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?
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.
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