bad debt

[theresa d]

facts: taxpayer owned a small retail store which was sold in 2003. he was the sole shareholder in the s corp. the proceeds on the sale consisted of $30,000 cash and a note for $100,000. the corporation was dissoved and the note was assigned to the shareholder.

the sale was being reported on the installment basis. the gain applicable to the recapture of depreciation is not eligible for installment sale treatment therefore taxpayer had to pick up $50000 in gain in 2003 applicable to this recapture even though it exceeded the cash payment he received.

problem: the buyer defaulted on the loan in early 2004 and the store has been closed.
taxpayer sued unsucessfully ( lost due to technicalities !) appealed and just received notice that the appeal was unsucessful. how is this bad debt handled?

since it is a business bad debt it should be ordinary business loss but the corporation was dissolved. where does it get deducted? schedule D would limit it to 3000\yr.
also can the entire loss be taken since cash basis taxpayer and recording gain on installment basis. therefore some of the gain has not been picked up yet. however it is a loss due to the default on a promissory note.

i'm confused and would appreciate any advice. sorry this is so long.

[OldJack]

If any proceeds were received in the year you would still report the installment sale for such proceeds on the same basis as though nothing had gone bad. Then the installment reporting simply stops.

I would report the defaulted note loss as a business bad debt on form 4797 which would offset ordinary income on the 1040.

[jainen]

I don't know

I don't know, but it doesn't sound right to me. The shareholder received the note as payment for stock in liquidation. Gain must be calculated from the value of the note and the basis of the stock--capital gain or loss in the hands of the shareholder, not a business debt. The gain can probably be deferred while installments are received, but the full amount of payment would be used, not the corporation's gross profit percentage.

There are some timing issues around the liquidation and the pass-through of profit and gain. I'm confused that the $50,000 already recognized was attributed to depreciation, with no mention of inventory. It doesn't sound right to me, but I don't know.

[Snaggletooth]

Recapture?

Theresa, I'm not sure I can answer with the information given, but I am somewhat perplexed as to the recapture of $50,000 of depreciation on a $130,000 sale.

Are you aware that (being section 1250 property), only the ACCELERATED portion of prior depreciation must be recaptured as ordinary income? Additionally, since 1987 almost all depreciation on real estate has been straight-line. So the $50,000 really blows me away.

Thinking of store equipment (section 1245 property) as being recaptured is really quite palatable, but if this is a $130,000 store including the building, inventory, and goodwill, it is unlikely there would be as much of $50,000 in equipment.

[BOB W]

I also...........

.......... have a problem with with the note being reassign to the shareholder. My understanding is, if the Scorp is dissolved, it must recognize the full sale as if the installment sale never took place.

I have kept scorps open for the duration of the note........

[theresa d]

details

hopefully this doesn't get to confusing. details are as follows:

sold inventory $5000
leasehold imp 15000
furniture & fixtures 1000
no compete covenant 19000
goodwill 100000

total sale 140000
basis - 53504
gain on sale 86496
legal & broker fees - 15500

net gain 70996

this was an installment sale. buyer paid 55,000 in cash and signed an 85000 note. 5000sale of inventory was reported as ordinary income on form 4797 cost and basis same.

the corp original cost basis for the assets sold was 107500 (as they had purchased goodwill,non compete covenant, F & F). due to depreciation and amortization of such assets the basis was 48,504 (53504 above minus inventory cost). they had depreciated 58996 in assets. in calculating the gain which must be picked up under the installment method the gain applicable to depreciation (58996) must be recognized (recaptured) in the year of sale. that is what i meant by recapture. while the taxpayer only received 50000 in cash the corp picked up a 58996 gain. the remining gain of 12000 would be picked up via
installment sale income over the note period. however buyer defaulted on note in 2004.

this gain was reported to the taxpayer on his k-1.

my problem is how does the loss on the remaining balance of the 85000 note get deducted by the taxpayer?

i'm so sorry this is so long and truly appreciate your responses when i know everyone is so busy.

[jainen]

that's quite a store

Dude, that's quite a store. Intangibles are 85% of the price. Next in value is the leasehold improvements that you don't even get to keep. The only asset smaller than the inventory is the shelf to put it on!

No wonder the buyer walked away. I'm dying to know what the "technicalities" were that proved he was entirely right to do so!

[theresa d]

section 453B(h)

bob it's my understanding that if the receipt of the installment obligation is governed by section 453(h) which allows shareholder to use the installment method if the sale of corporate propery occurs within twelve months after the corporation adopted a plan of complete liquidation,the s corp will not have to recognize gain upon distribution of the note.

this corp met that criteria.

[veritas]

.......... have a problem with with the note being reassign to the shareholder. My understanding is, if the Scorp is dissolved, it must recognize the full sale as if the installment sale never took place.

I have kept scorps open for the duration of the note........

If the sale occured within a 12 month period begining on the date of adoption of a plan of liquidation, the shareholder would report the gain on the note as an installment sale.

[theresa d]

answer

janein

this was a florist that had been in business in the same location for over 40 years under a long term lease. the seller had developed a signicant client base in the community and was basically selling that reputation i.e goodwill. obviously a forist inventory is of a very fragile nature and he had reduced his non perishable inventory to a relaively low level in anticipation of the sale.

the note was drawn up in the name of the corporation and there apparently there was some legal problem with the assignment to the shareholder. the buyers were making payments to the shareholder but claimed in court that since the corp no longer exist they do not have to make any further payments on the notes. the court bought it even when proof of the assignment was presented. i don't get it.

[jainen]

Bob W was right

I apologize for my insensitive interpretation. It sounds unfair to your client. You don't suppose the buyer would agree that the non-competition clause was also invalidated? Well, I hope at least the attorney paid for the appeal.

Bob W was right about keeping the corp open until the note is paid.

[OldJack]

All the discussion is nice but nobody but me has answered the question of where and how to deduct the loss.

[jainen]

I did

>>nobody but me has answered the question of where and how to deduct the loss<<

I did, but it wasn't the same answer you gave. I say it is a capital gain or loss related to the shareholder's stock basis.

[OldJack]

I say it is a capital gain or loss related to the shareholder's stock basis.

I disagree as it is a loss on a business note as the stock was disposed of prior to the determination of a loss and the only thing the taxpayer owned was the note.

[BOB W]

Without getting technical.....

....... any loss that would be deductible would be limited to any gain that was reported previously.

In some circumstance, restating the sale may be in order. This is done by filing an amended return using the exact monies received and when it was received.