In Uncategorized on 09/03/2011 at 19:41

Or, You Can’t Use It If You Can’t Lose It

Aside from bringing the law up to speed with the technology of the cellular telephone business (and incidentally deciding that holding a license to operate a cellular phone system is not a trade or business, unless you actually are operating the system), Judge Kroupa breaks new ground in the at-risk rules of Section 465 in deciding Robert and Kimberly Broz, 137 T.C. 5, filed 9/1/11.

Bob was a banker who got into the cellphone business in a big way when the FCC ran a lottery for cell license to RSAs (Rural Statistical Areas, areas underserved or unserved by the big cell operators). Bob set up a series of Sub S Corps, some of which would buy and hold the licenses, and another would build out the infrastructure and operate the system.

Bob borrowed money through his operating Sub S to pay for some of his build-out work, and pledged the stock of one of his license-holding sub Ss to secure repayment. The issue for Tax Court was whether the license holder was related, and if so, whether that disqualified the taxpayer from using the loan secured by the pledge of that stock as part of the amount for which he was at risk (and thus could use as basis and take losses currently).

Here’s Judge Kroupa: “We must decide for the first time whether stock in a related S corporation is property used in the business to preclude petitioners from being at risk for any pledge of property used in the business.

“We begin with an overview of the 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. The taxpayer is not at risk, however, for any pledge of property used in the business.” 137 T.C. 5, at pp. 28-29.

The magic words, of course, are “used in the business.”

After disposing of Bob’s assertion that stock in a business is not “used in the business”, because it can be sold without affecting the business’ balance sheet, and therefore is separate from the business, by saying that such an argument is too narrow a view because of the close interrelationship between the two Sub Ss at issue, Judge Kroupa went on: “Pledged property must be ‘unrelated to the business’ if it is to be included in the taxpayer’s at-risk amount.” 137 T.C. 5, at pp. 29-30.[citations and footnote omitted]

The stock is related apparently because the corporations are related. But the ultimate argument is the smell test.

Judge Kroupa again:” Moreover, even if the … stock is unrelated to the cellular phone business, petitioners were not economically or actually at risk with respect to their involvement with the … entities. Petitioners contend that petitioner was the obligor of last resort on the … loan. Petitioners were not actually at risk because they never personally guaranteed the … loan, nor were they ever personally liable on the purported loans to the … entities. Additionally, petitioners were not economically at risk. We have held that where the transaction has been structured so as to remove any realistic possibility of loss, the taxpayer is not at risk for the borrowed amounts. We have already determined that the structured transaction made it highly unlikely that petitioners would experience a loss.” 137 T.C. 5, at pp. 30-31.[citations omitted]

Footnote 12 at p. 30, which I omitted above, adds another wrinkle. Bob pledged the stock that he claimed put him at risk to borrow the money he claimed he lent to his other Sub S. The footnote: “Furthermore, the flush language of sec. 465(b)(2) provides that no property shall be taken into account as security for borrowed amounts if such property is directly or indirectly financed by indebtedness which is secured by the property. The … stock qualifies as “property * * * directly or indirectly financed by indebtedness” because … borrowed the funds from CoBank. Petitioners’ pledge of … stock therefore cannot be taken into account to determine whether petitioners were at risk.”

So be careful before you pledge your stock in one of your Sub Ss to secure a loan for another one of your Sub Ss. Make sure they’re different activities, trades or businesses.

And remember, whether related or not, you can’t use it if you can’t lose it.


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