Archive for Net Operating Loss

Trafficking under IRC § 280E

February 9, 2013 Appeals & Audit Resolution, Asset Classification, Business Expense, Cash Transaction, COGS, IRS Mediation, Marijuana, Net Operating Loss, NOL, Tax Abuse, Tax Court, Tax Guidance & Preparation, Tax Problems & Requests

The Internal Revenue Code is a complex beast.  In the lunacy of it all I’ve been asked to define ‘trafficking’ as it relates to 26 USC § 280E – Expenditures in connection with the illegal sale of drugs which states as follows:

“No deduction or credit shall be allowed for any amount paid or incurred during the taxable year in carrying on any trade or business if such trade or business (or the activities which comprise such trade or business) consists of trafficking in controlled substances (within the meaning of schedule I and II of the Controlled Substances Act) which is prohibited by Federal law or the law of any State in which such trade or business is conducted.”

As I understand the Controlled Substance Act the word trafficking is more often than not used in conjunction with the word ‘illicit’ as in nefarious or illegal.  This begs the very question as to whether the cultivating, possessing and distributing of marijuana in a state (Colorado) where the substance is fully legal under state law rises to the threshold of trafficking as it is used in the Controlled Substances Act.

Naturally the laws of interstate commerce should in my opinion generally prevail.  If however marijuana does not cross state borders then in my humble layman’s opinion the federal government in theory under our constitution has no basis for intervention.  Of course you will always find the pundits from the other side pontificating the evils of the drug as they swirl down their martinis and pop their pills but let’s not get into name calling.

When it comes to the IRS, the Service is obligated to enforce the letter of the federal law.  Marijuana is federally illegal and if taxpayers are in the business of cultivating it and distributing it for profit or otherwise then the argument goes they are by the letter of the federal law guilty of ‘trafficking’ in a controlled substance regardless of state law.

Presently and with all due respect the IRS seems to be lacking a standard of enforcement over dispensaries, cultivators and bakeries in these regards.  The recent court case of Olive v. Commissioner seems to make the efficacy of a dispensary’s income tax return achieve an allowable threshold when Cost of Goods sold are allowed as offsets to gross receipts but general business expenses are disallowed. This attempt at a standard is overtly far reaching in that the intent of IRC 280E as it pertains to the Controlled Substances Act was to curtail illicit activity.  If the activity is not illicit by state law then moving it around inside that state’s border should by default be transportation not trafficking.

It is my personal opinion that moving a fully legal product inside a state border is NOT ILLICIT NOR IS IT TRAFFICKING. If the substance is fully legal by state law than possessing it, cultivating it and even distributing it in no way reaches the threshold of ‘illicit activity’.

Until further tax court cases help iron out a standard I believe a reasonable solution is to narrowly define ‘trafficking’ under IRC 280E as a transaction where marijuana dispensary employee ‘X’ hands a product containing marijuana to a customer and the customer in turn hands employee ‘X’ money for the marijuana product.  In this limited time and space a transaction happens that could be argued to be perceived as trafficking and as such the expenses associated with that limited transaction should perhaps not be deductible under 280E of the Internal Revenue Code.

When trafficking is narrowly defined all other costs should by default in theory become legitimate business expenses be they general and administrative or cost of goods sold. This is just one simple man’s opinion and the Service presently has a vastly different opinion.  There is a middle ground somewhere and it appears the courts will have to find it for us. Because like it or not this is a growth industry. Tread lightly.  Stay tuned…

 

Pursuant to the requirements related to practice before the Internal Revenue Service, any tax advice contained in this communication (including any attachments) is not intended to be used, and cannot be used, for purposes of:  Avoiding penalties imposed under the United States Internal Revenue Code, or Promoting or recommending to another person any tax-related matter

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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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IRS Form 1040 Schedule C: Profit or Loss from Business

February 7, 2012 Accounting Method, Business Expense, Business Income, Car expense, Depreciation, Disallowed Expenses, Employee Business Expense, Entity Classification, FICA, Health Insurance, Hobby, Home Office, Husband/Wife, Medicare, Net Operating Loss, NOL, Passive Activity, Self Employ, Small Business, Social Security, Social Security Tax, Sole Proprietor, Start up costs, Sub-chapter S, Tax Guidance & Preparation, Tax Problems & Requests

The sole proprietorship or Limited Liability Corporation (LLC) is in my opinion the easiest type of business entity to set up and begin operating. It is not separate from its owner with the income and expenses reported on IRS Form 1040 Schedule C.

Some people have instant success with a venture that is profitable from the very beginning. However it is more common to be unprofitable in the first 24 to 36 months of operation. If you are loosing money it is important to remember that you MUST REPORT A PROFIT IN 2 OUT OF THE PREVIOUS 5 TAX YEARS TO AVOID BEING CONSIDERED BY THE IRS TO BE REALLY ENGAGED IN A HOBBY. For more details on the specifics of hobby versus business see my post at: http://johnrdundon.com/how-to-determine-what-is-a-business-vs-what-is-a-hobby/

When it comes to losses the other thing to keep in mind is that they can be limited basically in three different ways:

1. By the amount of your investment or basis limitation;
2. By the amount you have at risk or at-risk limitation; and
3. By the passive activity loss limitation.

Basis limitations do not apply to sole proprietors as they would with an S corporation shareholder or partner in a partnership. A sole proprietorship is predominantly financed by the proprietors own assets. Two obstacles must be overcome before a Schedule C loss is deductible as addressed in this particular order:

1. The at-risk limitations of IRC Sec. 465; and
2. The passive activity loss limitations of IRC Sec. 469.

The at-risk limitations apply before any loss is limited due to lack of material participation which is a threshold criteria of a passive activity. The proprietor’s at-risk limitation is calculated on IRS Form 6198. If a taxpayer cannot verify a material-participation level with respect to the Schedule C activity, then being at-risk for the loss is essentially immaterial. The at-risk concept is one that looks at the source of funds for the business. Usually sole proprietors would not be at-risk when:

• The business was financed with non-recourse loans – except for holding real property;
• A valid guarantee or stop-loss agreement is in force; or
• Amounts borrowed for use in the business are from a person with an interest in the business, other than a creditor, or who is
related to a person having an interest in the business under IRC Sec. 465(b)(3)(C).

Most all small businesses with gross receipts of $1 million or less are allowed to use the cash method of accounting (Rev. Proc. 2001-10). New proprietors generally begin using the cash method of accounting immediately. An existing business may qualify to change its accounting method by filing IRS Form 3115 – Application for Change in Accounting Method with its tax return under the automatic consent procedures. When changing from an accrual to a cash method of accounting usually a negative IRC Sec. 481(a) adjustment is deducted in the year of the change and a positive IRC Sec. 481(a) adjustment is generally reported in income over a four-year period.

Items withdrawn for contributions to charitable organizations are reported via to IRS Form 8283 Non-cash Charitable Contributions and finally to Schedule A Itemized Deductions.

Office-in-home deduction items are detailed separately on IRS Form 8829 Expenses for Business Use of Your Home rather than on the expense lines for rent, utilities, interest, etc.

Proper deduction of vehicle expenses includes a decision for utilizing the cents-per-mile deduction or the actual method. Both methods require maintaining a mileage log and an understanding
of which miles are business miles.

Additionally, an understanding of depreciation methods available, which includes knowing the weight of the vehicle, are important. IRC Sec. 179 deductions are limited to income, but regular depreciation, including bonus depreciation, can actually assist in creating or increasing an net operating loss (NOL).

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Net Operating Loss Carry Over and Carry Back – IRS Publication 536 – IRC 172 + 6511

January 20, 2012 Net Operating Loss, NOL

Generally speaking a net operating loss (NOL) for any tax year may be carried back two years and forward 20 years under Internal Revenue Code Sec. 172(b)(1)(A). A three-year carry back period applies to NOLs arising from property losses of individuals due to fire, storm, shipwreck, or other casualty, or from theft. It also applies to small businesses (average annual gross receipts under Code Sec. 448(c) are $5 million or less), farmers, and NOLs attributable to Federally declared disasters.

Chief Counsel advice (CCA) 201049035 states “Even though there are restrictions on the time within which the Service may allow a claim for credit or refund, no such statutory impediments exist to prevent the carry back of an NOL to reduce a taxpayer’s outstanding tax liabilities.” This advice was addressing a claim for refund, which actually has separate statute of limitation under §6511 – generally the longer of 2 years from date taxes were paid or 3 years from due date of return.

Carry backs of NOL’s are controlled by a separate statute of limitations (§172).  What the rules are saying is that if you qualify to carry back an NOL and file the amended return timely, you can still (sometimes) qualify to get a refund even if §6511 may otherwise block the normal statute. You need to look at both statutes separately: First the 172 NOL law, then the 6511 timing of refunds law.  Together what these laws are saying is that you can carry back an NOL and reduce taxes, but if you file the carry back too late for a refund, but still within the statute for carrying back the NOL, you can still reduce income for that carry back period, but may not be entitled to a refund.

IRS Publication 536 is a good next read on the specifics of NOL’s.

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Basis Calculation

September 20, 2011 Basis, Net Operating Loss, NOL

Under §165, in general, the basis of a partnership interest equals the sum of the amount of money contributed, the partner’s share of partnership liabilities and the partner’s distributive share of partnership income and losses. How to compute the adjusted basis of the partnership interest when there is an initial contribution to the partnership, followed by a large distributed loss that exceeds the partner’s original basis can become complicated.

Section 705(a) requires that the adjusted basis be determined by increasing the original basis by the sum of the partner’s distributive share of partnership income for the current and prior taxable years and decreasing it by the sum of the partner’s distributive share of losses for the current and prior taxable years.

It appears that if a partnership incurs and distributes
a significant loss in one taxable year, that loss is carried along in ultimately calculating what the adjusted basis of a partnership interest would be in a later year. The adjusted basis at any particular point cannot go below zero. However, this does not mean that the sum of the distributive shares of income and losses over the history of the partnership is permanently set to zero at any point that the sum becomes negative. The nondeductible portion of the loss is suspended and deducted in a subsequent year in which there is additional basis. The loss is not gone forever.

The calculation of basis will occur only when needed, and that
calculation will reflect all preceding distributed income and losses. The adjusted basis need not be calculated annually. In addition, the adjusted basis for one year does not begin with the basis set for the immediately preceding year, with any negative result for that prior period being set to zero.

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Net Operating Loss Carry Back

September 16, 2011 Alternative Minimum Tax (AMT), Net Operating Loss, NOL

I have been developing quite an expertise in resolving Net Operating Loss carry back matters yet with each new situation there is something new that seems to be discovered.

IRC section 6511(d)(2) states, a claim for credit or refund that corresponds with an over payment attributable to an Net Operating Loss (NOL) being carried back must generally speaking be filed within three years of the time prescribed by law for filing the return for the year the NOL occurred, including extensions. For example to claim a 2007 NOL carry back needed to be filed by April 15, 2010 in order for him to receive a refund of tax, assuming no extension was filed.

Also even if you are unable to receive a refund of tax for the NOL carry back, the NOL must still be carried back to determine the amount of NOL that can be carried forward unless a timely filed election is RECEIVED by the IRS foregoing the carry back.  The NOL carry back can however be used most of the time to offset past tax liabilities owed to the US Treasury.

What is troubling me today is Alternative Minimum Tax NOL Carry backs which I will blog about more as I learn.

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“NOL Carry Back Allowed to Reduce Outstanding Tax Liability”

July 21, 2011 Net Operating Loss, NOL

Check out what I read in a recent edition of the NATP‘s TaxPro Weekly publication about Net Operating Loss Carry backs (NOL)….

“Chief Counsel Advice (CCA) 201049035 cleared the air regarding whether there is any limitation period applicable to reducing a taxpayer’s tax liability based on a net operating loss (NOL) carry back.

Generally, a claim for credit or refund of an overpayment must be filed by the taxpayer within three years from the time the return was fi led or two years from the time the tax was paid, whichever is later [§6511(a)].  However, §6511(d)(2) provides an additional special period of limitation for a claim for a refund or credit relating to an over payment attributable to an NOL carryback.

The relevant portion of §6511(d)(2) provides, in lieu of the three-year period of limitation prescribed in §6511(a), the period shall be the period ending three years after the due date of the return (plus extensions) for the taxable year of the NOL.

In this case, the IRS disallowed the taxpayer’s claim for credit because it determined the claim was untimely. However, the NOL carry back, if allowed, would not result in an over payment, which would generate a credit or refund, but would simply reduce the taxpayer’s outstanding tax liability.

The CCA concluded that even though there are restrictions on the time within which the IRS may allow a claim for credit or refund, no such statutory limitation exists to prevent the carry back of an NOL to reduce a taxpayer’s outstanding tax liability. Therefore, if an NOL has not been claimed and the taxpayer has an outstanding
tax liability, the statute of limitations may prevent a refund but will not prevent the NOL carryback from being applied to reduce the taxpayer’s outstanding tax liability.”

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Financial Statements: Compilation Vs. Review (SSARS) No. 19

June 23, 2011 Accounting Method, Net Operating Loss, NOL, Self Employ, Small Business, Sub-chapter S, Tax Abuse, Tax Fraud, Tax Guidance & Preparation, Tax Problems & Requests, Tax Relief

Yesterday I had the please of attending a tax conference sponsored by the Public Accountant Society of Colorado.  This particular topic presented by Dr. Pat Seaton of the University of Norther Colorado caught my attention.  The following is a compilation of my notes from this most excellent presentation on the difference between compiling a financial statement and reviewing a financial statement. The bottom line is that there is a huge difference between a ‘compiled’ financial statement and a ‘reviewed’ financial statement in regards to the independence of people actually preparing the report.

Effective December 15, 2010 Statement of Standards for Accounting and Review Services (SSARS) No. 19 defines compilation as follows. A compiled financial statement represents the most basic level of attest service.  It is NOT an assurance. They are usually performed for privately held companies with simple situations that do not require third party review.  The objective of a compiled financial statement is to assist management in presenting financial information in the form of financial statements without undertaking to obtain or provide an assurance that there are no material modifications that should be made to the financial statements.

A compiled financial statement does not:

  1. Perform inquiry, analytic, or review procedures

  2. Understand or attempt to understand entities internal controls

  3. Assess fraud risk

  4. Test accounting records

  5. Perform audit procedures

A financial statement REVIEW is an attest engagement and an assurance engagement.  Procedures are conducted such that sufficient evidence is accumulated and reviewed to provide a reasonable basis for obtaining limited assurance that the financial statements are free of material misstatement.

Financial statement reviews require a more extensive level of knowledge of the taxpayers industry, business and accounting practices.  The detail required however is less than an audit. Limited assurance is obtained by designing and performing analytical procedures and inquiries based on an understanding of the taxpayers industry and perceived risk.

A financial statement REVIEW does NOT

  1. Understand the entities internal controls

  2. Assess fraud risk

  3. Test accounting records

  4. Perform audit procedures

In comparing and contrasting financial statement compilations vs. reviews based on the criteria of evidence, engagement letter, required procedure, management representation, documentation, independence and reports the following observations have been made.

  1. Evidence does not apply in a financial compilation. However in a financial review evidence is accumulated and reviewed using analytical procedures and inquiry that provide a reasonable basis for obtaining limited assurance.

  2. Engagement letters are NOW REQUIRED for both a financial compilation AND financial review.  An engagement letter for a financial compilation needs to include the statement that the objective of the compilation is to assist management in presenting financial information in the form of financial statements; that the information was obtained WITHOUT assurance that there are no material modifications that should be made to the financial statements for conformity; that a compilation differs significantly from a review or audit; that the person conducting the compilation has or does not have independence impairments; that the financial statements are to be used by a third party; and, that substantially all disclosures may be omitted. An engagement letter for a financial review needs to include a statement that the objective of the review is to obtain limited assurance that there are not material modifications to the financial statements and that limited assurance is obtained; that the taxpayer’s management will sign a letter confirming representation made during the review; that analytical procedures are applied to the taxpayer’s financial data; that a review is substantially less in scope than an audit and does not obtain an understanding of the entities internal control, fraud risk, or accounting record test.

  3. Procedures.  Compiled financial statements require that the person compiling the statements consider whether the statements appear to be appropriate in form and free from obvious material errors.  Financial statement reviews require that the person conducting the review design and perform analytical procedures; make inquiries; accumulate and review evidence; and obtain reasonable assurance.

  4. Management Representation. A compiled financial statement does not require written representation. However written representation is required for all reviewed financial statements stating that management represented facts accurately

  5. Required Documentation.  A compiled financial report requires an engagement letter; a statement of findings of significance; communications to taxpayer regarding fraud or illegal acts discovered.  However documentation for a financial statement review is intended to provide the principal support for the representations in the report and the conclusion that the person preparing the report is not aware of any material modifications that should be made to the financial statements including findings of significance such as fraud. Additionally a financial statement review will require the following addendum: analytical procedures performed; additional review procedures performed; significant matters covered in inquiry procedures; significant unusual matters considered; any other findings of significance; and. the management representation letter that all info provided was accurate.

  6. Independence. A person may not have expressed independence from the entity in question to compile a financial statement .  However the lack of independence should be disclosed and considered.  The reasons for the lack of independence may by disclosed but are not required.  However if the reasons for lacking independence are disclosed all reasons  must be disclosed. In a financial statement review independence of the people preparing the review is required.  A financial statement review engagement may not be performed if independence is impaired.

  7. Reports.  A financial statement compilation is required if third party usage is expected.  The report should be titled either Accountant’s Compilation Report or Independent Accountant’s Compilation Report followed by the date the report covers.  A financial statement review requires a written report titled Independent Accountant’s Review Report followed as well by the date the report covers.

A ‘compiled financial statement report’ usually has a date, title and three paragraphs. Paragraph 1 identifies the entity; states that the entities financial statements have been compiled; identifies the compiled financial statements; and, includes a statement that the financial statements have not been audited or reviewed and provide no opinion or assurance.  Paragraph 2 should state that the management is responsible for the financial statement and for internal controls over financial reporting.  The third paragraph states the objective of the compilation and that the compilation was conducted in accordance with SSARS No 19.

A ‘reviewed financial statement report’ usually has a date, title and four paragraphs.  Paragraph one identifies the entity; states that the financial statements have been reviewed; identifies which financial statements have been reviewed; includes a statement that the review consists applying analytical procedures and making inquiries as well as another statement that the review is substantially less in scope than an audit and that the person preparing the report has no opinion about the report.  The second paragraph should state the management’s responsibility for the financial statement and for internal controls over financial reporting.  The third paragraph should state that the review was conducted in accordance with SSARS No. 19 requiring the person preparing the review to perform procedures to obtain limited assurance and that the results of the procedures provide a reasonable basis for the report.  The fourth paragraph should state that based upon the review the person preparing the review is not aware of any material modifications that should be made to the financial statement other than modifications made in the report.

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How to Account for Net Operating Loss when Merging Entities

June 20, 2011 Net Operating Loss, NOL, Small Business, Tax Guidance & Preparation, Tax Problems & Requests, Tax Relief

You can merge both a profitable entity with an entity that has a Net Operating Loss assuming that both entities have common ownership or sufficient overlap and a limited history of owner shifts. The Net Operating Loss of the dissolved entity can be utilized for the surviving entity according to Section 381 of the Internal Revenue Code assuming that the merger is a tax free Type A reorganization.

However matters involving NOLs are often more complicated than you’d expect.  There may be some limitations on the use of the NOLs under IRC 384 which you may have to take into consideration depending on your future plans. The bottom line is that you need to either come up to speed on treatment of NOL’s according to the Internal Revenue Code or engage an expert to render an opinion before entering into any transaction.

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How to Properly Close Down Your Business

June 16, 2011 Appeals & Audit Resolution, Asset Classification, Back Taxes Owed, Debt, Disallowed Expenses, Distributions, Entity Classification, IRS Collections, IRS Enforcement, IRS Levy, IRS Lien, Net Operating Loss, NOL, Paying Taxes, Self Employ, Small Business, Sole Proprietor, Stock Options, Tax Guidance & Preparation, Tax Problems & Requests, Tax Relief

Closing down your business is hard and heart breaking and if you are at the point that you are actually reading this post then people have probably been nagging you for money and you are at the end of your rope.  You worked hard to create opportunity for yourself as an entrepreneur but if the best option going forward is to close the doors you are going to want to do it do it carefully and deliberately to minimize the myriad of potential negative after effects. Trust me on this I know. Unfortunately the services that I provide tend to serve as a major catalyst in forcing that which for many is a MAJOR LIFE DECISION to either close a business or re-dedicate stakeholder resources (time, money and/or risk appetite) towards keeping an operation viable.  Although I’ve been involved with many small business successes I’ve also been involved with many business closures.  Through that process I’ve come up with a check list of action items requiring attention after your accountant quits.

When closing a business typical actions are taken. You must file an annual return for the year you go out of business. If you have employees, you must file the final employment tax returns, in addition to making final federal tax deposits of these taxes. Also attach a statement to your return showing the name of the person keeping the payroll records and the address where those records will be kept.

The annual tax return for a partnership, corporation, S corporation, limited liability company or trust includes check boxes near the top front page just below the entity information. For the tax year in which your business ceases to exist, check the box that indicates this tax return is a final return. If there are Schedule K-1s, repeat the same procedure on the Schedule K-1.

You will also need to file returns to report disposing of business property, reporting the exchange of like-kind property, and/or changing the form of your business. If you do not have a pre-printed envelope in which to send your taxes, refer to the IRS’ Where To File page for a list of addresses. Below is a list of typical actions to take when closing a business, depending on your type of business structure:

Checklist

References/Related Topics

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