Plan Ahead to Avoid Tax Surprises and Temptations

November 19, 2018

“I Didn’t See That Coming”

Over the years, I have seen many business owners blanche when they learn how much income tax they will have to pay upon the sale of their business.[i] I have heard their disappointment at realizing that they may not be retaining a greater portion of the proceeds from the sale toward which they have worked for so long.

Of course, if this information is imparted to the owner well before they have even identified a buyer for their business – as it should be[ii] – they may choose not to sell the business at all,[iii] or they may conclude that the business is not yet ready to be sold.[iv] Alternatively, and having been forewarned, the owner may negotiate for a tax-friendlier – and economically more efficient – deal structure.

Then there are those owners who sold their business for what they believed was a great price, but who never consulted with a tax adviser prior to the sale, and who only learned after their returns had been prepared[v] that they were going to owe a significant sum to the government. These are the ones for which an adviser must watch out.

You Can’t Make this Up

For example, many years ago, I was brought into a Federal income tax audit that was not going well. The examiner was properly focused on the gains and losses reported on the taxpayer’s income tax return.[vi] The taxpayer’s S corporation had sold its business for a healthy sum, but his personal return also included a large capital loss that offset part of the gain from the sale. There was no information on the return from which to determine the source of the loss. When asked, the taxpayer was unable to provide any details;[vii] rather, he directed me to the accountant. The latter hemmed and hawed, and promised to provide the necessary back-up – and all the while I tried to hold the IRS examiner at bay. Finally, the accountant confessed that there was no such loss. He explained that his office had switched accounting software while the return was being prepared,[viii] and there had been a glitch in a program that added a few zeros to the loss reported on the return. Talk about creative accounting.[ix]

Lightning Strikes Again?

I wish I could say that cases like the one described immediately above are rare, but then I came across this decision just last week.

Taxpayer owned five restaurants, each of which was held in a separate and wholly-owned S corporation. Taxpayer began selling his restaurants in Tax Year, realizing a long-term capital gain in excess of $3.5 million,[x] which he reported on his IRS Form 1040, U.S. Individual Income Tax Return, for Tax Year.

Taxpayer offset this gain with a long-term capital loss of almost $3.0 million, which he claimed was attributable to an asset that was described on his return as an “overseas investment.” Taxpayer reported that he had acquired this investment approximately six years earlier, and had disposed of it at the end of Tax Year for no consideration.[xi]

Something Stinks

The IRS examined Taxpayer’s return. Neither Taxpayer nor his accountant offered a plausible explanation as to how the loss was determined; specifically, they could not substantiate the claimed cost basis of almost $3.0 million.[xii] In addition, neither of them was able to identify the “acquisition date” for the alleged investment; in fact, the accountant stated that he had arbitrarily chosen a date so as to indicate that the loss “was long term.” The accountant also stated that he had come up with the term “overseas investment,” and had listed the year-end as the date of disposition, on the basis of a conversation with Taxpayer.

The IRS concluded that Taxpayer had not substantiated (i) that he had made an investment, (ii) what his basis in that alleged investment was, or (iii) that the investment had become worthless during Tax Year. The IRS mailed Taxpayer a notice of deficiency,[xiii] and Taxpayer timely petitioned the U.S. Tax Court.

At trial, Taxpayer explained that an acquaintance had pitched an investment concept to him. Unbelievably, Taxpayer testified that he had no idea what this investment involved, but he believed it had something to do with “low interest rates” and an “opportunity *** to basically leverage *** bank funds.”

Taxpayer submitted into evidence some promotional materials which he claimed to have reviewed before investing. Notwithstanding his decades of business experience, however, Taxpayer did not seek advice about this investment from his long-time accountant, who was also a wealth manager, or from anyone else.

Despite having little understanding of the investment, Taxpayer testified that he agreed to invest $2.5 million. He submitted into evidence a copy of a purported “Investment Agreement” according to which Taxpayer would receive a 50% membership interest in a limited liability company by investing $2.5 million, which would be deposited into the escrow account of a specified law firm.

Apart from Taxpayer’s testimony,[xiv] there was no evidence that Taxpayer ever made the $2.5 million investment. He testified that the source of funds for the investment was a loan that his restaurants secured. The restaurants did appear to have secured such a loan, and the loan proceeds were allocated among them as shown in their QuickBooks entries. But there was no evidence that the S corporations disbursed any of these funds to the law firm’s escrow account or to Taxpayer; and there was no evidence, in the form of bank statements, wire transfer cover sheets, receipts, or any other document, to show that Taxpayer transferred $2.5 million (or any other sum) to the law firm.

Taxpayer also testified that he had subsequently contributed another $500,000 to this “overseas investment.” He submitted into evidence documents showing a couple of wire transfers, a cashier’s check, and a “transaction journal,” none of which established the fact of his investment.

Taxpayer also claimed to have invested in a second, previously undisclosed, investment, although he produced no evidence to establish the fact of his ownership or the amount of his investment. Taxpayer also claimed to have purchased from others their interests in this investment during the same period that he professed the investment had become worthless. However, there was no documentary evidence to establish that any of these purchases were made.

Although Taxpayer was supposed to have received regular payouts from his investments, he testified that he had never received any kind of payment. Yet Taxpayer took no action of any kind to recover his alleged investment, and did not even investigate the possibility of doing so. Instead, as his accountant explained, Taxpayer drew an inference that the investment was not doing well from the fact that his “correspondence with [the promoter] was less regular and they weren’t as upbeat.”

The Court Smells It Too

The Court began by noting that the IRS’s determination in the notice of deficiency was presumed correct, and that Taxpayer had the burden of proving it erroneous.

The Court then observed that, on his return for Tax Year, Taxpayer reported a capital loss from the disposition of a single “overseas investment.” At trial, however, Taxpayer testified that this loss was actually attributable to investments in two separate entities. In any case, Taxpayer contended that this loss was deductible as a loss from “worthless securities.”

The Court explained that, “[i]f any security which is a capital asset becomes worthless during the taxable year, the loss resulting therefrom shall * * * be treated as a loss from the sale or exchange, on the last day of the taxable year, of a capital asset.” For purposes of this rule, the Court continued, the term “security” means “a share of stock in a corporation,” the “right to subscribe for, or to receive, a share of stock in a corporation,” or a bond or other evidence of indebtedness issued by a corporation or governmental entity.

According to the Court, in order for Taxpayer to be entitled to deduct the purported loss under this rule, he had to establish three distinct facts:

  • First, that he owned a “security,” as defined in the Code;
  • Second, his “adjusted basis” in that security; and
  • Third, that the security “bec[ame] worthless during the taxable year” for which the deduction is claimed.

“Worthlessness is a factual question,” the Court stated, “and [Taxpayer] has the burden of proof to overcome [the IRS’s] determination” that the security did not become worthless during the year in question.

The Court found that Taxpayer had substantiated none of these facts.

First, Taxpayer did not show that he owned a “security.” He did not contend that the “overseas investments” took the form of a bond or other evidence of indebtedness. And he did not establish that either investment actually existed, that either was a corporation, or that he made any investment that took the form of “share[s] of stock in a corporation.”

Second, Taxpayer did not establish his basis (if any) in the investments. There was no credible evidence, documentary or otherwise, to show that he, or his S corporations, made an initial investment of $2.5 million to acquire shares of stock in any business or investment entity. In no case did any such entity furnish Taxpayer with an acknowledgment that it had received funds from him for investment, or that his ownership interest in the entity had changed. There was simply no credible evidence that any payments were made to acquire shares of corporate stock.

Third, Taxpayer did not carry his burden of proving that his alleged investments became worthless during Tax Year. To establish worthlessness in a particular year, the Court explained, a taxpayer must generally point to a “fixed and identifiable event” that caused the security to lose all value. Such an event may include a corporate dissolution or similar occurrence that “clearly evidences destruction of both the potential and liquidating values of the stock.” To establish that he has abandoned a security, the taxpayer “must permanently surrender and relinquish all rights in the security and receive no consideration in exchange.” This determination is made on the basis of “all the facts and circumstances.”

“Assuming arguendo,” the Court stated, “that [Taxpayer] made an investment in ***, he has pointed to no identifiable event evidencing that his investment became worthless during” Tax Year. He allegedly based his inference to that effect on the pessimistic tone of his communications with the promoter. But these emails did not refer to any investment that Taxpayer may have made.

In any event, Taxpayer provided at trial no reason to believe that his alleged investment had become worthless during Tax Year rather than during one of the previous six or seven years. On the other hand, he testified that he continued to make supposed investments, allegedly to buy out the interests of other investors. “These transfers sit uncomfortably with [Taxpayer’s] assertion that he viewed his investment as worthless” during that time.

The Court remarked that, by the end of the trial, “the circumstances surrounding [Taxpayer’s] alleged ‘overseas investment’ were as mysterious as they had appeared on his tax return.” Even assuming that he had made some sort of investment, the Court determined that Taxpayer did not carry his burden of proving that he had purchased a “security,” what his basis was in that security, or that the security had become worthless during Tax Year.

Thus, the Court found that Taxpayer had claimed “a fictitious loss deduction” of almost $3.0 million for Tax Year because he wished to offset the $3.5 million gain that he was required to report upon his sale of the restaurants.

“Do’s and Don’ts”

Yes, there are rogue advisers out there, and there are rogue taxpayers – somehow, they manage to find each other. Stay clear of them.[xv]

The tax-efficient disposition of a business is a process that begins at the inception of the business. There are no shortcuts. Different strategies and structures may be economically “more appropriate” at different stages in the life of the business. Some are more flexible than others. They are all aimed at growing the business and, ultimately, at maximizing the economic return on the owner’s investment.

At times, however, the owner may be presented with a choice under circumstances that are not ideal – they don’t adhere to the “plan.” For example, an offer to purchase the business from the owner may be premature from the owner’s perspective. The owner may reject the offer and rue the decision years later. Or the owner may accept the offer and rue the decision years later. Or the owner may try to change the terms of the offer, whether through an earn-out, a rollover of some of their equity, a joint venture, or some other means by which they can participate in the continued growth of the business in a tax efficient manner.

Every situation, every business, and every owner is different. The point is to consider with one’s advisers those scenarios that are likely to arise, to understand their consequences,[xvi] and to plan for them as best as reasonably possible. Avoid surprises that may trigger irrational acts.[xvii] When surprises occur, as they often do notwithstanding one’s preparation and planning, seek out those advisers before taking any action in response.[xviii]

[i] These will include Federal, state, and sometimes city, income taxes; the taxes may be imposed at the level of both the business entity and its owners. The sale may also trigger sales tax and real estate transfer tax, depending upon the form of the transaction and the nature of the assets being sold.

[ii] It may be a worthwhile exercise for the owner to informally appraise their business every few years. You never know when “that” offer is going to come and, although most owners have a ballpark idea of what their business is worth, it helps to have a more objective perspective.

[iii] That being said, there may be exigent circumstances that compel the sale.

[iv] For example, it may be that the business still has “room to grow.”

[v] In the year following the year of the sale.

[vi] Among other items, there were questions about the adjusted basis of some of the assets.

[vii] “I didn’t really review the return,” he said. “I just signed where I was told.”

[viii] “The dog ate my homework.” I guess that doesn’t resonate much in an age when kids do their homework on a computer.

[ix] The exam ended well, under the circumstances. I spoke very frankly with the examiner and their manager, fired the accountant, and restored a measure of credibility that facilitated a settlement.

[x] Meaning that the amount received by Taxpayer in exchange for the restaurants exceeded Taxpayer’s unrecovered investment (“adjusted basis”) in the restaurants by over $3.5 million.

[xi] In other words, he wrote it off as worthless.

[xii] After all, you can’t lose more than your unrecovered investment.

[xiii] The so-called “90-day letter,” which refers to the ninety days within which the taxpayer must file a petition with the Tax Court to contest the deficiency asserted in the letter. If the taxpayer fails to respond timely, the IRS is free to assess the tax, demand payment, and then seek to collect it.

[xiv] Which the Court did not find credible.

[xv] Some telltale signs: they intentionally draft ambiguity into a document; they say things like “this return is so convoluted, the IRS will never pick up the issue,” or “we control the preparation of the return, we can do whatever we want”; they ignore the legal separation among related entities; they bury questionable items in entries like “other expenses” and actually believe that no one will look.

[xvi] Which has to include running the numbers.

[xvii] One of my physics teachers was fond of saying, “Eschew obfuscation.”

[xviii] I know, I sound like your mother.