If you have investment gains to offset business losses this year, you may be in store for a direct head on collision with the IRS and the Tax Reform Act of 1986. The journey to disaster starts off innocently enough. You sell some stocks for a $10M gain to purchase a small retail shopping center for the same price. You think about structuring the deal so that the losses from the first year of operations at the shopping center could offset your capital gains from the sale of stocks. You never bothered to retain a tax attorney to create a tax plan because as you see it you have a no brainer zero tax due. You believe that a buy and sell for $10 Million equals a full and complete offset come April 15 2015; but perhaps not so fast says TaxView, because the offset is in great danger. There are land mines ahead that seem to explode at the worse possible moment with an IRS audit. If you are interested in how the IRS could dramatically change even your best tax plan for offsetting gains and losses, stay with us on TaxView with Chris Moss CPA to see how the Tax Reform Act of 1986 makes your no brainer into a brain strainer and a tax disaster for you the unfortunate taxpayer victim of the creation of Section 469 and the Passive Loss rules.
To get a better idea of the catastrophe ahead, first let’s all take a short trip back to the source of confusion to Washington DC. Fasten up your tax plan as we turn back the clock landing us right in the middle of the center table at the downtwon Palm. Dan Rostenkowski (House Ways Means) and Bob Packwood (Senate Finance) have gotten together to finalize some last minute provisions of the 1986 Act. Legendary Tommy Jacomo spots us immediately with a great table. We hear Rosti roar over the boisterous dinner crowd to Bob: You personally have quite a large portfolio in stocks and bonds. Would you really consider interest and dividends “positive” income? Rosti, you know I don’t like that word “positive” taken in this context. Besides, we can’t really tell the average American taxpayer that the wealthy making dividends and interest are working as hard as they are with “positive income”. Let’s just go with this term “Portfolio”. It bridges the gap between those darn “passive” tax shelters and the American W2 worker. I say we treat these items like positive income similar to a salary but call it “portfolio”. In other words we tell America that their stocks and bonds are…well like working 40 hours a week for them as their “portfolio”. Bob, you have got to be kidding, that is really dumb, really stupid… but you know, comparing portfolio to W2 earnings is so ridiculously outrageous it might just work. See Joint Committee on Taxation, page 209-213 which eventually morphed into IRS Code Section 469 Passive Loss Rules.
Agree or disagree with how my imaginary conversation might have unfolded that night, the fact is that Section 469 prohibits the offset of “portfolio” gains or losses and “passive” gains all losses. In order to see the bizarre consequences of how these two types of gains and losses can interact, let’s head over to US Tax Court just a five minute cab ride from the Palm over to Capitol Hill to survey a 2000 case More v IRS 115 T.C. No 9. More was an independent managing underwriter as part of a syndicate for Lloyds of London. In order to be accepted by Lloyds More had to demonstrate his ability to cover potential losses of his syndicate usually by posted a letter of credit. In 1988, More transferred his personal stock portfolio to a brokerage account at Bank Julius Baer (BJB), a London-based bank. During 1992 and 1993, petitioner underwrote £500,000 of Lloyd’s premiums which were secured by a letter of credit from BJB in the amount of £150,000. The policies written by More did in fact incur losses and More cashed in his stocks at a large gain to cover those losses as required by his letter of credit. More reported his losses and gains on his tax returns so that each offset the other. The IRS audited Moore, and disallowed all the losses, arguing “portfolio” income could not be offset against “passive” income. Moore appealed to US Tax Court.
Judge Vasquez in More writes a very short 16 page jam-packed with Section 469 Opinion. The Court then confirmed that Congress enacted passive loss regulations “to curb expansion of tax sheltering”. Judge Vasquez further noted that IRS regulation 469-2T makes an exception to the general rules regarding disposition of More’s stocks at a gain. Specifically, gross income derived in the ordinary course of a trade or business includes “income from investments made in the ordinary course of a trade or business of furnishing insurance or annuity contracts or reinsuring risks underwritten by insurance companies” The Court notices that More’s attorney, Louis B. Jack, did not refute or address this at all and was silent on the reason why More acquired the stock. If More could have shown that he primarily created this portfolio as a way to get into the insurance business and not as an investment More wins IRS loses. Unfortunately for More, no evidence was presented to the Court on when his investments in stocks turned primarily to assist More in keeping his job at Lloyds. I don’t know about you all, but it seemed More’s transfer to a brokerage account back in 1988 was primarily to show sufficient assets so he could work at Lloyds. Nevertheless, since More did not refute the Government’s argument leaving the Court no choice but to hold that More’s stocks were primarily created for investment and not for the convenience of Lloyds. Government wins, More loses.
What does this rather obscure Tax Court case and the provisions within Section 469 tell us working taxpayers regarding passive loss rules that create “portfolio income” and “passive income”? Anyone out there who wants to offset losses from one activity against gains of another: Be warned, the IRS is actively and aggressively audited these kinds of offsets, particularly any losses that offset W2 income or Investment Portfolio Income, or any gains that offset passive losses. Prior to filing your tax return with any offsets from different sources of gains and losses, review with your tax attorney the ramifications of Section 469, with particularly emphasis on what kind of offsets you have. If you have “portfolio” and “passive” losses or gains pay particular attention to whether or not the Section 369 allows those offsets. Finally have your tax advisors insert into your tax return detailed evidence of your tax strategy explaining how these offsets were created, what provision of Section 469 controls, and how your tax strategy is being implemented. For example if your tax strategy involves long range estate planning, make sure you disclose this in the tax return before filing. Better you should support and bullet proof your tax strategy now than to have to wait 4 years for the Government to do it for you during an IRS income tax return audit.
May your losses and gains offset wisely. Thanks for joining Chris Moss CPA on TaxView
Chris Moss CPA