Fish Bites Section 1239 Trap

 

Let’s talk about how a business purchase transaction can blow up.

The pepper in this stew is that the seller and buyer have different tax goals:

• The buyer wants to deduct as much as possible. In general, this means that the other side (the seller) will be recognizing ordinary income to offset those ordinary deductions.

• The seller wants as much capital gains as possible. In general, this means that the other side (the buyer) may have to amortize or depreciate assets over time rather than deducting them immediately.

M&A tax planning at heart comes down to the above tension.

Sometimes reading M&A cases can be difficult: numerous entities, mind-numbing detail, this move, that move, everyone come down and bust a move. Let’s take one case that caught my attention. As we have (sometimes) done before, we will modify the names to make the story easier to follow.

In 1996 Vernon started a one-man technology company in Kansas City. By 2004 it was one of the largest network security companies in the nation.

Let’s call his company Harry.

Vernon wanted cash for his troubles and travails. He would keep majority control of the company, but he would also have cash for little things - like expensive cars and multiple houses. I am with Vernon here.

Petunia was looking to invest in Harry.

Dial-in the tension between the seller and the buyer. Here is what they came up with

• Vernon owned 100% of Harry, an S corporation.
• Vernon transferred 100% of his stock in Harry to Hermione, a newly-formed S corporation.

COMMENT: There is a problem here: S corporations generally have to be owned by individuals, estates and certain trusts. A corporation cannot own an S corporation, except for …

• Harry immediately elected to be a Qualified Subchapter S Subsidiary (QSSS), an exception to that corporation-owning-an-S thing. Hermione owned Harry and it was all okay.

• Petunia dropped $10.5 million into Hermione in exchange for 43% of newly-issued preferred stock.

COMMENT: The money is now in play. The issue is getting it out to Vernon.

• We have a problem with Hermione. First, an S corporation must have only one class of stock, and Hermione now had two: common and preferred. Second, a QSSS can have only one shareholder: a parent who owns 100% of the QSSS stock. Hermione now had two shareholders. No surprise …

• Hermione’s S election blew up.

COMMENT: This was intentional. Harry was deemed to have transferred its interest in Hermione to a new corporation in exchange for 57% of the new stock. Petunia was deemed to have transferred $10.5 million for the remaining 43% interest. We will call the new corporation Ron.

COMMENT: There is a Code section (Section 351) that normally prevents incorporations from being taxable. There are ways to make it taxable, but most planners stay far away from them. One way? Pay money back to an incorporator (in this case, Harry via Hermione). The geek term for this money is “boot.”

• Ron paid $9.7 million in boot to Harry/Hermione upon reincorporation.

COMMENT: There you go: the planners deliberately sprung the trap. I do not recall ever doing this in my career. Why did they do it? To move the money to Vernon, of course, but also to have a chance at capital gains treatment by rinsing it through a Section 351 transaction.

• Let’s take stock of where we are.

a.     Petunia wanted ordinary deductions. She now has it in the way of amortization and depreciation. She put money into Hermione/Ron – and that money was buying assets; tangible, intangible, whatever. Petunia never bought stock.

b.    Vernon wanted capital gains. The easiest way would have been to sell Harry/Hermione stock, but Petunia wasn’t interested. All this ambulation was to mimic the sale of stock.

I admit: the tax work up to this point is clever.

But someone overlooked this interloper:

26 U.S. Code § 1239 - Gain from sale of depreciable property between certain related taxpayers

(a) Treatment of gain as ordinary income

In the case of a sale or exchange of property, directly or indirectly, between related persons, any gain recognized to the transferor shall be treated as ordinary income if such property is, in the hands of the transferee, of a character which is subject to the allowance for depreciation provided in section 167.

The idea here is simple: Congress did not want related parties to depreciate assets and then sell them to a related party to start the depreciation over again.

Tax being tax, the words have a loaded meaning. For example, does “depreciation” under Section 167 include amortization, which is the equivalent of depreciation but for intangible assets? “Related persons” also has multiple definitions, depending upon where you are in the Code.

Let’s continue.

Remember that we are dealing with a technology consulting company in Kansas City. This is a not a manufacturing plant in Pennsylvania with all kinds of real estate and machinery and equipment. Most of what Petunia bought for $10.5 million was intangible assets, amortizable under Section 197 over 15 years.

At which point I presume the tax planners stopped, reasoning that Section 197 is not Section 167 and therefore Section 1239 was not an issue.

Except for Reg 1.197-2(g)(8):

Also, an amortizable Section 197 intangible is section 1245 property and Section 1239 applies to any gain recognized upon its sale or exchange between related persons (as defined in Section 1239(b)).”

Buried deep, but there it is. Section 1239 slipped its first noose on the transaction.

But were the parties related? Could Harry/Hermione/Ron avoid the second noose?

Here is Section 267(f):

Think of Section 1563 as applying to consolidated corporations (where corporations own other corporations). Section 267 addresses individuals owning corporations (what we would call brother-sisters). Section 267 is taking a consolidation definition and changing it for brother-sisters. It is changing the definition to make it less stringent.

Section 1239 wants related parties, and Section 267 says you have related with more than 50% common ownership.

Vernon owned 100% of Harry and 100% of Hermione. He also owned 57% of Ron.

Yep, related.

Section 1239 applied.

Vernon got ordinary income, not capital gain, treatment on the $9-plus million dollars.

Petunia got her ordinary deductions - over time and not right away.

It is very tough to accommodate both sides.

But Vernon did get his $9-plus million dollars.

Our case this time, modified a spot for ease of writing and readability, was Fish v Commissioner, T.C. Memo 2013 - 270.

Pushing Accounting Methods Too Far

Way back when, when I was attending a one-room tax schoolhouse, some of the earliest tax principles we learned was that of accounting methods and accounting periods. An accounting method is the repetitious recording of the same underlying transaction – recording straight-line depreciation on equipment purchases, for example. An accounting period is a repetitious year-end. For example, almost all individual taxpayers in the U.S. use a December 31 year-end, so we say they use a calendar accounting period.

Introduce related companies, mix and match accounting methods and periods and magical things can happen.  Accountants have played this game since the establishment of the tax Code, and the IRS has been pretty good at catching most of the shenanigans.

Let’s talk about one.

Two brothers own two companies, India Music (IM) and Houston-Rakhee Imports (HRI). Mind you, one company does not own the other. Rather the same two people own two separate companies. We call this type of relationship as a brother-sister (as opposed to a parent-subsidiary, where one company owns another). IM sold sheet music. It used the accrual method of accounting, which meant it recorded revenues when a sale occurred, even if there was a delay in receiving payment. It bought its sheet music from its brother-sister HRI. Under accrual accounting, it recorded a cost of sale for the sheet music to HRI, whether it had paid HRI or not.

Let’s flip the coin and look at HRI. It used the cash basis of accounting, which meant it recorded sales only when it received cash, and it recorded cost of sales only when it paid cash. It is the opposite accounting from IM.

Both companies are S corporations, which means that their taxable income lands on the personal tax return of their (two) owners. The owners then commingle the business income with their other personal income and pay income taxes on the sum.

From 1998 to 2003 IM accrued a payable to HRI of over $870,000. This meant that its owners got to reduce their passthrough business income by the same $870,000.

But….

Remember that the other side to this is HRI, which would in turn have received $870,000 in income. That of course would completely offset the deduction to IM. There would be no tax “bang” there.

What to do, what to do?

Eureka! The two brothers decided NOT to pay HRI. That way HRI did not receive cash, which meant it did not have income. Brilliant!

The IRS thought of this accounting trick back when the tax Code was in preschool. Here is code Section 267:

             (a) In general

(1) Deduction for losses disallowed

No deduction shall be allowed in respect of any loss from the sale or exchange of property, directly or indirectly, between persons specified in any of the paragraphs of subsection (b). The preceding sentence shall not apply to any loss of the distributing corporation (or the distributee) in the case of a distribution in complete liquidation.

(2) Matching of deduction and payee income item in the case of expenses and interest

If—

(A) by reason of the method of accounting of the person to whom the payment is to be made, the amount thereof is not (unless paid) includible in the gross income of such person, and

(B) at the close of the taxable year of the taxpayer for which (but for this paragraph) the amount would be deductible under this chapter, both the taxpayer and the person to whom the payment is to be made are persons specified in any of the paragraphs of subsection (b),  then any deduction allowable under this chapter in respect of such amount shall be allowable as of the day as of which such amount is includible in the gross income of the person to whom the payment is made (or, if later, as of the day on which it would be so allowable but for this paragraph). For purposes of this paragraph, in the case of a personal service corporation (within the meaning of section 441 (i)(2)), such corporation and any employee-owner (within the meaning of section 269A (b)(2), as modified by section 441 (i)(2)) shall be treated as persons specified in subsection (b).

What the Code does is delay the deduction until the related party recognizes the income. It is an elegant solution from a simpler time.

Our two brothers were audited for 2004, and the IRS immediately brought Section 267 to their attention. The IRS disallowed that $870,000 deduction to IM, and it now wanted $295 thousand in taxes and $59 thousand in penalties.

The brothers said “No way.” Some of those tax years were closed under the statute of limitations. “You cannot come back against us after three years,” they said.

What do you think? Do the brothers have a winning argument?

Let me add one more thing. To a tax practitioner, there are a couple of ways to increase income in a tax audit:

(1)  An adjustment

This is a one-off. You deducted your vacation and should not have. The IRS adds it back to income. There is no concurrent issue of repetition: that is, no  issue of an accounting method.

(2)  An accounting method change

There is something repetitious going on, and the IRS wants to change your accounting method for all of it.

The deadly thing about an accounting method change is that the IRS can force all of it on you in that audit year. In our case, the IRS forced IM to give back all of its $870,000 for 2004. It did not matter that the $870,000 had accreted pell mell since 1998.

With that sidebar, do you now think the brothers have a winning argument?

You can pretty much guess that the brothers were arguing that the IRS adjustment was a category (1): a one-off. The IRS of course argued that it was category (2): an accounting method change.

The case went to the Tax Court and then to the Fifth Circuit. The brothers were determined. They were also wrong. The brothers advanced some unconvincing technical arguments that the Court had little difficulty dismissing . The Court decided this was in fact an accounting method change. The IRS could make the catch-up adjustment. The brother owed big dollars in tax, as well as penalties.

The case was Bosamia v Commissioner, by the way.

My thoughts?

The brothers never had a chance .  Almost any tax practitioner could have predicted this outcome, especially since Section 267 has a long history and is relatively well known. This is not an obscure Code section.

The question I have is how the brothers found a tax practitioner who would sign off on the tax returns. The IRS can bring a CPA up on charges (within the IRS, mind you, not in court) for unprofessional conduct. The IRS could then suspend – or bar – that CPA from practice before the IRS. To a tax CPA – such as me – that is tantamount to a career death sentence. I would never have signed those tax returns. It would have been out of the question.