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The split purchase option for small businesses.

The SPLIT Purchase Option for Small Businesses

For more than 60 years, a taxpayer has been able to claim straight-line amortization deductions for the purchase price of a term interest or life estate. It is well-established that the underlying property (typically held in trust) need not be depreciable or even income producing.(1) Thus, such items as raw land, works of art, antiques and collectibles held for investment purposes clearly qualify.(2) In fact, one court has even sanctioned the write-off of the cost of a term interest in tax-exempt municipal bonds!(3)

On the other hand, Section 273 denies amortization deductions for present interest acquired by gift, bequest or inheritance. Special disallowance rules were introduced in the Revenue Reconciliation Act of 1989 where the holders of the present and future interest in property are "related." Furthermore, the basis in the remainder is frozen, since the remainderman recognizes no income despite the continuous increase in the remainder's actuarial value through time, nor on the cessation of the present interest.(4)

Under Section 167(r), no amortization deduction are allowed with respect to term interests vested or acquired after July 27, 1989, but only if the holders of the present and future interests are "related" for tax purposes as defined in Section 267. This is not always a serious limitation. If the parties are related, however, the amortization deduction first reduces the present interest holder's basis in the term interest,(5) is then disallowed,(6) and finally it is added to the future interest holder's basis in the remainder interest.(7)

Example 1: Hans purchases a 10-year term interest in land for $60,000 and Fritz, his uncle, the remainder for $40,000. Hans expenses $6,000 of amortization deductions each year. After 10 years Hans has deducted $60,000 and Fritz owns the land outright with a basis of $40,000.

Example 2: Same as example 1, except that Fritz is Hans' son. Hans cannot deduct amortization, but his basis is still reduced by $6,000 a year and a like amount is added to Fritz basis. After 10 years Fritz owns the land outright with a basis of $100,000.

Split Purchases

In a split purchase, one person buys a life estate or a term interest (the "present" interest), and another person buys the remainder (the "future" interest). The two interests together constitute all ownership rights in the property. For the duration of the term interest, the present holder is treated as the owner for current income and deduction purposes. At the cessation of the present interest the remainderman's future interest ripens into full ownership.

The ownership of real property may be divided into present and future interests by deed. With personal property, such as securities, a trust is necessary.

Example 3: A is selling stocks for $100,000 to T and R who wish to acquire them in a split purchase. The following activities take place:

1. T and R set up a trust,

appointing a third party as a trustee. 2. T transfers $60,000 to the trust

in exchange for a 10-year term

interest in the trust. 3. R transfers $40,000 to the trust

in exchange for the remainder in

the trust. 4. The trustee purchases the stocks

from A for $100,000. 5. The trustee has a basis of

$100,000 in the stocks. 6. T has a original basis of $60,000

in the term interest to be

recovered straight-line over 10 years. 7. After 10 years T has neither

interest nor basis in the trust property. 8. R has a basis of $40,000 in the

remainder, frozen until trust

termination when the securities are

distributed to R. 9. The trustee holds legal title to

the securities while T and R are

the beneficial owners. 10. The trustee's adjusted basis of

$40,000 ($100,000 reduced by

$60,000 of amortization

deductions) carries over to R under

Section 643(a) upon

distribution to R.

The net result is that $60,000, or 60%, of the purchase price of the stocks have been expensed, sheltering T's dividends and income from other sources, while R has acquired a built-in gain of $60,000, plus/minus market fluctuations. Thus, current deductions have been converted into a potential capital gain. Furthermore, the gain is deferred, indefinitely until R sells the stock, or permanently if R retains the stock for life due to the step-up in basis to fair market value at R's death under Section 1014(a).

Advantages of Amortization of Present Interests

Compared to cost recovery, the amortization of a present interest offers the following advantages:

1. The property itself, i.e., the trust

corpus, does not have to be

depreciable or cost recovery property. 2. If the property is depreciable,

cost recovery deductions are

allowed in addition to amortization. 3. No "useful life" must be

established. Rather, the taxpayer

decides the amortization period.

Thus, if a seven-year write-off is

desired, a seven-year term

interest is created. 4. The availability of the

amortization deduction is well established

by court and IRS approval since

the 1920s.

These advantages are only partly offset by the fact that the holders of the present and future interests must be "unrelated" for tax purposes and that less than 100% of the cost basis may be expensed, e.g., approximately 60% in the case of a 10-year term interest when a 10% discount rate is used to compute its value.

The Discount Rate

The valuation of a term interest depends on the discount rate used and the duration of the term. For income tax purposes, any arm's length discount rate may be used which is agreed upon by the parties to the split purchase. Since no loan is involved, the applicable federal rate in Sections 1274 and 7872 may be disregarded. The rate used to determine actuarial value for estate and gift tax purposes (120% of the applicable federal midterm rate, determined monthly pursuant to Section 7520) is also largely irrelevant for income tax purposes.

The higher the discount rate used the greater the purchase price of a present interest (and the amortization deductions resulting from a purchase) and the lower the actuarial value of the future interest (the remainder), as shown in Table 1.

Example 4: C, Inc., purchased a 10-year interest in land worth $100,000, and its two unrelated 50% shareholders purchased the remainder as tenants in common. If the discount rate agreed upon was 8%, C, Inc., must pay $53,680 for its term interest, resulting in an annual amortization deduction of $5,368. Had the discount rate used been 12%, C, Inc.'s cost would have been $67,800, increasing the annual deduction to $6,780.

The actuarial valuation is based on the assumption that the investment yields current income equal to the discount rate used. Thus, the actuarial value of a 10-year term interest is 61.45% at a rate of 10% because $100 invested at 10% yields $10 a year and the present value of $10 a year for 10 years discounted at 10% equals $61.45.

On the other hand, given the discount rate, the present value of a term interest increases with the duration of the term as in Table 2.

Thus, increasing the term 100% from 10 to 20 years only increases the value of the interest 38.55%, from 61.45% to 85.14% More importantly the total amortization deduction is only increased by 38.55%, and the annual amortization is decreased from $6,145 a year to $4,257 a year, assuming a $100,000 price tag ($85,140/20).

Limitations on the Amortization Deduction

There are four basic situations where the amortization deduction with respect to a term interest is disallowed:

1. Gifts and Inheritances. Section

273 disallows any deductions

with respect to a present interest

acquired by gift, bequest or

inheritance. Since the deduction is

not disallowed because the

present and future interest

holders are related, no basis

adjustments result.(8) 2. Personal Use Property. Since

Section 167 is the authority for

amortization as well as

depreciation, the underlying property

must be held for the production

of income and/or for use in a

trade or business.(9) 3. Sale of Term Interest. A retained

term interest resulting from a

sale or gift of the remainder in

property is nonamortizable.(10)

Thus, it is important that a split

purchase is entered into so that

the present and future interest

are acquired simultaneously. 4. Split Purchase by Related Parties.

As explored in more detail

below, the amortization deduction

is disallowed and added to the

remainderman's basis if the two

parties to a split purchase are "related" for tax purposes.

Related Taxpayers

The following pairs of taxpayers are related for purposes of Section 167(r)(11):

1. A partnership and its partners. 2. A corporation and a partnership

where the same persons own more

than half the stock and more

than half of the capital and/or

profit interest. 3. An S corporation and its share-holders. 4. An individual and a C

corporation if the individual owns more

than half the value of the

corporation's stock. 5. Two S corporations where the

same persons own more than half

the stock value of both. 6. An S and a C corporation where

the same persons own more than

half the stock value of both. 7. An individual and his or her

siblings, spouse, ancestors and

lineal descendants. 8. A grantor and the trustee of a

trust. 9. A trustee and a beneficiary of a

trust. 10. Two trustees of trusts with a

common grantor. 11. A trustee of one trust and a

beneficiary of another trust with

common grantors.

Example 5: A and his mother, M, both own 50% of C, Inc. Since A's stock is indirectly owned by M and vice versa, A and M are both related to C, Inc., as well as to each other.

Example 6: A and his mother, M, both own 25% of C, Inc. In addition M's second husband, H, who is not A's father, owns 25% and an unrelated investor, I, owns the last 25%. M constructively owns 50% of C, Inc., her son's shares and her husband's shares, and is thus a 75% shareholder related to C, Inc. A only owns his own shares and the shares M owns directly for a total of 50%, and is thus unrelated to C, Inc.. M's constructive ownership of H's shares through family attribution is not reattributed to A.

Example 7: A and B, two unrelated taxpayers, are business partners in that each owns half of the stock in C, Inc. Neither A nor B is related to C, Inc. for tax purposes.

Example 8: Same as Example 1, except that A and B are limited partners in the same real estate partnership. Regardless of the size of their partnership interest, e.g., 5% or 60%, A's stock is constructively owned by B and vice versa. As a result, A and B, A and C, Inc., and B and C, Inc., are all related taxpayers.

Unrelated Taxpayers

The amortization of a purchased term interest is allowed as a deduction even if the holders of the present and future interests are related in an economic or practical sense, as they are unrelated for tax purposes. Thus, the following persons are considered unrelated:

1. A partnership or S corporation

and a third party investor, as

long as the latter is unrelated to

all partners or shareholders. 2. An individual and his or her

aunt, uncle, nephew or niece. 3. An individual and his or her

mother-in-law, father-in-law,

sister-in-law, brother-in-law,

daughter-in-law and son-in-law. 4. An unmarried couple, even if

living together. 5. A C corporation and a 50% or

less shareholder. 6. Two beneficiaries of the same

trust, such as an income

beneficiary and a remainderman. 7. An estate and its beneficiaries. The above list is illustrative only, not exhaustive.

Split Purchases of Municipal Bonds

Even a term interest in tax-exempt municipal bonds may be amortized under case law. This is because Section 265, which disallows expenses incurred to purchase or carry municipal bonds, does not apply to depreciation or amortization authorized by Section 167.(12)

Example 9: Uncle Herman transfer $60,000 to a trust in return for a 10-year income interest and Alice, his niece, transfers $40,000 for the remainder. The trustee purchases municipal bonds for $100,000, paying $8,000 a year in tax-exempt interest. The tax consequences are as follows, assuming no bond premium or discount:

1. Uncle Herman collects $8,000 a

year in tax-exempt interest for

10 years. 2. Since uncle and niece are

unrelated taxpayers, Herman receives

an amortization deduction of

$6,000 a year sheltering any

taxable income he may have. Being

a "portfolio expense," the passive

loss rules under Section 469 do

not apply. However, as a

"miscellaneous itemized expense,"

part of the deduction may be lost

if other such expenses do not at

least equal 2% of his adjusted

gross income (the floor under

Section 67). 3. After 10 years Herman has no

interest in the bonds or the trust

and has recovered his basis. 4. Alice recognizes no income on

the annual value increases of her

remainder, nor on the cessation

of Herman's interest, nor on the

termination of the trust and the

distribution of the bonds to her. 5. The trustee's basis has been

reduced to $40,000 by the

amortization deductions and carries over

to Alice. Thus, Alice's basis in

the bonds is effectively frozen at

$40,000 with a built-in gain of

$60,000, plus/minus

appreciation or depreciation. 6. Upon a sale after 10 years or

later, Alice's gain will be a long

term capital gain.

C Corporation/Shareholder Split Purchases

Because of the repeal of the General Utilities doctrine in the Tax Reform Act of 1986, double taxation normally results on the liquidation of a C corporation. As a result, it has become less attractive for a corporation to directly own properties it needs for business purposes. A frequently used alternative is for the corporation to lease property from its shareholders or from a third party. In addition, a split purchase by the corporation and its shareholders should be considered in many cases. The proper use of a split purchase will avoid any and all tax on a corporate liquidation, transfer wealth to the shareholders without divided distributions, shelter corporate income through the amortization of the term interest and reduce earnings and profits.

One advantage of a corporate/shareholder split purchase is the potential saving of double taxation on a later corporate liquidation. This advantage may be illustrated through the use of the following somewhat oversimplified examples.

Example 10: Corporate Purchase, Later Liquidation. C, Inc. purchases land for $100,000 to be rented out as a parking lot. Ten years later it distributes the land, now worth $200,000, to its unrelated 50% shareholders, A and B, as a liquidating distribution. A and B each have a basis of $50,000 in their stock, having provided the funds to purchase the land originally. The tax consequences are as follows:

1. C, Inc., incurs a tax liability of

$34,000 (at a 34% assumed rate)

on the appreciation on the land

under Section 336 upon the

liquidating distribution. 2. A and B pay a combined tax of

$18,480 (at a 28% assumed rate).

The taxable gain is $200,000,

less the $34,000 of corporate tax

for which A and B have

transferee liability, and less their bases

in their stock, or $66,000 under

Section 331. 3. Although A and B have a

combined basis of $200,000 in the

land under Section 334(a), the

total tax bill is $52,480. 4. Any net rental income of C, Inc.,

disregarded above, would be

subject to double taxation as well,

once at the corporate level when

earned, and once upon

distribution whether as a dividend and/or

as an additional liquidating

distribution.

Example 11: Split Purchase, No Liquidation. Same as Example 10, except that A and B transfer $60,000 to C, Inc., which purchases a 10-year term interest in the land, while A and B purchase the remainder as tenants in common for $40,000. A and B's total investment is the same, $100,000. The tax consequences are as follows:

1. C, Inc., incurs no tax liability

after 10 years when A and B

receive the land as full owners,

since no liquidating

distribution takes place. 2. A and B report no gain when C,

Inc. dissolves. 3. A and B will have a combined

basis of only $40,000 in the land,

rather than $200,000, but the

built-in gain may be postponed

indefinitely through a retention

of ownership or a tax-free

exchange. If the land is held for life

the gain is never taxed since a

successor in interest receives a

stepped-up basis under Section

1014(a). 4. The rental income of C, Inc.,

will be sheltered in full or in part

by the annual $6,000

amortization expense.

It should also be noted that the parking lot operation is not subject to the passive loss rules because of the exceptions for short-term rentals. Also, A and B still have a total basis of $60,000 in their stock, but a worthlessness deduction is doubtful since no loss has been actually sustained, a requirement for a loss deduction under Section 165.

To reduce taxable income and earnings and profits of the corporate holder of a term interest, the corporation should pay as many of the expenses of the property subject to a split purchase as possible. Under state law, it is generally the obligation of the holder of the present interest to pay current operating expenses. Thus, if the property is a building, for example, the corporation would normally pay property taxes, mortgage interest, repairs and maintenance. When coupled with amortization and cost recovery deductions, the corporation's taxable income will be minimized.

Split Purchases of Stock

If a C corporation purchases a term interest in income stock and one or more unrelated shareholders purchase the remainder, a number of tax advantages may result, including increased, but partly sheltered, cash flows to the corporation and the tax-free transfer of assets to the shareholder.

Example 12: C, Inc., is owned equally by two unrelated shareholders, A and B. C purchases a 10-year term interest in preferred stock for $60,000, and the shareholders purchase the remainder as tenants in common for $40,000. The dividend yield is 9%. The following noteworthy financial and tax consequences follow:

1. C collects $9,000 a year in

dividends, only $2,700 of which is

taxable due to the 70% dividend

received deduction under

Section 243. 2. C amortizes its term interest at

the rate of $6,000 a year for 10

years, which shelters the taxable

portion of the dividend, plus

$3,300 of income from other

sources. 3. After 10 years, A and B own the

stock outright without paying

any tax on a dividend or a

liquidating distribution. Since their

basis is only $40,000, a "buy-and-hold"

strategy is most appropriate.

Simultaneous Amortization and Cost Recovery

In cases where the property subject to a split purchase is depreciable, all depreciation or cost recovery is generally claimed by the holder of the term interest under Section 167(h). Even if Section 167(r) disallows the amortization deduction, cost recovery is still allowed under Section 167(r)(4)(B). Thus, where the parties to the split purchase are unrelated, both cost recovery of the property itself and amortization deductions of the basis in the term interest are allowable simultaneously. This has the effect of making accelerated depreciation available, even on buildings which can only be written off straight-line, if placed in service after 1986. However, the sum of cost recovery and amortization can never exceed the total cost basis. In the examples below, the cost of land is disregarded for illustrative purposes.

Example 13: Cost Recovery. C, Inc., buys a 10-year term interest in an apartment building for $60,000 and A and B, its two 50% shareholders, the remainder for $40,000. C, Inc. will cost-recover $100,000 over 27.5 years, straight-line, sheltering its income whether the parties are related or not.

Example 14: Cost Recovery Plus Amortization. Same as Example 1, but both cost recovery and amortization are claimed since C, Inc. is unrelated to A and B. The annual cost recovery deduction is $3,636 ($100,000/27.5), 60% of which, or $2,182, reduces C, Inc.'s basis in the term interest, 40% of which, or $1,455 reduces A and B's basis in the remainder. C, Inc.'s amortization deduction the first year is therefore ($60,000 - $2,180)/10, or $5,782. The total first year deduction is $9,418. Effectively, straightline cost recovery has been converted to accelerated depreciation. After 10 years A and B own the building. Its adjusted basis equals $40,000 less 40% 10 year's cost recovery, ($40,000 - 10 x 1,455), or $25,450, to be cost recovered straight-line over the remaining 17.5 years.

Split Purchases of the C Corporation Stock

The C corporation stock may itself be subject to a split purchase. Even in a family setting, many pairs of relatives are considered unrelated for tax purposes, such as an individual and his nieces, nephews and in-laws.

Example 15: Uncle Herman purchases a 10-year term interest in 30% of C, Inc., for $60,000, and his niece, Alice, the remainder for $40,000. Uncle Herman can write off his basis in the term interest, straight-line over 10 years, while Alice's basis is frozen at $40,000 until it becomes her basis in the 30% of the C, Inc. stock itself after 10 years.

Furthermore, there is no reason why the C corporation itself cannot shelter its own income by means of its own split purchases while the shareholders also are sheltering theirs through the amortization deductions of their own income interest in the corporate stock. [Table 1 and 2 omitted]

Footnotes

(1)Keitel v. Comm., 15 BTA 903 (1929), Bell v. Harrison, 212 F.2d 253 (CA-7, 1954), Reg. 1.1014-5(c) and Rev. Rul. 62-132, 1962-2 CB 73. (2)Reg. 1.1014-5(c), Example 3. (3)Manufacturers Hanover Trust v. Comm., 431 F. 2d 664 (CA-2, 1970). (4)Eileen M. Hunter, 44 TC 109 (1969). (5)Section 167(r)(3)(A). (6)Section 167(r)(1). (7)Section 167(r)(3)(B). (8)Section 167(r)(2). (9)Section 167(r)(1). (10)U.S. v. Georgia Railroad and Banking Co., 348 F. 2d 278 (CA-5, 1965), cert. denied, 382 U.S. 973 (1966), Gordon, 85 TC 309 (1980), Lomas Santa Fe, Inc., 74 TC 662(1980), aff'd 693 F. 2d 71 (CA-9), 1982). (11)Sections 167(r)(5)(B), 267(b) and (e). (12)See footnote 3, supra.

Rolf Auster is professor of taxation in the school of accounting at Florida International University in Miami. He holds a PhD in finance from Northwestern University, an LLM in taxation and is a CPA and a certified financial planner. He is the author of many books on finance and taxation and has authored approximately 150 articles in numerous professional publications.
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Title Annotation:part 1; the application of split purchase agreements for small business
Author:Auster, Rolf
Publication:The National Public Accountant
Date:Jun 1, 1991
Words:3896
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