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Discussion Forum Index --> Advanced Tax Questions --> Business bad debt? into 1120S? 1065? audit risks?

Discussion Forum Index --> Tax Questions --> Business bad debt? into 1120S? 1065? audit risks?

Etnacpa (talk|edits) said:

1 January 2009

1. Is Jack in the business of lending, in which case he gets ordinary losses on bad loans?

 Please estimate likelihood of winning on the merits.

2. If Jack contributes his entire business to a new wholly owned S corp, does the S corp have all the same arguments for being in the business of lending as Jack does if he does not contribute? 2.2 Does it matter if Jack uses an existing S corp [JS} which has existed seven years. JS's sole function so far is to be General Partner of Jack's Family Limited Partnership [FLP], with a 2% share in rental income and interest netting about 100k per year total, 2k to S corp. 3. Please estimate likelihood of audit if Jack claims loss on his Schedule C? 4. Please estimate likelihood of audit if Jack's S corp claims loss? 5. Please estimate likelihood of audit if Jack's FLP claims loss? [We understand we need FMV as of date of contribution, which is hard to know. We would have to allocate built in losses to Jack under IRC 704c regulations, so only future losses can be spread to five LP's other than Jack's living trust which owns 70 % of FLP, so we don't plan to do this 2008, maybe Jan 2009.] 6. Please estimate likelihood of audit if a new partnership claims a loss, maybe one between Jack and his 70 year old wife. [Both seem quite healthy.]

7. Jack wants to know if this is a business bad debt or a loss on the stock. 8. Any other ideas are welcome.

Facts: >From 2002 to 4/24/06 My client Jack, a California resident, made seven loans totaling about 2.2M to Startup, via a dba, JB Financial Services which has been in the business of lending money since 1985. Jack had no relationship to Startup before these loans. JB Financial Services [JB] was licensed as a broker dealer by the state of California Dept of Corporations in 1995.

JB's 29 loans since 1995 totaled over 2.7 million [2.7M]. From 1985 to 1995 JB made about 22 loans totaling more than 1.6M. Jack's Sched C reported the interest received and expenses paid on the cash basis. The business has been designated as "consulting lending." and has paid SE tax when appropriate. All loans have prom notes, interest, records are good. Jack thinks he has been in the lending business. However, Jack is 88 and 1040 says he is retired through 2007.

1/1/07 the Startup debt was converted to 4.0 M sh of common stock at which date the quoted value was 15 cents, or 600k. [This was almost forced, as Startup not been paying interest off and on since 2005, and owners had found new financing which insisted that Jack convert his debt to equity. As result stock jumped to 2.85 briefly in 2007.] The 3 Startup Founders executed a personal guarantee that they would make up the difference between Jack's realized value on October 1, 2008 and 60 cents a share.

On October 1, 2008 the stock was worth 4.0 Million shares x .015 cents a share = 60k and the guarantee might then be value at 2.4 M less 60k About 2.3M

However, guarantors seem to have no assets other than home of two of them. Guarantee is backed by a second deed of trust on on that California residence. The stock certificates are still stamped "restricted" despite an agreement by Startup to get the shares freely traded. Also, Startup has advised Jack that he is an insider under SEC rules. Rule 144 limits how much he can sell to about 400k a quarter even if stock were not "Restricted." Schwab and Edwards, 2 brokerage firms, refused to sell any of the stock with Restricted stamp on it.

Startup is almost broke so Jack is trying to realize from the guarantors. He has counsel, and is seeking non judicial foreclosure, and tells me he would have a judgment against the guarantors. Guarantors claim guarantee is void. Result is uncertain.

Jack anticipates he will lose about a half million. Could be he will lose everything,we have not found a market for guarantees in litigation. Or he might, eventually, make money if he buys at foreclosure. Maybe he would buy with cash, still get judgment?

Question 7: Jack wants to know if this is a business bad debt or a loss on the stock.

Taxea (talk|edits) said:

1 January 2009
I'm just so curious as to your motivation for this post especially after looking at your "resume".taxea

Etnacpa (talk|edits) said:

2 January 2009

thanks for reply.

After 20 hours research, many points I have not yet found discussed in Checkpoint. Maybe some other source, or your experience, would be helpful. Supposedly Harvard and honors on CPA exam mean I am bright, but I only am familiar with part of the relevant law.

Of course, what we do discuss might help someone else. I have read a lot I have not restated here.

Below are some more questions. B and C are maybe easiest to address....

A. Is it so obvious client got equity? He got a guarantee of 2.4M, and stock worth 600k at time of exchange, if it was not restricted and insider stock, making it unsaleable by him, even now. I recognize that this looks somewhat like preferred stock.... He points out that the value was and is in the guarantee. Guarantee of 2.4M did not mature till Oct 1, 2008, when stock's bid price was only 60k, and he was and is still unable to sell the stock at all. If stock originally, did it become a guarantee then?

Is it a return position to say it is not stock, since value is primarily not in stock?

B. Is a guarantee a debt? Checkpoint is clear that guarantors get a bad debt when and only when they pay, or maybe later if prospect of reimbursement. I have not yet found any discussion of whether creditorunderline text has a bad debt under IRC 166 if guarantors cannot or will not pay, as opposed to a loss under IRC 165.

C. Also he has another group of loans, 1.2M to a corp he owns 3% of. Up to 2 years in default. If he contributes entire lending Sch C, assets and activity, to an S corp not now in the lending business, does he weaken his case that lending activity is a business? Checkpoint's FTC 2nd is clear that it's ok if and only if transferee is in lending business when loan goes bad. But I have found no discussion when transferee is S corp, C corp or partnership. And certainly S corp does not have same history that Sch C does. Is 20 years of Sch C lending imputed to transferee S corp? IRC 355 is analogous, and favorable. But analogy is not conclusive.


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