The Sum Of The Parts Is Less Than The Whole

 

I am looking at a case involving valuations.

The concept starts easily enough:

·      Let’s say that your family owns a business.  

·      You personally own 20% of the business.

·      The business has shown average profits of $1 million per year for years.

·      Altria is paying dividends of over 7%, which is generous in today’s market. You round that off to 8%, considering that rate fair to both you and me.

·      The multiple would therefore be 100% divided by 8% = 12.5.   

·      You propose a sales price of $1,000,000 times 12.5 times 20% = $2.5 million.  

Would I pay you that?

Doubt it.

Why?

Let’s consider a few things.

·      It depends whether 8 percent is a fair discount rate.  Considering that I could buy Altria and still collect over 7%, I might decide that a skinny extra 1% just isn’t worth the potential headache.

·      I can sell Altria at any time. I cannot sell your stock at any time, as it is not publicly-traded. I may as well buy a timeshare.

·      I am reasonably confident that Altria will pay me quarterly dividends, because they have done so for decades. Has your company ever paid dividends? If so, has it paid dividends reliably? If so, how will the family feel about continuing that dividend policy when a non-family member shows up at the meetings? If the family members work there, they might decide to increase their salaries, stop the dividends (as their bumped-up salaries would replace the lost dividends) and just starve me out.

·      Let’s say that the family in fact wants me gone. What recourse do I – as a 20% owner – have? Not much, truthfully. Own 20% of Apple and you rule the world. Own 20% of a closely-held that wants you gone and you might wish you had never become involved.

This is the thought process that goes into valuations.

What are valuations used for?

A ton of stuff:

·      To buy or sell a company

·      To determine the taxable consequence of nonqualified deferred compensation

·      To determine the amount of certain gifts

·      To value certain assets in an estate

What creates the tension in valuation work is determining what owning a piece of something is worth – especially if that piece does not represent control and cannot be easily sold. Word: reasonable people can reasonably disagree on this number.

Let’s look at the Estate of Miriam M. Warne.

Ms Warne (and hence the estate) owned 100% of Royal Gardens, a mobile home park. Royal Gardens was valued – get this - at $25.6 million on the estate tax return.

Let’s take a moment:

Q: Would our discussion of discounts (that is, the sum of the parts is less than the whole) apply here?

A: No, as the estate owned 100% - that is, it owned the whole.

The estate in turn made two charitable donations of Royal Gardens.

The estate took a charitable deduction of $25.6 million for the two donations.

The IRS said: nay, nay.

Why?

The sum of the parts is less than the whole.

One donation was 75% of Royal Gardens.  

You might say: 50% is enough to control. What is the discount for?

Here’s one reason: how easy would it be to sell less-than-100% of a mobile home park?

The other donation was 25%.

Yea, that one has it all: lack of control, lack of marketability and so on.

The attorneys messed up.

They brought an asset into the estate at $25.6 million.

The estate then gave it away.

But it got a deduction of only $21.4 million.

Seems to me the attorneys stranded $4.2 million in the estate.

Our case this time was the Estate of Miriam M. Warne, T.C. Memo 2021-17.

Qualifying As A Real Estate Professional

 

The first thing I thought when I read the opinion was: this must have been a pro se case.

“Pro se”” has a specific meaning in Tax Court: it means that a taxpayer is not represented by a professional. Technically, this is not accurate, as I could accompany someone to Tax Court and they be considered pro se, but the definition works well enough for our discussion.

There is a couple (the Sezonovs) who lived in Ohio. The husband (Christian) owned an HVAC company and ran it as a one-man gang for the tax years under discussion.

In April 2013 they bought rental property in Florida. In November 2013 they bought a second. They were busy managing the properties:

·      They advertised and communicated with prospective renters.

·      They would clean between renters or arrange for someone to do so.

·      They hired contractors for repairs to the second property.

·      They filed a lawsuit against the second condo association over a boat slip that should have been transferred with the property.

One thing they did not do was to keep a contemporaneous log of what they did and when they did it. Mind you, tax law does not require you to write it down immediately, but it does want you to make a record within a reasonable period. The Court tends to be cynical when someone creates the log years after the fact.

The case involves the Sezonovs trying to deduct rental losses. There are two general ways you can coax a deductible real estate rental loss onto your return:

(1) Your income is between a certain range, and you actively participate in the property. The band is between $1 and $150,000 for marrieds, and the Code will allow one to deduct up to $25 grand. The $25 grand evaporates as income climbs from $100 grand to $150 grand.

(2)  One is a real estate professional.

Now, one does not need to be a full-time broker or agent to qualify as a real estate professional for tax purposes. In fact, one can have another job and get there, but it probably won’t be easy.

Here is what the Code wants:

·      More than one-half of a person’s working hours for the year occur in real estate trades or businesses; and

·      That person must rack-up at least 750 hours of work in all real estate trades or businesses.

Generally speaking, much of the litigation in this area has to do with the first requirement. It is difficult (but not impossible) to get to more-than-half if one is working outside the real estate industry itself. It would be near impossible for me to get there as a practicing tax CPA, for example.

One more thing: one person in the marriage must meet both of the above tests. There is no sharing.

The Sezonovs were litigating their 2013 and 2014 tax years.

First order of business: the logs.

Which Francine created in 2019 and 2020.

Here is what Francine produced:

                                     Christian              Francine

2013 hours                        405                      476                

2014 hours                         26                        80                 

Wow.

They never should have gone to Court.

They could not meet one of the first two rules: at least 750 hours.

From everything they did, however, it appears to me that they would have been actively participating in the Florida activities. This is a step down from “materially participating” as a real estate pro, but it is something. Active participation would have qualified them for that $25-grand-but-phases-out tax break if their income was less than $150 grand. The fact that they went to Court tells me that their income was higher than that.

So, they tried to qualify through the second door: as a real estate professional.

They could not do it.

And I have an opinion derived from over three decades in the profession: the Court would not have allowed real estate pro status even if the Sezonovs had cleared the 750-hour requirement.

Why?

Because the Court would have been cynical about a contemporaneous log for 2013 and 2014 created in 2019 and 2020. The Court did not pursue the point because the Sezonovs never got past the first hurdle.

Our case this time was Sezonov v Commissioner. T.C. Memo 2022-40.

Reorganizing A Passive Activity

 

I am looking at a case that stacks a couple of different tax rules atop another and then asks: are we there yet?

Let’s talk about it.

The first is something called the continuity of business doctrine. Here we wade into the waters of corporate taxation and - more specifically - corporate reorganizations. Let’s take an easy example:

Corporation A wants to split into two corporations: corporation B and corporation C.

Why? It can be any number of things. Maybe management has decided that one of the business activities is not keeping up with the other, bringing down the stock price as a result. Maybe two families own corporation A, and the two families now have very strong and differing feelings about where to go and how to get there. Corporate reorganizations are relatively common.

The IRS wants to see an active trade or business in corporations A, B and C before allowing the reorganization. Why? Because reorganizations can be (and generally are) tax-free, and the IRS wants to be sure that there is a business reason for the reorganization – and avoiding tax does not count as a business reason.

Let me give you an example.

Corporation A is an exterminating company. Years ago it bought Tesla stock for pennies on the dollar, and those shares are now worth big bucks. It wants to reorganize into corporation B – which will continue the exterminating activity – and corporation C – which will hold Tesla stock.

Will this fly?

Probably not.

The continuity of business doctrine wants to see five years of a trade or business in all parties involved. Corporation A and B will not have a problem with this, but corporation C probably will. Why? Well, C is going to have to argue that holding Tesla stock rises to the level of a trade or business. But does it? I point out that Yahoo had a similar fact pattern when it wanted to unload $32 billion of Alibaba stock a few years ago. The IRS refused to go along, and the Yahoo attorneys had to redesign the deal.

Now let’s stack tax rules.

You have a business.

To make the stack work, the business will be a passthrough: a partnership or an S corporation. The magic to the passthrough is that the entity itself does not pay tax. Rather its tax numbers are sliced and diced and allocated among its owners, each of whom includes his/her slice on his/her individual return.

Let’s say that the passthrough has a loss.

Can you show that loss on your individual return?

We have shifted (smooth, eh?) to the tax issue of “materially participating” and “passively nonparticipating” in a business.

Yep, we are talking passive loss rules.

The concept here is that one should not be allowed to use “passively nonparticipating” losses to offset “materially participating” income. Those passive losses instead accumulate until there is passive income to sponge them up or until one finally disposes of the passive activity altogether. Think tax shelters and you go a long way as to what Congress was trying to do here.

Back to our continuity of business doctrine.

Corporation A has two activities. One is a winner and the other is a loser. Historically A has netted the two, reporting the net number as “materially participating” on the shareholder K-1 and carried on.

Corporation A reorganizes into B and C.

B takes the winner.

C takes the loser.

The shareholder has passive losses elsewhere on his/her return. He/she REALLY wants to treat B as “passively nonparticipating.” Why? Because it would give him/her passive income to offset those passive losses loitering on his/her return.

But can you do this?

Enter another rule:

A taxpayer is considered to material participate in an activity if the taxpayer materially participated in the activity for any five years during the immediately preceding ten taxable years.

On first blush, the rule is confusing, but there is a reason why it exists.

Say that someone has a profitable “materially participating” activity. Meanwhile he/she is accumulating substantial “passively nonparticipating” losses. He/she approaches me as a tax advisor and says: help.

Can I do anything?

Maybe.

What would that something be?

I would have him/her pull back (if possible) his/her involvement in the profitable activity. In fact, I would have him/her pull back so dramatically that the activity is no longer “materially participating.” We have transmuted the activity to “passively nonparticipating.”

I just created passive income. Tax advisors gotta advise.

Can’t do this, though. Congress thought of this loophole and shut it down with that five-of-the-last-ten-years rule.

This gets us to the Rogerson case.

Rogerson owned and was very involved with an aerospace company for 40 years. Somewhere in there he decided to reorganize the company along product lines.

He now had three companies where he previously had one.

He reported two as materially participating. The third he treated as passively nonparticipating.

Nickels to dollars that third one was profitable. He wanted the rush of passive income. He wanted that passive like one wants Hawaiian ice on a scorching hot day.

And the IRS said: No.

Off to Tax Court they went.

Rogerson’s argument was straightforward: the winner was a new activity. It was fresh-born, all a-gleaming under an ascendent morning sun.

The Court pointed out the continuity of business doctrine: five years before and five after. The activity might be a-gleaming, but it was not fresh-born.

Rogerson tried a long shot: he had not materially participated in that winner prior to the reorganization. The winner had just been caught up in the tide by his tax preparers. How they shrouded their inscrutable dark arts from prying eyes! Oh, if he could do it over again ….

The Court made short work of that argument: by your hand, sir, not mine. If Rogerson wanted a different result, he should have done - and reported - things differently.

Our case this time was Rogerson v Commissioner, TC Memo 2022-49.

The IRS Caught Dumping A Collection Case

Let’s look at a taxpayer win on an issue not known for taxpayer wins.

Thomas Hamilton was an attorney and Edith Hamilton was a chaplain. They filed a 2016 tax return showing tax due of almost $72 thousand. They however did not pay the tax in full.

The IRS assessed.

The IRS then issued a Notice of Federal Tax Lien (NFTL) to secure its assessment.

This presented a procedural option: the Hamiltons could request a Collection Due Process (CDP) hearing. If they could work-out a payment agreement perhaps they might avoid the lien. Liens can be embarrassing.

They requested a CDP hearing.  

The IRS Settlement Officer (SO) asked for a lot of information, including:

(1)  Proof of 2018 estimated tax payments

(2)  Their 2017 personal tax return

(3)  Six months of bank statements

(4)  Three months of pay stubs

(5)  Proof of various expenses for the preceding three months

The SO also wanted the law practice to catch-up on its (mostly payroll-related) tax returns from 2015 through 2017.

The SO did stagger some of the due dates for the above: some were due on October 17, others were due October 24. The hearing itself was November 15, 2018.

The Hamiltons did not provide any documents by October 24.

Oh oh.

They did write a letter on October 31, explaining that their (now) previous bookkeeper failed to keep many documents, a fact which came to light as they were trying to comply with the SO’s request. They hired a CPA, who was helping reconstruct records as well as representing them during the CDP hearing. Finally, they had reordered online bank statements and would forward the requested documentation as soon as possible. They reiterated their desire for a payment plan.

Let me retract the “oh oh” comment, although they should have responded – in some manner - by the October 17 date.

Why? To discourage the SO from thinking that they were stalling.  

Between November 2 and November 15, the Hamiltons sent five faxes totaling hundreds of pages. They sent bank statements, copies of bills and some (but not all) of the payroll tax returns for the law practice.

The day before the hearing they also faxed personal and business financial information (Forms 433-A and 433-B) as well as a copy of their 2017 individual tax return and its electronic acceptance by the IRS.

The SO had spent no time on the case from October 1 to the date of the hearing, when she spent an hour preparing beforehand.

At the hearing the SO pressed on the following:

·      They had not filed their 2017 individual tax return.

·      They had not provided proof of their expenses.

·      They were not making 2018 estimated tax payments.

·      They had not filed payroll returns for the law practice.   

The CPA chimed in:

·      They had filed their 2017 tax return and provided proof of electronic acceptance by the IRS.

·      They had provided bank statements and documentation for the vast majority of their expenses.

·      They would be current with their 2018 estimated taxes as soon as the following month.

·      They had file some of the payroll returns the SO was considering unfiled.

The SO said she would recommend filing the NFTL.

Mr Hamilton requested additional time to provide the missing information.

The SO said: no chance.

The IRS sustained the filing of the NFTL for 2016 and also rejected their request for an installment agreement.

Sheesshh. That CDP hearing blew up.

And so we get to Tax Court.

Let’s set up the issue:

·      There was a proposed lien

·      To which taxpayers requested a CDP hearing

·      And got turned down for not complying with the SO’s documentation requests

You can take one of these to Tax Court, but it is very tough to win. In short, you must show that the IRS was capricious and abused its discretion. 

The Court went through the file:

1. The Hamiltons sent an 11-page fax on November 9. The fax included one of the payroll tax returns the SO considered missing.

    The SO had included the fax cover sheet in her record.

    But not the other 10 pages.

    One wonders how accurate the SO’s records were.

    Human error, one supposes.

2. They had filed their 2017 individual tax return and had faxed the SO a copy. They had also informed her of this filing at the hearing.

    But the SO had included the non-filing as a reason for her bounce.

    Odd.

3. Between November 2 and the November 15 hearing date, they had sent at least five faxes, totaling hundreds of pages of financial documentation

    But the SO said they had not provided documentation.

    Here is the Court:

The failure of the administrative record to capture some documents makes us question the completeness of the administrative record that the settlement officer considered and that we are reviewing.

    And here the case turned.

    The third strike.

The Court pointed out that the Hamiltons made efforts to keep the SO apprised – of the bookkeeper debacle, of the request for copies of documents and bank statements. They asked the SO to apprise them of any questions or issues while they could still react.

Then the Court emphasized that the SO had not even looked at the file until the day of the hearing.

The hearing where she nonetheless chastised the Hamiltons for not having provided all the paperwork.

Here is the Court:

She did not take them up on that offer; her doing so would have allowed the Hamiltons to address any issues before the November 15, 2018 hearing.”

The Court continued:

… the settlement officer made up her mind after a cursory one-hour review of the Hamiltons’ materials and failed to give proper consideration to the issues they raised …”

The cumulative effect of the settlement officer’s conduct in this case was to deprive the Hamiltons of fair consideration of their issues and concerns. The Hamilton’s conduct was by no means perfect, but it reflected consistent cooperation and good-faith effort throughout the CDP process.”

The SO’s decision was found arbitrary and lacking sound basis in fact or law.

The case was returned to IRS Appeals for another hearing.

The SO had gotten the case off her desk.

But she had not done her job.

And there you have a rare taxpayer win in the CDP arena.

Our case this time was Hamilton v Commissioner, T.C. Memo 2022-21.

Company’s Tuition Payment Was Not Deductible

 

Let me give you a fact pattern and you tell me whether there is a tax deduction.

·      You own a company.

·      A young man is dating your daughter.

·      The young man wants to take a computer course at Northwestern University. If it turns out he has both aptitude and interest, perhaps he can maintain the company’s website, at least for a while.

·      The company pays for the course.

Let me up the ante: is there a tax deduction to you and tax-free income to the young man?

You are thinking: maybe.

For example, my firm pays for my expenses when I attend professional seminars or conferences. Then again, my CPA license carries a continuing education requirement, so the seminars and conferences are necessary for me keep my gig as a practicing CPA.

Sounds like a working condition fringe benefit. The “working condition” qualifier means that the employer is paying for something that the employee could deduct (at least before the tax Code nixed miscellaneous itemized deductions) had the employee paid for it.

Alternatively, there are companies who pay (or help pay) tuition for employees who go to college. There are hitches to this educational assistance arrangement, though: it has to be available to everybody, cannot discriminate in favor of highly-compensated employees, and so on.

I am not seeing a tax deduction down either path. Why? Notice that a fringe benefit or assistance program requires an employer:employee relationship. You have no such relationship with the young man.

I suppose you could make him an employee.

No, you say.  Dating your daughter does not put him on the payroll.

You circle back to the possibility that he could take care of your website, at least for a while. That costs money to do. If he did so for free, or at a substantially reduced rate, the cost of that course could be a drop in the bucket compared to what you would have paid a webmaster.

OK. I am certain that the tuition is more than $600, so you pay for the course, send him a 1099 and he will have to settle-up while he files his tax return. On the upside, he should get a tax credit for taking that course.

Nope, you say. You want to deduct it as a business expense but not issue a W-2 or a 1099. None of that.

And that is how Robert and Swanette Ward appeared before the Tax Court. Clearly the IRS disagreed with the tax outcome they wanted.

Here is the Court:

While [] has provided services to Sherwin [CTG: Mrs Ward’s company] free of charge that would likely have cost Sherwin more than the amount of the tuition, we nonetheless find that the petitioners have not established that Sherwin is entitled to deduct the tuition.”

Why not?

Mr [] was not an employee of Sherwin.”

Yes, but what of the possibility that he would help with the website?

The Wards did not have an agreement with Mr [] that he would perform any services in exchange for the tuition payment.”

What, do you want a written contract or something?

Sherwin paid the tuition without any expectation of a return and thus did not have a business purpose for the payment. The tuition was a personal expense, and Sherwin is not entitled to deduct it.”

Why is the Court is circling the wagons on this one?

Folks, sometimes tax law occurs in the folds and the corners. There is something I have not yet told you that might explain the Court’s obstinacy.

That young man eventually married your daughter.

The Court saw a personal expense all the way.

I get it.

There is a distinction in the Code between deductible business expenses and nondeductible personal expenses. One could reason that showing some business angle or benefit – however abstract or hypothetical – can make the expense deductible, even if the primary factor for incurring the expense was personal. One would be wrong, but one could reason.

Our case this time was Sherwin Community Painters Inc v Commissioner, T.C. Memo 2022-19.

Part Time Bookkeeper, Big Time Penalty

 

We filed another petition with the Tax Court this week.

For a client new to the firm.

Much of this unfortunately was ICDIM: I can do it myself. The client did not understand how the IRS matches information. There was an oddball one-off transaction, resulting in nonstandard tax reporting. Stir in some you-do-not-know-what-you-do-not-know (YDNKWYDNK), some COVIDIRS202020212022 and now I am involved.

I am looking at case that just screams YDNKWYDNK.

Here is part of the first paragraph:

This case is before the Court on a Petition for review of a Notice of Determination Concerning Collection Action(s) Under Section 6320 and/or 6330, dated February 13, 2018 (notice of determination). The notice of determination sustained a notice of federal tax lien (NFTL) filing (NFTL filing) with respect to trust fund recovery penalties (TFRPs) under section 6672. The TFRPs were assessed against petitioner for failing to collect and pay over employment taxes owed by Urgent Care Center, Inc. (Urgent Care), for taxable quarters ending June 30 and September 30, 2014 (periods at issue), resulting in outstanding liabilities of $6, 184.23 and $4, 190.77, respectively.

That section 6330 is hard procedural, and it is going to hurt.

Mr Kazmi was a bookkeeper. He worked part-time at Urgent Care. Urgent Care did not remit employment taxes for a stretch, and unfortunately that stretch included the period when Mr Kazmi was there.

We are talking the big boy penalty, otherwise known as the responsible person penalty. The point of the penalty is to migrate the tax due to someone who had enough authority and responsibility to have paid the IRS but chose not to.

Mr Kazmi had no ownership interest in Urgent Care. He was not an officer. He was not a signatory on any bank accounts. He had no authority to decide who got paid. At all times he worked under the authority of the person who owned the place (Dr Senno). What he did have was a tax power of attorney.

Folks, I probably have a thousand tax powers of attorney out there.

Sounds to me like Mr Kazmi was the least responsible person (at least for payroll taxes) at Urgent Care.

The IRS Revenue Officer (RO) thought otherwise and on December 16, 2015 issued Mr Kazmi a letter 1153, a letter which said “tag, you are a responsible party; have a nice day.”

From what I am reading, this was a preposterous position. I generally have respect for ROs, but this one is a bad apple.  

Still, there are consequences.

Procedurally Mr Kazmi had 60 days to challenge the 1153.

He did not.

Why?

He did not know what he did not know.

A little time passed and the IRS came for its money. It wanted a lien. It also wanted a vanilla waffle ice cream cone.

Mr Kazmi yelled: Halt! He filed for a Collection Due Process (CDP) hearing. In the paperwork he included the obvious:

I am just a part-time bookkeeper. I am not responsible for collection or accounting or making payments for any tax payments for Urgent Care.

Makes sense.

Doesn’t matter.

He did not know what he did not know.

Let’s talk about the “one bite at the apple” rule.  In the current context, the rule means that a taxpayer cannot challenge an underlying liability if he/she already had a prior opportunity to do so.

One bite.

Mr Kazmi had his one bite when he received his letter 1153. You remember – the one he blew off.

He was now in CDP wanting to challenge the penalty. He wanted a second bite.

Not going to get it.

CDP was happy to talk about a payment plan and deadbeat taxpayers and whatnot. What it wouldn’t do was talk about whether Mr Kazmi deserved the penalty chop to begin with.

I am not a fan of such hard procedural. The vast majority of us will go a lifetime having no interaction with the IRS, excepting perhaps a minor notice now and then. It seems unreasonable to hold an average someone to stringent and obscure rules, rules that most attorneys and CPAs – unless they are tax specialists – would themselves be unaware of.

Still, it is what it is.

Does Mr Kazmi have any options left?

I think so.

Maybe a request for reconsideration.

Odds? So-so, maybe less.

A liability offer in compromise?

I like that one better.

Folks, it would have been much easier to pop this balloon back when the IRS trotted out that inappropriate letter 1153.

Mr Kazmi did not know what he did not know.

Our case this time was Kazmi v Commissioner, T.C. Memo 2022-13.

  

Basis Basics

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?

                                     Me             You

         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.