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.

Government Forces Sale to Cover Partner’s Tax Debt

 I was reading a case recently that bothered me. It involves something that – fortunately – I rarely see in practice.

Here is the Code section:

§ 7403 - Action to enforce lien or to subject property to payment of tax

(a) Filing. In any case where there has been a refusal or neglect to pay any tax, or to discharge any liability in respect thereof, whether or not levy has been made, the Attorney General or his delegate, at the request of the Secretary, may direct a civil action to be filed in a district court of the United States to enforce the lien of the United States under this title with respect to such tax or liability or to subject any property, of whatever nature, of the delinquent, or in which he has any right, title, or interest, to the payment of such tax or liability. For purposes of the preceding sentence, any acceleration of payment under section 6166(g) shall be treated as a neglect to pay tax.

(b) Parties. All persons having liens upon or claiming any interest in the property involved in such action shall be made parties thereto.

(c) Adjudication and decree. The court shall, after the parties have been duly notified of the action, proceed to adjudicate all matters involved therein and finally determine the merits of all claims to and liens upon the property, and, in all cases where a claim or interest of the United States therein is established, may decree a sale of such property, by the proper officer of the court, and a distribution of the proceeds of such sale according to the findings of the court in respect to the interests of the parties and of the United States. If the property is sold to satisfy a first lien held by the United States, the United States may bid at the sale such sum, not exceeding the amount of such lien with expenses of sale, as the Secretary directs.

(d) Receivership. In any such proceeding, at the instance of the United States, the court may appoint a receiver to enforce the lien, or, upon certification by the Secretary during the pendency of such proceedings that it is in the public interest, may appoint a receiver with all the powers of a receiver in equity.

And here is where you leave your tax CPA and hire a tax attorney.

Section 7403 permits a court to authorize the sale of property when a delinquent person owns property with a nondelinquent person. The IRS cannot do this on its own power, however; it must first go to district court and obtain approval.

To be fair, one is deep into the IRS Collection machinery before Section 7403 is even an issue. I would be screaming at you – and likely fired you as a client – long before we got here, unless bad fortune was involved. If there was bad fortune, we likely would be submitting an offer in compromise.

The heavyweight case in this area is United States v Rodgers. Rodgers was a Texas gambler who died, leaving a $900,000 tax debt. He (well, now his estate) and his wife owned their home. Under Texas law the surviving spouse had a lifetime right to live in the home. The government of course wanted its money.

The case went all the way to the Supreme Court, which identified four issues before the government could force any sale to collect taxes.

 (1) Statutory authority

Does the taxpayer have any “right, title or interest” to the property in question?

 

In Rodgers, yes. The deceased had the same rights to the entire home as did the widow.

 

The type of ownership can have a drastic effect on the government’s ability to reach the asset. A tenancy by the entirety, for example, might result in a different answer from a tenancy in common (which we will see below). 

            (2) Constitutional authority

This goes back to eminent domain. The government is not an ordinary creditor in this situation; rather it is exercising the prerogatives of a sovereign. Think of the government as a super creditor.

            (3) Practical undercompensation

Think actuarial calculations. For example, one could think that a 50/50 split of marital assets is fair. However, the value of a life estate to a surviving spouse aged fifty can be up to 95% of the home’s sales price. The spread between 95% and 50% is referred to as “practical undercompensation.”

            (4) Four-factor balancing test

             (a)  Will a non-sale prejudice the government?

   (b) Does the spouse have a legally recognized expectation of the house not being sold?

   (c)  Will the spouse suffer prejudice from practical undercompensation and dislocation costs?

   (d)  What are the relative characters and values of the two ownership interests?

Subsequent application of Rodgers focuses on these four factors.

Let’s move on to Driscoll.

Thomas Driscoll was a dentist. He owned a dental practice with Dr Vockroth. Together they also owned the building in which the dental practice was located.

Common enough.

Dr Driscoll became substantially delinquent with his tax obligations.

In April 2023, the government filed a motion for forced sale of both the practice and the building.

Meanwhile. Dr V had no tax issues. He may have made the mistake of partnering with someone who did, but that was the extent of his culpability.

The government – to its credit – allowed additional time to sell both assets.

But there were issues: trying to sell a dental practice in a small town and a building housing said practice in said small town. Let’s just say there was limited interest in buying either.

The government now wanted a forced sale.

Let’s go through the Rodgers four factors:

One

The Court decided Dr V could not show that the government would not be prejudiced by going after 50% rather than 100% of the practice and building.

Yes, the double negative is a bit difficult to follow.

This was a practice in a small town. It was going to be tough enough to sell without trying to sell half rather than the whole.

         The court decided that factor one weighed in favor of a sale.

         Two

Was Dr V as a tenant in common subject to a forced sale?

Here is the Court discussing the real estate:

This conclusion is also supported by the fact that, unlike tenants by the entirety or joint tenants, tenants in common enjoy no protections from forced sales or partition actions.”

Tough to be a tenant in common in New Jersey.

The court decided factor two weighed in favor of a sale.

Three

 Was there prejudice to Dr V in terms of personal dislocation of costs and undercompensation of interest?

Here is the Court:

 Dr Vockroth asserts that he will be ‘forced to lay off all of [his] employees,’ and that he will ‘no longer be able to see [his]  patients.'”

OK, Dr V may be laying it on thick, but that does not mean there is no truth here. Relocating a practice costs money. There are – for example - additional electrical and plumbing needs before a building can house a dental practice. Patients may not follow. Employees may not follow. The court is playing cavalierly with other people’s lives.

Here is the court in its best Frasier Crane voice:

 Furthermore, even if Dr Vockroth is negatively affected by the LLC in some way, this is not an undue prejudice of a magnitude to prevent a forced sale. It is axiomatic that LLCs and partnerships change, fail, dissolve and are bought and sold with regularity. Partners die or sell their shares The reality is simply part of being in business, and Dr. Vockroth is not exempt from this fact, especially when he fails to offer any reliable evidence to support his contentions.”

What is Dr V to do: poll his patients and employees to see whether they would follow? Oh, that will go swimmingly.

BTW the sale of a dental practice will certainly include a noncompete, meaning that Dr V could not open a dental practice within so many miles of the existing practice. Well, he could, but he would be sued.

One would think a judge would know that.

Four

  The relative character and value of the property owned by the two owners.

There was not much play here as both doctors owned 50%.

The court decided that the government could foreclose on both the practice and the real estate.

Technically right, but lousy law. Consider this menacement from Rodgers:

We do emphasize, however, that the limited discretion accorded by § 7403 should be exercised rigorously and sparingly, keeping in mind the Government's paramount interest in prompt and certain collection of delinquent taxes.

Section 7403 is not taxpayer friendly.

Our case this time was United States v Driscoll, 2025 BL 2655, D.N.J. No. 3:18-cv-11762, 1/6/25.

An IRS Employee And Unreported Income

 

You may have heard that Congress is tightening the 1099 reporting requirements for third party payment entities such as PayPal and Venmo. The ultimate goal is to report cumulative payments exceeding $600. Because of implementation issues, the IRS has adjusted this threshold to $5,000 for 2024.

Many, I suspect, will be caught by surprise.

Receiving a 1099-K does not necessarily mean that you have taxable income. It does mean that you were paid by one of the reporting organizations, and that payment will be presumed business-related. This is of concern with Venmo, for example, as a common use is payment of group-incurred personal expenses, such as the cost of dining out. Venmo will request one to identify a transaction as business or personal, using that as the criterion for IRS reporting  

What you cannot do, however, is ignore the matter. This IRS matching is wholly computerized; the notice does not pass by human eyes before being mailed. In fact, the first time the IRS reviews the notice is when you (or your tax preparer) respond to it. Ignore the notice however and you may wind up in Collections, wondering what happened.

The IRS adjusted the 2004 and 2005 returns for Andrea Orellana.

The IRS had spotted unreported income from eBay. Orellana had reported no eBay sales, so the computer match was easy.

There was a problem, though: Orellana worked for the IRS as a revenue officer.

COMMENT: A revenue officer is primarily concerned with Collections. A revenue agent, on the other hand, is the person who audits you.

Someone working at the IRS is expected to know and comply with his/her tax reporting obligations. As a revenue officer, she should have known about 1099-Ks and computer matching.

It started as a criminal tax investigation.

Way to give the benefit of the doubt there, IRS.

There were issues with identifying the cost of the items sold, so the criminal case was closed and a civil case opened in its place.

The agent requested and obtained copies of bank statements and some PayPal records. A best guess analysis indicated that over $36 thousand had been omitted over the two years.

Orellana was having none of this. She requested that the case be forwarded to Appeals.

Orellana hired an attorney. She was advised to document as many expenses as possible. The IRS meanwhile subpoenaed PayPal for relevant records.

Orellana did prepare a summary of expenses. She did not include much in the way of documentation, however.

The agent meanwhile was matching records from PayPal to her bank deposits. This proved an unexpected challenge, as there were numerous duplicates and Orellana had multiple accounts under different names with PayPal.

The agent also needed Orellana’s help with the expenses. She was selling dresses and shoes and makeup and the like. It was difficult to identify which purchases were for personal use and which were for sale on eBay.

Orellana walked out of the meeting with the agent.

COMMENT: I would think this a fireable offense if one works for the IRS.

This placed the agent in a tough spot. Without Orellana’s assistance, the best she could do was assume that all purchases were for personal use.

Off they went to Tax Court.

Orellana introduced a chart of deposits under dispute. She did not try to trace deposits to specific bank accounts nor did she try to explain – with one exception - why certain deposits were nontaxable.

Her chart of expenses was no better. She explained that any documents she used to prepare the chart had been lost.

Orellana maintained that she was not in business and that any eBay activity was akin to a garage sale. No one makes a “profit” from a garage sale, as nothing is sold for more than its purchase price.

The IRS pointed out that many items she bought were marketed as “new." Some still had tags attached.

Orellana explained that she liked to shop. In addition, she had health issues affecting her weight, so she always had stuff to sell.

As for “new”: just a marketing gimmick, she explained.

I always advertise as new only because you can get a better price for that.” 

… I document them as new if it appears new.”

Alright then.

If she can show that there was no profit, then there is no tax due.

Orellana submitted records of purchases from PayPal.

… but they could not be connected or traced to her.

She used a PayPal debit card.

The agent worked with that. She separated charges between those clearly business and those clearly personal. She requested Orellana’s help for those in between. We already know how that turned out.

How about receipts?

She testified that she purchased personal items and never kept receipts.

That would be ridiculous, unheard of. Unless there was some really bizarre reason why I keep a receipt, there were no receipts.”

The IRS spotted her expenses that were clearly business. They were not enough to create a loss. Orellana had unreported income.

And the Court wanted to know why an IRS Revenue Officer would have unreported income.

Frankly, so would I.

Petitioner testified that she ‘had prepared 1040s since she was 16’ and that she ‘would ‘never look at the instructions.’”

Good grief.

The IRS also asked for an accuracy penalty.

The Court agreed.

Our case this time was Orellana v Commissioner, T.C. Summary Opinion 2010-51.