Thought Leadership in Taxation-Related Valuation and Transfer Pricing IssuesEditors for This Issue: Ben R. Duffy and Sam S. Nicholls Tax Pass-Through Entity Thought Leadership
S Corporations, Limited Liability Companies, and Limited Partnerships—How to Avoid Costly Estate Planning Pitfalls When Making Stock Transfers and Recapitalizations Involving Nonvoting Stock
Steven B. Gorin, Esq.
S corporation shareholder agreements should be carefully crafted by legal counsel in order to avoid certain events that can imperil the company’s S election. One important consideration is the language in the shareholder agreement related to nonvoting stock transfer restrictions. This issue is important because S corporations are not permitted to have a second class of stock. Such language, if properly drafted, can enable the private company owner to transfer more shares to the next generation at the appraised value of the gifted ownership interest. This discussion addresses how issues can arise in the course of estate planning or in the course of a private company sale, how to address such issues, and how a capital structure—including nonvoting shares—can reduce the private company’s future tax liability. This discussion provides an example of an S corporation recapitalization involving both voting stock and nonvoting stock.1
S Corporation Valuation Analysis Considerations
This discussion addresses issues that the valuation analyst (“analyst”) may consider when developing the business or stock valuation of an S corporation. These valuation issues include (1) the appropriate level of value for the valuation, (2) the sources of empirical data on which the analyst may rely, (3) the economic benefits associated with the S corporation’s tax pass-through entity (“TPE”) income tax status, (4) the quantitative models that analysts apply to account for the economic benefit associated with TPE tax status, and (5) the judicial precedent related to TPE valuation adjustments. Specifically, this discussion summarizes the so-called dividend income tax avoidance valuation adjustment model that was applied in the Estate of Jones U.S. Tax Court judicial decision.
The Coca-Cola Company & Subsidiaries v. Commissioner: Tax Court Rejects Coca-Cola Experts’ Alternative Transfer Pricing Methods
Connor Thurman and John C. Ramirez
This discussion considers the recent judicial decision issued by the U.S. Tax Court (the “Tax Court”) in The Coca-Cola Company & Subsidiaries v. Commissioner of Internal Revenuematter (the “Coca-Cola case”).1Specifically, this discussion describes (1) the background of the Coca-Cola case and (2) the intercompany transfer pricing issues involved in the judicial decision. Further, this discussion considers the Tax Court’s conclusions related to the various transfer pricing methods applied by the parties’ experts. In summary, the Tax Court concluded that the Coca-Cola Company (“Coca-Cola”) experts’ transfer pricing analyses did not result in an arm’s-length price (“ALP”) to be paid between Coca-Cola and its foreign affiliates. Further, the Tax Court concluded that the Internal Revenue Service’s reallocation of taxable income to Coca-Cola from its affiliates, through the application of a comparable profits method transfer pricing analysis, did provide the best method for determining an ALP to be paid between Coca-Cola and its foreign affiliates.
Now More Complex than Ever: Intercompany Loan and Financial Guarantee Pricing Considerations
Michael L. Binz
The impact on financial markets from the COVID-19 pandemic and related interest rate volatility has attracted increased scrutiny of intercompany loan pricing by taxing authorities. The use of financial guarantees has also become more pervasive as external lenders are more inclined to request parent company guarantees. The Organisation for Economic Cooperation and Development (“OECD”) recently issued guidance regarding the transfer pricing for intercompany financial transactions. This OECD guidance has made validating intercompany financial transactions a more complex process. Transfer pricing analysts are often asked to develop transfer pricing studies necessary to support the pricing for intercompany loans and financial guarantees. These studies provide economic support for a multinational corporation’s transfer pricing decisions in the event of challenge or dispute by the Internal Revenue Service or other national tax authorities. This discussion focuses on Internal Revenue Service and OECD guidance with regard to the transfer pricing considerations for multinational corporation intercompany loans and financial guarantees.
Thought Leadership Discussion
Reasonableness of Shareholder/Employee Compensation Analysis for C Corporations and S Corporations
John C. Ramirez and Connor J. Thurman
The reasonableness of private company shareholder/employee compensation is often a controversial issue in the context of federal income taxation. This is because what is considered reasonable compensation by the employer corporation taxpayer is often considered unreasonable by the Internal Revenue Service (“Service”). According to Internal Revenue Code Section 162, in order to be deductible for federal income tax purposes, executive compensation must be (1) “reasonable in amount” and (2) “based on services actually rendered.” The income-tax-related consequences associated with unreasonable shareholder/employee compensation can be significant (and include payroll taxes, late payments, and tax return filing penalties). For this reason, it is important that financial analysts understand the factors that the Service and the federal courts consider when analyzing the reasonableness of shareholder/employee compensation. This discussion focuses on the generally accepted factors and methods applied to analyze the reasonableness of private company shareholder/employee compensation.
Best Practices Discussion
Service Alleges Taxable Gift for Exchange of Promissory Notes Based on Differences in Note Values
Samuel S. Nicholls
This discussion provides an illustrative example of an unintentional gift that arose when one family generation exchanged assets with the next family generation. The assets were debt securities. The Internal Revenue Service (the “Service”) alleged that the size of the gift was equal to the difference in the debt security face values—which was a substantial difference—on each side of the exchange. As it turned out, the difference in the debt security fair market values, which was the appropriate measurement of the amount of the gift, was significantly less than the amount of the gift alleged by the Service.
Annuity Payment Analysis for Grantor Retained Annuity Trusts
Ben R. Duffy
A grantor retained annuity trust (“GRAT”) is an estate planning instrument that may be used to transfer wealth from the trust grantors to the trust beneficiaries. During the GRAT term, the grantor receives annuity payments. From time to time, valuation analysts are asked to estimate the fair market value of the GRAT annuity payment stream. Because a GRAT typically has predetermined payments during its remaining term, a GRAT annuity payment stream is generally comparable to a debt instrument. And, the valuation of GRAT annuity payments is generally comparable to the valuation of promissory note payments. This discussion provides an overview of GRATs. And, this discussion illustrates the valuation of transferred GRAT annuity payments.
Income Tax and Other Considerations Related to Debt Restructuring and Debt Cancellation
C. Ryan Stewart
In an environment caused by the COVID-19 pandemic, many debtor entities have become financially distressed—due to decreased revenue and inconsistent cash flow. As a result, these debtor entities may take advantage of government-sponsored aid programs as well as opportunities to work with creditors to gain relief through debt restructuring. When debt is forgiven in a debt restructuring, it causes the debtor taxpayer to recognize cancellation of debt (“COD”) income for federal income tax purposes. However, under certain circumstances, the debtor taxpayer can avoid recognition of a portion—or all—of the COD income to the extent that the debtor taxpayer is insolvent or in bankruptcy. This discussion summarizes (1) the federal income tax rules for COD income recognition and (2) the provisions for the nonrecognition of COD income in certain circumstances. Further, this discussion summarizes both the income tax and valuation considerations that boards of directors, debtor company managers, and valuation analysts may consider when evaluating debt restructuring strategies.
Estate of Miriam M. Warne v. Commissioner: Valuation Discounts Allowed on Controlling Ownership Interests
Curtis R. Kimball
This discussion summarizes the judicial decision in the Estate of Miriam M. Warne v. Commissioner of Internal Revenue. Specifically, this discussion focuses on the valuation issues of the case, including the calculation and the application of a discount for lack of control and a discount for lack of marketability with regard to the valuation of private company controlling ownership interests.
Nelson v. Commissioner: Tax Court Opines on the Transfer of Fixed-Dollar Value Amounts and the Application of Multitier Discounts
George Haramaras, CPA
This discussion reviews the 2020 U.S. Tax Court decision, Nelson v. Commissioner. In particular, this discussion (1) summarizes the factual background of the case, (2) considers both the valuation and the taxation issues addressed in the judicial decision, and (3) examines the implications of this Tax Court judicial decisions with regard to taxpayers, tax counsel, and valuation analysts.