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.

A Model Home As A Business

 

What does a tax CPA do a few days after the filing deadline?

This one is reviewing a 17-page Tax Court case.

Yes, I would rather be watching the new Batman movie. There isn’t much time for such things during busy season. Maybe tomorrow.

Back to the case.

There is a mom and dad and daughter. Mom and dad (the Walters) lived in Georgia. They had launched three successful business in Michigan during the 70s and 80s. They thereafter moved to Georgia to continue their winning streak by developing and owning La-Z-Boy stores.

During the 90s dad invested in and subsequently joined the board of an environmentally oriented Florida company. He followed the environmental field and its technology, obtained certifications and even guest lectured at Western Carolina University.

Daughter received an undergraduate degree in environmental science and then a law degree at a school offering a focus on environmental law.

After finishing law school, daughter informed her parents that she was not interested in the furniture business. Mom and dad sold the La-Z-Boy businesses but kept the real estate in an entity called D&J Properties. They were now landlords to La-Z-Boy stores.

The family decided to pivot D&J by entering the green real estate market.

Through the daughter’s connections, mom and dad became aware of a low-density housing development in North Carolina, emphasizing land conservation and the incorporation of geothermal and solar technologies.

You know this caught dad and daughter’s attention.

They bought a lot. They built a house (Balsam Home). They stuck it in D&J Properties. The house received awards. Life was good.

They received an invitation to participate in a “Fall Festival of Color.” Current and potential property owners would tour Balsam Home, meet with members of the team and attend a panel discussion. Word went out to the media, including the Atlanta Journal-Constitution.

Balsam Home became a model home for the development. Awards and certificates were hung on the walls, pamphlets about green technology were placed on coffee tables. A broker showed Balsam Home when mom and dad were back at their regular residence.

Sometimes the line blurred between model home and “home” home. Mom and dad registered cars at the Balsam Home address, for example, and dad availed himself of a golf membership. On the flip side, the green technology required one to be attentive and hands-on, and mom and dad did most of that work themselves.

Where is the tax issue here?

Balsam Home never showed a profit.

The La-Z-Boy stores did.

The IRS challenged D&J Properties, arguing that Balsam Home was not a business activity conducted for profit and therefore its losses could not offset the rental income from the furniture stores.

This “not engaged in for profit” challenge is more common than you may think. I am thinking of the following from my own recent-enough experience:

·      A mom supporting her musically inclined twin sons

·      A young golfer hoping to go pro

·      A model certain to be discovered

·      A dancer determined she would join a professional company

·      A dressage rider meeting “all the right people” for later success

The common thread is that some activity does not make money, seems likely to never make money but is nonetheless pursued and continued, normally by someone having (or subsidized by someone having) enough other income or wealth to do so. It can be, in other words, a tax write-off.

But then again, someone will be the next Bruno Mars, Scottie Scheffler or Stevie Nicks. Is it a long shot? Sure, but there will be someone.

Not surprisingly, there is a grid of questions that the IRS and courts go through to weigh the decision. It is not quite as easy as having more “yes” than “no” answers, but you get the idea.

Here is a (very) quick recap of the grid:

·      Manner in which taxpayer carried on the activity

·      Taxpayer’s expertise

·      Taxpayer’s advisors’ expertise

·      Time and effort expended by the taxpayer

·      Expectation that activity assets will appreciate in value

·      Success of the taxpayer on carrying on similar activities

·      History of activity income and loss

·      Financial status of the taxpayer

·      Elements of personal pleasure or recreation

Let’s review a few.

·      Seems to me that mom, dad and daughter had a fairly strong background in green technology. The IRS disagreed, arguing “yes this but not that.”  The Court disagreed with the IRS.

·      Turns out that mom and dad put a lot of time into Balsam House, and much of that time was as prosaic as fertilizing, weeding and landscaping. The Court gave them this one.

·      Being real estate, it was assumed that the asset involved would appreciate in value.

o  BTW this argument is often used in long-shot race-horse challenges. Win a Kentucky Derby, for example, and all those losses pale in comparison to the future income.

·      I expected financial status to be a strong challenge by the IRS. Mom and dad owned those La-Z-Boy stores, for example. The Court took pains to point out that they had sold the stores but kept the real estate, so the ongoing income was not comparable. The Court called a push on this factor, which I considered quite generous.

The Court decided that the activity was conducted for profit and that losses could be used to offset income from the furniture stores.

A win for the taxpayers.

Could it have gone differently?

You bet. Court decisions in this area can be … quixotic.  

Our case this time was Walters v Commissioner, T.C. Memo 2022-17.

Losing Deductions By Not Filing A Tax Return

I have become increasingly reluctant to accept a nonfiler as a client. That said, a partner somehow sneaks one or two a year into Command Center, and I – reluctant or not – become involved. It would not be so bad if it was just a matter of catching-up with the paperwork, but often one needs to stave off Collections, establish a payment plan, request penalty abatement (done after the taxes are paid, meaning I have to monitor it in my spare time) and on-and-on.

Try doing this during IRSCOVID202020212022. It is zero fun.

I am looking at a nonfiler that took a self-inflicted wound.

Let’s talk about Shawn Salter.

Salter was a loss prevention manager over 10 Home Depot stores in Arizona.  He worked from home but drove regularly to his stores. Home Depot offered to reimburse his mileage, but he turned it down. He thought that claiming the mileage on his return would give him a bigger refund.

COMMENT: Well, yes, as he was paying out-of-pocket for gasoline and wear-and-tear on his car. Clearly he is not a Warren Buffet successor.

Salter got laid off in 2013.

He took money out of his IRA to get through, but that is not the point of our discussion today.

He needed to file a 2013 return so he could get that tax refund, especially since he turned down the opportunity to be reimbursed.

What did he not do?

He did not file a 2013 return.

Eventually the IRS figured it out and asked for a tax return.

Salter blew it off.

The IRS prepared a “substitute for return.” You do not want the IRS to do this, by the way. The IRS will file you as single with no dependents (whether you are or not), include all your gross income and do its very best to not spot you any deductions. It is intentionally designed to maximize your tax liability.

The IRS wanted over $6 grand in tax, with all the assorted interest and penalty toppings.

Now Salter cared.

He told the IRS that he had used H&R Block software to file his return.

The IRS clarified that it had no 2013 tax return, either from H&R Block or from anyone else. Send us a copy, they said.

He did not have a copy to send. He did not have certified mail receipts or record of electronic filing. He had nothing.

Hard to persuade anyone with nothing.

Here is the Court:

We find that the petitioner did not file a return for 2013, ...”

This created a problem.

Salter wanted to claim that mileage, meaning that he needed to itemize his deductions.

OK.

Not OK. There is a tax issue.

Which is …?

Did you know that itemizing your deductions is considered a tax election?

And …?

You have to file a tax return to make the election.

Easy, you say, Salter should prepare and file a 2013 return claiming itemized deductions. Doing so is the election.

Too late. That window closed when the IRS prepared the substitute for return. The substitute is considered a return, and it did not itemize. Remember how a substitute works: income is reported at gross; deductions are grudgingly given, if given at all. 

No mileage. No deduction. No refund. Tax due.

As we said: self-inflicted wound.

Our case this time was Salter v Commissioner, T.C. Memo 2022-29.