Tax challenges of partnerships

Case 1: Leverage as a preliminary question to property trading

Facts

Since the 1990s, X. has held a 50% share in each of several apartment buildings in various cantons, which are fully let. The other shares are held by a third party. The first apartment building was acquired in 1992 in A., Canton of Zurich. Since 1993, the wife Y. has held two units in an apartment building in G., Canton of Schwyz. These are also rented out. The income generated from renting out these apartment buildings was primarily reinvested by X. and Y. in the maintenance of the properties.

At the end of the 1980s, X. and Y. purchased a single-family house in B. Canton of Schwyz, which they occupied themselves and sold in 2009 after the children moved out. In the same year, they bought a condominium in C., Canton of Zurich, which they still occupy themselves. In 2001, they also acquired a holiday home in E., Canton of Ticino, half with a third party, which they converted into a two-family house for their own exclusive use between 2002 and 2004. To finance this conversion, the apartment building in A. was sold in 2002. No further properties were sold until 2017.

X. founded Bellaua AG in 1980 together with a partner, which specialised in the construction and sale of conservatories. In June 2010, he sold the company and retired on 1 April 2012.

In addition, X. founded Luna AG in 1997. The original business idea could not be realised profitably in the time available, which is why Luna AG was inactive for a long time.

Upon retirement, X. and Y. withdrew their pension fund assets as a lump sum (CHF 200,000). Their main pension provision consisted and still consists of rented real estate. The rental income from these properties replaces the pension from a Pillar 2. For this reason, the complainants decided to acquire further properties for rent when X. stopped working and to manage these themselves (for cost reasons).

X. and Y. acquired an apartment building in D., Canton of Solothurn, in 2011 and, with most of the pension fund assets, an apartment building in G., Canton of Aargau, in 2013.

Luna AG changed its purpose and took over the management of both properties.

Soon after acquiring the apartment building in D., X. and Y. realised that the management of the property was much more intensive than originally assumed and planned due to the frequent change of tenants and regular repair and renovation work. In 2015, an external property management company therefore took over the management of the apartment building in D. Due to the further necessary investments in the property and the expensive external management, X. and Y. decided to sell this property in 2016. The profit from the sale was not reinvested in a new property.

In its assessment proposal of 3 August 2018 concerning direct federal tax, the Zurich Cantonal Tax Office claimed that the capital gain on the sale of the property in D. (Canton of Solothurn), the Cantonal Tax Office of Zurich claimed that the capital gain from the sale of the property in D. (Canton of Solothurn) was a sideline trade in real estate and calculated CHF 300,000 each for X. and Y. as income from self-employment after deduction of the OASI contributions.

The Cantonal Tax Office argued mainly with a high degree of debt financing of the purchase of the property in D.

The purchase price of the D. property of CHF 3,900,000 was financed as follows:

Mortgage CHF 2,900,000 on property D.

Mortgage CHF 600,000 on property F.

Own funds CHF 400,000

Total CHF 3'900'000

The financing bank confirmed this in writing during the assessment procedure in a letter dated Sept. 2018.

The Cantonal Tax Office determined the debt financing ratio as follows: CHF 3,500,000 in relation to the purchase price of CHF 3,900,000 = 89.74%. This was far in excess of the usual level of debt financing for non-owner-occupied residential property and was a strong indication of commercial property trading.

Question

How is the degree of debt financing to be determined in the circumstantial test for commercial property trading?

The asset situation in 2011 after the acquisition of the property in D. as well as the indebtedness is as follows:

Case 2: Commercial property trading

Facts

In 2014, the brothers A. and B. acquired an undeveloped plot of land in the municipality of O., canton of Valais, by means of an advance inheritance. In 2015, the two brothers had an apartment building with nine flats built on the plot (construction costs around CHF 7 million; borrowed capital CHF 2 million). Already during the construction of the house, they sold two flats in 2015 for a total of Fr. 3,500,000. In 2016, they sold a third flat for Fr. 1,500,000.

The apartment building was completed in 2017. Of the remaining six flats, the two brothers each retained a 5½-room flat for themselves to live in. The remaining four flats are rented to permanent tenants.

A. (trained chef and hotelier), who runs a hotel business in the form of a sole proprietorship in the municipality of O., also acquired a restaurant from part of the proceeds from the sale of the flats in 2017, which he has since rented out to a third party. B. works as a teacher and has no relevant experience in the real estate sector.

Questions

• Are the requirements for commercial property trading fulfilled due to the sale of the three flats?
• If the existence of commercial property trading is to be affirmed, are the four rented flats to be allocated to the private or the business assets of A. and B.?
• Is the restaurant to be allocated to A's private or business assets?

Facts variant

The brothers A. and B. (neither of whom had any connection with an activity in the real estate sector) acquired a property with two buildings in 2007 by means of an advance inheritance. In 2011 and 2012, they had maintenance work carried out on the existing buildings. However, in view of the age of the buildings (built in 1920), this proved to be a bad investment. On the recommendation of real estate experts, they had the existing buildings demolished in 2016 and 2017 and built a new development. This comprised an apartment building with six flats. From December 2017 to February 2018, A. and B. sold four flats. A. and B. each took over one of the other two flats.

Question on the factual variant

Are the requirements for commercial property trading fulfilled due to the sale of the four flats?

Case 3: Division of inheritance - assumption of deferred hidden reserves and taxes

Facts

A. took up self-employment in 1997 to run the G. restaurant. This is located on parcel X and was previously operated by his deceased father B. Initially, half of parcel X was co-owned by the community of heirs B. and the other half by the community of heirs H. The community of heirs B. consisted of the surviving wife of B. and the three children E., F. and A.

In 1997, A. purchased half of the co-ownership share from the community of heirs H. and leased the other half of the co-ownership share from the community of heirs B. This half co-ownership share was assigned to A. on 7 January 2017 as part of the division of the estate of community of heirs B., making him the sole owner of parcel X including restaurant G. The other heirs received other assets. The other heirs received other assets.

In November 2019, A. sold the parcel of land X in question (incl. Restaurant G.) to a third party for a purchase price of CHF 1.4 million and at the same time terminated his self-employment.

Questions

• Is the division of the estate of 7 January 2017 (half co-ownership of parcel X) to be regarded as an act of realisation?
• In the event that a realisation event is affirmed, what consequences does this have with regard to the cessation of A.'s self-employment in November 2019?

Case 4: Inheritance contract concluded during 5-year retention period

Facts

X. (husband) and Y. (wife) live in an unseparated marriage and have two children. X. ran a sole proprietorship until 2011. In June 2011, he founded A. AG with a share capital of CHF 100,000 and contributed the assets and liabilities of the sole proprietorship at income tax values (HR entry 21 June 2011). The shares have since been held in full by X.

X. is managing director of A. AG with sole signature. Their joint son is a director, also with sole signature. In its assessment ruling of 2 July 2015, the competent tax office taxed the liquidation profit of the sole proprietorship in relation to the 2011 tax period with a tax amount of CHF 97,200 for Vaud cantonal and communal taxes and a tax amount of zero for direct federal tax.

On 7 March 2013, the spouses X. and Y. and their children concluded an inheritance contract which provides, in particular in its Article 5, that "the company A. AG, which is currently wholly owned by X., will be sold on 30 June 2016 to E. AG for a price of CHF 3,351,817.00 by means of a separate contract to be drawn up subsequently. This price corresponds to the market value accepted by the co-heirs. The settlement of the aforementioned price, taking into account the amounts to be paid by Z., is attached as Annex 2 to the present inheritance contract and forms an integral part thereof". In this annex, the sale price of all shares in the company A. AG, in particular through the assumption of a debt and the repayment of a loan, is detailed. The further provisions of the inheritance contract provided for various scenarios, such as the predeath of X. or of the two spouses X. and Y. or their divorce before the time of the sale.

On 28 June 2016, X. and his son (instead of E. AG) concluded a purchase agreement for the entirety of the shares in A. AG. The sale price was set at CHF 1,730,817, i.e. the purchase price of CHF 3,351,817 provided for in the inheritance contract, less a debt assumption of CHF 685,000, less a share in a dividend of CHF 936,000 distributed by the company to the seller in 2016.

According to the tax administration, Article 5 is in fact a sale and not merely a promise to conclude a contract. Even if it were only a promise to sell, Article 5 contained all the essential elements of a contract of sale. The five-year lock-up period had therefore been violated with the conclusion of this inheritance contract on 7 March 2013.

Question

Does the conclusion of the inheritance contract violate the five-year vesting period?

Case 5: Lease and private withdrawal

Facts

Since 2005, X. has been running a self-employed agricultural business in the canton of Thurgau and had previously operated an agricultural business in the canton of Schwyz. Until the 2011 tax period, he was the owner of two plots of land there, Nos. 998 and 999 (farmhouse, meadowland), which he leased out after moving away in 2005.

X. had financed the acquisition of the agricultural business in the canton of TG with a loan of Fr. 1,200,000. X. had received this loan in return for granting a right to purchase the two plots of land no. 998 and 999. X. had carried the loan as a liability. He amortised the loan when the sale of the properties was completed.

There was a covenant with the tax administration of the Canton of Schwyz that the land could remain in the business assets until the lease was terminated (for a maximum of 9 years).

Following the rezoning of the two properties from the agricultural zone to the construction zone on 1 June 2011 and the associated release from the subordination under the farming land law on 6 June 2011, X. sold the two properties in December 2011.

In its financial statements under commercial law for the 2011 business year, X. transferred the properties from business to private assets as of 1 January 2011 and only recorded the accumulated depreciation on the properties as extraordinary operating income.

In the assessment procedure, the tax administration of the Canton of Thurgau did not accept the transfer of the properties from business to private assets (private withdrawal) claimed by the taxpayer in the tax return and considered the sale of the properties in December 2011 as a disposal from business assets. Accordingly, the tax administration recorded the entire profit from the sale of the properties as income from self-employment.

Question

Is a private withdrawal to be assumed as of 1 January 2011?

Case 6: Self-employment or hobby business

Facts

The married couple X. (born 1943) and Y. reside in A. (Canton of Zurich) and are founders of a clothing company and owners of various properties. The husband X. is also the owner of the sole proprietorship "Gasthof B.", X., with registered office in C., Canton of Zurich, which was entered in the Commercial Register in 2007. X. acquired the historic inn property in need of renovation in 2001. From 2003 onwards, he invested around CHF 5 million from his own funds.

In 2007, the inn was reopened as an upscale hotel and restaurant with top chefs. In the business years 2007 up to and including 2012, the business generated losses totalling around CHF 3.1 million (for details, see the table below). In the 2012 business year, a loss of CHF 516,093 was incurred.

In the 2012 business year, X. achieved gross operating income of CHF 1,843,987 with the inn, or net operating income of CHF 116,202 after deduction of the cost of goods (CHF 582,044 and personnel expenses of CHF 1,145,741). After deduction of other expenses, a loss before depreciation of around CHF -350,000 resulted.

In the tax return for the 2012 tax period, X. and Y. declared a loss for the year of CHF 516,093 and claimed the previous year's loss of around CHF 645,000 that had not yet been offset. Their taxable assets amounted to CHF 10.4 million.

In the assessment rulings of 8 March 2017 (direct federal tax and Zurich state and municipal taxes), the tax office of the Canton of Zurich does not allow the deduction of either the annual or the previous year's losses. In the absence of an intention to make a profit - contrary to previous assessment practice - self-employment was to be denied.

X. wants to defend himself against this view. He employs 21 full-time staff, other part-time staff and temporary staff and has been receiving advice from a trust company specialising in catering businesses since 2010. The inn is a member of two restaurant and hotel cooperatives and is present on relevant booking platforms.

At the beginning of 2017, a new manager took over the inn. Together with X.'s son, Z., who is now involved, he changed the business concept and oriented the cuisine towards a simpler, but still high-quality, home-style cooking. He significantly reduced the number of staff. Previously, staff costs accounted for a large part of the respective annual operating income. The new concept foresees a profit surplus for 2017.

Question

Is X. self-employed for the 2012 tax year or is he acting as a patron/lover for tax purposes?

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