In Uncategorized on 06/13/2012 at 20:05

 Can Section 269 Ever Apply to a Sub S Corp?

Although I can’t think that this is a question that has kept any of us awake on any night in recent memory, Judge Swift deftly ducks it in Kevin H. Love and Ronda J. Love, et al., 2012 T. C. Mem. 166, filed 6/13/12.

Kev and Ronda aren’t even mentioned outside the caption, although their facts parallel those of Mark McKay and Christine A. Beck-McKay. So as Mark and Christine and Kevin and Ronda, and a lot of other people, all stipulate to the necessary facts and consolidate, Judge Swift goes with the flow.

Taxpayer runs a couple of successful fast-food franchises in Utah. They create two Sub S corps, one to run the deep-fryers and the other to do back-office (payroll, taxes, bookkeeping). They start a profit-sharing plan, but that doesn’t do too well, so they flip it into an ESOP, and create a Non-Qualified Deferred Comp plan for the heavy hitters, which gets paid ahead of the ESOP contributions. Of course, the deferred comp heavies get the cherries and the ESOP gets the pits, to the extent of $3 million deferred for the one-percenters, and a hundred grand for the lackeys.

Congress wakes up, and for the year at issue amends the IRC to impose monumental excise tax, penalties and flogging around the fleet, if the heavies don’t disgorge the deferred comp, pay tax, and restructure the ESOP so as to give the lackeys something more.

Restructuring is a pain, so the heavies kill the ESOP, and go back to the profit-sharing plan of yesteryear. In the process, their Sub S takes a $2.9 million paper whack when it buys back the Sub S stock formerly in the ESOP. The heavies split the year in question in two halves. In half one, the heavies get the $3 million ordinary from the Deferred Comp distribution; in half two, the Sub S’s $2.9 hit creates a loss that flows through to the heavies.

The heavies increase their basis in the Sub S by throwing enough of their cash into the sub S to take the loss in half two.

IRS is not amused. They first allege Section 482 and Section 382 (reallocate income and deductions among related entities for income, and reduce loss to basis in sub S pre-contribution), but they drop this (why, I don’t know; not a bad argument, as the heavies are on all sides of this deal), but then ring in Section 269, the old tax-loss corporation rule. You can’t buy a losing entity for the principal purpose of laying off your winnings.

Judge Swift: “Section 269 applies only if tax evasion or avoidance is the principal purpose for the acquisition. In the context of section 269, ‘principal purpose’ means that the evasion or avoidance purpose must exceed in importance any other purpose. In considering what is the principal purpose, it is appropriate to aggregate all tax avoidance purposes and compare them with the aggregate business purposes for the acquisition.” 2102 T. C. Mem. 166, at p. 18 (Citations omitted.)

The heavies have the burden of showing their principal motivation was not tax avoidance. This they do, by showing that the new requirements for the ESOP were administratively burdensome, and the old management structure was inefficient and costly. Section 1377 allowed the half-year split, because of the management changes required by the new ESOP rules.

And the heavies really put $2.9 million of cash into the Sub S to build up their basis and take the loss. See my blogpost “Winning the Paper Chase”, 6/6/12; if you put in something of value, you can take the loss.

Also, there’s no caselaw on the application of Section 269 to Sub S corps. But Judge Swift isn’t making any, either: “Having decided the factual issue before us in favor of petitioners, we need address neither the legal issue petitioners and respondent raise (whether section 269 ever may be applied to a taxpayer’s acquisition of the stock in an S corporation), nor the penalties determined by respondent.” 2012 T. C. Mem. 166, at p. 26.

Too bad; I can think of a scenario where Section 269 would apply. My Sub S is sinking fast, with heavy-duty loss carryforwards. I can’t use the losses. Your sub S is a home run, but it’s generating all ordinary income, and you’re in max bracket. You buy my Sub S, whose business has nothing to do with your Sub S’s business, at a deep discount. At least I have some cash.

You merge the two Sub Ss, but your combined basis is too low to use all the losses I sold you. But next year will be even better, and you can contribute enough cash to your Sub S to take all the losses I sold you.

What do you think?

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