Monday, June 21, 2010

The Magic of S Corporations - Tax Alchemy in Reverse

I remember a time when we had an Internal Revenue Code that was almost as old as I was. The Internal Revenue Code of 1954. Thankfully they kept the numbering scheme intact. Back then we had real tax shelters. Pure tax shelters worked on two principles. Defferal and conversion. You sheltered ordinary income with de

ductions in excess of your cash outlay. That turned around on you eventually but you recognized the turn around as a capital gain. That’s the conversion. Ordinary income taxed at 70% converted into capital gains taxed at 20%. Lead into gold.

I think it takes someone of my age to fully feel the pain of the Nathel brothers who managed to turn gold into lead with their S corporations. The arguments to salvage the situation were clever, but the tax court would have none of them and the second circuit recently confirmed the tax court. The Nathel brotheres each owned 25% of three S corporation. The same unrelated person owned the remaining 50% in each of the corporations. They entered into an agreement whereby one of the corporations was liquidated, they redeemed the third party from another and they were redeemed from the third. The third one called G&D was the source of their tax troubles.

G&D had been experiencing losses so the basis in their stock was exhausted. Additional losses had reduced their basis in loans of $649,775 that they had each made to around 112,547 each. In addition they had guaranteed about 2.5 million of G&D debt. In 2001 G&D fully repaid their debt. Then they each made a capital contribution of $537,228 to G&D which allowed them to be released from their guarantees. Then they surrendered their stock in G&;D in accordance with the restructuring.
The bottom line of their check swapping with G&D was ordinary income of $537,228 from the debt repayment and $537,228 of capital loss from the stock redemption. They tried two arguments. The first was that the capital contribution was a form of exempt income to the corporation. If the corporation had income it would go first to restore debt basis rather than stock basis. The second argument was that the capital contribution was motivated by getting out of the debt guarantee and therefore should be an treated as an ordinary loss. Neither argument went anywhere.

There are two observations to be made here. The first is that it is possible that LLC’s would have better served their purposes. The unified basis of partnership interests would likely have prevented this odd result. The other is that just a little bit of paperwork might have also saved the day. If the S corporation loans had had written evidence of indebtedness then the repayment would have been a capital gain.

All in all, it is a sad tale.

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