Posts Tagged ‘debt’

William Rutter is no dummy. A world-renowned scientist in the field of biotechnology, he earned a degree from Harvard and PhD from the University of Illinois before performing postdoctoral work at the Nobel Institute in Sweden. He has published over 400 scientific papers, holds over 25 patents, and has earned millions upon millions of dollars developing HIV and Hepatitis vaccines.

Late last week, however, all of Rutter’s accomplishments and accolades served only to validate a suspicion Albert Einstein voiced decades ago: the hardest thing in the world to understand is the income tax. After all, if a genius like Rutter can wind up on the losing end of a Tax Court decision, what hope do the rest of us have?

Continue reading on, Forbes.com

Authored by Tony Nitti, Withum Partner and writer for Forbes.com.

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Guillermo Arguello worked for Guggenheim Investments, a conglomerate of entities of uncertain purpose. Mr. Guggenheim struck up a business relationship with another corporation, Netrostar, that was intended to be symbiotic: Guggenheim Investments would share customer lists and provide financing, while Netrostar would provide web development work to the Guggenheim entities.

Times got tough at Netrostar, and Arguello, who performed some small bookkeeping services for the company, was asked to help bail it out.

First, Arguello spent $24,000 on a used Alfa Romeo that was needed — for some odd reason — to keep Netrostar alive, and sold it to the company in exchange for a note.

In addition, Arguello cosigned Netrostar credit card debt in excess of $35,000.

At the end of 2007, Arguello was still owed $21,000 on the Alfa Romeo note, and he was justifiably getting antsy with his precarious position as creditor of a dying corporation. As a result, Mr. Guggenheim worked up an agreement by which Netrostar would pay Arguello an additional $2,000 towards the note, and then Arguello would “forgive” the remaining $19,000 balance in exchange for his release as cosigner of the credit card debt.

On his 2007 tax return, Arguello claimed a worthless debt deduction of $19,000. The IRS promptly denied the debt, arguing that it had not become worthless during 2007.

Relevant Law

Under Section 166, a taxpayer is entitled to a deduction for a debt, business or nonbusiness, that becomes wholly or partially worthless during the taxable year. There is no standard test for determining worthlessness; whether and when a ebt becomes worthless depends on all the facts and circumstances.[i] In general, the year of worthlessness must be established by identifiable events constituting reasonable grounds for abandoning any hope of recovery.[ii]

The Tax Court concluded that Arguello’s receivable from Netrostar did not become worthless during 2007, primarily because the debt was not forgiven due to Netrostar’s inability to pay, but rather in exchange for getting Arguello off the hook for this co-signed credit card debt:

We cannot assume, and do not find, that as of the close of 2007, Netrostar’s financial condition, although shaky, prompted petitioner to relinquish his rights to collect the balance on the note. The evidence shows, and we find, that the debt was extinguished not so much on account of Netrostar’s ability or inability to pay, but rather pursuant to an arrangement that allowed petitioner to avoid potential liabilities in connection with the credit card accounts.

The court summarized its decision thusly:  “A debt is not worthless where the creditor for considerations satisfactory to himself voluntarily releases a solvent debtor from liability.”

The takeaway lesson, of course, is that in today’s economy, where debts are being forgiven left and right, when you are on the creditor side there is a distinction between a debt becoming uncollectible and simply forgiving the debt in exchange for some form of noncash consideration. Under the tax law, the debtor must establish that the debt has become wholly or partially worthless in order to secure a bad debt deduction.

[i] Dallmeyer v. Commissioner, 14 T.C. 1282, 1291 (1950).

[ii] See Crown v. Commissioner, 77 T.C. 582, 598 (1981).

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The following question came into Double Taxation HQ last night:

If I have a client with a 1,200,000 mortgage that was taken out to acquire a home and no home equity loan, am I limited to deducting interest on only $1,000,000 of mortgage, since it is all acquisition debt, or can I treat an additional $100,000 of the mortgage as home equity debt even though it’s “really” acquisition debt?

It’s an interesting question, because Section 163 provides a deduction for interest on $1,100,000 of mortgage interestfor “qualified residence interest,” which is further defined as “interest paid on acquisition indebtedness or home equity indebtedness…”

Section 163(h)(3)(B)(i) further provides that acquisition indebtedness is any indebtedness that is incurred in acquiring, constructing, or substantially improving a qualified residence and is secured by the residence. However, Section163(h)(3)(B)(ii) limits the amount of indebtedness treated as acquisition indebtedness to $1,000,000 ($500,000 for a married individual filing separately). Accordingly, any indebtedness described in Section 163(h)(3)(B)(i) in excess of $1,000,000 is, by definition, not acquisition indebtedness.

Under Section 163(h)(3)(C)(i) home equity indebtedness is any indebtedness secured by a qualified residence other than acquisition indebtedness, to the extent the fair market value of the qualified residence exceeds the amount of acquisition indebtedness on the residence. However, § 163(h)(3)(C)(ii) limits the amount of indebtedness treated as home equity indebtedness to $100,000 ($50,000 for a married individual filing separately).

In the question above, it would be reasonable to conclude that interest on only $1,000,000 of the $1,200,000 mortgage would be deductible, because there is only acquisition indebtedness; there is no home equity debt. In two court cases — Pau v. Commissioner, T.C. Memo 1997-43 and Catalano v. Commissioner, T.C. Memo 2000-82 — the Tax Court embraced this exact theory, denying a taxpayer an interest deduction on their mortgage balance in excess of $1,000,000 when there was ONLY acquisition debt.

In Revenue Ruling 2010-25, however, the IRS announced that it would not follow the Tax Court’s decisions in Pau and Catalano. Instead, in the fact pattern above, the IRS will allow the taxpayer to treat the first $1,000,000 of mortgage debt as acquisition debt, and a second $100,000 piece of the same debt as home equity debt, even though it is simply an additional part of the original debt. The theory being that by definition, acquisition debt cannot exceed $1,000,000 for purposes of Section 163(h)(3)(B)(ii).

This means that the first $100,000 debt in excess of that amount satisfies all the requirements of home mortgage debt: it is secured by the residence, it is not acquisition debt, and it does not exceed the FMV of the home.

Thus, even though the taxpayer has only one mortgage with a balance of $1,200,000 that was used to acquire the property, only $1,000,000 is treated as mortgage debt, and the next $100,000 is treated as home equity debt. This gives the taxpayer an interest deduction on an additional $100,000 of debt than was given to the taxpayers in Pau and Catalano.

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As we’ve discussed previously, a shareholder in an S corporation may only utilize the loss allocated to them on Schedule K-1 to the extent of the shareholder’s basis in the stock and debt of the corporation.

While a shareholder’s stock basis is fairly straightforward, establishing debt basis is another matter entirely; with the vagaries in the Code having been manipulated enough times to foster reams of case law and new proposed regulations that would liberalize, to some extent, what types of transactions give a shareholder debt basis.

And while the IRS appears willing to make some concessions within the proposed regulations, one element of shareholder debt basis remains unchanged: the loan must be made directly from the shareholder to the S corporation, and perhaps just as importantly, the shareholder must be able to prove that this requirement has been met.

To illustrate the importance of attention to detail, the courts have blessed so-called “back to back loans,” whereby a shareholder borrows money and in turn loans it directly to the corporation, provided the shareholder can establish that they, and not the corporation, borrowed the money from the third party, and that they in turn loaned the borrowed amounts to the S corporation. To the contrary, should the same third party loan the amounts directly to the corporation without passing through the shareholder first, the faulty structuring dooms the shareholder’s claimed debt basis.

Late last week, the Tax Court drove this point home once again in Welch v. Commissioner, in which an S corporation shareholders claimed she had debt basis sufficient to allow her to absorb large flow-through losses from her S corporation. Her failure to establish that the purported advances were made directly from her to the corporation, however, convinced the Tax Court to deny the debt basis and the related losses.

In Welch, Ms. Welch owned 80% of the stock of Respira, an S corporation. During 2005 and 2006, Ms. Welch had no stock basis in the S corporation, but she asserted that she had substantial debt basis. Ms. Welch claimed that she had borrowed nearly $600,000 from a Dr. Levenson and lent all these funds to Respira.

These advances, however, were either paid directly by Dr. Levenson to Respira or else represented amounts that he charged to his credit card as payments of Respira’s expenses. Dr. Levenson wrote no checks to Ms. Welch, nor did he otherwise make any payments to her with regard to the alleged loans. Ms. Welch contributed no personal funds to Respira, nor did Respira execute a loan agreement or any notes evidencing any loans from Ms. Welch.

Respira’s trial balance as of December 31, 2005, listed a $60,848 shareholder loan from Ms. Welch. Respira’s balance sheet as of December 31, 2006, listed liabilities of $66,349 “Due to Majority Shareholder”.

When it came time to file the Forms 1120S for 2005 and 2006, Respira reported net operating losses of $50,294 for 2005 and $683,059 for 2006. On her separate individual Federal income tax returns for 2005 and 2006, Ms. Welch deducted her share of the losses — 80% — against her claimed debt basis.

Ms. Welch argued that she made loans to Respira by contributing funds she received as personal loans from Dr. Levenson. She claimed that as of December 31, 2005 and 2006, she had $521,061 and $480,826 of debt basis in Respira, respectively, for amounts personally borrowed from Dr. Levenson and reloaned to the S corporation.

The IRS denied the losses, arguing that the shareholders lacked sufficient basis in either the stock or debt of Respira. The Tax Court agreed, holding that Ms. Welch could not prove that she loaned any amounts directly to the S corporation.

Foremost among the damning evidence against Ms. Welch was that while she claimed to have made loans approximating half a million dollars to Respira, the books and records of the S corporation revealed loan payable balances of only $65,000 for the years at issue, rather than the $500,000 Ms. Welch claimed to have advanced.  This, the court reasoned, was because the amounts used to fund the S corporation were not borrowed directly from Ms. Welch, but rather from Dr. Levenson, and thus were evidenced as normal liabilities on the balance sheet, rather than loans to shareholders.

Because the S corporation’s debt could not be proven to be owed directly to Ms. Welch, the Tax Court denied her claimed debt basis, and more importantly, the utilization of the underlying allocated losses.

The lesson? Even in the face of the proposed regulations, S corporation shareholders must take care in structuring any advances to the corporation. Any amounts borrowed from a third party must follow the proper channels — from the lender to the shareholder then to the corporation — and be properly recorded. In a back-to-back loan situation, each set of loans should be evidenced by formal written documents requiring interest and a stated maturity date.

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Way back in 2001, I was an indentured servant aspiring manager at PwC when I was assigned to oversee the preparation of the tax returns of a large public utility by the name of PacifiCorp. For the next two years, I’d spend 1-2 weeks a month on location at PacifCorp’s main office in Portland, Oregon. 

Looking back, I’ve got nothing but fond memories of my travels to PacifiCorp and the experiences garnered. Those trips earned me a friendship with the company’s tax director that remains to this day, introduced me to the beauty of the Pacific Northwest and the wonders of the Westin Heavenly Bed, and most importantly, it was from a PacifiCorp conference room that I first mustered the courage to call my future wife and tell her she was the most beautiful woman I’d ever seen.

My days on PacifiCorp also triggered a sea change in the focus of my career from compliance to consulting, because for the first time, I was being exposed to big, highly technical issues, and I dug it.  

Foremost among the issues facing PacifiCorp was the deductibility of interest paid by PacifiCorp’s parent holding company to its foreign shareholder. The PacifiCorp stock had recently been acquired by this newly formed U.S. holding company, and the acquisition was financed in part through loans from the foreign shareholder. At issue was whether the sizable loans — totaling nearly $5 billion — would be respected as debt from a federal tax perspective, or whether they would be reclassified as equity, making the interest payments from the holding company to the foreign shareholder nondeductible dividend payments. Because the interest payments totaled nearly $1 billion over a three-year period, there was clearly a lot at stake.

By 2003, I would flame out of PwC in highly predictable fashion, putting an end to my trips to Portland before I’d had the opportunity to find out just what the firm’s tax geniuses had concluded: were the advances debt, or were they equity?

Today, my curiosity was finally answered, as much to my surprise, the PacifiCorp debt versus equity issue made it to the Tax Court, with the court deciding in PacifiCorp’s favor that the advances were in fact debt. Apparently, shortly after I left PwC, the IRS challenged the interest deductions, litigation ensued, and the issue was finally put to bed nine years later.

First, some background into the debt v. equity debate:

Whether an advance from a shareholder to a corporation is debt or equity is an important determination. If the advance is respected as debt, payments of interest back to the shareholder will be deductible to the corporation. To the contrary, if the advance is treated as equity under federal tax principles, payments of purported interest from the corporation to the shareholder will be reclassified as nondeductible dividends.

Any analysis of debt versus equity is highly fact specific; thus, to further an understanding of the court’s reasoning in respecting the advances in the immediate case as debt, the relevant facts are listed below:

  • NAGP was a newly formed U.S. corporation established for the sole purpose of purchasing the PacifiCorp stock on behalf of a Scottish corporation, ScottishPower.
  • As part of the acquisition, NAGP issued notes totaling $4.8 billion to ScottishPower.
  • $4 billion of the notes had a fixed interest rate of 7.3% and matured in 2011.
  • The remaining $800 million in notes had a floating interest rate and matured in 2014.
  • Formal notes were issued, and both ScottishPower and NAGP treated the advances as debt on their financial statements.
  • The notes ranked equally with other debt obligations of NAGP.
  • All communication between the parties labeled the advances as debt, and the advances were treated as debt in SEC filings.
  • While interest was not always timely paid, NAGP did eventually pay all interest owed on the notes, totaling nearly $1 billion over the three years.
  • The interest was paid largely out of dividends made from PacifiCorp to NAGP.
  • In 2002, PwC determined that the debt should be capitalized; thus, ScottishPower contributed enough cash to NAGP to allow them to repay the debt and remove it from their balance sheet. No future interest payments were necessary.

The IRS challenged the treatment of the advances, arguing that they represented an equity infusion and recharacterizing the interest payments as nondeductible dividends.

The Tax Court, however, sided with PacifiCorp. Because the court’s decision would be appealable to the Ninth Circuit, the Tax Court analyzed the advance according to the 11 factors previously utilized by the appeals court:

(1) the name given to the documents evidencing the indebtedness;

(2) the presence of a fixed maturity date;

(3) the source of the payments;

(4) the right to enforce payments of principal and interest;

(5) participation in management;

(6) a status equal to or inferior to that of regular corporate creditors;

(7) the intent of the parties;

 (8) “thin” or adequate capitalization;

(9) identity of interest between creditor and stockholder;

(10) payment of interest only out of “dividend” money; and

(11) the corporation’s ability to obtain loans from outside lending institutions.

In its analysis, the Tax Court concluded that the advances were supported as debt by the following factors and for the following reasons:

(1) Because formal promissory notes were issued;

(2) Both advances had specified maturity dates;

(3) NAGP had sufficient funds, through PacifiCorp distributions, to repay the debt;

(4) If interest payments were late, ScottishPower had the right to call the notes, and NAGP pledged its PacifiCorp stock as security for the notes;

(6) The loan did not subordinate ScottishPower’s right to repayment to that of other creditors;

(7) The evidence indicates that the parties intended to create a debtor-creditor relationship; the choice of debt was not motivated by tax avoidance goals; the momentary delay in paying interest as it became due was not fatal; a subsequent short-term loan to NAGP to allow it to pay interest back to ScottishPower when PacifiCorp was temporarily barred from making dividend payments was not problematic;

(8) An 82% debt-to-equity ratio was acceptable given NAGP’s business risk;  and

(10) NAGP had sufficient cash flow to pay the interest.

Based on the foregoing, the advances made from ScottishPower to NAGP were respected as debt, and the resulting interest deductions were permitted, thus concluding a once unresolved chapter in my life. So this is what it feels like, when doves cry.

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I’m like Randall from Clerks, only the exact opposite: I like people, but I hate gatherings. Particularly dinner parties. Oh, how I hate dinner parties.

This is largely due to the fact that I’m awful at small talk, which in turn is largely due to the fact that I’m only well-versed on two things in life: sports and The Simpsons. And while this may make me a hit with the 14-21 year old demographic, most adults seem largely unimpressed with my ability to list 20 people who’ve worked alongside Homer at the Springfield Nuclear Power Plant.

No, the majority of my contemporaries prefer to talk about grown-up topics like mortgage rates and lawn care and the various pros and cons of the local school systems. Now, call me immature, but when I get stuck talking about any of this stuff, it makes my brain want to flee my body, sort of like this:

As my wife constantly reminds me, however, I am now a husband and a father, and by extension, a grown-up. I can no longer avoid uncomfortable conversations by stuffing my pockets with cocktail shrimp and waiting out a party in an upstairs guest bathroom. I’ve got to grin and bear it, which means I’ve got to be prepared.

And you should be too. Whether you’re socially challenged like me or not, as CPAs, new acquaintances expect us to be experts on all things finance. It matters little if you’ve spent your entire career preparing consolidated corporate tax returns, your neighbor Bill will inevitably look to you for advice on funding little William’s 529 plan.

That’s why I’ve put together the following FAQ. As you may have heard, our nation has been dealing with a bit of a debt problem. On Tuesday, legislation was passed as part of a “deficit reduction deal,” allowing the U.S. to narrowly avoid defaulting on its obligations and preventing us from becoming the largest province in the Chinese empire.

It’s only a matter of time before someone asks you what the deal is about the deal. So read on, and you can thank me after your next dinner party.

Wait…what happened?

The U.S. almost defaulted on its outstanding debt. The U.S. Treasury is no different then MC Hammer or Mike Tyson; it can’t cover its expenses strictly from the revenue it earns. As a result,  it looks to borrow.  However, the Treasury can only borrow money as long as the total debt doesn’t exceed a ceiling stated by law.  As of July 2011, the U.S. had maxed out its $14.3 trillion borrowing limit, meaning unless the President found some serious loose change under his couch cushions, we would have to either increase the debt limit or risk becoming unable to service our obligations, potentially leading to default.

So how did we avoid default?  

To change the debt ceiling, new legistlation must be passed. This was accomplished mere hours before default was likely, when lawmakers agreed to increase the amount the U.S. could borrow from its lenders, while simultaneously requiring the government to cut its spending in an effort to reduct the deficit. This may seem counterintuitive — akin, if you will,  to trying to curb your wife’s shopping habit by handing her a shiny new VISA but advising her to take it easy at Ann Taylor Loft —  but it accomplished the task of keeping us out of default.

How much additional cash can we borrow?

The legislation will raise the debt ceiling by $400 billion today, then another $500 billion in September. It will then be increased by another $1.2 trillion to $1.5 trillion. That’s a total debt ceiling increase of $2.4 trillion, or just enough to cover Albert Pujols next contract.

What kind of budget cuts are we facing? 

Much of the first $900 billion of spending cuts will likely come from our defense budget. So while we may become a more fiscally responsible nation,  in ten years there will be nothing to prevent the King of England from marching right through your front door and pushing you around. So there’s that to consider.

Where are the tax increases?

Despite an abundance of rhetoric over the past few months, the current proposal doesn’t account for any additional revenue raisers — tax or otherwise. Only reduced spending.

Can you really reduce a deficit by merely cutting spending and not raising additional revenue?

Sure you can, but as Chris Rock once said, you can also drive a car with your feet, but that don’t make it a good idea. It’s extremely likely that when the bipartisan committee assigned to reducing the deficit puts their heads together later this year, tax reform will be on the menu.

What kind of tax reform might we see?

In light of these recent developments, I would wager a guess that any reform may well be sweeping, the likes of which we haven’t seen since 1986. I just wouldn’t expect to see any major changes in 2011, since the bipartisan committee has a tight window to work with in meeting its November 2011 deadline for recommending additional deficit reduction strategies.

From a long-term standpoint, however, several proposals are currently on the table, including the following:

Obama’s Plan:

  • Includes an extension of the Bush tax cuts after 2012 for only those earning less than $200,000 ($250,000 for MFJ).
  • Eliminating tax breaks for big oil and corporate jets.
  • A permanent extension of the R&D credit.
  • Keeping the 3.8% Medicare contribution tax on certain unearned income after 2012.

These proposals keep with Obama’s theme of targeting the wealthy and demanding that they pay their “fair share.”

The Gang of Six Plan

White House Deficit Commission

  • Reducing tax rates, but eliminating or reducing many current tax incentives, including the deduction for home mortgage interest, accelerated depreciation, lower rates on capital gains and the earned income credit.
  • Individual rates would drop to a range from 8-23%, though dividends and capital gains would be taxed as ordinary income.
  • Eliminating the AMT.
  • Repealing the state and local tax itemized deduction and reducing the charitable contribution deduction.
  • A single corporate rate of 26% and elimination of the Section 199 deduction.

That should give you everything you need to handle any unsolicited questions with aplomb. You’ll notice I’ve only provided facts; no opinion. It’s been my experience that in a social setting, one should never offer their views on politics, religion, or just how overrated Lady Gaga is. It can never end well.

Instead, just drop some deficit reduction deal knowledge. You’ll be a bigger hit at parties than this dude. 

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