Unforced Error on Short Stop

 I am reading a case concerning interest expense. While I have seen similar accounting, I do not recall seeing it done as aggressively.

Let’s talk about it.

Bob and Michelle Boyum lived in Minnesota and owned a company named Short Stop Electric. Bob was primarily responsible for running the company. Michelle had some administrative duties, but she was mostly responsible for raising the nine Boyum children.

Short Stop was a C corporation.

Odd, methinks. Apparently, the Court thought so also:

One might regard this as an eccentric choice for a small, privately owned business because income from C corporations is taxed twice.”

Let’s talk about this taxed-twice issue, as it is a significant one for tax advisors to entrepreneurial and closely held companies.

Let’s say that you start a company and capitalize it with a $100 grand. Taxwise, there are two things going on.

At the company level you have:

                   Cash                     100,000

                   Equity                 (100,000)                                 

The only thing the company has is the $100 grand you put in. If it were to liquidate right now, there would be no gain, loss, or other income to the company, as there is no appreciation (that is, deferred profit) in its sole asset – cash.

At a personal level, you would own stock with a basis of $100 grand. If the company liquidated and distributed its $100 grand, your gain, loss, or other income would be:

          $100 grand (cash) - $100 grand (basis in stock) = -0-

Make sense.

Let’s introduce a change: the company buys a piece of land for $100 grand.

At the company level you now have:

                   Land                     100,000

                   Equity                 (100,000)

Generally accepted accounting records the land at its acquisition cost, not its fair market value.

Now the change: the land skyrockets. It is now worth $5 million. You decide to sell because … well because $5 million is $5 million.

Is there tax to the company on the way out?

You betcha, and here it is:

          $5 million - $100 grand in basis = $4.9 million of gain

          Times 21% tax rate = $1,029,000 in federal tax

          $5 million - 1,029,000 tax = $3,971,000 distributed to you

Is there tax to you on the way out?

Yep, and here it is:

          $3,971,000 - 100,000 (basis in stock) = $3,871,000 gain

          $3,871,000 times 23.8% = $921,298 in federal tax

Let’s summarize.

How much money did the land sell for?

$5 million.

How much of it went to the IRS?

$1,950,298

What is that as a percentage?

39%

Is that high or low?

A lot of people - including me - think that is high. And that 39% does not include state tax.

What causes it is the same money being taxed twice – once to the corporation and again to the shareholder.

BTW there is a sibling to the above: payment of dividends by a C corporation. Either dividends or liquidation will get you to double taxation. It is expensive money.

Since the mid-80s tax advisors to entrepreneurial and closely held businesses have rarely advised use of a C corporation. We leave those to the Fortune 1000 and perhaps to buyout-oriented technology companies on the west coast. Most of our business clients are going to be S corporations or LLCs.

Why?

Because S corporations and LLCs allow us to adjust our basis in the company (in the example above, shareholder basis in stock was $100 grand) as the company makes or loses money. If it makes $40 grand, shareholder basis becomes $140 grand. If it then loses $15 grand, basis becomes $100 grand + $40 grand - $15 grand = $125 grand. 

The reason is that the shareholder includes business income on his/her individual return and pays taxes on the sum of business and personal income. The effect is to mitigate (or eliminate) the second tax – the tax to the shareholder – upon payment of a dividend or upon liquidation.

Back to our case: that is why the Court said that Short Stop being a C corporation was “an eccentric choice.”

However, Bob had a plan.

Bob lent money to Short Stop for use in its business operations.

Happens all the time. So what?

Bob would have Short Stop pay interest on the loan.

Again: so what?

The “what” is that no one – Short Stop, Bob, or the man on the moon – knew what interest rate Bob was going to charge Short Stop. After the company accounting was in, Bob would decide how much to reduce Short Stop’s profit. He would use that number as interest expense for the year. This also meant that the concept of an interest rate did not apply, as interest was just a plug to get the company profit where Bob wanted.   

What Bob was doing was clever.

There would be less retained business profit potentially subject to double taxation.

There were problems, though.

The first problem was that Bob had been audited on the loan and interest issue before. The agent had previously decided on a “no change” as Bob appeared receptive, eager to learn and aware that the government did not consider his accounting to be valid.

On second audit for the same issue, Bob had become a recidivist.

The second problem was: Short Stop never wrote a check which Bob deposited in his own bank account. Instead, Short Stop made an accounting entry “as if” the interest had been paid. Short Stop was a cash-basis taxpayer. Top of the line documentation for interest paid would be a cancelled check from Short Stop’s bank account. Fail to write that check and you just handed the IRS dry powder.

The third problem is that transactions between a company and its shareholder are subject to increased scrutiny. The IRS caught it, disallowed it, and wanted to penalize it. There are variable interest rates and what not, but that is not what Bob was doing. There was no real interest rate here. Bob was plugging interest expense, and the resulting interest rate was nonsensical arithmetic. If Bob wanted the transaction to be respected as a loan and interest thereon, Bob had to follow normal protocol: you know, the way Bank of America, Fifth Third or Truist loan money. Charge an interest rate, establish a payment schedule, perhaps obtain collateral. What Bob was doing was much closer to paying a dividend than paying interest. Fine, but dividends are not deductible.

To his credit, Bob had been picking up Short Stop’s interest expense as interest income on his personal return every year. This was not a case where numbers magically “disappeared” from one tax return to another. It was aggressive but not fraud.

Bob nonetheless lost. The Court disallowed the interest deductions and allowed the penalties.

My thoughts?

Why Bob, why? I get the accounting, but you were redlining a tax vehicle to get to your destination. You could have set it to cruise control (i.e., elect S status), relaxed and just …moved … on.

Our case this time was Short Stop Electric v Commissioner, T.C. Memo 2023-114.

Reorganizing A Passive Activity

 

I am looking at a case that stacks a couple of different tax rules atop another and then asks: are we there yet?

Let’s talk about it.

The first is something called the continuity of business doctrine. Here we wade into the waters of corporate taxation and - more specifically - corporate reorganizations. Let’s take an easy example:

Corporation A wants to split into two corporations: corporation B and corporation C.

Why? It can be any number of things. Maybe management has decided that one of the business activities is not keeping up with the other, bringing down the stock price as a result. Maybe two families own corporation A, and the two families now have very strong and differing feelings about where to go and how to get there. Corporate reorganizations are relatively common.

The IRS wants to see an active trade or business in corporations A, B and C before allowing the reorganization. Why? Because reorganizations can be (and generally are) tax-free, and the IRS wants to be sure that there is a business reason for the reorganization – and avoiding tax does not count as a business reason.

Let me give you an example.

Corporation A is an exterminating company. Years ago it bought Tesla stock for pennies on the dollar, and those shares are now worth big bucks. It wants to reorganize into corporation B – which will continue the exterminating activity – and corporation C – which will hold Tesla stock.

Will this fly?

Probably not.

The continuity of business doctrine wants to see five years of a trade or business in all parties involved. Corporation A and B will not have a problem with this, but corporation C probably will. Why? Well, C is going to have to argue that holding Tesla stock rises to the level of a trade or business. But does it? I point out that Yahoo had a similar fact pattern when it wanted to unload $32 billion of Alibaba stock a few years ago. The IRS refused to go along, and the Yahoo attorneys had to redesign the deal.

Now let’s stack tax rules.

You have a business.

To make the stack work, the business will be a passthrough: a partnership or an S corporation. The magic to the passthrough is that the entity itself does not pay tax. Rather its tax numbers are sliced and diced and allocated among its owners, each of whom includes his/her slice on his/her individual return.

Let’s say that the passthrough has a loss.

Can you show that loss on your individual return?

We have shifted (smooth, eh?) to the tax issue of “materially participating” and “passively nonparticipating” in a business.

Yep, we are talking passive loss rules.

The concept here is that one should not be allowed to use “passively nonparticipating” losses to offset “materially participating” income. Those passive losses instead accumulate until there is passive income to sponge them up or until one finally disposes of the passive activity altogether. Think tax shelters and you go a long way as to what Congress was trying to do here.

Back to our continuity of business doctrine.

Corporation A has two activities. One is a winner and the other is a loser. Historically A has netted the two, reporting the net number as “materially participating” on the shareholder K-1 and carried on.

Corporation A reorganizes into B and C.

B takes the winner.

C takes the loser.

The shareholder has passive losses elsewhere on his/her return. He/she REALLY wants to treat B as “passively nonparticipating.” Why? Because it would give him/her passive income to offset those passive losses loitering on his/her return.

But can you do this?

Enter another rule:

A taxpayer is considered to material participate in an activity if the taxpayer materially participated in the activity for any five years during the immediately preceding ten taxable years.

On first blush, the rule is confusing, but there is a reason why it exists.

Say that someone has a profitable “materially participating” activity. Meanwhile he/she is accumulating substantial “passively nonparticipating” losses. He/she approaches me as a tax advisor and says: help.

Can I do anything?

Maybe.

What would that something be?

I would have him/her pull back (if possible) his/her involvement in the profitable activity. In fact, I would have him/her pull back so dramatically that the activity is no longer “materially participating.” We have transmuted the activity to “passively nonparticipating.”

I just created passive income. Tax advisors gotta advise.

Can’t do this, though. Congress thought of this loophole and shut it down with that five-of-the-last-ten-years rule.

This gets us to the Rogerson case.

Rogerson owned and was very involved with an aerospace company for 40 years. Somewhere in there he decided to reorganize the company along product lines.

He now had three companies where he previously had one.

He reported two as materially participating. The third he treated as passively nonparticipating.

Nickels to dollars that third one was profitable. He wanted the rush of passive income. He wanted that passive like one wants Hawaiian ice on a scorching hot day.

And the IRS said: No.

Off to Tax Court they went.

Rogerson’s argument was straightforward: the winner was a new activity. It was fresh-born, all a-gleaming under an ascendent morning sun.

The Court pointed out the continuity of business doctrine: five years before and five after. The activity might be a-gleaming, but it was not fresh-born.

Rogerson tried a long shot: he had not materially participated in that winner prior to the reorganization. The winner had just been caught up in the tide by his tax preparers. How they shrouded their inscrutable dark arts from prying eyes! Oh, if he could do it over again ….

The Court made short work of that argument: by your hand, sir, not mine. If Rogerson wanted a different result, he should have done - and reported - things differently.

Our case this time was Rogerson v Commissioner, TC Memo 2022-49.

Basis Basics

I am looking at a case involving a basis limitation.

Earlier today I accepted a meeting invite with a new (at least to me) client who may be the poster child for poor tax planning when it comes to basis.

Let’s talk about basis – more specifically, basis in a passthrough entity.

The classic passthrough entities are partnerships and S corporations. The “passthrough” modifier means that the entity (generally) does not pay its own tax. Rather it slices and dices its income, deductions and credits among its owners, and the owners include their slice in their own respective tax returns.

Make money and basis is an afterthought.

Lose money and basis becomes important.

Why?

Because you can deduct your share of passthrough losses only to the extent that you have basis in the passthrough.

How in the world can a passthrough have losses that you do not have basis in?

Easy: it borrows money.

The tax issue then becomes: can you count your share of the debt as additional basis?

And we have gotten to one of the mind-blowing areas of passthrough taxation.  Tax planners and advisors bent the rules so hard back in the days of old-fashioned tax shelters that we are still reeling from the effect.

Let’s start easy.

You and I form a partnership. We both put in $10 grand.

What is our basis?

                                     Me             You

         Cash                  10,000       10,000                  

 

The partnership buys an office condo for $500 grand. We put $20 grand down and take a mortgage for the rest.

What is our basis?

                                     Me             You

         Cash                  10,000       10,000                  

         Mortgage        240,000       240,000

                                250,000       250,000

So we can each have enough basis to deduct $250,000 of losses from this office condo. Hopefully that won’t be necessary. I would prefer to make a profit and just pay my tax, thank you.

Let’s change one thing.

Let’s make it an S corporation rather than partnership.

What is our basis?

                                     Me             You

         Cash               10,000        10,000                   

         Mortgage             -0-              -0-

                                10,000        10,000

Huh?

Welcome to tax law.

A partner in a general partnership gets to increase his/her basis by his/her allocable share of partnership debt. The rule can be different for LLC’s taxed as a partnership, but let’s not get out over our skis right now.       

When you and I are partners in a partnership, we get to add our share of the mortgage - $480,000 – to our basis.

S corporations tighten up that rule a lot. You and I get basis only for our direct loans to the S corporation. That mortgage is not a direct loan from us, so we do not get basis.

What does a tax planner do?

For one thing, he/she does not put an office condo in an S corporation if one expects it to throw off tax losses.

What if it has already happened?

I suppose you and I can throw cash into the S. I assure you my wife will not be happy with that sparkling tax planning gem.

I suppose we could refinance the mortgage in our own names rather than the corporate name.

That would be odd if you think about. We would have personal debt on a building we do not own personally.

Yeah, it is better not to go there.

The client meeting I mentioned earlier?

They took a partnership interest holding debt-laden real estate and put it inside an S corporation.

Problem: that debt doesn’t create basis to them in the S corporation. We have debt and no tax pop. Who advised this? Someone who should not work tax, I would say.

I am going to leverage our example to discuss what the Kohouts (our tax case this time) did that drew the Tax Court’s disapproval.               

Let’s go back to our S corporation. Let’s add a new fact: we owe someone $480,000. Mind you, you and I owe – not the S corporation. Whatever the transaction was, it has nothing to do with the S corporation.

We hatch the following plan.

We put in $240,000 each.

You: OK.

We then have the corporation pay the someone $480,000.

You: Hold up, won’t that reduce our basis when we cut the check?

Ahh, but we have the corporation call it a “loan” The corporation still has a $480,000 asset. Mind you, the asset is no longer cash. It is now a “loan.”  Wells Fargo and Fifth Third do it all the time.

You: Why would the corporation lend someone $480,000? Wells Fargo and Fifth Third are at least … well, banks.

You have to learn when to stop asking questions.

You: Are we going to have a delay between putting in the cash and paying - excuse me - “loaning” someone $480,000?

Nope. Same day, same time. Get it over with. Rip the band-aid.

You: Wouldn’t a Court have an issue with this if we get caught … errr … have the bad luck to get audited?

Segue to our court case.

In Kohout the Court considered a situation similar enough to our example. They dryly commented:

Courts evaluating a transaction for economic substance should exercise common sense …”

The Court said that all the money sloshing around could be construed as one economic transaction. As the money did not take even a breather in the S corporation, the Court refused to spot the Kohouts any increase in basis.

Our case this time was Kohout v Commissioner, T.C. Memo 2022-37.

An Attorney Learns Passthrough Taxation

 

I have worked with a number of brilliant attorneys over the years. It takes quite a bit for a tax attorney to awe me, but it has happened.

But that law degree by itself does not mean that one has mastered a subject area, much less that one is brilliant.

Let’s discuss a case involving an attorney.

Lateesa Ward graduated from law school in 1991. She went the big firm route for a while, but by 2006 she opened her own firm. For the years at issue, the firm was just her and another person.

She elected S corporation status.

We have discussed S status before. There is something referred to as “passthrough” taxation. The idea is that a business – an S corporation, a partnership, an LLC – skips paying its own tax. Rather the tax-causing numbers are pushed-out to the owners – shareholders, partners, members – who then include those numbers on their personal return and pay the taxes thereon personally.

Why would a rational human being do that?

Sometimes it makes sense. A lot of sense, in fact.

I will give you one example. Say that you have a regular corporation, one that the tax nerds call a “C.” Say that there is real estate in there that has appreciated insanely. It wouldn’t hurt your feelings to sell the real estate and pocket the money. There is a problem, though. If the real estate is inside a “C,” the gain will be taxed to the corporation upon sale.

That’s OK, you reason. You knew taxes were coming.

When you take the money out of the corporation, you pay taxes again.

Huh?

If you think about, what I just described is commonly referred to as a “dividend.”

That second round of income taxes hurts, unless one is a publicly-traded leviathan like Apple or Amazon. More accurately, it hurts even then, but ownership is so diluted that it is unlikely to greatly impact any one owner.

Scale down from the behemoths and that second round of tax probably locks-in the asset inside the C corporation. Not exactly an efficient use of resources, methinks.

Enter the passthrough.

With some exceptions (there are always exceptions), the passthrough allows one – and only one – round of tax when you sell the real estate.

Back to Lateesa.

In 2011 the S corporation deducted salary to her of $62,388.

She reported no salary on her personal return.,

In 2012 the S deducted salary to her of $73,448.

She reported salary of $47,171.

In 2011 her share (which was 100%, of course) of the firm’s profits was $1,373.

She reported that.

Then she reported the numbers again as though she was self-employed.

She reported the numbers twice, it seems.

The IRS could not figure out what she was doing, so they came in and audited several years.

There was the usual back-and-forth with documenting expenses, as well as quibbling over travel and related expenses. Standard stuff, but it can hurt if one is not keeping adequate records.

I was curious why she left her salary off her personal return. I have a salary. Maybe she knew something that has escaped me, and I too can run down my personal taxes.

She explained that only some of the officer compensation was salary or wages.

Go on.

The rest of the compensation was a distribution of “earnings and profits.” She continued that an S corporation shareholder is allowed to receive tax-free distributions to the extent she has basis.

Oh my. Missed the boat. Missed the harbor. Nowhere near water.  Never heard of water.

What we are talking about is a tax deduction, not a distribution. The S corporation took a tax deduction for salary paid her. To restore balance to the Force, she has to personally report the salary as income. One side has a deduction; the other side has income. Put them together and they net to zero. The Force is again in balance.

Here is the Court:

Ward also took an eccentric approach to the compensation that she paid herself as the firm’s officer.”

It did not turn out well for Ms. Ward. Remember that there are withholdings and employer-side payroll taxes required on salary and wages, and the IRS was already looking at other issues on those tax returns. This audit got messy.

There was no awe here.

Our case this time was Lateesa Ward v Commissioner and Ward & Ward Company v Commissioner, T.C. Memo 2021-32.

Mean It When You Elect S Corporation Status

I am looking at an odd case.

I see that the case went to Tax Court as “pro se,” which surely has a great deal to do with its general incoherence. Pro se generally means that the taxpayer is representing himself/herself. Technically this is not correct, as I could represent someone in Tax Court and the case still be considered pro se. There was no accountant involved here, however, and it shows.

We are talking about Hong Jun Chan. 

He founded a restaurant named Younique Café Inc (YCI) in August, 2010.

In March, 2011 he filed an election with the IRS to be treated as an S corporation. All the owners have to agree to such an election, and we learned that Chan was a 40% shareholder of YCI.  

Let’s fast forward to 2016.

Chan and his wife filed a joint tax return for 2015, but they did not include any numbers from YCI. That does not make sense, as the purpose of an S corporation is to avoid corporate tax and instead report the entity’s tax numbers on the shareholder’s individual/separate return.

A year later the Chan’s did the same with their 2016 joint tax return.

This caught the attention of the IRS, which started an audit in 2019. The revenue agent (RA) found that no business returns had ever been filed.

Standard procedure for the IRS is to contact the taxpayer: perhaps the taxpayer is to visit an IRS office or perhaps the audit will be conducted via correspondence. The IRS did not hear from Chan. Chan later explained that they had moved to Illinois and received no IRS correspondence.

The RA went all Kojak and obtained YCI’s bank records. The RA added up all the deposits and determined that the Chan underreported his taxable income by $1,139,879 and $731,444 for 2015 and 2016 respectively.

Yep, almost $2 million.

Off to Tax Court they went.

Chan had a straightforward argument: YCI was not an S corporation. It was a C corporation, meaning it filed its own tax returns and paid its own taxes. Let’s be fair: the restaurant had gone out-of-business. It is unlikely it ever made money. Unless there was an agency issue, the business tax could not be attributed to Chan personally.

Got it.

ISSUE: YCI filed an S election. The IRS had record of receiving and approving the election. YCI was therefore an S corporation until it (1) was disqualified from being an S, (2) revoked its election, or (3) failed an obscure passive income test.

PROBLEM: YCI was not disqualified, had no passive income and never revoked its election.

But …

Chan presented C corporation tax returns for 2015 and 2016. They were prepared by a professional preparer but were not signed by the preparer.

COMMENT: That is odd, as a paid preparer is required to sign the taxpayer’s copy of the return. I have done so for years.

The IRS of course had no record of receiving these returns.

COMMENT: We already knew this when the RA could not find a copy of the business return. Any search would be based on YCI’s employer identification number (EIN) and would be insensitive to whether the return was filed as a C or S corporation.

Hopefully Chan mailed the business return using certified mail.

Chan had no proof of mailing.

Of course.

At this point in the case, I am supposed to believe that Chan went to the time and trouble of having a professional prepare C corporation returns for two years but never filed them. Righhhttt ….

But maybe Chan thought the preparer had filed them, and maybe the preparer thought that Chan filed them. It’s a low probability swing, but weird things happen in practice.

This is easy to resolve: have the preparer submit a letter or otherwise testify on what happened with the business returns.

Crickets.

The IRS in turn was not above criticism.

It added up deposits and said that the sum was taxable income.

Hello?? This is a RESTAURANT. There would be food costs, rent, utilities and so forth. Maybe the RA should have spent some time on the disbursement side of that bank statement.

Then the IRS charged 100% of the income to Chan.

Hold on here: didn’t Form 2553 show Chan as owning 40% - not 100% - of YCI?

We don’t believe that, said the IRS.

Both sides are bonkers.

Chan went into Tax Court without representation after the IRS tagged him with almost $2 million of unreported income. This appears a poor decision.  

The IRS - relying on a Form 2553 to treat Chan as a passthrough owner – could not keep reading and see that he owned 40% and not 100%.

Can you imagine being the judge listening to this soap opera?

The Court split its decision:

(1) Yep, Chan is an S corporation shareholder and has to report his ownership share of the restaurant’s profit or loss for 2015 and 2016.

(2)  Nope, both sides must go back and do something with expenses, as well as decide Chan’s ownership for the two years.

Our case this time was Hong Jun Chan and Suzhen Mei v Commissioner, T.C. Memo 2021-136.

Qualifying For Stock Loss Under Section 1244

 

I am looking at a case having to do with Section 1244 stock.

And I am thinking: it has been a while since I have seen a Section 1244.

Mind you; that is not a bad thing, as Section 1244 requires losses. The most recent corporate exit I have seen was a very sweet rollup of a professional practice for approximately $10 million. No loss = no Section 1244.

Let’s set up the issue.

We are talking about corporations. They can be either C or S corporations, but this is a corporate tax thing. BTW there is a technical issue with Section 1244 and S corporations, but let’s skip it for this discussion.

The corporation has gone out of business.

A corporation has stock. When the corporation goes out of business, that stock is worthless. This means that the shareholder has incurred a loss on that stock. If he/she acquired the stock for $5,000, then there is a loss of $5,000 when the corporation closes.

Next: that loss is – unless something else kicks-in – a capital loss.

Capital losses offset capital gains dollar-for-dollar.

Let’s say taxpayer has no capital gains.

Capital losses are then allowed to offset (up to) $3,000 of other income.

It will take this person a couple of years to use up that $5,000 loss.

Section 1244 is a pressure valve, of sorts, in this situation.

A shareholder can claim up to $50,000 of ordinary loss ($100,000 if married filing joint) upon the sale, liquidation or worthlessness of stock if:

 

(1)  The stock is be either common or preferred, voting or nonvoting, but stock acquired via convertible securities will not qualify;

(2)  The stock was initially issued to an individual or partnership;

(3)  The initial capitalization of the corporation did not exceed $1 million;

(4)  The initial capitalization was done with stock and property (other than stock and securities);

(5)  Only persons acquiring stock directly from the corporation will qualify; and

(6)  For the five tax years preceding the loss, the corporation received more than 50% of its aggregate gross receipts from sources other than interest, dividends, rents, royalties, and the sale or exchange of stocks or securities.

The advantage is that the ordinary loss can offset other income and will probably be used right away, as opposed to that $3,000 year-by-year capital loss thing.

Mind you, there can also be part Section 1244/part capital loss.

Say a married couple lost $130,000 on the bankruptcy of their corporation.

Seems to me you have:

                      Section 1244                     100,000

                      Capital loss                         30,000

Let’s look at the Ushio case.

Mr Ushio acquired the stock of PCHG, a South Carolina corporation, for $50,000.

PCHG intended to was looking to get involved with alternative energy. It made agreements with a Nevada company and other efforts, but nothing ever came of it. PCHG folded in 2012.

Ushio claimed a $50,000 Section 1244 loss.

The IRS denied it.

There were a couple of reasons:

(1)  Mr. Ushio still had to prove that $1 million limit.

 

The issue here was the number at the corporate level: was the corporation initially capitalized (for cash and property other than stock and securities) for $1 million or less? If yes, then all the issued stock qualified. If no, the corporation must identify which shares qualified and which shares did not.

        

It is possible that PCHG was not even close to $1 million in capitalization, in which a copy of its initial tax return might be sufficient. Alternatively, PCHG’s attorney or accountant might/should have records to document this requirement.        

 

(2)  PCHG never had gross receipts.

 

This means that PHGC could not meet the 50% of gross receipts requirement, as it had no gross receipts at all.

 

Note that opening a savings or money market account would not have helped. PCHG might then have had gross receipts, but 100% of its gross receipts would have been interest income – the wrong kind of income.

Mr Ushio did not have a Section 1244 loss, as PCHG did not qualify due to the gross-receipts requirement. You cannot do percentages off a denominator of zero.

My first thought when reviewing the case was the long odds of the IRS even looking at the return, much less disallowing a Section 1244 loss on said return. That is not what happened. The IRS was initially looking at other areas of the Ushio return. In fact, Ushio had not even claimed a capital loss – much less a Section 1244 loss – on the original return. The issue came up during the examination, making it easy for the IRS to say “prove it.”

How would a tax advisor deal with this gross-receipts hurdle in practice?

Well, the initial and planned activity of PCHG failed to produce any revenues. It seems to me that an advisor would look to parachute-in another activity that would produce some – any – revenues, in order to meet the Section 1244 requirement. The tax Code wants to see an operating business, and it uses gross receipts as its screen for operations.

Could the IRS challenge such effort as failing to rise to the level of a trade or business or otherwise lacking economic substance? Well, yes, but consider the alternative: a slam-dunk failure to qualify under Section 1244.

Our case this time was Ushio v Commissioner, TC Summary Opinion 2021-27.

Section 1202 Stock And A House Tax Proposal

I am not a fan of fickleness and caprice in the tax law.

I am seeing a tax proposal in the House Ways and Means Committee that represents one.

It has been several years since we spoke about qualified small business stock (QSBS). Tax practice is acronym rich, and one of the reasons is to shortcut who qualifies – and does not qualify – for a certain tax provision. Section 1202 defines QSBS as stock:

·      issued by a C corporation,

·      with less than $50 million in assets at time of stock issuance,

·      engaged in an active trade or business,

·      acquired at original issuance by an eligible shareholder in exchange for either cash or services provided, and

·      held for at least five years.

The purpose of this provision is to encourage – supposedly – business start-ups.

How?

A portion of the gain is not taxed when one sells the stock.

This provision has been out there for approximately 30 years, and the portion not taxed has changed over time. Early on, one excluded 50% (up to a point); it then became 75% and is now 100% (again, up to a point).

What is that point?

The amount of gain that can be excluded is the greater of:

·      $10 million, or

·      10 times the taxpayer’s basis in the stock disposed

Sweet.

Does that mean I sell my tax practice for megabucks, all the while excluding $10 million of gain?

Well, no. Accounting practices do not qualify for Section 1202. Not to feel singled- out, law and medical practices do not qualify either.

I have seen very few Section 1202 transactions over the years. I believe there are two primary reasons for this:

                 

(a)  I came into the profession near the time of the 1986 Tax Reform Act, which single-handedly tilted choice-of-entity for entrepreneurial companies from C to S corporations. Without going into details, the issue with a C corporation is getting money out without paying double tax. It is not an issue if one is talking about paying salary or rent, as one side deducts and the other side reports income. It is however an issue when the business is sold. The S corporation allows one to mitigate (or altogether avoid) the double tax in this situation. Overnight the S corporation became the entity of choice for entrepreneurial and closely-held companies. There has been some change in recent years as LLCs have gained popularity, but the C corporation continues to be out-of-favor for non-Wall Street companies. 

 

(b)  The sale of entrepreneurial and closely-held companies is rarely done as a stock purchase, a requirement for Section 1202 stock. These companies sell their assets, not their stock. Stock acquisitions are more a Wall Street phenomenon.

So, who benefits from Section 1202?

A company that would be acquired via a stock purchase. Someone like … a tech start-up, for example. How sweet it would have been to be an early investor in Uber or Ring, for example. And remember: the $10 million cap is per investor. Take hundreds of qualifying investors and you can multiply that $10 million by hundreds.

You can see the loss to the Treasury.

Is it worth it?

There has been criticism that perhaps the real-world beneficiaries of Section 1202 are not what was intended many years ago when this provision entered the tax Code.

I get it.

So what is the House Ways and Means Committee proposing concerning Section 1202?

They propose to cut the exclusion to 50% from 100% for taxpayers with adjusted gross income (AGI) over $400 grand and for sales after September 13, 2021.

Set aside the $400 grand AGI. That sale might be the only time in life that someone ever got close to or exceeded $400 grand of income.

The issue is sales after September 13, 2021.

It takes at least five years to even qualify for Section 1202. This means that the tax planning for a 2021 sale was done on or before 2016, and now the House wants to retroactively nullify tax law that people relied upon years ago.

Nonsense like this is damaging to normal business. I have made a career representing entrepreneurs and their closely-held businesses. I have been there – first person singular - where business decisions have been modified or scrapped because of tax disincentives. Taxing someone to death clearly qualifies as a business disincentive. So does retroactively changing the rules on a decision that takes years to play out. Mind you – I say that not as a fan of Section 1202.

To me it would make more sense to change the rules only for stock issued after a certain date – say September 13, 2021 – and not for sales after that date. One at least would be forewarned.   

Should bad-faith tax proposals like this concern you?

Well, yes. If our current kakistocracy can do this, what keeps them from retroactively revoking the current tax benefits of your Roth IRA?  How would you feel if you have been following the rules for 20 years, contributing to your Roth, paying taxes currently, all with the understanding that future withdrawals would be tax-free, and meanwhile a future Congress decides to revoke that rule - retroactively?

I can tell you how I would feel.