All business owners and entrepreneurs are at one time or another having to deal with a “basis” computation analysis when they sell their interests in the company they started. Likewise real estate developers and builders use basis to compute their gains and losses when they sell their property. Moreover, all taxpayers who sell real estate have to know their basis to compute a gain. Even if you sell your primary home you have to know your basis if the gain is over the $250,000 exemption ($500,000 married joint). But in the unlikely event of an IRS audit are you prepared to prove to the government your “basis computation” both inside and out? How can you bulletproof your annual tax return each year when it may not be for another ten or twelve years that you sell the property or membership interest? Is basis just your cost or does a valid indebtedness like a promissory note or mortgage increase your basis? Is you current tax advisor keeping annual track of your inside and outside basis and are you being informed of what your basis is each year?
To answer these questions, let’s head on down to the US Tax Court on Capitol Hill in Washington DC and take a look at some “basis” cases. First a few basics: Your individual “outside” basis is your cost to you of the real estate or membership or shares you purchased. The “inside” basis on that purchase is how the LLC or partnership values the real estate, membership or shares on their books on the balance sheet. As per the IRS partnership audit guide, “A partner’s basis in his/her partnership interest is referred to as “outside basis.” Upon formation of the partnership, a partner’s initial outside basis will generally equal the amount of money and the adjusted basis of property contributed. If the partner purchases his/her partnership interest, the outside basis will equal the purchase price.” The inside basis is how the partnership carries that partnership interest on the balance sheet of the books and records.
In Barnes vs IRS decided in March of 2012, Washington, D.C. based entrepreneurs Barnes were engaged in several different lines of business, including restaurants, nightclubs, and event promotion. The IRS audited the 2003 tax return for Barnes almost 5 years later and by June 3, 2008, the IRS issued the Barnes a statutory notice of deficiency, determining a deficiency in tax of $54,486, a section 6662(a) accuracy-related penalty of $10,897, and a section 6651(a)(1) late-filing addition to tax of $5,691 with respect to their 2003 return. Judge Morrison’s 44 page Opinion meticulously, methodically, and almost painstakingly precisely, goes through year by year from 1995 to 2003 to conclude that the Barnes tax advisors had computed his cost basis incorrectly over the years thereby ultimately giving the Government victory in Court.
Note the government does not fool around during a basis computation audit either in a small simple case like Barnes or a bigger more complex 2005 case like Santa Monica Pictures and Corona Film vs IRS. This 332 page opinion by Judge Thornton involves complicated transactions that occurred in the wake of the 1996 sale of the “legendary motion picture company Metro-Goldwyn-Mayer (MGM) by the French banking giant Credit Lyonnais.” Peter Ackerman, his business partner Perry Lerner, and their related entities (Ackerman) had helped organize a consortium which made a bid to purchase MGM from Credit Lyonnais. Although Ackerman lost out to Kirk Kerkorian’s winning bid, Ackerman nevertheless set out to acquire MGM’s parent company, Santa Monica Holdings Corp. (SMHC) which Credit Lyonnais still owned. Ackerman set up a controlled partnership Santa Monica Pictures (SMP) which successfully bid to purchase SMHC. A short time later SMP then sold the assets of SMHC at a loss to various other entities allowing SMP to deduct over $400 million in losses. The IRS audited the basis computations and disallowed all losses claiming the losses were based on invalid basis computations by Ackerman because the whole series of transactions lacked a primary business purpose. Judge Thornton in finding for the Government sends a strong message that “cost basis” computations are valid only for parties doing legitimate business together with tax savings playing a secondary role. “The transaction between the banks and Ackerman carried the seeds of its own undoing: it depended upon the banks’ withdrawing from the very partnership they purported to join. The banks’ “contributions” to the partnership were not intended to have any economic significance apart from transferring built-in tax losses.” Id at 226.
Finally, in Moore vs IRS Moore reported on his 2005 Schedule D, Capital Gains and Losses, a capital loss of $1,502,519 from Mr. Moore’s sale of the ATS stock. In calculating the capital loss, his CPA Catherine Fox from BDP Seidman reported a basis of $4,502,519 in the ATS shares. The IRS audited Moore’s basis computation for 2005 and recomputed the 2005 tax return to show a $1 Million basis. Moore appealed to US Tax Court. The facts in the case are relatively simple: In turns out ATS loaned Moore $5 Million to buy ATS stock from Baker in 2000. In 2002 however Moore sued ATS claiming he was misled to the value of ATS. Moore eventually won a judgment allowing Moore to reduce his debt to ATS to $1 Million the actual market value of the stock that Moore purchased. As a result on December 31, 2002 ATS decreased Moore’s loan by over $5 Million and then increased on the same date the loan to $1 Million. In 2005 Moore sold all his ATS shares for $3 Million. Judge Thornton easily concludes that Moore’s original debt to ATS was not absolute and that the actual debt was only $1 Million. Therefore the Court concluded Moore had a gain of $2 Million- sales price of $3 Million less cost basis of $1 Million.
What does all this mean for us? In my view the IRS aggressively is auditing taxpayer basis computations, usually finding that the taxpayer basis was incorrectly computed, and is winning regularly in US Tax Court. What can you do to help protect your tax return from adverse audit consequences? Next time you meet your tax advisors make sure they discuss with you how they are keeping track of your basis each year to year and whether or not they are prepared to defend your basis in the event of an IRS basis adjustment audit. Each taxpayer has unique basis issues and so there is no “cookie cutter” basis computation for all taxpayers. Best practice requires your tax advisor to go over with you in person all your real estate purchases and sales including purchases, sales, acquisitions and mergers of closely held partnership, LLCs and corporations. Finally when you sell anything that has a basis have your tax professionals fully disclose your basis calculations in your tax return prior to filing that tax return. You can then relax knowing your tax returns are bulletproofed, safe and secure against IRS audit. How cool is that?
Thank you for us on TaxView with Chris Moss CPA
See you next time, Kindest regards
Chris Moss CPA