Archive for September 2nd, 2011

As CPAs, we tend to believe that in the tax world, there’s nothing new under the sun. When dealing with an issue for the first time, our default thinking is that at some point, somewhere, the IRS or the courts must have addressed our specific fact pattern and provided just the authority we’re looking for. 

All too often, however, that’s not the case. The Code and Regulations are an ever-changing collection of cross-references, nuanced requirements, and exceptions to exceptions,  making it impossible for the governing bodies to interpret and rule on every possible scenario.

As testament to this contention, look no further than Broz v. Commissioner, 137 T.C. 5, (9.1.11), decided yesterday by the Tax Court. In Broz, the court examined two issues one would have thought would have long since been settled, but in reality were decided for the first time:

1. Does a taxpayer’s pledge of stock in related S corporation A as security for amounts borrowed by related S corporation B give the shareholder of B at-risk basis under Section 465?

2. Is a taxpayer permitted to begin amortizing a Section 197 intangible on the date of acquisition, or only upon the conduct of an active trade or business?

Facts in Broz:

Robert Broz (Broz) worked in the cellular industry. In 1991, he organized RFB, an S corporation, to acquire FCC licenses permitting him to provide cellular service to rural areas. Broz sought to expand his business, but RFB’s lenders required that Broz form new entities that would only acquire FCC licenses and hold the amounts borrowed from the lenders or RFB.

To accommodate his lenders, Broz formed Alpine, another S corporation. Alpine bid on FCC licenses for rural areas that were given away via lottery. The licenses were financed by the FCC, so Alpine routinely had amounts owing to the FCC for the balance due on acquired licenses. Alpine serviced the FCC debt by borrowing amounts from RFB. At no point did Alpine actually operate a cellular network; that activity was isolated to RFB. RFB would use Alpine’s licenses, however, to provide digital services in areas RFB’s analog licenses already covered. As a result, Alpine did not generate its own income from its ownership of the FCC licenses; rather, RFB generated the income and allocated a portion of its income and related expenses to Alpine.

Alpine claimed amortization deductions on its acquired FCC licenses beginning on the acquisition date.

As noted above, Alpine’s business was financed through advances from RFB which in turn were borrowed by RFB from an unrelated lender. While Broz never personally guaranteed the third-party loans, he did pledge his RFB stock as collateral securing the loan.


1. Does the pledge of RFB stock as collateral for the third-party loans give Broz at-risk basis in Alpine?

2. Was Alpine engaged in an active trade or business? If not, was Alpine’s amortization of its FCC licenses as of their acquisition date proper?

Tax Court:

At-risk Rules:

The at-risk rules ensure that a taxpayer deducts losses only to the extent he or she is economically or actually at risk for the investment. The amount at risk includes cash contributions and certain amounts borrowed with respect to the activity for which the taxpayer is personally liable for repayment. Pledges of personal property as security for borrowed amounts are also included in the at-risk amount. Sec. 465(b)(2)(B). The taxpayer is not at risk, however, for any pledge of property used in the business.

The Tax Court disagreed with Broz’ contention that the RFB stock was not used in the Alpine business. Broz argued that because stock represents an ownership interest in the business that can be sold or transferred without affecting corporate assets, it is inherently separate and distinct from the activities of a corporation. Thus, Broz contended, the pledge of stock of a related corporation should allow Broz to be treated as at-risk.

In reaching its decision, the court looked to the language of Section 465, which provides that pledged property must be “unrelated to the business” if it is to be included in the taxpayer’s at-risk amount. See sec. 465(b)(2)(A) and (B). Because the Alpine entities were formed to expand RFB’s existing cellular networks, and because Alpine’s only income and expense was allocated to it from RFB, the RFB stock was related to Alpine, and did not provide Broz with at-risk basis in Alpine.

Amortization of FCC Licenses:

In the most surprising aspect of the decision (more on that later), the Tax Court held that Alpine was not conducting an active trade or business. Citing prior case-law, the Tax Court noted that a trade or business does not begin until the business has begun to function and has performed the activities for which it was organized. More germane to Broz, the court also provided that “the determination of whether an entity is engaged in a trade or business must be made by viewing the entity in a stand-alone capacity and not in conjunction with other entities.”

Viewing Alpine as a stand-alone entity, the Tax Court held that it was not engaged in an active trade or business. Even though Alpine held two FCC licenses, there was no evidence that Alpine ever operated an on-air network. Instead, the on-air networks were operated by RFB, and RFB’s trade or business could not be attributed to Alpine.

Examining the language of Section 197, the court then determined that Alpine was not entitled to begin amortizing its FCC licenses, as Section 197 defines an intangible asset covered by that section as one held “in connection with the conduct of a trade or business.” As a result, Alpine could not begin amortizing the FCC licenses upon acquisition; rather, Alpine could only begin amortizing the licenses upon conducting a trade or business, which it had not done.


I found two aspects of Broz to be particularly noteworthy. First, while examining the Section 465 issue established a much-needed precedent, I am not certain why the Tax Court bothered to determine if Broz was at-risk for his investment in Alpine, as the court had already determined that Broz had no stock or debt basis in Alpine, as stock basis had been reduced to zero and Alpine was funded by loans from RFB, not directly from Broz, as is required under Section 1366. If  Broz were held to be at-risk for the pledge of the RFB stock as collateral for the Alpine loans , would that have somehow given Broz debt basis in Alpine, even though the Alpine borrowings were not loaned directly from Broz, as required? Unfortunately, the court did not clarify.

I also found it surprising that the court was unwilling to attribute RFB’s activities to Alpine for purposes of determining if Alpine was conducting its own active trade or business. It is not uncommon for taxpayers to isolate key assets — like an FCC license — in an entity for use by related entities. Clearly, RFB was utilizing the licenses owned by Alpine to operate its networks, and was even going so far as to allocate a portion of its income and expense to Alpine. This decision clearly issues a warning to other taxpayers that each individual entity that is part of an affiliated group must separately meet the requirement of conducting an “active trade or business.”

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Imagine you’re a hard-working CPA, trying to eke out a living in these troubled times. Ten years ago, you decided to go it alone, and set up your own accounting firm, a Personal Service Corporation (PSC) taxed as a “C” corporation.

As the sole shareholder and employee of your PSC, you’ve seen your blood, sweat, and tears single-handedly build your practice up from nothing to the thriving 1040 sweat-shop it is today. Along the way you’ve established countless client relationships and, as a result, a reputable name in the marketplace.

Your hard work hasn’t gone unnoticed, either. A rival CPA has recently approached you with an offer you simply can’t pass up: $1M to buy your practice. This is the day you’ve been anxiously awaiting for the past ten years, and you’ve got big plans for the money. Half of it you’ll spend on booze and fast women. The other half, you’ll waste.

Because your accounting practice doesn’t have much in the way of hard assets, the buyer is clearly purchasing the name and customer relationships; the “goodwill.” This begs the question…who owns the goodwill, the PSC, or you? After all, wasn’t it you who worked all those long hours and shook all those hands, not some faceless corporation?  

It doesn’t take long to see why someone in this situation would prefer to treat the goodwill as a personal, rather than corporate-level asset. Assume $800,000 of the $1.0M purchase price is allocated to goodwill. If the goodwill belongs to the PSC, the PSC will pay corporate-level tax on the $800,000, with no reduced capital gains rates available under the current corporate tax regime. To access the cash, the shareholder will have to either liquidate the corp or take the $800,000 out as a dividend, generating the despised double-taxation (free promotion for the blog!) common to C corporations.

If, however, the shareholder treats the goodwill as a personal asset, the $800,000 purchase price will be subject to the 15% long-term capital gain rate, with no second level of taxation. Not a bad deal when compared with the alternative.

For this reason, it is common for shareholders of PSCs, upon selling the business, to take the position that the goodwill is a personal asset. Sometimes it works. Sometimes it doesn’t. Today, in U.S. v. Howard, 108 AFTR.2d 2011- (8.29.11), it didn’t.

Here’s why…

Larry Howard was a dentist. He incorporated his wholly-0wned dentistry practice as a PSC in 1980. During that same year, he entered into an employment agreement and a covenant not to compete with the corporation. The covenant provided that Dr. Howard, as an employee, would not practice in the dentistry business within a 50-mile radius of his PSC for 3 years after the date on which held stock in the PSC. It is this agreement that would be Dr. Howard’s undoing.

In 2002, Dr. Howard’s PSC sold its assets to another dentist. As part of the agreement, $549K was allocated to goodwill, which the asset purchase agreement (APA) indicated was owned by Dr. Howard personally. As a result, on his 2002 individual tax return, Dr. Howard reported the portion of the proceeds allocated to goodwill as a long-term capital gain.

The IRS disagreed with Dr Howard’s position, arguing that the goodwill was a corporate asset, the sale of which was taxable to the corporation and the proceeds of which were taxable to Dr. Howard a second time upon the subsequent deemed distribution. The IRS took this position for one major reason:  Because Dr. Howard was an employee of the PSC with a covenant not to compete for three years after he no longer held stock in the PSC, the goodwill was a corporate asset.

The District Court, and subsequently the Ninth Circuit Appeals Court, sided with the IRS, holding that the goodwill was a corporate asset. In reaching its decision, the courts cited two prior cases which represent the leading authority on this issue, Martin Ice Cream Co. v Commissioner and Norwalk v C.I.R.

In Martin, the Tax Court established that “accrued goodwill can be attributed to an employee or to a company, depending on the employment relationship between the two.” The court added “goodwill of a corporation was an individual asset when the employer had not ‘obtained exclusive rights to either the employee’s future services or a continuing call on the business generated by the employee’s personal relationships.'” Thus, because Dr. Howard voluntarily entered into a covenant not to compete with his wholly-owned PSC, he effectively transferred his goodwill to the practice.

Similarly, in Norwalk the Tax Court determined that if an employee works for a corporation under contract and with a covenant not to compete with that corporation, then the corporation, and not the individual, owns the goodwill that is generated from the professional’s work. Even when a corporation is dependent upon a key employee — like in Dr. Howard’s dentistry practice — the employee may not own the goodwill if the employee enters into a covenant not to compete whereby the employee’s personal relationships with clients become property of the corporation.

Based on these two prior decisions, both the District Court and Ninth Circuit agreed that Dr. Howard doomed himself by entering into the covenant not to compete with his wholly-owned PSC. Both courts lended no credence to the language in the APA indicating that the goodwill was a personal asset belonging to Dr. Howard, as this would ignore the substance of the transaction, which was the sale of a corporate asset.

What Can We Learn? Martin Ice Cream established that the personal relationships of a shareholder-employee are not corporate assets when the employee has no employment contract with the corporation. Unfortunately for Dr. Howard, he had such an agreement. The decisions in Howard reinforce the already established position that only in the situation where a shareholder-employee has not entered into a covenant not to compete with his corporation-employer — thereby creating a valuable asset to the shareholder-employee that he can take elsewhere — can goodwill be treated as a personal asset rather than a corporate asset. For shareholder-employees of corporations in the service industry, this must be given careful consideration before entering into a covenant with the corporation.


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