Originally published on Forbes.com.
You will rarely see a better illustration of Reilly’s Fourth Law of Tax Planning, than the Tax Court’s decision yesterday in the case of William and Amaryllis Tinsley. The Fourth Law by the way is – Execution isn’t everything but it’s a lot. The Tinsleys were hoping to post a good sized negative number ($110,480) from their S Corporation (Command Computers of West Florida Inc) on their individual return. The loss was disallowed because of lack of basis. The Tinselys thought they had solved the problem of basis. Maybe they had in some sense, but not to the satisfaction of the Tax Court.
Jumping Through The Hoops
As I explain here, to post a negative number to the front page of your Form 1040, you have to jump through a series of hoops. The business generating the loss has to be a real business and the loss has to be properly allocable to you. You have to have sufficient basis, be “at-risk” and satisfy the passive activity loss rules. In that order.
Command Computers financed its money-losing activities with a loan, that was guaranteed by Mr. Tinsley. A reasonable person might make an argument that Mr. Tinsley was thereby “at-risk” for the borrowing. (There is a technical problem with that argument). It really does not matter though. The basis hoop comes before the “at-risk” hoop. And, unlike partnerships or single-member LLCs, the obligations of S corporations do not provide basis to S corporation shareholders.
But What Happens When You Liquidate?
We know that the losses of Command Computers were suspended because of loss of basis, but what happens when the company liquidates and Mr. Tinsley becomes directly liable on the debt. The Tax Court indicated that could create the basis that would free up the loss
….the Court of Appeals held that a shareholder’s guaranty of a loan to an S corporation “may be treated for tax purposes as an equity investment in the corporation where the lender looks to the shareholder as the primary obligor.”
And that is what Mr. Tinsley claims happened at the end of 2010. Command Computers liquidated, making him directly liable.
Only You Have To Prove It
This is where the execution problems come in. The business continued to operate under the name Command Computers and when the bank renewed the note in 2011, it did so in the name of Command Computers. Mr. Tinsley argued that it was merely a matter of administrative convenience. That argument went nowhere.
There is insufficient evidence in the record to permit us to make, with confidence, a finding that in both 2006 and 2011 the loan was made to Mr. Tinsley personally, as opposed to Command Computers, and that Mr. Tinsley, as the borrower, advanced the loan proceeds to Command Computers. Because petitioners failed to establish that the Bank looked primarily to Mr. Tinsley to satisfy the debt obligation or that Mr. Tinsley made an economic outlay with respect to the loan, they failed to prove they had a basis in Command Computers as of December 31, 2010, sufficient for them to deduct the reported business losses.
A detail that is worth noting that was not in the decision is that Command Computers of West Florida is recorded as having been administratively dissolved for not filing its annual report. The effective date of the dissolution is September 23, 2011. I believe it is a common practice to not do a formal filing for a liquidation and just let non-filing take care of the matter, but here we see that could be an expensive way of saving legal work. It is also worth noting that the Tinsleys were representing themselves in Tax Court.
The Moral
If you are starting a business and have income that initial losses might shelter, you are probably better off starting out as a limited liability company, which will be treated as a partnership or disregarded. This should avoid most basis and at-risk problems. Consider becoming an S corporation which can save you a bit of self-employment tax after you have achieved consistent profitability. That and try to get your documentary ducks in a row. Execution isn’t everything, but it is a lot.
Other Coverage
Lew Taishoff, the early bird of Tax Court coverage, posted something yesterday. Mr. Taishoff suggest that there might be a way to reopen the record on the case.
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