Income shifting is a fundamental income tax planning concept. It involves strategically allocating income among related taxpayers to minimize the overall tax liability.
This may be intended to use up tax attributes of one taxpayer (such as deductions or tax credits), take advantage of tax deferral options to delay paying taxes, or take advantage of more favorable tax rates.
Income shifting is often the trigger that allows for the tax savings. For example, by shifting income from a high-tax-rate entity to a lower-tax-rate entity, taxpayers can reduce their effective tax rate and keep more of their profits.
The recent case of Parkway Gravel Inc. et al. v. Commissioner, T.C. Memo. 2024-59, provides an example of how income shifting can be used to achieve a favorable tax outcome. It involves a real estate owner using an option agreement, which is just a simple piece of paper, to shift income to another related legal entity that gets more favorable tax rates while allowing the original legal entity to defer its tax liability– potentially paying no income tax on the sale of the real estate.
Contents
Facts & Procedural History
Parkway Gravel Inc. (“Parkway”), a corporation, owned a 58-acre parcel of land. In August 2006, Parkway entered into an Option Agreement with V&N, a related partnership, granting V&N the option to purchase the land for $6.9 million. This was the appraised value at the time the option was exectued.
The option was set to expire on August 15, 2011. The agreement was intended to shift any gain from the property’s sale above the $6.9 million appraised value from Parkway to V&N. In exchange, V&N agreed to use its political connections and real estate development expertise to help rezone the land from industrial to commercial use, thereby increasing its value and marketability.
In December 2012, the land was sold for a total of $11.1 million. As per the Option Agreement, V&N received $4.2 million, while Parkway received $6.9 million. Here is how the gain was allocated:
| Item | Amount | Reported By |
|---|---|---|
| Sale price allocated to Parkway | $6.9M | Parkway |
| Sale price allocated to V&N for the Option Agreement | $4.2M | V&N |
| Total sale price of the land | $11.1M |
Parkway sought to defer paying tax on its $6.9 million by engaging in a like-kind exchange under Section 1031. This means that Parkway purchased a replacement property, which was likely purchased for an amount in excess of $6.9 million but less than $11.1 million. V&N reported the $4.2 million as long-term capital gain on its 2012 partnership tax return. The result was no tax due for Parkway.
August 2006 August 2011 December 2012
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| | |
Option Agreement Option Expiration Land Sold for $11.1M
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Parkway grants V&N rezones land V&N receives $4.2M
V&N option to from industrial Parkway receives $6.9M
purchase land to commercial to use for 1031 exchange
for $6.9MThe IRS challenged this arrangement, arguing that the entire $11.1 million should be recognized as income by Parkway. The dispute ended up in the U.S. Tax Court.
Tax Rate Differentials: Corporations vs. Partnerships
The key to the tax planning strategy in this case involves the different tax treatment of corporations and partnerships.
Corporations are subject to a double taxation system. Income is taxed at the corporate level and then again at the shareholder level when profits are distributed as dividends. In contrast, partnerships are pass-through entities, meaning that income flows through to the partners and is taxed only once at the individual level.
Moreover, corporations have historically not had a preferential tax rate for capital gains; all corporate income was subject to the same graduated tax rates. On the other hand, individuals and pass-through entities like partnerships can benefit from lower long-term capital gains rates on qualifying income.
By shifting the $4.2 million of gain from the sale of the land to V&N, a partnership, the gain was characterized as long-term capital gain and, presumably, taxed at the lower individual rates when it passed through to V&N’s partners. Had this gain been recognized by Parkway, a corporation, it would have been subject to higher corporate tax rates.
It’s worth noting that the Tax Cuts and Jobs Act (“TCJA”) of 2017 changed the corporate tax rate to a flat 21% for tax years beginning after December 31, 2017, and before January 1, 2026. During this period, the advantage of shifting income from a corporation to a partnership to benefit from lower capital gains rates may have been diminished. However, with the TCJA rates set to lapse after 2025, income shifting strategies like the one used in this court case may once again become more attractive.
The Value Freeze: The Option Agreement
The option agreement in this case serves as a value freeze technique, a common feature in many tax planning strategies involving legal entities or trusts. A value freeze helps to lock in the value of an asset at a particular point in time, thereby limiting the amount of potential future appreciation that may be subject to tax in the hands of the original owner.
Value freeze techniques are common in tax planning–both estate tax planning and income tax planning. Here are a few common examples:
- Estate Planning with Family Limited Partnerships (“FLPs”)
- Parents transfer appreciating assets (e.g., real estate, business interests) to an FLP in exchange for limited partnership interests.
- Parents retain control as general partners while gifting limited partnership interests to children over time.
- The value of the gifted interests is frozen at the time of the transfer, and future appreciation is shifted to the children, potentially reducing estate taxes.
2. Grantor Retained Annuity Trusts (“GRATs”)
- Grantor transfers appreciating assets to an irrevocable trust (“GRAT”) for a fixed term, retaining the right to receive an annuity payment.
- The annuity is set so that the present value of the payments equals the fair market value of the assets transferred, resulting in a “zeroed-out” GRAT.
- If the assets appreciate faster than the IRS’s assumed rate (Section 7520 rate), the excess growth passes to the trust beneficiaries tax-free.
3. Intentionally Defective Grantor Trusts (“IDGTs”)
- Grantor sells appreciating assets to an irrevocable trust in exchange for a promissory note, purposely triggering grantor trust rules.
- The trust is “defective” for income tax purposes, meaning the grantor pays the trust’s income taxes, allowing the assets to grow tax-free for the beneficiaries.
- The value of the sold assets is frozen at the time of the sale, and future appreciation is shifted to the trust beneficiaries.
4. Charitable Remainder Trusts (“CRTs”)
- Donor transfers appreciating assets to a charitable trust, retaining an income stream for a fixed term or lifetime.
- The donor receives a charitable deduction based on the present value of the remainder interest going to the charity.
- The trust sells the assets tax-free and reinvests the proceeds, providing income to the donor and ultimately transferring the remainder to the charity.
Value freeze techniques can be applied in various contexts, such as estate planning, gift tax planning, and charitable giving. By freezing the value of appreciating assets at the time of the transfer, taxpayers can shift future growth to other parties (e.g., children, trusts, or charities) while minimizing their tax liabilities.
In this court case, the option agreement effectively capped the amount of gain that Parkway, the corporation, would recognize upon the sale of the land. Any appreciation in the land’s value above the $6.9 million option price would be shifted to V&N, the partnership. This value freeze not only limits Parkway’s tax exposure but also sets the stage for the next step in the tax planning process, which is the deferral strategy.
By combining the value freeze with the income shifting to a lower-taxed entity and the tax deferral through a Section 1031 exchange, Parkway was able to minimize its overall tax liability and retain more of the profits from the sale of the land.
Tax Deferral: The Section 1031 Exchange
The other piece to this transaction is the tax deferral. Tax deferral is a time value of money concept. The idea is to pay taxes later, preferably for off in the future. Then, instead of paying the IRS, the taxpayer can use their funds to invest and produce additional income.
Tax deferral techniques are also common in tax planning. Contributions to 401(k) and traditional IRAs are the most common examples. With these plans, contributions escape immediate tax only to be taxed on withdrawal.
Tax deferral techniques are also common. Here are several examples:
- Deferred Sales Trusts (“DSTs”)
- Seller transfers appreciated assets to a trust in exchange for an installment note, deferring capital gains tax.
- The trust sells the assets to a third party and invests the proceeds, providing periodic payments to the seller.
- Capital gains tax is paid as the seller receives the installment payments, spreading the tax liability over time.
2. Structured Sale
- Similar to a DST, the seller transfers appreciated assets to a third party in exchange for an installment note, deferring capital gains tax.
- The third party sells the assets and invests the proceeds, making periodic payments to the seller.
- Capital gains tax is paid as the seller receives the installment payments. This is similar to the monetized installment sale.
3. Qualified Opportunity Zones (QOZs)
- Investors can defer capital gains tax by reinvesting gains into Qualified Opportunity Funds (QOFs) within 180 days.
- QOFs invest in real estate or businesses located in designated Qualified Opportunity Zones.
- Deferred gains are recognized on December 31, 2026, or when the QOF investment is sold, whichever is earlier.
- If the QOF investment is held for 10+ years, the investor may be eligible for a permanent exclusion of gains on the QOF investment itself.
4. Oil and Gas Investments
- Investors can defer income tax by investing in oil and gas drilling projects.
- Intangible Drilling Costs (“IDCs”) and Depletion Allowances provide significant upfront deductions, offsetting the initial investment.
- Income from successful wells is often treated as long-term capital gains, taxed at a lower rate.
5. Real Estate Investment Trusts (“REITs”)
- REITs are companies that own and operate income-producing real estate.
- REITs are required to distribute at least 90% of their taxable income to shareholders as dividends.
- Shareholders can defer tax on REIT dividends by reinvesting them through a Dividend Reinvestment Plan (“DRIP”).
- Deferred taxes are paid when the REIT shares are eventually sold.
Tax deferral techniques allow taxpayers to postpone the recognition of income or capital gains, providing the opportunity to invest and grow the deferred funds before the tax liability is ultimately paid. By spreading the tax burden over time or waiting for more favorable tax conditions, taxpayers can potentially minimize their overall tax liabilities and maximize their investment returns.
That brings us back to this case. Parkway used a Section 1031 exchange, which is perhaps the most common tax deferral technique. Section 1031 allows real estate owners to trade one property for another tax-free. There are nuanced timing and other rules that apply, but if met, this can be an excellent way to defer paying taxes on the sale of real estate. The taxpayer is able to defer paying tax until they sell the replacement property. The deferral works if the taxpayer trades up in value. If they trade down, the excess is treated as boot and taxable.
In this case, Parkway capped the amount of gain using the option agreement, as noted above, which provided guidelines for what value of replacement property it could acquire. The tax savings result from acquiring a property that is equal to or nearly equal to the $6.9 million set by the option agreement. Acquiring a replacement property in an amount in excess of $11.1 million (the full sales price by V&N), would negate the tax savings from this type of transaction. Regardless, the exchange allowed Parkway to defer paying income taxes on the sale.
The Economic Substance Doctrine
The IRS’s primary argument was a challenge to the option agreement. The IRS’s argument was based on the economic substance doctrine. This is a judicial doctrine that allows the IRS to disregard transactions that lack economic substance or business purpose apart from tax avoidance. It is similar to the IRS’s sham transaction arguments to avoid recognizing a legal entity as a separate taxpayer. The economic substance doctrine focuses on the substance of a transaction, whereas the sham transaction doctrine can also be applied to the recognition of legal entities.
The economic substance doctrine consists of two prongs:
- An objective prong, which examines whether the transaction has any practical economic effects other than tax benefits.
- A subjective prong, which looks at the taxpayer’s motivation for entering into the transaction.
In this case, the IRS contended that the option agreement lacked economic substance and should be disregarded for tax purposes. It argued that:
- V&N did not pay any consideration for the option and stood to benefit from the agreement without taking on any risk.
- Parkway, on the other hand, signed away potential future gains while continuing to bear the risks of ownership.
- The Option Agreement itself was invalid under Delaware law due to a lack of consideration.
Essentially, the IRS believed that the Option Agreement was primarily motivated by tax avoidance and did not have a meaningful economic impact or business purpose beyond the tax benefits. By arguing that the transaction lacked economic substance, the IRS sought to disregard the Option Agreement and treat the entire $11.1 million gain as income to Parkway, rather than allowing the $4.2 million to be shifted to V&N and taxed at the lower capital gains rates.
However, the U.S. Tax Court ultimately disagreed with the IRS, finding that the Option Agreement did have both objective economic substance and a valid business purpose, based on the efforts of V&N to rezone the property and the parties’ long-standing practice of allocating different business activities among separate entities.
The Takeaway
This case provides instructions on an easy-to-implement tax planning strategy that many real estate investors can use to avoid and defer paying income taxes. As noted by this case, taxpayers who use this technique have to go to some lengths to document the substantive non-tax reasons for entering into transactions. Efforts to rezone the property and the long-standing practice of allocating different business activities among separate entities should be documented, as that was the valid business purpose in this court case. They should also take steps to avoid the step-transaction doctrine, which was likely avoided here given the number of years between the option agreement and the eventual sale to a third party.
Besides this specific transaction, this court case is also important as it illustrates the power of combining multiple tax planning strategies to achieve significant tax savings. Income shifting is often key to tax plans like this. By shifting income from a high-tax corporation to a lower-tax partnership, freezing the value of the appreciated property, and deferring the recognition of gain through a Section 1031 exchange, the taxpayers were able to minimize their overall tax liability and retain more of the profits from the sale of the land. The tax savings can be significant, as in this court case.
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