Wasted Basis?

[Beersheba]

A subchapter S shareholder has a basis of $700,000, and after 40 years of business as a contractor, retires. Upon retirement he is able to pull out $400,000 in cash and other assets to reduce his basis to $300,000. The corporation was attached to him as a contractor, and is worthless without him, and there are no children willing to carry on his business. In other words, there is nothing left in the corporation, no value, and he has a remaining basis of $300,000.

Can he take advantage of this basis evaporating, as it is worthless, and use it as a deduction - maybe a LT capital loss?

One possible solution is to sell his shares to his next-door neighbor for $1, and take a loss of $299,999. However, I wouldn't touch this because it loses under the "form versus substance" doctrine.

Can anyone suggest some way for him to take advantage of this left-over basis??

[Maribeth]

If the corporation has completely liquidated and there are no assets remaining; and if your client's outside basis in the stock of that corporation is $300,000 after receiving any and all assets of the corporation, AND if the stock in the hands of your client is and was considered to be a capital investment; then you have a long term capital loss of $300,000. However, if you have a $300,000 receivable on the books of the corporation as a "due from shareholder", then you do not have a loss. You simply have a distribution back to the shareholder of the receivable that he owes the company.
It is not unusual to have inside basis different than outside basis in an S corporation. My experience tends to be those clients that take excess distributions during the year. And that's not an unusual occurrence for a contractor.

[Beersheba]

Thank you Maribeth. Actually after a couple years of receiving tax free PPP Loans, some owners have large outside basis. In the example above, the amount taken out is after accounting for all accounts, including receivables, Due to, Due from, etc. so it appears he will have a huge $300,000 capital loss. However, unless there is other gains to apply, this will have to dribble out at $3000 per year, so he may never have the maximum benefit of it.

[TaxGuyBill]

It is not unusual to have inside basis different than outside basis in an S corporation.

I may need to refresh myself on that matter. I don't do Partnership and Corporations, but I thought that "inside" and "outside" Basis was just a Partnership thing. How does that apply to a S-corporation?

[kathyc2]

Actually after a couple years of receiving tax free PPP Loans, some owners have large outside basis..

How so? The transactions for it would have gone through company books.

[Beersheba]

The owners would have a large basis compared to their taxable income. The money, to whatever extent exempt, should still have be available, or have been available at the point of forgiveness.

[kathyc2]

The owners would have a large basis compared to their taxable income.

But it will also show as equity on company books. It doesn't give you a higher "outside basis" than the equity showing on balance sheet. By the very definition of how a balance sheet works, if there is a positive amount in equity account there has to be a corresponding asset amount.

For a shareholder to have a higher basis than what shows as equity would be to have something outside of the books happen, would it not? Only thing that comes to mind would be a taxable distribution to shareholder that would cause book equity to drop below zero.

[Beersheba]

For a shareholder to have a higher basis than what shows as equity would be to have something outside of the books happen, would it not?

Absolutely correct, Kathy. The event of PPP forgiveness would not (by itself) create a difference between basis and capital account. If anything I said implied otherwise, it was not intended.

[kathyc2]

I am curious how your client got such a large off book basis if you don't mind sharing.

[Beersheba]

I don't mind sharing, but I use big round numbers when giving examples, as the real numbers may not be quite that large. Kinda grisly story, as his ex-wife had half the stock at one time and he had to buy her out, in excess of her balance. Don't know if related party rules change anything, and they weren't married by the time it happened. Happened with a previous accountant - a friend of mine who has passed on.

[kathyc2]

Aahhhh. Back to your original question: I assume he will be investing the cash he liquidated from business. If so, I'd advise him to look at mutual funds that are more likely to pay out capital gains rather than dividends. The dividends could be taxable and potentially make more SS taxable, whereas the CG from a mutual would be offset by the capital loss.

[Beersheba]

If he wants advice from me, it would be to invest in a diversified portfolio of individual stocks. Mutual funds have some degree of fees off the top, and dividends are taxable but not available because they are usually reinvested.

A broad spectrum of individual stocks will create taxation on dividends only, but the dividends are actually available to the owner. Not only that, but he can control the capital gains, by choosing what to sell, One possible strategy is to sell the losers every year to create capital losses, and there will be no capital gains on those gain stocks unless he sells. After long experience in investing (not just mine but my customers), I have tracking evidence that diversified individual stocks outperform mutual funds more often than not.

Since he will have a large capital loss, he can also sell winners if he chooses, and escape LTCG taxation.

One of the arguments posed by sellers of mutual funds is that savvy investment managers know more than the usual populace, and can buy & sell more profitably.. Maybe so, but the average age of mutual fund managers is 29.

I have seen stockbrokerage accounts with these mutual funds where the taxpayer has been talked into allowing the firm to buy and sell at will without the taxpayers' consent for each transaction. I have found this to be a recipe for disaster. It is very common for a 1099-DIV + 1099-B to total $1000 in income, and at the back of the statement the stockbrokers' fee is $2800.

Don't know whether this kind of conversation is what you wanted, but I perceive you are a very smart lady, and can read through this post if you choose.

[kathyc2]

I find very few people have both the time and knowledge to research individual company stock, trends, etc. I'm very happy with mutual funds. I just checked and none of them have expense ratios over 1%; most are in the .6% to .7% range.

If someone needs cash they can easily set it up to have dividends and CG paid directly to them instead of reinvesting without tax consequence.

It's not my place to advise clients what to invest in. I only tell them how different types will affect taxation.

[RWG1950]

It should be noted that the tax consequences on the 1040 are the same whether mutual fund income dividends and capital gain distributions are taken in cash or reinvested.