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Showing posts with label develop. Show all posts
Showing posts with label develop. Show all posts

Monday, October 26, 2020

No Shareholder, No S Corporation Election

 Our case this time takes us to Louisville.

There is a nonprofit called the Waterfront Development Corporation (WDC). It has existed since 1986, and its mission is to development, redevelop and revitalize certain industrial areas around the Ohio river downtown. I would probably shy away from getting involved - anticipating unceasing headaches from the city, Jefferson county and the Commonwealth of Kentucky - but I am glad that there are people who will lift that load.

One of those individuals was Clinton Deckard, who wanted to assist WDC financially, and to that effect he formed Waterfront Fashion Week Inc. (WFWI) in 2012. WFWI was going to organize and promote Waterfront Fashion Week – essentially a fundraiser for WDC.

Seems laudable.

Mr Deckard had been advised to form a nonprofit, on the presumption that a nonprofit would encourage people and businesses to contribute. He saw an attorney who organized WFWI as a nonprofit corporation under Kentucky statute.

Unfortunately, Waterfront Fashion Week failed to raise funds; in fact, it lost money. Mr Deckard wound up putting in more than $275,000 of his own money into WFWI to shore up the leaks. There was nothing to contribute to WDC.  What remained was a financial crater-in-the-ground of approximately $300 grand. Whereas WFWI had been organized as a nonprofit for state law purposes, it had not obtained tax-exempt status from the IRS. If it had, Mr Deckard could have gotten a tax-deductible donation for his generosity.

COMMENT: While we use the terms “nonprofit” and “tax-exempt” interchangeably at times, in this instance the technical difference is critical. WFWI was a nonprofit because it was a nonprofit corporation under state law. If it wanted to be tax-exempt, it had to keep going and obtain exempt status from the IRS.  One has to be organized under as a nonprofit for the IRS to consider tax-exempt status, but there also many more requirements.

No doubt Mr Deckard would have just written a check for $275 grand to WDC had he foreseen how this was going to turn out. WDC was tax-exempt, so he could have gotten a tax-deductible donation. As it was, he had ….

…. an idea. He tried something. WFWI had never applied for tax-exempt status with the IRS.

WFWI filed instead for S corporation status. Granted, it filed late, but there are procedures that a knowledgeable tax advisor can use. Mr Deckard signed the election as president of WFWI. An S election requires S corporation tax returns, which it filed. Mind you, the returns were late – the tax advisor would have to face off against near-certain IRS penalties - but it was better than nothing.

Why do this?

An S corporation generally does not pay tax. Rather it passes its income (or deductions) on to its shareholders who then include the income or deductions with their other income and deductions and then pay tax personally on the amalgamation

It was a clever move.

Except ….

Remember that the attorney organized WFWI as a nonprofit corporation under Kentucky statute.

So?

Under Kentucky law, a nonprofit corporation does not have shareholders.

And what does the tax Code require before electing S corporation status?

Mr Deckard has to be a shareholder in the S corporation.

He tried, he really did. He presented a number of arguments that he was the beneficial owner of WFWI, and that beneficial status was sufficient to allow  an S corporation election.

But a shareholder by definition would get to share in the profits or losses of the S corporation. Under Kentucky statute, Mr Deckard could NEVER participate in those profits or losses. Since he could never participate, he could never be a shareholder as intended by the tax Code. There was no shareholder, no S corporation election, no S corporation – none of that.

He struck out.

The sad thing is that it is doubtful whether WFWI needed to have organized as a nonprofit in the first place.

Why do I say that?

If you or I make a donation, we need a tax-exempt organization on the other side. The only way we can get some tax pop is as a donation.

A business has another option.

The payment could just be a trade or business expense.

Say that you have a restaurant downtown (obviously pre-COVID days). You send a check to a charitable event that will fill-up downtown for a good portion of the weekend. Is it a donation? Could be. It could also be just a promotion expense – there are going to be crowds downtown, you are downtown, people have to eat, and you happen to be conveniently located to the crowds. Is that payment more-than-50% promotion or more-than-50-% donation?

I think of generosity when I think of a donation. I think of return-on-investment when I think of promotion or business expenses.

What difference does it make? The more-than-50% promotion or business deduction does not require a tax-exempt on the other side. It is a business expense on its own power; it does not need an assist.

I cannot help but suspect that WFWI was primarily recruiting money from Louisville businesses. I also suspect that many if not most would have had a keen interest in downtown development and revitalization. Are we closer to our promotion example or our donation example?

Perhaps Mr Deckard never needed a nonprofit corporation.

Sunday, February 23, 2020

When Bidding Is Not Marketing

I was talking with a client recently. He is a real estate developer, and he was telling me about a tense run-in several years ago with the county about a proposed development. Think NIMBY (not in my backyard) and you have the context.

Believe it or not, there is a tax issue there.

Let’s set it up by discussing Hisham Ashkouri (HA).

HA was an architect. He was bidding on projects in Washington state and Utah. He was also bidding on projects in Libya and in the Republic of Tartarstan, which is in Russia.

Those last two are certainly off the beaten path.

Using different companies, he submitted development bid proposals. I am not sure what was in these bid proposals, but over three years (2009 – 2011), he deducted over $500 grand in bid expenses.

Sounds expensive.

The IRS audited the three years.

And disallowed the bid expenses.

That doesn’t sound right, thought I.

HA argued that he had deducted marketing and promotion expenses.

Then HA went foot-in-mouth:
“If any of those projects had resulted in ‘a real estate transaction …, I would be having 20 percent ownership.’”
Let’s introduce Code Section 263A. That bad boy generally deals with the acquisition of property, and its intention is to make you capitalize everything under the sun when you acquire – including constructing or developing – property. “Capitalize” is accounting-speak for depreciating something rather than deducting it immediately.

If you depreciate over one year, then I suppose the net effect is approximately the same. If you have to depreciate over 39 years, well, it is going to hurt.

HA fired off first and strong:

The deductions …"could not be capitalized as they were used for marketing and promotion with no real estate transaction." Although petitioners fail to cite any authority in support of that claim, they are correct that section 263A does not require the capitalization of "marketing, selling, advertising, and distribution costs." 

The Court however nailed the issue:
Mr. Ashkouri's testimony regarding the projects he pursued was not particularly detailed, but we take him as having acknowledged that, had he been awarded any of the projects, he would have acquired an ownership interest in the property being developed. He did not identify any project for which he claimed deductions in which he would not have received an ownership interest had he been awarded the contract.”
Every project would have resulted in the acquisition of an ownership interest. This is not marketing or promotion in a conventional sense. HA’s possible ownership interest at the end lands these transactions within the Section 263A dragnet.

So what? He did not win any of these bids, and he would get to deduct the bid costs when the contract was awarded to someone else. Granted, the deduction might be held-up a year or two – until the bid was awarded – but HA would eventually get his deduction.

Here comes the Scooby Doo mystery portion of the case:
But petitioners have not established when (if ever) the development contracts Mr. Ashkouri sought were awarded to others, when Mr. Ashkouri received written notice that no contract would be awarded, or when he abandoned his bid or proposal for each project.”

Seriously? He could not show that the bid went to someone else or was withdrawn entirely? I am not getting this at all.

The Tax Court then backed-up and ran over the body a second time – apparently to make sure that it had stopped breathing:
Even if we were to accept that the expenses in issue were not subject to deferral under section 1.263A-1(e)(3)(ii)(T), Income Tax Regs., we would still conclude that respondent properly disallowed the deductions for architectural or contract services claimed on the Schedules C for Mr. Ashkouri's proprietorship because petitioners did not adequately substantiate the expenses underlying the claimed deductions. In general, section 162(a) allows a deduction for "all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business". When called upon by the Commissioner, however, a taxpayer must substantiate his expenses.”
Bam! Even if HA provided evidence about the bid outcomes, the Court was still going to say “No.”

Back to my real estate guy.

What was the tax issue back when?

His transaction involved real estate development. There is no question that he would have had an ownership interest if the project went through; in fact, he would be the only owner.

Let’s say he incurred significant expenses – legal, engineering and the like – while battling the county.

Would have had to capitalize those expenses rather than deduct them right away?



Saturday, February 14, 2015

Distinguishing Capital Gains From Ordinary Income



The holy grail of tax planning is to get to a zero tax rate. That is a rare species. I have seen only one repeatable fact pattern in the last few years leading to a zero tax rate, and that pattern involved not making much money. You can guess that there isn’t much demand for a tax strategy that begins with “you cannot make a lot of money….”

The next best plan is capital gains. There is a difference in tax rates between ordinary income (up to 39.6%) and capital gains (up to 20%). A tax geek could muddy the water by including phase-outs (such as itemized deductions or personal exemptions), the 15% capital gains rate (for incomes below $457,600 if you are married) or the net investment income tax (3.8%), but let’s limit our discussion just to the 20% versus 39.6% tax rates. You can bet that a lot of tax alchemy goes into creating capital gains at the expense of ordinary income.

The tax literature is littered with cases involving the sale of land and capital gains. If you or I sell a piece of raw land, it is almost incontrovertibly a capital gain. Let’s say that you are a developer, however, and make your living selling land. The answer changes, as land is inventory for you, the same as that flat screen TV is inventory for Best Buy.

Let’s say that I see you doing well, and you motivate me to devote less energy to tax practice and more to real estate. At what point do I become a developer like you: after my second sale, after my first million dollars, or is it something else?

The tax Code comes in with Section 1221(a), which defines a capital asset by exclusion: every asset is a capital asset unless the Code says otherwise.

For purposes of this subtitle, the term “capital asset” means property held by the taxpayer (whether or not connected with his trade or business), but does not include—

(1)  stock in trade of the taxpayer or other property of a kind which would properly be included in the inventory of the taxpayer if on hand at the close of the taxable year, or property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business;

Let’s take Section 1221(a)(1) out for a spin, shall we? Let’s talk about Long, and you tell me whether we have a capital asset or not.

Philip Long lives in Florida, which immediately strikes me as a good idea as we go into winter here. From 1994 to 2006 he operated a sole proprietorship by the name of Las Olas Tower Company (LOTC). Long had a drive and desire to build a high-rise condominium, which he was going to call Las Olas Tower.

He is going to build a condo, make millions and sit on a beach.

Problem: he doesn’t own the land on which to put the condo. Solution: He has to buy the land.

He finds someone with land, and that someone is Las Olas Riverside Hotel (LORH). LORC and LORH are not the same people, by the way, although “Las Olas” seems a popular name down there. Long enters into an agreement to buy land owned by LORH.

Long steps up his involvement: he is reviewing designs with an architect, obtaining government permits and approval, distributing promotional materials, meeting with potential customers. The ground hasn’t even been cleared or graded and he has twenty percent of the condo units under contract. Long is working it.

LORH gets cold feet and decides not to sell the land.

Yipes! Considering that Long needs to land on which to erect the condo, this presents an issue. He does the only thing he can do: he sues for specific performance. He needs that land.

He is also running out of cash. A friend of his lends money to another company owned by Long to keep this thing afloat. Long is juggling. Who knows how much longer Long can keep the balls in the air?

In November, 2005 Long wins his case. The Court gives LORH 326 days to comply with the sales agreement.

But this has taken its toll on Long. He wants out. Let someone finish the lawsuit, buy the land, erect the condo, make the sales. Long has had enough. He meets someone who takes this thing off his hands for $5,750,000. He sells what he has, mess and all. 

    QUESTION: Is this ordinary or capital gain income?

The difference means approximately $1.4 million in tax, so give it some thought.

The closer Long gets to being a developer the closer he gets to a maximum tax rate. The Courts have looked at the Winthrop case, which provides factors for divining someone’s primary purpose for holding real property. The factors include:
  1. The purpose for acquisition of property
  2. The extent of developing the property            
  3. The extent of the taxpayer’s efforts to sell
The Tax Court looked and saw that Long had a history of developing land, had hired an architect, obtained permits and government approvals and had even gotten sales contracts on approximately 20% of the to-be-built condo units. A developer has ordinary income. Long was a developer. Long had ordinary income.

Is this the answer you expected?

It wasn’t the answer Long expected. He appealed to the Eleventh Circuit.

What were the grounds for appeal?

Think about Long’s story. There is no denying that a developer subdivides, improves and sells real estate. Long was missing a crucial ingredient however: he did not have any real estate to sell. All he had was a contract to buy, which is not the same thing. In fact, when he cashed out he still did not have real estate. He had won a case ordering someone to sell real estate, but the sale had not yet occurred.

The IRS did not see it that way. As far as they were concerned, Long had found a pot of gold, and that gold was ordinary income under the assignment of income doctrine. That doctrine says that you cannot sell a right to money (think a lottery winning, for example) and convert ordinary income to capital gains. You cannot sell your winning lottery ticket and get capital gains, because if you had just collected the lottery winnings you would have had ordinary income. All you did was “assign” that ordinary income to someone else.

The problem with the IRS point of view is that someone still had to buy the land, finish the permit process, clear and grade, erect a building, form a condo association, market the condos, sell individual units and so on. Long wasn’t going to do it. There was the potential there to make money, but the money truck had not yet backed into Long’s loading dock. Long was not selling profit had had already earned, because nothing had yet been “earned.”

Long won his day in Appeals Court.

He had ordinary income in Tax Court and then he had capital gains in Appeals Court.

Even the pros can have a hard time telling the difference sometimes.