September 9, 2020

Frank Kronthal


In a recent memorandum opinion involving the application of the passive activity rules (see Brown v. Commissioner,T.C Memo. 2019-69), the U.S. Tax Court held that the taxpayers, despite failing to prove they met any of the quantitative material participation tests provided for in regulatory guidance, nonetheless materially participated in their restaurant business. 

The court affirmed the taxpayers' ability to fully deduct currently their share of the operating losses as a non-passive activity pursuant to IRC section 469.

Generally, a taxpayer may Not deduct net losses from passive activities - defined as any activity involving the conduct of a trade or business in which the taxpayer does not materially participate. Treasury regulations provide several quantitative tests a taxpayer can meet in order to establish material participation with the majority of those tests relying on various quantitative hours thresholds (most notably, the 500+ hours test). The taxpayers in Brown believed they satisfied several of these quantitative tests, but the court disagreed. 

However, the regulations also provide a "facts and circumstances" test. To satisfy this test, taxpayers must prove, based on all facts and circumstances that, they participated in an activity on a regular, continuous and substantial basis. Although the taxpayers in Brown did not have detailed records of the time spent in the activity, the court concluded that in each relevant year the taxpayers did satisfy the following participation tests:

1. Participated for more than 100 hours (ie,the minimum  threshold)  to potentially rely on the minimum facts and circumstances test)

2. Performed important operational roles in the restaurant - including finance/accounting product development and other activities

The court ultimately found that the taxpayers' participation was integral to the company's operation, and  as such was sufficient to satisfy the facts and circumstances test.

 In its decision, the court found that the taxpayers were able to prove material participation pursuant to Regulations 1.469-5 (T) based on all the facts and circumstances and they did in fact participate in the activity on a regular, continuous and substantial basis.

The case is interesting in that it provides rare insight into the circumstances where taxpayers may be able to rely on the facts and circumstances test to establish material participation. Satisfying one of the quantitative tests as always provides much more certainty than does relying on the facts and circumstances test at issue in this case.


Disclaimer: This article is designed to provide information in regard to the subject matter and has been prepared with the understanding that neither the Illinois CPA Society nor the author of this article is providing accounting, tax or legal advice or is performing any legal, accounting or other professional service. If accounting, tax or legal advice or other expert assistance is required, the services of a competent professional person should be sought.

September 9, 2020

Jerry Mauer
[email protected]
 
IRC Section 741 provides that the sale or exchange of a partnership interest is treated as a sale or exchange of a capital asset, except to the extent that IRC Section 751 applies, pertaining to unrealized receivables and substantially appreciated inventory. However, IRC Section 165(a) allows a deduction for any loss sustained during the taxable year and not covered by insurance or otherwise. Further, Income Tax Regulation Section 1.165-2 provides that absent a sale or exchange, a loss that results from the abandonment or worthlessness of non-depreciable property is an ordinary loss even if the abandoned or worthless asset is a capital asset.

The abandonment of a partnership interest is not a “sale or exchange” and, therefore, can result in ordinary loss as long as no consideration is received as a result of the abandonment. Any amount of consideration received (even a de minimus amount) will result in sale or exchange treatment resulting in a capital loss. Relief of liabilities is a deemed distribution pursuant to IRC Section 752 and is a type of consideration and will result in capital loss treatment. Even if a partnership has liabilities, the abandonment of a partnership interest by a partner who does not include any portion of the liability in determining outside basis should not be a sale or exchange. Also, there should be no deemed distribution or sale or exchange, and no amount realized if the withdrawing partner remains primarily liable for their share of partnership recourse liabilities after the partnership interest is abandoned, and ordinary loss treatment should be available. In the case of nonrecourse liabilities, no partner is liable for the liability. Therefore, abandonment of a partnership interest will result in a deemed distribution and a deemed sale that will result in a capital loss since the withdrawing partner cannot be liable for the liability.

To establish the abandonment of a partnership interest, the partner must show an intent to abandon, and must overtly act to abandon the asset. In Echols, 935 F.2nd 709 (CA-5, 1991), and Citron, 97 T.C. 200, the partner showed his intent to abandon his partnership interest by announcing to the other partners of his intention not to participate further. In Rev. Rul. 93-80, the partner gave written notice to the partnership of his intention to abandon.

Note: In order to abandon, the abandonment must be permissible. Therefore, it is necessary to confirm that abandonment is not prohibited under the partnership or LLC agreement.

A recent case (MCM Investment Management, LLC, 118 T.C.M. 437) (MCMIM) illustrates that an ordinary loss for a worthless partnership interest is allowed without abandoning the partnership interest. In that case, MCMIM had a controlling interest in a lower-tier partnership, McMillin Companies LLC (Companies). Companies was in the business of home building and remodeling. When the subprime mortgage crisis began in 2007, home values declined. By 2009, the year at issue, Companies had $100 million of senior debt and $65 million of subordinate debt. These debts were personally guaranteed by MCMIM and the MCMIM class A members. In 2009, MCMIM filed its partnership tax return reflecting a loss deduction of about $41 million, based on the interest in Companies having become worthless during the year. MCMIM did not abandon its partnership interest in Companies.

MCMIM and the IRS agreed that the character of the loss would be ordinary, although no mention of liability relief was discussed. The issue for the court to decide was whether MCMIM met all of the requirements for claiming a loss pursuant to IRC Section 165(a). The court looked to both a subjective and an objective determination of worthlessness.

Subjective determination. MCMIM met this test because, first, when  MCMIM filed its 2009 tax return it claimed an ordinary loss deduction for its investment in Companies, and, second, the owners and management of MCMIM credibly  testified they believed the interest was worthless in 2009 based on the devastating impact of the financial crisis that began in 2007 and Companies consistent net operating losses in the years leading up to and including 2009.

Objective determination. Companies conservative cash flow projections showed its inability to pay the senior lender in full or to have any assets remaining for the owners. MCMIM asserted that its partnership interest in Companies lacked both “liquidating valve” and “potential value” and the evidence indicated that it was extremely unlikely Companies would ever recover any value.

MCMIM holds that abandonment of the underlying partnership interest is not a prerequisite for claiming a worthless deduction under IRC Section 165(a) and provides guidance for taxpayers seeking to claim a deduction for worthlessness.

Disclaimer: This article is designed to provide information in regard to the subject matter and has been prepared with the understanding that neither the Illinois CPA Society nor the author of this article is providing accounting, tax or legal advice or is performing any legal, accounting or other professional service. If accounting, tax or legal advice or other expert assistance is required, the services of a competent professional person should be sought.

February 10, 2020

Jake Thompson
Benning Group
[email protected]

In a recent district court case (Tomseth, et al v. U.S., DC OR, 124 AFTR 2d ¶2019-5304), the court held that a C corporation that did not distribute its entire accumulated adjustment account (AAA) balance from a prior S corporation period within the post-termination transition period (PTTP) could not distribute its remaining AAA balance tax free after it re-elected S corporation status.

The taxpayers argued that any AAA balances that were not distributed to shareholders during the PTTP were still distributable on a tax-free basis when the C-corps re-elected S-corporation status (rather than a taxable dividend). According to the taxpayers, the PTTP provision only placed a temporary bar on accessing the old AAA balance tax-free while the corporation remained a C-corporation. But, once the corporation elected to be an S-corporation again, the old AAA balance could be distributed to them tax-free.

The IRS argued that once the PTTP expires, the old AAA balances are no longer available for tax-free distribution even if the corporation reverts to S-corporation status. Once the PTTP expires, the IRS’s position was the AAA balance resets to $0 after a new S-corporation election.

The district court sided with the IRS that the AAA balance resets to $0 after the PTTP expires.  Therefore the amounts were not available for tax-free distribution when the corporation re-elects S-corporation status.

Disclaimer: This article is designed to provide information in regard to the subject matter and has been prepared with the understanding that neither the Illinois CPA Society nor the author of this article is providing accounting, tax or legal advice or is performing any legal, accounting or other professional service. If accounting, tax or legal advice or other expert assistance is required, the services of a competent professional person should be sought.

February 10, 2020

Marlene Valero
marlene,[email protected]

Taxpayer held several business entities:

1. Sole Proprietorships - Schedule C _Commercial Construction and Remodeling
2. S Corp - Pinnacle _ Cast Stone Manufacturing for which Taxpayer is Majority Shareholder.
3. C Corp - RFI _ General Contractor for which Taxpayer is an Employee.

A.) Homeowner complains that quality of work done regarding cast stone project and construction was not adequate; 2011 settlement has taxpayer paying homeowner a settlement check drawn on personal funds.  Taxpayer records check payment on the books of S Corp (Pinnacle) as a loan from taxpayer to S Corp, without drawing loan documents. In 2012, S Corp (Pinnacle) has no income and is shut down later in the year. Pinnacle claims a deduction on S Corp with losses flowing into Taxpayers 1040.  IRS denies the losses because it states that the S Corp did not pay the settlement amount; it states the Taxpayer paid the settlement amount with his personal funds as a an employee of the C Corp (RFI).

B.) Taxpayer then asserts that he may deduct the settlement payment on Schedule C of the 1040, because it was paid to protect the reputation of all of his businesses.  Tax court then focuses on the origin of the loss:  Was it as a business entity or an employee activity?
Court then decides that the claim is to be only directed to the C and S Corp businesses, and 50% of the settlement amount is allocated to each the C and S Corp: 50% of the payment is allocated as a capital contribution to the S Corp and deductible by the S Corp; 50% of the payment is allocated as not deductible by the C Corp, but as an unreimbursed employee business expense deductible by the taxpayer as an itemized deduction on Schedule A and not part of AGI.

C.)  The years of activity for this case are 2011-2012.  Present tax law has discontinued the deduction of employee business expenses on Schedule A.

Disclaimer: This article is designed to provide information in regard to the subject matter and has been prepared with the understanding that neither the Illinois CPA Society nor the author of this article is providing accounting, tax or legal advice or is performing any legal, accounting or other professional service. If accounting, tax or legal advice or other expert assistance is required, the services of a competent professional person should be sought.