Wednesday, September 22, 2010

OOPS I Should Have Had A LLC

Randy M. Javorski, et ux. v. Commissioner, TC Summary Opinion 2010-136

I try to cultivate humility.  I have several people who assist me in this most notably my children.  And I do plenty of things to be humble about.  I mention this because I reread the Javorski case after coming up with the flippant title to the post.  I noticed that the company involved was a Canadian company, so there may have been practical cross-border issues that dictated the structure that they used. 

Nonetheless, the tale of woe in this case is a great illustration of the benefits of an LLC structure.  Randy Javorski was a manufacturer's rep for several lines of furniture and lighting.  He had long wanted to own his own furniture store.  In 2002 he formed Lucca Interiors, Inc with Stephan Eberle.  Mr. Javorski contributed $150,000 in exchange for a 49% ownership position in Lucca.  Mr. Eberle received the balance of the stock in exchange for his services.  Besides its own profit potential Mr. Javorski would also benefit from having Lucca as a customer.

Lucca was not profitable.  Mr. Javorski exhausted one line of credit and then another in making advances to allow Lucca to fund its operations.  Design Institute of America, one of the lines that Mr. Javorski represented, held him accountable for Lucca's failure to pay its bills promptly, creating more pressure for Mr. Javorski to advance funds.  In total Mr. Javorski put $382,000 into Lucca.

Lucca was unsuccessful and went into bankruptcy in 2005.  Mr. Javorski did not put in a claim, but it was conceded that he would not have received anything if he did.  The controversy in the case was the nature of Mr. Javorski's loss.  He was arguing for bad debt treatment in 2005.  The IRS said a capital loss in 2006.  The advances were not well documented as loans so the Court went with the IRS on characterization.

What would have happened if this were an LLC ?  The entity's operating losses would have been 100% allocated to Mr. Javorski (loss allocations to Mr. Eberle would not have had substantial economic effect).  It is possible that the losses would have been suspended depending on how much time Mr. Javorski spent on the enterprise and whether it would have been permissible to group it with his manufacturer's rep activity (possibly not).  Even if the losses were suspended, they would have been allowed in full since the bankruptcy would have been a total disposition.

Now we just have to hope that Mr. Javorski has some good returns in the stock market to use up that capital loss carryover.  Maybe next year.

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