When Can a Loss Hurt Your Tax Bill?

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There’s nothing like misunderstanding tax loopholes to ruin a perfectly good day … or a perfectly good tax strategy! But it happens all the time, usually at a cost to the taxpayer in question. For example, I had a client recently whose misunderstanding wound up tacking another $25,000 onto her tax bill!

Sinking money into a business venture that ultimately fails is no fun. But when you get to pay over and above your lost investment for that privilege, it becomes a really lousy experience.

That’s what happened to a taxpayer who owned 25% of an S Corporation in Florida. The S Corporation was a heavy-construction contractor that worked on government public works projects. To be able to bid on such huge contracts the company was required to have construction bonds in place first, which it did … to begin with.

Despite some pretty significant revenues on paper, the company lost money in 4 out of 6 years, mostly due to cost overruns on a major project. About two years before the company went under it began defaulting on its bonds. This meant that no other company would provide a bond for it, which essentially left the company unable to function. Around the same time the company got into a major lawsuit over the cost overruns.

Without the ability to obtain construction bonds the company folded. It took about 2 years to work everything out, but at the end of the day the corporation had about $20 million in debts cancelled. It had hoped for money from the lawsuit, but that wound up eventually settling with everyone walking away. No damages were ever awarded to the company in the case.

Over the years our taxpayer had accumulated over $5 million of passive losses in the S Corporation, but these far outstripped his basis (the money he originally invested). S Corporation shareholders can only deduct losses up to the value of their basis. After that they are stuck with the losses until they can create more basis in the company – usually by providing additional funds or assets. And in most cases passive losses can only offset passive income … so without passive income the losses become “suspended” and just hang around until they are either used up, or you sell or otherwise dispose of your interest in the investment.

A funny thing happens when debts are cancelled. The IRS performs a sleight-of-hand magic trick that turns the amount of that forgiven debt into income … and then taxes you on it! This is an example of “phantom income” – income that only exists on paper, yet incurs taxes that are all too real.

In this case, as a 25% owner of the S Corporation our taxpayer received about $5 million in “income” as his share of the $20 million in forgiven debt. That meant he was going to become liable for taxes on $5 million. He figured that as he had more than $5 million in passive suspended losses hanging around, the two should offset each other and he’d be finally done with this bad investment. He set about filing an amended return for the year that everything had become finalized.

Unfortunately for him, the IRS disagreed with his amended return. Their position was that the taxpayer’s stock had been disposed of in the year the company ceased operations, and not several years later, when the lawsuit had settled and the company had finally wound down. This was a huge problem for the taxpayer, because under the IRS’s position he couldn’t file an amended return – the time limit for doing that had come and gone. That meant he had no passive losses to offset the phantom income hit.

Even more unfortunately for our taxpayer, the Tax Court agreed with the IRS. They ruled that the S Corporation’s stock became worthless in the year that it ceased operations, and that was the year it stopped getting construction bonds. The fact that the company was hoping to receiving money from winning the lawsuit wasn’t enough to characterize the company as being “in business” – its business had stopped when it couldn’t get construction bonds anymore.

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