Another Taxpayer Loss – But There is Hope

Date November 20, 2019
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HBK CPAs & Consultants

In an October 2019 U.S. Tax Court ruling, the IRS denied federal tax deductions proposed by the petitioner in the case, Northern California Small Business Assistants Inc. (NCSBA) v. Commissioner of Internal Revenue, 153 T.C. No. 4 (October 23, 2019).

NCSBA, a California corporation that operates a medical-marijuana dispensary legally under California law, argued the following points:

(1) Internal Revenue Code (“IRC”) Section 280E (“280E”) violates the Eighth Amendment to the US Constitution;
(2) Only ordinary and necessary business expense deductions (under IRC Section 162) are disallowed and does not apply to other sections of the IRC; and
(3) NCSBA was operating legally under state law and therefore is not subject to 280E.

The Eighth Amendment states that, “excessive bail shall not be required, nor excessive fines imposed, nor cruel and unusual punishments inflicted.” If it was determined that 280E violates the Eighth Amendment, the following would be viewed as facts: the Eighth Amendment applies to corporations; 280E functions as a penalty; and the penalty is excessive.

The Court ruled that 280E is not a penalty because the denial of a tax deduction is not a punishment or penalty. Further, the Court stated 280E was meant to limit or deter certain actions of a taxpayer (selling controlled substances).

NCSBA argued that 280E only disallowed ordinary and necessary business expenses (under Section 162). The Court determined Congress “could not have been clearer” when it stated, “No deduction or credit should be allowed.”

Finally, the petitioner argued that 280E applies only to businesses that engage in illegal or disreputable sales of controlled substances. They contend that the word “trafficking” in 280E implies some illicit purpose in the business’ operations. The Judge pointed to case law such as Canna Care Inc v. Commissioner, which set the precedent that the sale of medical cannabis pursuant to California law constitutes trafficking within the context of 280E.

In its conclusion, the Court stated that it is limited in its powers based on the law, and that the proper avenue to redress petitioner’s grievances is through Congress because changing tax laws is a legislative process that must originate with Congress. The fight to allow tax deductions for dispensaries operating legally under state law is a legislative fight not a judicial one.

To contact a member of HBK’s Cannabis Industry Group about this or related tax issues, please call 330-758-8613.

EDITOR’S NOTE: This article was written by HBK Senior Associate Dominic Pinina and reviewed by HBKVG Director Stacey Udell.

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Court Case Denies S Corp Shareholder’s Losses for Insufficient Debt Basis

Date July 10, 2019
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S corporation shareholders can deduct losses only to the extent of their adjusted stock and debt basis in the corporation (see Can You Deduct Your S Corp Losses?, Passive Activity Loss Rule).

A shareholder creates stock basis by contributing capital, and debt basis by lending money to the S corporation, both of which are considered “actual economic outlays” by the shareholder. As described in a recent court case (Meruelo v. Comm., 123 AFTR 2d. 2019), to claim a loss from the activity the shareholder must have been “left poorer in a material sense after the transaction.”

Meruelo
In Meruelo, the S corporation suffered a nearly $27 million loss after banks foreclosed on its condominium complex. The taxpayer claimed he had sufficient basis to claim his $13 million share of the loss. His basis comprised of $5 million of capital contributions and more than $9 million of debt basis for transfers from other businesses in which he was an owner. The IRS ruled, and the Tax and Appellate Courts confirmed, that the taxpayer was entitled to claim a $5 million loss, but denied the deduction for any loss claimed on the debt as it was not directly from the shareholder.

The Problem with Debt Basis
It’s clear that a loan from a shareholder to their S corporation creates debt basis. Debt basis is also established when the shareholder borrows funds that it then loans directly to the S corporation, commonly referred to as a “back-to-back loan.” However, the IRS and courts have consistently ruled that anything outside a direct loan from the shareholder to the S corporation does not create debt basis.

In Meruelo, the taxpayer’s CPA was aware of this rule and drafted a promissory note from the S corporation to the taxpayer for a $10 million unsecured line of credit with a 6 percent interest rate. The CPA also reported the taxpayer’s share of related entity debt as shareholder loans on the S corporation’s tax return. The Court rejected the taxpayer’s argument that the arrangement was in effect a back-to-back loan, because there was no evidence that the funds had been lent to the taxpayer and then back to the S corporation. It explained that a shareholder could create debt basis by borrowing from an affiliated company and then lending the funds to an S corporation. But it also held that taxpayers are bound by the form of the transaction they initially choose; the funds advanced as intercompany loans cannot later be reclassified as shareholder loans to create basis.

What Should Shareholders Do?
The fact pattern in Meruelo is one we often encounter, a taxpayer with ownership in multiple entities using earnings from one or more to fund the losses of another. The case highlights the potential tax pitfalls of using this arrangement without proper planning. Shareholders should avoid using intercompany transfers to fund operations where basis limitations could become an issue. Instead, they should consider taking distributions or loans from their related businesses and either contributing or loaning the funds to the entity in need of cash. Done properly, this will create basis.

For questions on this or related tax matters, please contact Ben DiGirolamo at BDiGirolamo@hbkcpa.com.

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1099-Cs: Meeting IRS Requirements

Date January 29, 2019
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The requirement to execute a 1099-C IRS form to a customer in relation to cancelled debt of $600 or more is not a new one. The rule has been in effect for many years. Still, some dealers have ignored issuing 1099-Cs and the IRS has taken notice. Scrutiny has been increased and dealers who don’t comply face an increased risk of the $250 penalty for each missed 1099-C.

The regulation can be confusing, though its basic aspects are clear. Dealers with a related finance company (RFC) are required to issue the forms to anyone with a debt of $600 or more that has been discharged. The form must be filed with the IRS by the end of February (March if you’re filing electronically) of the calendar year after the year in which the debt was charged off. But the notice must be sent to the debtor by the end of January, so you have to complete the forms by then.

The rule addresses debts discharged in one of three ways:
– by bankruptcy
– as a result of expiration of your nonpayment testing period (NTP)
– by agreement between the dealer and debtor

Bankruptcy: You are not required to issue a 1099-C if the debt is cancelled by bankruptcy. Bankruptcy courts have their own IRS reporting mechanisms for debt discharges.

Expiration of NTP: The expiration of a non-payment testing period of 36 months after the last payment is an identifiable event, that is, an event that requires you to issue and file a 1099-C. But only as the NTP expires, meaning the dealer has to keep track of payment and NTP dates, as well as any “stay” periods – breaks in the 36 months for such interruptions as a bankruptcy hearing – in order to send and file the form in a timely manner. As well, you might be taking a loss in one year but not filing the 1099-C for another three or more years.

By agreement: When you agree to write off a receivable, that triggers the requirement. For example, they’re not going to pay the $1,100 they owe, but they agree to pay $500. That triggers a $600 1099-C.

Generally, if you agree not to pursue the debt or settle it for less than what is owed, you’ve lost the legal right to pursue it and should issue the 1099-C. In a state with no legal recourse after repossession, it should be issued at the time of repossession. If you have a policy for abandoning pursuit of a debt after a certain period, issue it at the time of abandonment. You should have a written policy defining your collection practices that includes a timeline for abandoning collection so you are able to issue your 1099-Cs in a timely manner.

Some dealers are concerned about upsetting customers by issuing a 1099-C. After all, your loss is treated like income to them, just as if they’d received a standard 1099. But those customers have likely failed to pay other bills, such as credit cards; you won’t be the only business sending them a 1099-C. And if they are insolvent or bankrupt, the reported amount is not taxable income.

Guidelines for issuing 1099-Cs

  • Only report for $600 of debt or more.
  • Report contracts discharged by expiration of NTP only if they were discharged prior to NTP expiration dates.
  • Never report a contract discharged by NTP expiration if it was discharged prior to expiration and by agreement or bankruptcy.
  • Never report a discharge in bankruptcy because it is covered by a bankruptcy exception.
  • If not previously reported as a discharge on NTP expiration, report for the calendar year of the agreement.

Please contact Rex Collins, Principal and Director of HBK’s Dealership Industry Group at RCollins@hbkcpa.com with any questions.

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Families with College Students May Get 2017 Tax Breaks

Date February 16, 2018
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Whether you had a child in college (or graduate school) last year or were a student yourself, you may be eligible for some valuable tax breaks on your 2017 return. One such break that had expired December 31, 2016, was just extended under the recently passed Bipartisan Budget Act of 2018: the tuition and fees deduction.

But a couple of tax credits are also available. Tax credits can be especially valuable because they reduce taxes dollar-for-dollar; deductions reduce only the amount of income that’s taxed.

Higher Education Breaks 101

While multiple higher-education breaks are available, a taxpayer isn’t allowed to claim all of them. In most cases you can take only one break per student, and, for some breaks, only one per tax return. So first you need to see which breaks you’re eligible for. Then you need to determine which one will provide the greatest benefit.

Also keep in mind that you generally can’t claim deductions or credits for expenses that were paid for with distributions from tax-advantaged accounts, such as 529 plans or Coverdell Education Savings Accounts.

Credits

Two credits are available for higher education expenses:

  1. The American Opportunity credit — up to $2,500 per year per student for qualifying expenses for the first four years of postsecondary education.
  2. The Lifetime Learning credit — up to $2,000 per tax return for postsecondary education expenses, even beyond the first four years.

But income-based phaseouts apply to these credits.

If you’re eligible for the American Opportunity credit, it will likely provide the most tax savings. If you’re not, consider claiming the Lifetime Learning credit. But first determine if the tuition and fees deduction might provide more tax savings.

Deductions

Despite the dollar-for-dollar tax savings credits offer, you might be better off deducting up to $4,000 of qualified higher education tuition and fees. Because it’s an above-the-line deduction, it reduces your adjusted gross income, which could provide additional tax benefits. But income-based limits also apply to the tuition and fees deduction.

Be aware that the tuition and fees deduction was extended only through December 31, 2017. So it won’t be available on your 2018 return unless Congress extends it again or makes it permanent.

Maximizing your savings

If you don’t qualify for breaks for your child’s higher education expenses because your income is too high, your child might. Many additional rules and limits apply to the credits and deduction, however. To learn which breaks your family might be eligible for on your 2017 tax returns — and which will provide the greatest tax savings — please contact your HBK representative.

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