Preserving tax losses of failed start-up ventures.by Feibel, Laurence I.
When Benjamin Franklin uttered his immortal words about death and taxes, he undoubtedly knew that among the least certain occurrences is success in commercial enterprise. One thing that may be even less certain is the ability to obtain maximum tax benefits in the unfortunate eventuality that expenditures of start-up ventures prove fruitless.
In Rev. Rul. 57-418, the IRS has taken the position that expenses incurred by noncorporate taxpayers in the preliminary investigation eventually rises to the level of a trade or business. In the absence of such classification, the expenditures are treated as nondeductible personal expenses, failing to qualify as either ordinary and necessary business expenses or expenses for the production of income. The problem is exacerbated by the fact that loss deductions will be unavailable because individual taxpayers, unlike their corporate counterparts, can generally only deduct losses which are incurred in a trade or business or a transaction with a profit motive. Only where activities rise above a general investigatory search will a possibility of obtaining ordinary deductions exist.
As a result of the tax traps inherent in start-up expenditures, careful pre-investigatory tax planning is essential. Absent such planning, a would-be entrepreneur may be faced with the unpleasant consequence of severely restricted capital losses or even of completely nondeductible expenses. This tax planning places a premium on forming a corporation before any investigation is commenced. By doing so, a would-be entrepreneur ensures himself at a minimum of generating a capital loss upon liquidation and, if certain requirements are met, keeps alive the possibility of setting up a corporation whose stock qualifies as Sec. 1244 stock, the loss on which is fully deductible, subject to annual limitations. An ounce of prevention is truly worth a pound of cure.
Ordinary and Necessary Trade or
Income tax deductions are allowed with respect to expenditures incurred while carrying on a trade or business. Thus, it is of vital concern to determine when an enterprise actually begins operations. Generally the courts have viewed this to occur at the time when the corporation performs the activities for which is was organized. This rationale can pose severe tax problems with respect to investigatory expenses incurred in pursuit of business or investment activity.
The tax treatment of unsuccessful start-up expenses depends on whether the taxpayer is of a corporate or non-corporate nature. A corporation that pays or incurs expenses in the search for, or investigation of, a new venture which proves fruitless, may deduct these start-up costs as a business loss when the corporation abandons the search or investigation. However, this loss will be trapped inside the corporation rendering it usable by shareholders only as a capital loss, deductible only against capital gains and against ordinary income to the extent of $3,000 in any one taxable year. Noncorporate taxpayers may be faced with the even more unpalatable nondeductible expense classification unless a trade or business or a transaction entered into for profit can be established.
Both the IRS and the courts generally treat activities that go beyond a general investigation search and which focus on the acquisition of a specific business or investment as a transaction entered into for profit. Thus, in such circumstances, a business loss deduction can potentially be available to non-corporate taxpayers. The key to substantiating the requisite level of activity lies in the ability to demonstrate that expenditures are not exploratory in nature but, rather, are an expansion of a sphere already within the taxpayer's domain. In other words, the expenditures must not be a part of a new pursuit but, rather, be related to an established one. Written account of preliminary meetings should be helpful substantiation in this regard, but related investigatory expenditures incurred during this time are subject to the risks described previously. In summary, it may well be advisable for a noncorporate taxpayer who has incurred fruitless investigatory expenditures to undertake activities related to the venture explored which are sufficient to be classified as a trade or business or a transaction entered into for profit.
Sec. 1244 Stock
Individuals may deduct as an ordinary loss, a loss from the disposition or worthlessness of "small business stock" issued by a qualifying small business corporation. The maximum amount deductible as an ordinary loss in any year is limited to $50,000 ($100,000 on a joint return). This possibility is appealing in that, normally, any of the aforementioned triggering events would give rise to capital loss treatment to the shareholder.
There are a number of statutory tests which must be met in order for a corporation to qualify as a small business corporation, the most critical of which is an income test. In addition, the regulations provide a judicially approved requirement that the corporation be "largely an operating company." The importance of this requirement is highlighted by its similar relevance in determining the deductibility of ordinary and necessary trade or business expenses. The remaining requirements (which, unlike the "operating company" and income requirements, apply at the time of stock insurance and not at the time of the loss) are objective in nature and are not repeated here, where a focus on planning within the Sec. 1244 provisions is maintained.
The income test requires that one of the following two conditions be satisfied during the corporation's five most recent taxable years (or, if less, the time the corporation has been in existence):
1. Less than 50% of the gross receipts of the corporation were derived from royalties, rents, dividends, interest, annuities, and sales or exchanges of stock or securities; or
2. The aggregate amount of deductions of the corporation (excluding certain deductions) exceeded the aggregate amount of its gross income.
The operating company requirement was originally inserted into the provisions to prevent situations where the Sec. 1244 requirements would literally be met but where the corporations were merely devices to convert capital losses into ordinary ones. Normally, this devise took the form of placing assets producing passive income but which have the potential for appreciation in a corporation. For example, a passive investment in common stock would normally yeild either capital gain or loss upon disposition depending on the success of the venture. However, were such an investment placed in a corporation, the investor/shareholder would be in a position to realize a capital gain if it were successful, and an ordinary loss if it were not, by qualifying under Sec. 1244.
As a result of the above described legislative history of the operating company requirement, the courts have looked to the type of income that the corporation would have derived had it been successful. Generally, if such income would have been passive in nature, then the corporation would not qualify as an operating company. Conversely, in the case of an unsuccessful venture, if the corporation's income would have been active, it is likely that the corporation would be considered an operating company despite the fact that no operations were undertaken. Therefore, it appears reasonable to conclude that the operating company requirement would not preclude the availability of Sec. 1244 loss where there is an unsuccessful attempt to begin business operations.
Tax Planning Under Sec. 1244
Because of the special ordinary loss treatment available with respect to qualified Sec. 1244 stock, it may be advisable for an investor to eschew loaning money directly to the corporation, and, alternatively, to receive Sec. 1244 stock from that corporation. This strategy has the advantage of ensuring the availability of an ordinary loss deduction in the event that the venture does not successfully materialize. In the case of loan capital, an investor's tax position would be determined under the nebulous bad debt provisions, under which an ordinary deduction will only be available if the loan to the corporation is considered a business bad debt. By utilizing Sec. 1244 stock, it may even be possible to generate an ordinary loss currently and still keep ownership of the corporation within a taxpayer's family by selling the stock of a start-up venture with growth potential as its fair market value. There are no restrictions with respect to stock sales made to a related party which are based on arm's length consideration.
The use of Sec. 1244 stock in conjunction with an S Corporation election under Sec. 1372 may also be advisable. The S Corporation election provides an investor with the ability to deduct operating losses against his other income during the start-up phase of operations. Through the use of Sec. 1244 stock, an investor obtains a measure of ordinary loss protection in the event that the venture does not materialize. Tandem use of these provisions provides an investor with a measure of "maximum tax benefit" insurance.
Timing is also of primary importance in planning Sec. 1244 stock transactions. Stock need not become worthless in order to obtain benefits under this section. Thus, a sale of stock for less than its basis to the selling shareholder would realize the ordinary loss benefit. The annual limitation on deductibility presents a tax planning opportunity if stock is in the process of becoming worthless. If near the end of taxpayer's taxable year the taxpayer has decided to terminate the venture, that taxpayer should sell stock in amount equal to the maximum ordinary deduction allowable under Sec. 1244. In the succeeding taxable year, when a "new" annual Sec. 1244 limitation is applicable, the remainder of the stock could then be sold, again at an ordinary loss. Even if complete worthlessness occurs during that succeeding year, a Sec. 1244 ordinary loss would also be available. Absent such transaction timing, the portion of the loss in excess of the annual limitation will be afforded capital loss treatment which may be usable only in part by the taxpayer.
Tax losses related to the preliminary investigation of business and investment ventures can present severe tax traps for the unsuspecting. Proper pre-investigatory tax planning through the use of corporations is therefore essential and can prevent the potential loss of tax benefits at a most unwelcome time.
Tax Planning with the AMT
The alternative minimum tax (AMT) enacted by TRA 86 provides an interesting planning opportunity concerning the creation of net operating losses (NOLs). This planning opportunity arises because the alternative tax NOL deduction is limited to 90% of alternative minimum taxable income (AMTI) determined without the NOL deduction itself. (Sec. 56(d)(1)(A).)
Say a calendar year cash-basis corporate taxpayer is operating at a substantial loss for book and tax purposes in the current year but expects to have book and tax profits in the next year of more than $400,000. A large expense item is usually paid around year-end but may be deferred to January, if tax considerations so dictate. The taxpayer should consider deferring the payment to next year rather than increasing the NOL deduction, which is subject to a limitation of 90% of AMTI before the NOL deduction. The benefit of such deferral is a current tax savings of 1% of the deferred deduction assuming the deferral generates a book/tax difference in the subsequent year.
Here's an example. Larky Corporation, a cash-basis calendar year taxpayer, expects a book loss of $1 million for 1988. It has incurred a $100,000 expense item in December 1988 which, if paid in December, would bring its tax loss in conformity with the book loss of $1 million. The corporation expects its economic situation to turn around in 1989 and anticipates book and taxable income of $500,000. This example assumes no book/tax differences other than the one created by the deferral and no differences between regular taxable income and AMTI other than the application of the NOL deduction limitation. The current benefit of deferring the $100,000 deduction to 1989 is $1,000, which is 1% of the deferred deduction. This tax benefit is the result of the interplay between the NOL deduction limitation for AMTI purposes, and the book/tax adjustment.
It should be noted that the savings in the example may essentially be a timing difference because the amount of the AMT NOL deduction not utilized due to the 90% limitation may be utilized against AMTI in future years. In this regard, the taxpayer must keep separate records of the AMT NOL deduction and the regular tax NOL deduction available for carryover purposes.
Although the planning concerning the 90% limitation is more readily implemented by cash-basis taxpayers in situations outlined above, it can also be applied by accrual basis taxpayer in a loss situation who is considering paying salaries to its more than 50% shareholders before year-end or to its employees within two and one-half months after year- end, should reconsider this strategy if AMTI (before NOL deductions) is expected to exceed $400,000 in the next taxable year. Also, an accrual basis taxpayer who can avoid incurring a large year-end expense in a situation similar to the example above should consider doing so to achieve current tax savings.
Note that when AMTI is $400,000 or less, there is no tax benefit to the deferral because the 10% of AMTI not offset by the NOL deduction would be offset by the AMT exemption amount of $40,000. Automatic Change in Method to Comply with Sec. 263A
Sec. 263A, enacted by TRA 86, provides uniform capitalization rules that apply to the production of property and the acquisition of property for resale.
Taxpayers were permitted to automatically change to the new method of tax accounting in order to comply with these rules, subject to procedures prescribed by the Commissioner. IRS Notice 88-92 explains certain of those procedures.
Taxpayers to which these procedures apply include any person, as defined in Sec. 7701(a)(1), who is required to change the method of accounting under Sec.263A, regardless of whether such person is required to pay federal income taxes (e.g., a partnership).
Those taxpayers required to change their method of accounting under Sec. 263A must attach to their return a current Form 3115 (Rev. 11-87) and complete Sec. A (items 1a, 3a, 3b, 4a, 11, and 12) and Sec. D. The following statement must be printed on top of page 1 of Form 3115: "Automatic Change in Accounting Method Under Section 263A." In addition, a 263A checklist must be attached to the tax return.
The questions required for the checklist vary depending on whether the taxpayer is a: 1. Producer of inventory property; 2. Producer of property that is not inventory but is held for sale to customers (for example, homes constructed for sale by a homebuilder); 3. Producer of property to be used in the taxpayer's trade or business ("self- constructed property"); or 4. Acquirer of property held for resale.
The IRS has not printed a "Sec. 263A checklist." Therefore, it is necessary for the taxpayer to create his or her own checklist using the headings and questions as outlined in the Notice. If a question has already been answered on Form 3115, merely reference the checklist to the applicable Form 3115 answer.
A taxpayer that has already filed, on or before October 21, 1988, an income tax return for which Sec. 263A applies but did not file Form 3115; or filed Form 3115 but not the checklist, should attach a Form 3115 (or a copy of the previously filed Form 3115) and the checklist to the first income tax return filed subsequent to October 21, 1988.
Certain taxpayers are exempted from the requirement to file Form 3115 or the checklist. These are: 1. Taxpayers in the farming business; 2. Taxpayers required to change their method of accounting merely for self- constructed property, if the average annual gross receipts for the three years before the year of change does not exceed $10 million.
Notice 88-92 serves as an "administrative pronouncement" and may be relied upon to the same extent as a revenue ruling or revenue procedure. Computing the Accumulated Adjustments Account Correctly
S corporations are required to maintain an "accumulated adjustments account" (A.A.A.) which, simply put, reflects post-1982 accumulated Sub- chapter S taxable income. The purpose of the A.A.A., is to measure the taxability of distributions made by corporations with accumulated Subchapter C earnings and profits, and avoid the double taxation of income that was already taxed to the shareholders. The A.A.A. is of little consequence to corporations with no accumulated earnings and profits (E&P) unless the S election is someday terminated and the shareholders receive distributions during the post-termination transition period.
Since distributions first reduce A.A.A. before E&P (unless all shareholders elect otherwise), proper calculation of the A.A.A. is essential for S corporations making distributions. Fortunately, once the corporation's taxable income and deductions have been determined, the A.A.A. can be calculated relatively simply: Items that Increase A.A.A.
A. Ordinary income.
B. Separately computed items of
taxable income, e.g., net income
from rental real estate, portfolio
C. Corporate-level depletion (i.e.
not oil and gas) in excess of
basis of depletable property. Items that Decrease A.A.A.
A. Ordinary loss.
B. Separately computed items of
loss and deductions, e.g., charitable
contributions, portfolio expenses,
C. Nondeductible, non-capitalizable
expenses (other than those
relating to tax exempt income),
e.g. officers' life insurance premiums,
penalties, 20% of meals
and entertainment, etc.
D. Shareholder-level oil and gas
depletion which does not exceed
basis in depletable property.
E. Adjustment for redemptions,
F. Distributions to shareholders
which are not taxable as dividends.
Note that all of the above adjustments correspondingly affect a shareholder's tax basis in the corporation, with the exception of the redemption adjustment, which does not affect the bases of the remaining stockholders. Conversely, tax exempt income (net of related expenses) increases basis, but does not increase A.A.A.
One serious logistical problem in properly computing A.A.A. is in the manner in which it is presented on the Federal income tax return, Form 1120S. The correct balance in the A.A.A. is arrived at by filling out Schedule M of the form. Unfortunately, the caption "accumulated adjustments account" also appears on Schedule L (the balance sheets). Since the A.A.A. is purely a tax concept, and the balance sheets are prepared using financial accounting concepts, the results are often incongrous. Unlike Form 1120, there is no Schedule M-1 to report differences between book and tax income. Nevertheless, the Schedule L version of A.A.A. must reflect net income per books in order to balance the balance sheets. Many return preparers feel mistakenly compelled (contrary to the Form 1120S instructions) to make the A.A.A. on Schedules L and M equal by flowing book-tax differences through the "other additions" and "other reductions" captions of Schedule M. Others reflect these differences in the "other adjustments account" column of Schedule M; however, the I.R.S. intended this column to reflect only tax exempt income and related expenses.
The problem of presenting two different A.A.A.'s on the tax return was compounded by TRA 86 which created differences in accounting for inventories, bad debts, etc., as well as the resulting Sec. 481(a) adjustment required by the changes. Other common book-tax differences which also do not affect the A.A.A. include excess depreciation, deffered deductions and losses under Sec. 267, and amortization of goodwill.
The proper method of presenting the Schedules L and M differences in the A.A.A. involves preparation of a separate reconciliation schedule attached to the return. The effect of the reconciling items will generally be cumulative and, as a practical matter, the total differences from prior years' items can be shown as one amount, and the current year's differences detailed.
In conclusion, the proper computation of S corporations' A.A.A.'s is vital in determining the amount that can be distributed to shareholders tax-free, and is accomplished by correctly filling out Schedule M of Form 1120S.
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