By Stephen J. Dunn
A client recently came to me after his company had undergone an excruciating IRS audit. He was represented in the audit by one of the larger law firms in town—I did not recognize the name of the attorney. The audit ended in a negotiated settlement which the client believed favorable. But the audit drained the company of hundreds of thousands of dollars paid in attorney and accountant fees. And the client has no hope of paying the settlement amount, however favorable he believes it to be. Upon my advice, the client will do something he should have done long ago: abandon the company.
Internal Revenue Code Section 165(a) allows a deduction for losses incurred during the year and not compensated by insurance or otherwise. Deductible losses include investment securities, such as stocks or bonds, that become worthless during the taxable year. For an investment security which does not trade on an established exchange, insolvency of the issuing corporation is the best evidence of worthlessness. A company is insolvent if the amount of its liabilities exceeds the fair market value of its assets, or if it is unable to pay its debts as they come due.
Under Internal Revenue Code Section 165(g)(1), a loss from an investment security becoming worthless during the taxable year is a capital loss. Capital losses may be offset against capital gains. In addition, an individual taxpayer can deduct against ordinary income no more than $3,000 of capital losses in excess of capital gains realized during the taxable year. An individual taxpayer’s unused capital losses may be carried forward and treated as realized in future tax years indefinitely.
But if the taxpayer is an individual, and the worthless stock is Internal Revenue Code Section 1244 stock, then the taxpayer may treat up to $50,000 of the loss as ordinary (up to $100,000 of the loss in the case of a husband and wife filing a joint tax return). “Section 1244 stock” is stock in a domestic corporation if—
(A) at the time such stock was issued, such corporation was a “small business corporation,”
(B) such stock was issued by such corporation for money or other property (other than stock and securities), and
(C) such corporation, during its five most recent taxable years, derived more than 50% of its aggregate gross receipts from sources other than royalties, rents, dividends, interest, annuities, and sales or exchanges of securities.
A corporation is a small business corporation if the aggregate amount received by the corporation for its stock, or as a contribution to its capital, does not exceed $1,000,000.
If the old company has valuable assets which the taxpayer wishes to use in the new company, the taxpayer should have them appraised at forced sale value, and have the new company pay the old company that amount for them. Alternatively, the old company could file a chapter 7 bankruptcy case, and the new company could attempt to buy the assets from the bankruptcy trustee.
Successful implementation of this strategy will yield the taxpayer a loss deduction, ordinary or capital, for his cost basis in the abandoned company. If the abandoned company was effectively organized and operated as a corporation, and the taxpayer did not personally guarantee any of its debts, then the taxpayer will not be personally liable for any of the its debts. This includes tax obligations, with one possible exception. If the old company has unpaid payroll taxes, the IRS likely will assess the trust fund portion of those taxes personally against the taxpayer. The trust fund portion consists of income tax and Social Security tax withheld from employees’ wages and not remitted to the IRS. Trust fund taxes exclude employer matching Social Security tax. An assessment of trust fund taxes personally against a principal of a business is called a “trust fund recovery penalty.” I will address such penalties in a separate post.
The IRS Examination Division may challenge whether the stock in the old company has become worthless, or the year in which the taxpayer claims it became worthless.
My client is a good candidate for the above strategy. His business is a service business. His only significant asset is himself. He will abandon the old corporation, and begin doing business in a new one. He does not face a trust fund recovery penalty assessment. His business always paid its payroll taxes. The just-completed audit did involve retroactive reclassification of independent contractors as employees (how did this happen, given Section 530(a)(1) of the Revenue Act of 1978?), but there is no trust fund, as the compensation was entirely paid out to the workers.
We are working with a Revenue Officer from the IRS Collection Division with respect to the old company. We will have to complete a Form 433-B, Collection Information Statement, for the old company and submit it to the Revenue Officer. We will make sure that the Form 433-B is true and complete to the best of the client’s information and belief, and we will be forthright with the Revenue Officer about the new company and the client’s plans for the future.