In Chief Counsel Advice 201653017, released on December 30, 2016 (the CCA), the National Office of the Office of Chief Counsel, the Internal Revenue Service (i.e., the headquarters of the IRS's tax counsel's office), advised an IRS Field Office that the "accumulated earnings tax" (AET) applied to a "blocker" corporation in a hedge fund investment manager's ownership chain. This is significant for the fund community because (1) AET is a tool rarely invoked to attack tax avoidance, (2) the National Office is where the IRS agency-level tax law interpretation is made, and (3) interposing a "blocker" corporation in the ownership chain of an investment fund is part of a routine corporate and tax planning matter for the fund community.
AET is a punitive 20% tax the IRS can impose on undistributed after-tax income of corporations (domestic and foreign) that do not regularly pay dividends so as to enable their shareholders to defer or avoid shareholder-level tax on dividends. The IRS has the discretion to impose AET at the conclusion of an audit if it establishes the tax avoidance motive by a showing of the corporation's accumulation of "earnings and profits" (similar in concept to "retained earnings" for financial accounting purposes) beyond the reasonable needs of its business. The taxpayer can rebut this tax avoidance motive by a preponderance of evidence (i.e., using the more-likely-than-not standard), a relatively low threshold. Therefore, the IRS has rarely invoked AET in the past.
The corporation in the CCA appears to be a domestic "C" corporation owned by a U.S. individual living abroad. The individual performed services for several LLCs and partnerships (that acted as managers for hedge funds) and received equity interests in the entities as compensation. The partnerships appear to have earned a mix of management fee income and "carry" or "promote" from the managed funds during the years in audit. The partnerships made only tax distributions to the corporation during this period, so that the corporation did not have any cash after paying its taxes. The individual had a vote on the management of the partnership but did not appear to have the management control to force a regular distribution.
The corporation did not engage in any activities other than holding of the partnership interests, and did not have any employees. In addition, the corporation appears to have advanced money to the shareholder, but there was no documentation (e.g., minutes, board resolutions, business plans) of the nature of the advance or business reasons for the lack of dividend distributions. Upon questioning by the IRS, the shareholder indicated that one reason for the organization of the corporation was to avoid paying tax in the states where the partnerships were located, and in the foreign country where he lived.
The CCA concluded that AET applied to the corporation because the corporation was a "holding company" or an "investment company," a prima facie case of a tax avoidance motive. In other words, AET applied because the corporation did not do anything other than hold partnerships, period. This was notwithstanding the fact that the bulk of the income was "phantom income" (because there was no corresponding distribution of cash), and the corporation did not otherwise have the management control of the partnerships to force the distributions, and had no cash after paying the taxes.
This conclusion does not seem to mirror the real-world case of cash circulation through a typical investment fund ownership chain, or the lack of dividend distributions by corporate blockers in such a chain, which could be due more to any one or more reasons not motivated by tax avoidance. Instead, it is, in a sense, reminiscent of last year's IRS advice regarding "bad boy guarantees," where the IRS reversed its course in a matter of two months after realizing its misunderstanding of the business practices. In that case, an IRS field attorney issued advice (CCA 201606027), released February 5, 2016, that a customary "bad boy guarantee" (i.e., a guarantee provided by the borrower's principals that they would not mismanage or otherwise run the borrower into ground) was a real (and not merely a remote and speculative) liability of the guarantor and, therefore, could turn a nonrecourse real estate loan into a recourse loan for partnership debt allocation purposes. In April of 2016, the National Office released an agency-level legal memorandum (AM 2016-001), overruling the conclusion of the earlier advice, and restoring the status quo in the partnership debt classification world.
Perhaps a more persuasive case for imposing AET in this case could be made based on the lack of contemporaneous evidence supporting the business case for not paying dividends, and the apparent informality associated with advances from the corporation to its shareholder, common features in many "real" tax avoidance schemes. In any event, CCA 201653017 reminds us of the need not to take the use of blocker corporations in an investment ownership chain for granted, and to establish and maintain contemporaneous corporate documents consistent with a prudent business operation.
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This article was prepared for marketing purposes and does not constitute tax opinion or advice to any taxpayer. Each taxpayer should consult its own tax advisor for the application of the tax laws to its own facts. In addition, this article is based on current U.S. federal income tax law, and the author will not update any reader on any future changes, including those with retroactive effect, in U.S. federal income tax law.