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.

A Call From Chuck

I was speaking with a client this week. He told me that he recently retired and his financial advisor recommended he discuss a matter with me.

Me:              So, what are we going to talk about?”

Chuck:         I worked for Costco for many years.”

Me:              OK.”

Chuck:         I bought their stock all along.”

Me:              Not sure where this is going. Are you diversifying?”

Chuck:         Have you heard of Net Unrealized Appreciation?”

Me:              Sure have, but how does that apply to you?”

That was not my finest moment. I did not immediately register that Chuck had – for many years – bought Costco stock inside of his 401(k).

Take a look at this stock chart: 

Costco stock was at $313 on February 7, 2020. Five years later it is at $1,043.

It has appreciated – a lot.

I missed the boat on that one.

The appreciation is unrealized because Chuck has not sold the stock.

The difference between the total value of the Costco stock in his 401(k) and his cost in the stock (that is, the amount he paid over the years buying Costco) is the net unrealized appreciation, abbreviated “NUA” and commonly pronounced (NEW-AHH).

And Chuck has a tax option that I was not expecting. His financial advisor did a good job of spotting it.

Let’s make up a few numbers as we talk about the opportunity here.

Say Chuck has 800 shares. At a price of $1,043, the stock is worth $834,400.

Say his average cost is 20 cents on the dollar: $834,400 times 20% = cost of $166,880.

Chuck also owns stocks other than Costco in his 401(k). We will say those stocks are worth $165,600, bring the total value of his 401(k) to an even $1 million.

Chuck retires. What is the likely thing he will do with that 401(k)?

He will rollover the 401(k) to an IRA with Fidelity, T Rowe, Vanguard, or someone like that.

He may wait or not, but eventually he will start taking distributions from the IRA. If he delays long enough the government will force him via required minimum distributions (RMDs).

How is the money taxed when distributed from the IRA?

It is taxed as ordinary income, meaning one can potentially run through all the ordinary tax rates.

It was not that long ago (1980) that the maximum tax rate was 70%. Granted, one would need a lot of income to climb through the rates and get to 70%. But people did. Can you imagine the government forcing you to take a distribution and then taking seventy cents on the dollar as its cut?

Hey, you say. What about those capital gains in the 401(k)?  Is there no tax pop there?

Think of a 401(k) as Las Vegas. What happens in Las Vegas stays in Las Vegas. What leaves Las Vegas is ordinary income.

And that gets us to net unrealized appreciation. Congress saw the possible unfairness of someone owning stock in a regular, ordinary taxable brokerage account rather than a tax-deferred retirement account. The ordinary taxable account can have long-term capital gains. The retirement account cannot.

Back to NEW-AHH.

How much is in that 401(k)?

A million dollars.

How much of that is Costco?

$834,400.

Let’s roll the Costco stock to a taxable brokerage account. Let’s roll the balance ($165,600) to an IRA.

This would normally be financial suicide, as stock going to a taxable account is considered a distribution. Distributions from an IRA are ordinary income. How much is ordinary income tax on $834,400? I can assure you it exceeds my ATM withdrawal limit.

Here is the NUA option:

You pay ordinary tax on your cost - not the value - in that Costco stock.

OK, that knocks it down to tax on $166,880.

It still a lot, but it is substantially less than the general rule.

Does that mean you never pay tax on the appreciation – the $667,520?

Please. Of course you will, eventually. But you now have two potentially huge tax planning options.

First, hold the stock for at least a year and a day and you will pay long-term capital gains (rather than ordinary income tax) rates on the gain.

QUIZ: Let’s say that the above numbers stayed static for a year and a day. You then sold all the stock. How much is your gain? It is $667,520 (that is, $834,400 minus $166,880). You get credit (called “basis” in this context) for the income you previously reported.

What is the second option?

You control when you sell the stock. If you want to sell a bit every year, you can delay paying taxes for years, maybe decades. Contrast this with MRDs, where the government forces you to distribute money from the account.

So why wouldn’t everybody go NUA?

Well, one reason is that (in our example) you pony up cash equal to the tax on the $166,880. I suppose you could sell some of the Costco stock to provide the cash, but that would create another gain triggering another round of tax.

A second reason is your specific tax situation. If you just leave it alone, distributions from a normal retirement account would be taxable as ordinary income. If you NUA, you are paying tax now for the possibility of paying reduced tax in the future. Take two people with differing incomes and taxes and whatnot and you might arrive at two different answers.

Here are high-profile points to remember about net unrealized appreciation:

(1)  There must exist a retirement account at work.

(2)  There must be company stock in that retirement account.

(3)  There is a qualified triggering event. The likely one is that you retired.

(4)  There must be a lump-sum distribution out of that retirement account. At the end of the day, the retirement account must be empty.

(5)  The stock part of the retirement account goes one way (to a taxable account), and the balance goes another way (probably to an IRA).

(6)  The stock must be distributed in kind. Selling the stock and rolling the cash will not work.

BTW taking advantage of NUA does not have to be all or nothing. We used $834,400 as the value of the Costco stock in the above example. You can NUA all of that – or just a portion. Let’s say that you want to NUA $400,000 of the $834,400. Can you do that? Of course you can.

Chuck has a tax decision that I will never have.

Why is that?

CPA firms do not have traded stock.

Taxing A 5-Hour Energy Drink

 

I am skimming a decision from the Appeals Court for the District of Columbia. I am surprised that it is only 15 pages long, as it involves a gnarly intersection of partnership tax and the taxation of nonresident aliens.

Let’s talk about it.

In general, partnerships are not treated as a taxable entity. A partnership is a reporting entity; it reports income and expenses and then allocates the same to its partners for reporting on their tax returns. Mind you, this can get mind-numbing, as a partner in a partnership can itself be another partnership. Keep this going a few iterations and being a tax professional begins to lose its charm.

A partner will - again, in general - report the income as if the partner received the income directly rather than through the partnership. If it was ordinary income or capital gain to the partnership, it will likewise be ordinary income or capital gain to the partner.

Let’s introduce a nonresident alien partner.

We have another tranche of tax law to wade through.

A nonresident alien is fancy talk for someone who does not live in the United States. That person could still have U.S. income and U.S. tax, though.

How?

Well, through a partnership, for example.

Say the partnership operates exclusively in the United States. A nonresident alien generally pays tax on income received from sources within the United States. Let’s look at one type of income: business income. We will get to nonbusiness income in a moment.

The tax Code wants to know if that business income is “effectively connected” with a U.S. trade or business.

The business income in our example is effectively connected, as the partnership operates exclusively in the United States. One cannot be any more connected than that.

The partnership will issue Schedules K-1 to its partners, including its nonresident alien partner who will file a U.S. nonresident tax return (Form 1040-NR).

Question: Will any nonbusiness income on the K-1 be reportable on the nonresident?

The tax Code separates business and nonbusiness income because they might be taxed differently for nonresidents. Nonbusiness income can go from having 30% withholding at the source (think dividends) to not being taxed at all (think most types of interest income).

What if the Schedule K-1 reports capital gains?

I normally think of capital gains as nonbusiness income.

But they do not have to be.

There is a test:

If the income is derived from assets used or held for use in the conduct of an effectively connected business – and business activities were a material factor in generating the income  – then the income will taxable to a nonresident alien.

Think capital gain from the sale of farm assets. Held for use in farming? Check. Material factor in generating farm income? Check. This capital gain will be taxable to a nonresident.

Forget the K-1. Say that the nonresident alien sold his/her partnership interest altogether.

On first impression, I am not seeing capital gain from the sale of the partnership interest (rather than assets inside the partnership) as meeting the “held for use/material factor” test.

Problem: partnership taxation has something called the “hot asset” rule. The purpose is to disallow capital gains treatment to the extent any gain is attributable to certain no-no assets – that is, the “hot assets.”

An example of a hot asset is inventory.

The Code does not want the partnership to load up on inventory with substantial markup and then have a partner sell his/her partnership interest rather than wait for the partnership to sell the inventory. This would be a flip between ordinary and capital gain income, and the IRS is having none of it.

Question: have you ever had a 5-hour Energy drink?

That is the company we are talking about today.

Indu Rawat was a 29.2% partner in a Michigan partnership which sells 5-hour Energy. She sold her stake in 2008 for $438 million.

I can only wish.

At the time of sale, the company had inventory with a cost of $6.4 million and a sales price of $22.4 million. Her slice of the profit pending in that inventory was $6.5 million.

A hot asset.

The IRS wanted tax on the $6.5 million.

Mind you, Indu Rawat did not sell inventory. She sold a partnership interest in a business that owned inventory. That would be enough to catch you or me, but could the hot asset rule catch a nonresident alien?

The Tax Court agreed with the IRS that the hot asset gain was taxable to her.

That decision was appealed.

The Appeals Court reversed the Tax Court.

The Appeals Court noted that there had to be a taxable gain before the hot asset rule could kick in. The rule recharacterizes – but does not create – capital gain.

This capital gain does not appear to meet the “held for use/material factor test” we talked about above. You can recharacterize all you want, but when you start at zero, the amount recharacterized cannot be more than zero.

Indu Rawat won on Appeal.

By the way, tax law in this area has changed since Rawat’s sale. New law would tax Rawat on her share of effectively connected gain as if the partnership had sold all its assets at fair market value. Congress made a statement, and that statement was “no more.”

Our case this time was  Indu Rawat v Commissioner, No 23-1142 (D.C. Cir. July 23, 2024).

Section 1244 Stock: An Exception To Capital Loss

I was looking at a case involving Section 1244 stock.

I remember studying Section 1244 in school. On first impression one could have expected it a common quiver in tax practice. It has not been.

What sets up the issue is the limitation on the use of capital losses. An easy example of a capital asset is stock. Buy and sell stock and you have capital gains and losses (exempting those people who are dealers in stocks and securities). You then net capital gains against capital losses.

·      If the result is net capital gain, you pay tax.

·      If the result is net capital loss, the Code allows you to deduct up to $3,000 of net loss against your other types of income.

QUESTION: What if the net loss is sizeable – say $60 grand?

ANSWER: The Code will allow you to offset that loss dollar-for-dollar against any future capital gains.

QUESTION: What if the experience left a mark? You have no intention of buying and selling stocks ever again.

ANSWER: Then we are back to the $3,000 per year.

Mind you, that $3,000 entered the Code back in 1978. A 1978 dollar is comparable to $4.82 in 2024 dollars. Just to keep pace, the capital loss limit should have been cumulatively raised to $14,460 by now. It has not, of course, and is a classroom example of structural anti-taxpayer Code bias. 

Section 1244 is there to relieve some of the pressure. It is specialized, however, and geared toward small businesses.

What it does is allow one to deduct (up to) $50 grand ($100 grand for joint returns) as an ordinary loss rather than a capital loss.

There is a downside: to get there likely means the business failed. Still, it is something. Better $50 grand at one time than $3 grand over umpteen years.

What does it take to qualify?

(1)  First, there must be stock. Being a partner in a partnership will not get you there. This means that you organized as a corporation. Mind you, it can be either a C or an S corporation, but it must be a corporation.

(2)  The corporation must be organized in the United States.

(3)  The total amount of capital contributions to the corporation (stock, additional capital, whatever) must not exceed $1 million. If you are the unfortunate who puts the number above $1 million, then some of your stock will qualify and some will not.

(4)  The capital contribution must be in cash or other property (excluding stocks and securities). This would exclude stock issued as compensation, for example.

(5)  You must be the original owner of the stock. There are minimal exceptions (such as inheriting the stock because someone died).

(6)  You must be an individual. Corporations, trusts, estates, trustees in bankruptcy and so on do not qualify.

(7)  There used to be a prohibition on preferred stock, but that went out in 1985. I suppose there could still be instances involving 1984-or-earlier preferred stock, but it would be a dwindling crowd.

(8)  The company must meet a gross receipts test the year the stock is issued.

a.    For the preceding five years (or life of the company, if less), more than 50% of aggregate gross receipts must be from active business operations.

b.    Another way to say this is that passive income (think interest, dividends, rents, royalties, sales or exchanges of stocks and securities) had better be less than 50% of aggregate gross receipts. This Code section is not for mutual funds.

An interesting feature is that no formal election is required. Corporate records do not need to reference Section 1244.  Board minutes do not need to approve Section 1244.  Nothing needs to go with the tax return. The corporation must however retain records to prove the stock’s qualification under Section 1244.

And therein can be the rub.

Let’s look at the Ushio case.

In 2009 David Ushio acquired $50,000 of common stock in PCHG.

PCHG in turn had invested in LifeGrid Solutions LLC (LGS), which in turn was seeking to acquire rights in certain alternative energy technology.

PCHG never had revenues. It ceased business in 2012 and was administratively dissolved by South Carolina in 2013.

The IRS selected the Ushio’s joint individual return for 2012 and 2013. The audit had nothing to do with Section 1244, but the IRS saw the PCHG transaction and allowed a $3,000 capital loss in 2012.

Mind you, the Ushios had not claimed a deduction for PCHG stock on either their 2012 or 2013 return.

Mr. Ushio said “wait a minute …”

Some quick tax research and Ushio came back with a counter: he wanted a $50,000 ordinary loss deduction rather than the puny $3,000 capital loss. He insisted PCHG qualified under Section 1244.

The IRS had an easy response: prove it.

Ushio was at a disadvantage. He had invested in PCHG, but he did not have inside records, assuming those records even existed.

He presented a document listing “Cash Input” and “Deferred Pay,” noting that the deferred amount was never paid. Sure enough, the amount paid-in was less than $1 million.

The IRS looked at the document and noted there was no date. They wanted some provenance for the document - who prepared it? what records were used? could it be corroborated?

No, no and no.

In addition, PCHG never reported any gross receipts. It is hard to prove more-than-50% of something when that something is stuck at zero. Ushio pushed back: PCHG was to be an operating company via its investment in LGS.

The IRS could do this all day: prove it.

Ushio could not.

Meaning there was no Section 1244 stock.

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