Archive for Basis

How to calculate stock and loan basis in an S Corp for tax purposes

February 27, 2013 Basis, Corporation, Cost Basis, Depreciation, Self Employ, Small Business, Sole Proprietor, Sub-chapter S, Tax Guidance & Preparation, Tax Problems & Requests

If you are a shareholder of an S corporation you are responsible for keeping track of your own basis (investment value) in the S corporation of which you own shares.  Tracking shareholder basis is usually not the S corporation’s responsibility.

You can have stock basis and loan basis, which are usually adjusted each year based on the S corporation’s operations. 

It is important to annually calculate your shareholders basis in the S corporation stock you own for the following reasons:

• You can claim losses and deductions passed through on Schedule K-1 to the extent of their stock and loan basis [§1366(d)(1)].

• If you receive a non-dividend distribution from the S corporation, it’s nontaxable to the extent of you stock basis [§1368(b)(1)].

• When you disposes of the S corporation stock, gain or loss on the disposition is calculated using you stock basis.

Stock basis starts with your initial contribution of capital to the S corporation’s capital account or the price paid for the stock. This amount is adjusted annually, as of the last day of the S corporation year, in the following order [Reg. §1.1367-1(f)]:

(1) Increased by all income including tax-exempt income reported on Schedule K-1 and excess depletion.

(2) Decreased by property distributions including cash made by the S corporation that are reported on Schedule K-1 in Box 16 with code D.

(3) Decreased by nondeductible non capital expenses, such as illegal bribes, kickbacks, fines and penalties, expenses and interest related to tax-exempt income, and the nondeductible portion of meals and entertainment.

(4) Decreased by deductible losses and deductions reported on Schedule K-1.

Stock basis can never go below zero.

If non dividend distributions exceed stock basis, the excess is taxed as capital gain on your personal return [§1368(b)(2)].

If deductible losses and deductions exceed stock basis, they can be deducted to the extent you have loan basis and any amount in excess of loan basis is suspended and carried over to the succeeding tax year.

You can elect to reduce your stock basis by deductible losses and deductions before decreasing their basis by non deductible expenses [Reg. §1.1367-1(g)]. If this election is made and nondeductible expenses exceed your stock and loan basis, the excess retains its character and is carried over to the succeeding tax year. If the election is not made, any excess nondeductible expenses are lost, not suspended and not carried over.

Loan basis starts with a loan substantiated with loan documentation from you the shareholder of the S corporation to the S corporation. In other words, it includes a traditional, written note with a reasonable stated rate of interest. It does not include third party loans to the S corporation that you guarantee or co-signs.

Loan basis is adjusted as follows:

• Losses and deductions (deductible and nondeductible) passed through on Schedule K-1 reduce stock basis before they reduce loan basis.

• Loan basis can never go below zero. If deductible losses and deductions exceed your stock and loan basis, the excess is suspended and carried over.

• If there are different types of losses and deductions, the allowable loss and deduction items must be prorated.

• If loan basis has been reduced by pass-through losses and deductions, any net increase in a subsequent year restores the reduced loan basis before it increases your stock basis [Reg. §1.1367-2(c)].

A net increase is the amount by which the increases to stock basis exceed the decreases to stock basis including non dividend distributions.

• Non dividend distributions are not taxable if there is a “net increase” for the year, even if you have no stock basis.

• Reduced loan basis is restored by any “net increase” for the year before any loan repayments during the year are taken into account [Reg. §1.1367-2(d)(1)].

These loan repayments must be allocated in part to a return of your basis and in part to the receipt of income. If the loan is a written note, the note is a capital asset and the income will be capital gain.

As an S corporation shareholder you must establish that you have enough basis in the S corporation before you can claim any pass-through losses or deductions. Basically S corporation shareholders usually tend to get into trouble when they assume that non dividend distributions from an S corporation are entirely nontaxable. Be sure to verify that the distribution does not exceed your stock basis. Also be sure to be aware of the various ordering rules for adjusting stock and loan basis in an S corporation.

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Are You A Trader or an Investor? Van Der Lee v. Commissioner TC Memo 2011-234

November 29, 2012 Basis, Business Expense, Business Income, Capital Gain, Capital Loss, Cost Basis, Deductible Expense, Mark to Market, Net Operating Loss, NOL, Tax Court, Tax Deductible Expenses, Tax Records

While many individual taxpayers claim to be traders in securities
as compared to investors, in Henricus C. van der Lee, et ux. v. Commissioner TC Memo 2011-234 we learn in my humble opinion that the facts and circumstances of each and every specific taxpayer’s operation must be reviewed to make a proper determination in these regards. The bottom line is though as best I can tell if you want to be considered a ‘trader of securities’ you must at the very least be able to:

1. show that your activity is for the purposes of profiting from market fluctuation rather than appreciation in underlying investment securities

2. have frequent and regular transactions and

3. elect to use the mark-to-market method of accounting under §475(f).

In Henricus the taxpayer tried to avoid the capital loss treatment of stock transactions due to the $3,000 ceiling on capital losses under §1211(b) as investors in securities cannot treat their losses on the sale of securities in any other way. As an aside ‘Dealers’ in securities are exempt from these rules due to the nature of their business as ‘Securities’ are treated like inventory. ‘Traders’ or those who buy and sell stock on a regular basis to profit from the short-term market fluctuations, are subject to the $3,000 capital loss limit unless they elect to use the mark-to-market method of accounting under §475(f).

Regardless of whether the mark-to-market election is made, traders are allowed to deduct their investment expenses as business expenses on Schedule C under §212. However the ‘trader’ has the burden of proof that these expenditures are ordinary and necessary in the production or collection of income.

In the case of Mr. Van Der Lee the main area of dispute was his trading activity. The IRS reclassified his loss on stock trades as capital losses and disallowed the claimed business expenses because the filed tax return did not have a mark-to-market election under §475(f) attached. The Tax Court considered Mr. Van Der Lee’s intent, nature of derived income, as well as frequency, extent and regularity of the securities transactions. In 2002 148 trades were processed. Of these 35 were sales of shares acquired before 2002. Also not a single security was bought and sold on the same day, a purported norm of the ‘trading’ community. As such it was determined that the potential for profit in these sales was based on the general expectation of market appreciation rather than market fluctuation.

The Tax Court agreed with the IRS that Mr. van der Lee was not a trader, but rather an investor in securities in 2002. The loss of $1,388,327 reclassified by the Service as a capital loss was appropriate and as such only $3,000 per year is available to offset ordinary income under §1211(b).

To add insult to injury the legal, travel and meal expenses were not substantiated sufficiently with no specific business purpose stated and as such were disallowed. Additionally the home office expenses claimed were disallowed under §280A because investing in securities is not a trade or business. The net result of the Court’s findings was a complete dis-allowance of all expenses. What a kick in the jimmie.

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Tax Treatment of Charitably Donated Artwork

November 27, 2012 Artists, Asset Classification, Basis, Capital Gain, Charitable Contribution, Cost Basis, Estate Tax, Tax Abuse, Tax Guidance & Preparation

Please refer to IRC 170 as well as Publication 526, Charitable Contributions (PDF), Publication 561, Determining the Value of Donated Property (PDF), and Publication 1771, Charitable Contributions Substantiation and Disclosure Requirements (PDF) for detailed information on charitable contributions. This is what I’ve learned about issues involving charitable contributions of artwork that tax examiners focus on:

1. The charitable contribution deduction for artwork by Art Galleries, Dealers or the Artist who created the artwork is generally limited to the smaller of fair market value on the date of contribution or its adjusted cost basis taking into consideration cost of goods sold to prevent a double deduction.

2. A charitable contribution deduction is generally based upon the fair market value of the property at the time of the contribution. If a sale of donated property would have generated ordinary income or a short term capital gain, the amount otherwise deductible is reduced by the amount of ordinary income or short term capital gain that would have been recognized.

3. As stated in IRC § 1.170A-4(b)(1): “The term ‘ordinary income property’ means property any portion of the gain on which would not have been long term capital gain if the property had been sold by the donor at its fair market value at the time of its contribution to the charitable organization. Such term includes, for example, property held by the donor primarily for sale to customers in the ordinary course of his trade or business, a work of art created by the donor *** ”. IRC § 1221(a)(3)(A) excludes from treatment as a capital asset property in the possession of the person who created it. In other words art created by an artist and sold by the artist is treated as ordinary income.

4. Artwork donated to a charitable organization by an Art Gallery owner or a Dealer in artwork creates a consideration as to whether the artwork being donated is actually held as an investment or is inventory of the owner. The difference being that a charitable contribution deduction for the long-term capital gain property is generally its fair market value, while the deduction for a contribution of inventory is limited to the lower of cost or fair market value.

5. The deduction for artwork that was gifted by the artist who created it to the investor is generally limited to the smaller of the gift basis or the fair market value on the date of the charitable contribution.

6. Appraisals and Valuations

  • All taxpayer cases selected for audit that contain artwork with a claimed value of $50,000 or more per item must be referred to the IRS’ Art Appraisal Services for review by the Commissioner’s Art Advisory Panel. IRM 4.48.2 provides this mandate and the procedures and information needed to make the referral can be found in IRS Rev. Proc. 96-15. Generally the best course of action is to request a review of art valuations for income, estate, and gift returns and subsequently obtain a Statement of Value from the IRS prior to filing the return. Even if the value is under $50,000, the Art Appraisal Services will assist the examiner upon request.

  • A written acknowledgment from the person making the donation is required for donations of $250 or more. For claimed charitable contributions over $500, IRS Form 8283 must be attached to the return and the taxpayer must maintain certain records.

  • For a charitable donation of property in excess of $5,000 the donor has an additional requirement of obtaining a “qualified appraisal”. IRS Form 8283 requires that the appraisal for donated art valued at $20,000 or more must be attached to the return. For property valued at more than $5,000, an appraisal summary must be attached to the return. Appraisals in the entirety for art valued in excess of $500,000 must be attached to the return. The specifics of “qualified appraisal” requirements as well as “appraisal summary” and other related requirements can be found in IRS Notice 2006-96 and 2006-45 IRB 902.

  • A charitable donee is required to file IRS Form 8282 if it sells, exchanges, or otherwise disposes of (with or without consideration) charitable deduction property (or any portion) within 3 years after the date the original donee received the property. The form is filed with the IRS and provided to the donor of the property. A third party contact should be considered to determine if the form 8282 was required and not provided.

  • In order for a taxpayer to claim a deduction for the full fair market value of tangible property donated to charity the property must be used by the charitable organization in a way that is related to its charitable purpose. For example art is generally treated as ‘use property’ for an art museum, and perhaps a school, but probably not necessarily for a rescue organization.

  • It is possible to claim a deduction for a donation of a fractional interest in art, but immediately before the donation the property must be wholly owned by the donor or shared by the donor and the charity. Special valuation rules apply to subsequent fractional gifts. The deduction may be recaptured if the gift is not completed within the earlier of 10 years after the initial fractional gift or the date of the donor’s death.

  • Section 6695A imposes penalties on appraisers in certain circumstances. Section 6662 provides accuracy related penalties on the donor.

7. Examiners consider whether corporate officers are unreasonably compensation for the duties performed when large artwork transactions are reported by corporations.

8. Examiners investigate as to whether travel is not personal in nature as travel is usually a significant item in the art and art gallery industry. Gallery owners and artists alike tend to travel to buy, sell, and track art. Only the owner’s travel expenses are deductible, NOT the expenses of family members. Trips to vacation locations such as Hawaii, California, Florida, or Colorado have the potential to be personal in nature, and are usually disallowed.

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US v. Home Concrete Reinforces IRS’ Limited Audit Authority

November 25, 2012 Basis, Tax Court

Generally, the IRS has a three year statute to audit a return. However this changes to six years if there is a substantial understatement of income, when 25% of more of gross income is omitted. The definition of what it means to omit gross income is often up for debate as shown by numerous tax court cases.

In a recent court case, United States v. Home Concrete & Supply, the Supreme Court decided that despite overstated basis, the IRS can only audit the last three years.

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Determining Tax Basis and Holding Period

November 11, 2012 1031 Exchange, 1231 Exchange, Asset Classification, Basis, Capital Gain, Capital Loss, Cost Basis, Tax Guidance & Preparation

According to IRS Publication 544 holding period is generally speaking the length of time a capital asset is owned. It is important because of the tax benefits of long term capital gain or loss treatment according to IRC Sec 1223. If the capital gain property is held for more than 12 months, gain or loss is long-term according to IRC Sec. 1222.

In determining a property’s holding period you generally exclude the purchase date but include the sale date. To determine if property has been held long enough to qualify as long-term capital gain, begin counting the holding period on the day after the property was acquired.

When the basis of transferred property carries over, as in an IRC Sec. 1031 exchange, the holding period of the prior owner “tacks on” to the current owner’s holding period according to IRC Sec. 1223(1).

If property is constructed over a period longer than one year and is sold after completion, it may have been held partly for the short-term and partly for the long-term holding periods. The cost of construction completed within the short-term holding period ending with the date of sale has a short-term holding period. The cost of construction completed more than 12 months before the date of sale has a long-term holding period. Land and improvements usually tend to have different holding periods because most people buy land first and then build on that land at a later date. As such the holding period varies based on when development begins and/or improvements constructed.

The purpose of taxing capital gains at lower rates than other income was to stimulate consummation of profitable transactions in property bought for investment according to the Revenue Act 1921, § 206(b).

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Calculating Adjusted Basis in an S-Corporation

May 16, 2012 Basis, Corporation, Sub-chapter S

It seems to me that a relatively significant problem for most Sub chapter S Corporations is accounting for the capital accounts of each and every single shareholder. The company must maintain reasonably detailed records of each shareholder’s equity investments of cash and property, loans that each shareholder advances to the company as well as distributions made to shareholders to arrive at shareholder’s equity.

Shareholder’s Equity is reflected in the shareholder’s capital account. This account should show the dollar amount of cash investments, and value of property donated to the company. A shareholder who contributed cash of $100,000, a computer worth $20,000, and software worth $4,000 would have a capital account showing a total investment of $124,000. The capital account is adjusted from time to time to reflect additional equity investments. Additionally, the capital account is adjusted at the end of the year to reflect each shareholder’s pro-rata share of income and expenses.

Unlike limited partnerships and limited liability companies, shareholders of S-corporations must divide the corporation’s net income in strict proportion to their share of ownership. If a shareholder has contributed exactly one-third of the company’s capital, then exactly one-third of the company’s net profit or loss must be allocated to that shareholder. A shareholder’s capital account needs to reflect the shareholder’s investments and current basis in the S-Corporation’s equity or liabilities. A shareholder is invested in the S-Corporation to the extent that a shareholder has made an equity investment or advanced a loan to the company.

The capital accounts come into play in two crucial parts of an S-Corporation’s financial and tax reporting. First, the capital accounts are reported on the company’s balance sheets as shareholder equity and loans from shareholders. Second, each shareholder’s capital account can be summarized on Form 1120S Schedule K-1. Insufficient capital investments can cause shareholders to fail to meet the At-Risk rules for losses and can cause business losses to be suspended or even become non-deductible. Generally speaking the adjusted basis of a shareholder’s stock is calculated as follows:

  • Adjusted basis at the beginning of the year

  • + Share of all income items that are separately stated, including tax-exempt income

  • + Share of all non-separately stated income items

  • + Share of deduction for excess depletion of oil & gas properties

  • - Distribution of cash or property to the shareholder that was not included in the shareholder’s wages

  • - Share of all loss and deduction items that are separately stated, including Section 179 deductions and capital losses

  • - Share of all non-separately stated losses

  • - Share of non-deductible expenses, such as the non-deductible portion of meals & entertainment expense or non-deductible fines and penalties

  • - Share of depletion for oil & gas properties not in excess of the property’s basis.

  • = Adjusted basis in S-Corporation stock at the end of the year

Overall, the S-Corporation reports total income and expenses at the company level, and passes-through a share of net profit or loss to individual shareholders. The S-Corporation needs to maintain excellent records regarding each shareholder’s investment of cash or property. These records are crucial for establishing each shareholder’s percentage of ownership in the company.

Generally, S-Corporation accounting is the same as C-Corporation accounting. Income and expenses are reported at the corporate level, and the nature of various types of income and expense are identified at the corporate level as well. S-Corporations can choose an accounting method best suited to report the income and expenses of the company. S-Corporations are not required to use the accrual method of accounting; they may choose the cash method or a hybrid method of accounting if those methods of accounting.

Income and expense items retain their character when they are passed-through to S-corporation shareholders. Long-term capital gains, for example, earned by the S-corporation are passed through as long-term capital gains to shareholders. S-Corporations therefore need to identify types of income and types of expenses for the benefit of their shareholders.

Donating Property to an S-Corporation. Shareholders can invest cash or property to an S-Corporation. A shareholder might contribute a computer, desk, reference books, and software programs to her newly formed S-Corporation in addition to her cash investment. The value of the shareholder’s property is the lower of (a) the fair market value of the property, or (b) the shareholder’s adjusted basis in the property.

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Acquisition Debt and Divorce

March 22, 2012 Basis, Debt, Family, Gift Tax, Home Office, Marriage, Tax Guidance & Preparation

Generally speaking IRS regulations provide that debt incurred to acquire the interest of a spouse or former spouse in a residence, incident to divorce or legal separation, may be treated as acquisition indebtedness under IRC Sec. 163 (mortgage interest deductions) without regard to the treatment of the transaction under IRC Sec. 1041 (spousal transfers).

This debt is considered incurred to acquire a residence. The IRS has ruled it is deductible for both regular tax and AMT purposes.

Acquisition indebtedness interest may also be included on IRS Form 8829 - Business Use of Home – subject to the business-use percentage for purposes of an ultimate Schedule C deduction. But when developing the tax basis in your home for purposes of depreciation deductions, a transfer subject to IRC Sec. 1041(a) is generally treated as a gift for income tax purposes. The transferee’s basis in the transferred asset is the transferor’s adjusted basis immediately before the transfer, even if the asset is subject to liabilities exceeding such basis.

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Lessons From Mitt Romney’s Tax Return

January 30, 2012 Abusive Tax Shelter, Accounting Method, Alternative Minimum Tax (AMT), Asset Classification, Audit Technique Guide, Basis, Business Expense, Business Income, Charitable Contribution, Cost Basis

Check out Mitt Romney’s 2010 tax return and learn how he does it. The most important lesson I learned in perusing his return (besides the significance of sheltering your $$ outside of the USA) is the immediate impact of targeted charitable contributions. In my professional opinion the absolute best way to reduce your tax liability is to make charitable donations of money or property. Also you can try to:

  • Avoid salary, wagesand tips if you can. Instead generate income from long-term capital gains

  • Avoid Muni-bond interest. It triggers Alternative Minimum Tax (AMT) making this investment vehicle laughable at best for the truly wealthy

  • Pursue Qualified dividends.  They are essentially ordinary dividends that meet the requirements to be taxed as net capital gains. Check out Publication 550, Investment Income and Expenses

  • Avoid the home-office deduction. It offers a small tax benefit requiring large tax prep effort (aka $$). Usually not worth the time and effort.

  • Itemizing deductions is probably not worth the personal disclosure required

  • Beware that capital gains and dividends can also trigger the AMT

  • Offshore investments are abusive because they rob the US Treasury of much needed tax revenue. Basically the US Tax Code encourages the wealthy to invest OUTSIDE OF THE UNITED STATES which is so backwards it makes my head spin.

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Communicating with the IRS Requires Organized + Detailed Note Taking

October 4, 2011 Appeals & Audit Resolution, Basis, IRS Appeal, IRS Audit, IRS Collections, IRS Enforcement, IRS Examination, Tax Court, Tax Guidance & Preparation, Tax Problems & Requests

When you call the IRS I suggest doing it as early in the work day as possible to minimize wait time.  Have a pen and pad of paper in hand and ideally be sitting in front of a computer.  Write your questions down in advance of picking up the phone and be calm yet alert. Be sure to record on the top of your notes the date and time of the call.

THE VERY FIRST QUESTIONS YOU ALWAYS WANT ANSWERED:

1. Who are you talking to?

2. How is their name spelled?

3. What is their IRS identification number?

Be polite when asking but do know that the person you are talking to is obligated to provide you this minimal information. This is also particularly important because sometimes when defending against allegations it may prove beneficial to request that the actual taped phone conversation be reviewed for accuracy and without this above information the IRS will simply not comply.  When the IRS provides documented misinformation they can and sometimes do create a basis for you to seek relief from their allegations.

Remember the person on the other end of the phone is obligated and trained (usually very well) to advocate on behalf of the US government. And this person is skilled at using what I refer to as phone tactics in pursuit of their obligations to their employer which manifests itself in a variety of ways and can cause you to experience a variety of emotions if you let it. Take solace in knowing that politeness and calmness usually prevail.

In the US Tax Court Case Stephen Meeh v. Commissioner - TC Memo 2009-18, the Court noted that the IRS settlement officer had a history of being unavailable and misrepresenting or failing to record the taxpayers’ efforts to contact the officer. The Court was of the opinion that both the tax payer and the IRS are partially at fault, but because the IRS records were so “badly muddled,” the appropriate action was to honor the taxpayers’ request for an installment plan.

Lesson here is to take better notes than your opponent because more often than not it distills down to who ever has the more precise and organized documentation gets a ruling more in their favor, unless of course their is an overt violation of the code.

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Overstated Basis Causes Understated Income However …..

October 3, 2011 Asset Classification, Basis, Business Expense, Rental Real Estate

The lesson I learned today is that an overstatement of basis (cost of an asset) could result in an understatement of income in the future when the asset is sold but is not necessarily the same as under reported income that, if in excess of 25% of reported income, would subject your tax return to a six-year statute of limitations for assessment of taxes, penalties + interest under §6501(e)(1).

The IRS’s position on overstating basis is that when the asset is sold the gain on the sale would be understated resulting in an omission of income. The Tax Court’s position as far as I can tell generally disagrees with the IRS and not all district courts seem to be on the same page either.

As such because of this confusion in the judicial system it is always best to keep precise records on the purchase of assets along with any adjustments that may affect the basis of the assets (ie improvements, depreciation expense). These records will provide tremendous support when determining the gain or loss after disposing or selling the asset.

Another reasonable report worth considering is disclosing the transaction and attaching supporting documents that provide a record of basis and adjustments to the basis. These documents will support the assessment period of the regular three-year statute of limitations.

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