corporation. The IRS appraiser then applied an S corporation premium to increase the value of the Company. He also applied a lack of marketability discount of 11%.

The district court held that the IRS appraiser erroneously applied a premium to the S Corporation. It held that the "S status is a neutral consideration with respect to valuation of the stock."

The court then turned to the IRC § 2703 matter and the Family Transfer Restriction. IRC § 2703(a) provides the value of property shall be determined without considering transfer restrictions unless: (1) the restriction is a "bona fide business arrangement;" (2) the restriction is not a device to transfer such property to members of the decedent's family for less than full and adequate consideration; and (3) the terms are comparable to similar arrangements entered into by persons in an arms' length transactions. IRC § 2703(b). The court found:

1. The first prong was satisfied because it was a bona fide business arrangement consistent with the goals of maintaining a family business.
2. The second prong was satisfied because the gifts were lifetime transfers. The court held that this section only applies to at death transfers to a "decedent's" family.
3. The third prong was not satisfied because the taxpayers did not prove that the transfer restrictions were comparable to similar arms' length arrangements.

Because all three prongs were not met, the Family Transfer Restriction should not have been considered in the valuation.

The application of 2703(a) had little impact on the final value determination. The court only reduced the taxpayer's discount by 3%, applying a discount of 25% (otherwise agreeing with taxpayer's position).

Since this a district court decision, it is not binding on the tax...