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 CPA Takes Tax Advice

 

The facts are not difficult. In fact, they are rather straightforward.

What puzzles me is the player:

Mr. Igboke has been a certified public accountant for more than 30 years and regularly prepares tax returns for his clients. He knows how the federal income tax rules work ….”

I get it: not all CPAs do taxes. Some do taxes, but so few and infrequent as to not count. I used to work with a CPA - since retired - who was a career auditor. He could run circles around me when it came to reports and disclosures and such. He however prepared two returns a year, and his personal return was one of them. He had me review the other.

Mr. Igboke prepared taxes, we are told.

Let’s go through it.

Mr. and Mrs. Igboke (Igboke) lived in Long Beach, California. In 2003 they borrowed from Bank of America. They ran into financial issues not long after, and in 2006 their loan somehow wound up with Select Portfolio Servicing (SPS).

In 2020 Igboke refinanced with a credit union; the mortgage servicing was done by Cenlar.

Let’s go forward one year.

Igboke claimed a mortgage interest deduction of $47,119 on his joint 2021 individual tax return.

Problem: Cenlar issued a Form 1098 for $18,411.

Not the hardest thing for IRS computers to match.

The IRS sent notices. Back and forth they went, to no avail. In 2024 the IRS issued a Notice of Deficiency (called a NOD or sometimes SNOD).

Igboke filed with the Tax Court.

A 30-year CPA with some tax experience. I have no idea if this was his first time in Tax Court, but I am nonetheless expecting a ball with some movement over the plate.

Igboke provided the Court with:

(1)  A “substitute” 2021 Form 1098 from SPS

(2)  An explanatory letter from SPS

Wait, I thought SPS was paid-off in 2020?

Here is the Court on the 1098:

It states in box 1 that Mr. and Mrs. Igboke paid $71,618 of mortgage interest in 2021 …”

Here is the Court on the letter:

Dear Henry Igboke: SPS is in receipt of your recent request for information about the account. Our records show that for calendar year 2021, you paid a total mortgage interest of $31,635.”

I admit: I am not following the numbers:

(1)  The unexplained mortgage interest on the 2021 return was $28,708 ($47,119 – 18,411).

(2)  Then we have a $71,618.

(3)  And next we have a $31,635.

These numbers are parachuting from the sky.

The Court looked closely at the 2021 Form 1098.

All the numbers on the purported 2021 form are identical to those from 2020, including the interest paid and loan balance. But, on the purported 2021 form, the year 2020 has been replaced with 2021, and there appear to be irregular photocopier markings around the year.”

Oh oh.

The Court looked at the SPS letter:

… SPS’s recordkeeper could not find copies of either document in SPS’s records.”

As Ricky would say: someone has some explainin’ to do.

Igboke admitted he had no outstanding loan with SPS and paid no interest in 2021.

Nahhhh, really?

Igboke asserted that SPS sent the Form 1099 because they were unable to deduct the full $71,618 of interest paid in 2020.

QUESTION: How would SPS know this?

SPS told him that he could carry over some portion of that undeducted interest from 2020 to 2021.

COMMENT: And who does he get his medical advice from: Tik Tok?    

Folks, the rules for deducting interest expense can get complicated.

It helps to categorize the interest: investment interest is deducted this way; mortgage interest that way, and vehicle loan interest yet another way. It gives some order to the rules.

Some interest can carry over from year to year. Most interest cannot. You know which interest cannot?

Mortgage interest cannot.

It has been that way since before I heard of accounting.

Here is the 2013 Smoker tax case:

It is well settled that a cash basis taxpayer … is allowed a deduction for interest paid during the year in cash or its equivalent.”

In other words: show me the money.

Back to the Court:

We do not credit Mr. Igboke’s explanation.”

… the discrepancies noted above strongly suggest that these documents are not authentic and were created for the purposes of supporting the Igboke’s claimed deduction.”

This could have gone much worse.

I would have expected heightened penalties for a 30-year CPA.

Maybe a visit from the IRS Office of Professional Responsibility.

Or contact from the California State Board of Responsibility.

Worst case: all of the above.

Igboke lost the deduction, of course, but he may have been lucky to even survive this.

Our case this time was Igboke v Commissioner, T.C. Docket 12275-24, dtd 6.3.26.

If Only

 

It isn’t much. The Tax Court decision itself is scarcely 4 pages long.

Still, it made me laugh.

It also made me think that - if he could pull it off - this might have been best tax planning idea I ever came across.

His name is Kelby Daniel Reyes Barrios (Barrios). He lives in California and he appears to be a gig worker.

He filed a 2022 tax return showing $8,964 of total income.

The IRS was chasing him for $3,842 of additional tax on unreported income of $15,206.

COMMENT: I still don’t see how that is enough money to live on, not to mention … California.

Barrios filed a timely petition with the Tax Court.

Then he disappeared.

The IRS motioned for summary judgement. The Court, to its credit, provided Barrios a final opportunity to respond.

He ghosted.

The only thing the Court had to review in his favor was his declaration on the Court filing:

On his petition he asserted that he did not report the income because the tax ‘forms were mailed to a [previous] address’ and he received them only after filing his return.”

We have probably all heard a version of this logic: no form, no tax.

The IRS held for the IRS, of course. The tax Code asserts that all income is reportable, whether it draws a 1099 or not (granted, the “not” is an increasingly endangered species).

Still, think about it: one could beat the tax man by getting a return in before 1099s are distributed.

If only.

Our case this time was Kelby Daniel Reyes Barrios, T.C. Memo 2026-32.

Kentucky To Tax Prediction Markets

 

Something landed in my inbox about Kentucky HB 757.

So I am reading about prediction markets.

You have probably heard of these things: they are being used as an oracle of a sort. What are the odds that so-and-so will be elected to the political office of such-and-such in whatever state this fall? It is more than a poll, as people are wagering hard cash. I may tell a pollster just about anything to wrap-up the call, but I am certainly not parting with money.

I read that Kentucky will impose a 14.25% transaction tax on “event contracts” beginning January 1, 2027.

I get the concept of an “event contract.” It is a binary arrangement between two parties, with the contract resolving as either a “yes” or a “no.” To me the perfect example is a sports game: either the Reds will win or they will lose when they play the Mets on May 27. Bet your heart out accordingly.

I would have thought that these transactions were already being taxed.

Here is the point: they are not.

It is due to technology.

The sports betting you and I grew up with involved a house, a handle and the house establishing the odds. The key here is that the house (or DraftKings, FanDuel or whatever) received the bets, determined the handle and odds, paid-out the winners, and kept the difference (the “juice”).

The above is called “betting,” folks. It was taboo in major professional sports until the 2018 Supreme Court decision in Murphy v NCAA. Those of us who have been around for a moment remember the NFL barring Tony Romo from attending a fantasy football convention in Las Vegas, which act seems quaint today as gambling commercials blare at us on football Sundays. Fantasy was considered too close to betting, and sports betting would diminish the integrity of the game. Fast forward and the NFL started partnering with DraftKings and FanDuel in 2021.  Heck, they have probably had a baby by now.

The “new” sports betting is cribbing on territory belonging to futures contracts: both are considered derivatives and both are regulated by the Commodity Futures Trading Commission (CFTC).

Let’s say you and I bet on the May 27 Reds game.

Here is Robinhood:

This is easy: I will pay you 49 cents on the dollar that the Reds will win. If the Reds win. I win a dollar. If the Reds lose, I lose 49 cents. There will also be commissions and such, because … of course.

The fiction here is that you and I are not betting. We are instead “investing” in “financial instruments” subject to the CFTC. Granted, one of us will win and the other lose as the “event contracts” settle, but we are not “betting.” We are competing against each other on future events. We are not betting against a house, as that would describe a sportsbook. Nothing to see here, officer. Have a good day.

Hit somebody’s wallet and they will deny the very law of gravity.  

Almost 90% of these “financial instruments” are tied to sports betting.

This my shocked face: 

           

The effect of this is to remove the prediction markets from the routine and customary state gambling regulatory apparatus.

Which means that state taxes are taking a hit as money leaves their sportsbooks.

Enter Kentucky.

Since 2023 Kentucky has levied a 9.75% tax for on-track wagers and 14.25% for online and mobile wagers.  The last time I checked, the horse racing industry was contributing upwards of $200 million annually to state tax revenue. You can bet your bippy Kentucky is going to protect it.

The new 14.25% tax on prediction markets is the same as for other online betting.

And the tax will apply whether one bets via DraftKings or DraftKings Predictions. Or FanDuel or FanDuel Predicts.

Yep, same companies but two platforms.

This is new frontier in state taxation, and you can be certain there will be litigation before the matter is settled.  I suspect this will go to the Supreme Court eventually.

The issue affects all states, of course. We limited our discussion today to Kentucky for one nontechnical reason: I live here.