Is loss of down payment by S-corp a cap.loss?

[JAinNC]

Please, I need your advice. Client is S-corp in graphics and design business. In fall of 2006 client paid 42,000 down to a broker to purchase a similar business in DC. (He paid 1000 in earnest money before the down payment) Has attorney working on case. DC corp (that he was buying business from) liquidated and has not returned the money. My client was declined a loan because of bank's knowledge of books of business for which he wanted the loan to purchase. (P&L and reports my client brought to me last summer as he checked out the business were likely a product of creative accounting)

My client has spent over 9000 to have lawyer gather info to sue the brokerage firm and the 5 individuals who did own the corp that no longer exists. Lawyer wants another 10000 to continue. If my client decides to give up this fight and cuts his losses now, will this the down payment be a capital loss? Are the attorney fees added to the 42,000? It was paid in late September and and he hired attorney in October 06. Client's plan was to operate that business in DC and also continue his NC business. The 42000 is posted as an asset in his books.

I am grateful for all your help.

Jeannie Allen EA

[OldJack]

Sounds like a deductible business bad debt and not a capital loss. The main question is when is it bad and therefore deductible. If the C-corp has liquidated I would think the deduction should be in the year it liquidated without paying/refunding the debt/deposit.

Lawyer wanting another $10,000 is not a good indication of him considering his effort real successful.

[New York Enrolled Agent]

Revenue Ruling 77-254 (including the last paragrah) might be of help

Rev. Rul. 77-254

1977-2 C.B. 63

Section 165 -- Deduction for Losses
Section 263 -- Capital Expenditures
Section 461 -- Tax Year of Deduction

IRS Headnote

Losses; attempted acquisition of business. An individual may deduct, in accordance with section 165(c)(2) of the Code, expenses incurred in the unsuccessful attempt to acquire a SPECIFIC business, such as legal expenses incurred in drafting purchase documents. However, expenses incurred in the course of a general search for or preliminary investigation of a business, such as expenses for advertisements and travel to search for a new business, are ont deductible. Rev. Rul. 57-418 amplified.

Full Text

Rev. Rul. 77-254

Advice has been requested whether, under the circumstances described below, a deduction in accordance with section 165(c)(2) of the Internal Revenue Code of 1954 is allowable to a taxpayer for a loss that was not compensated for by insurance or otherwise.

An individual taxpayer began to search for a business to purchase. The individual placed advertisements in several newspapers and traveled to various locations throughout the country to investigate various businesses that the individual learned were for sale. The individual commissioned audits to evaluate the potential of several of these businesses. Eventually, the individual decided to purchase a specific business and incurred expenses in an attempt to purchase this business. For example, the individual retained a law firm to draft the documents necessary for the purchase. Because of certain disagreements between the individual and the owner of the business that developed after this decision was made, the individual abandoned all attempts to acquire the business.

Section 165(a) of the Code allows as a deduction any loss sustained during the taxable year that is not compensated for by insurance or otherwise. Section 165(c) provides that, in the case of individuals, the deduction is limited to (1) losses incurred in a trade or business, (2) losses incurred in any transaction entered into for profit, though not connected with a trade or business, and (3) losses of property not connected with a trade or business, if such losses arise from fire, storm, shipwreck or other casualty, or from theft.

Rev. Rul. 57-418, 1957-2 C.B. 143, holds that losses incurred in the search for a business or investment are deductible only when the activities are more than investigatory and the taxpayer has actually entered a transaction for profit and the project is later abandoned.

In Seed v. Commissioner, 52 T.C. 880 (1969), acq., 1970-2 C.B. xxi, the United States Tax Court allowed a deduction for expenses incurred by a taxpayer during an unsuccessful attempt to secure a charter to operate a savings and loan association. The court found that the taxpayer's extensive activities in the venture qualified as a transaction entered into for profit. Following the decision in Seed the court has continued to find that a taxpayer has entered a transaction for profit in cases in which the facts indictate that the taxpayer has gone beyond a general search and focused on the acquisition of a specific business or investment. See Price v. Commissioner, T.C. Memo. 1971-323; Domenie v. Commissioner, T.C. Memo. 1975-94.

In view of the decision in Seed, Rev. Rul. 57-418 is amplified to provide that a taxpayer will be considered to have entered a transaction for profit if, based on all the facts and circumstances, the taxpayer has gone beyond a general investigatory search for a new business or investment to focus on the acquisition of a specific business or investment.

Expenses incurred in the course of a general search for or preliminary investigation of a business or investment include those expenses related to the decisions whether to enter a transaction and which transaction to enter. Such expenses are personal and are not deductible under section 165 of the Code. Once the taxpayer has focused on the acquisition of a specific business or investment, expenses that are related to an attempt to acquire such business or investment are capital in nature and, to the extent that the expenses are allocable to an asset the cost of which is amortizable or depreciable, may be amortized as part of the asset's cost if the attempted acquisition is successful. If the attempted acquisition fails, the amount capitalized is deductible in accordance with section 165(c)(2). The taxpayer need not actually enter the business or purchase the investment in order to to obtain the deduction.

Accordingly, in the present case, the individual may deduct as losses incurred in a transaction entered into for profit the expenses incurred in the unsuccessful attempt to acquire a SPECIFIC business. Thus, the individual's expenses in retaining a law firm to draft the purchase documents and any other expenses incurred in the attempt to complete the purchase of the business are deductible. The expenses for advertisements, travel to search for a new business, and the cost of audits that were designed to help the individual decide whether to attempt an acquisition were investigatory expenses and are not deductible.

Rev. Rul. 57-418 is amplified.

[OldJack]

>>Revenue Ruling 77-254 (including the last paragrah) might be of help<<

Unfortunantly this post was about an S-corp and not an individual taxpayer.

[geekgirldany]

I think it would be a bad business debt also.

http://www.irs.gov/taxtopics/tc453.html

Interesting article that may relate:

http://findarticles.com/p/articles/mi_m6280/is_4_189/ai_61793837

[jainen]

I disagree

>>it would be a bad business debt<<

No, I disagree. He did not LOAN anybody anything, so there was never an obligation to repay a debt. The broker was only holding the money as his agent. The process failed so he lost his investment.

I would tend to think of that as a capital loss, but since he was expanding an existing business I might consider it as some kind of business expense or loss. The legal fees (to the extent they are reasonable and appropriate) I would treat in the same manner as the lost money.

[Corduroy Frog]

New York Enrolled Agent

Great job in presenting relevant information, NYEA. Not sure whether this is a
short-term capital loss or a business bad debt, and the effect of taking the deduction in either place is drastically different than the other.

NYEA, you mentioned some costs that were not deductible, such as exploratory, precursory travel, etc. I believe what is meant is that the IRS requires these costs to be capitalized rather than written off.

Problem is, for business, all capitalized costs eventually become expense at some point. Does this mean when these costs are ultimately written off, that they are non-deductible even as a capital loss? A unique perspective is these capitalized costs if receiving a delayed deduction changes the character from short-term to long-term. This may be better posed as a GAAP question instead of a tax forum. Jack, you still out there??

[JAinNC]

To: NYEA, Old Jack, geekgirldany, Jainen, and Corduroy Frog
Thanks for all the great input. The fact that this is not an individual, but is an S-Corp made it difficult for me to research. Please continue with your expert advice on how to handle this.

He is waiting for me to let him know about discontinuing with the lawyer. It sounds like the S-corp can at least recover the lost investment one of the suggested ways, so I will let him know.

As Jainen stated, this was not a loan. It was a down payment on a business investment. The broker took a cut and gave the remainder to the now desolved corporation. The earnest money was an earlier and separate transaction that he can never recover.

I am interest in hearing Old Jack's response to Corduroy Frog.

Jeannie EA

[OldJack]

>>it would be a bad business debt<<

No, I disagree. He did not LOAN anybody anything, so there was never an obligation to repay a debt.

You do NOT have to LOAN money or have a loan document to have a business bad debt. Of course you have to have proof of the amount and when it became noncollectable. Uncollected accounts receivables are business bad debt deductions. In this case the corporation made a down payment or deposit on a business deal and lost. It is clearly a ordinary deduction as a business bad debt. The legal fees are also ordinary and necessary business expenses. Even if you contend that the corporation was purchasing a capital asset... that didn't happen.

[OldJack]

Problem is, for business, all capitalized costs eventually become expense at some point. Does this mean when these costs are ultimately written off, that they are non-deductible even as a capital loss? A unique perspective is these capitalized costs if receiving a delayed deduction changes the character from short-term to long-term. This may be better posed as a GAAP question instead of a tax forum. Jack, you still out there??

I agree that capitalized costs eventually become expense (if retained by amortization or depreciation) or basis on sale.

Determination of capital or ordinary tax treatment depends upon the business entity and facts of the asset.

As an example if the capitalized costs is a "business use asset" owned by a S-corp or C-corp the asset disposition loss is reported on form 4797 with the loss treated as ordinary loss deducted against ordinary income.

If the property is owned as "capital asset-investment property" then it is a capital asset reported on Sch-D by a S-corp and C-corp. The difference is the S-corp passes the capital loss to the shareholder for 1040 Sch-D deduction whereas the C-corp reports 1120-SchD and the loss is suspended (carryback 3 forward 5) until the C-corp has a capital gain to offset. A C-corporation's excess capital loss (1120Sch-D) can't be deducted from a corporations ordinary income[§1211(a)]. A C-corp suspended capital loss "expires" in 5 years.

If the asset is an intangible asset it is written off as expense when no longer considered an asset. As an example leasehold improvements such as fixed partition walls in a leased building is written off to "expense" in the year when the business is no longer leasing and using the building.

The only basic difference in GAAP vs tax treatment is usually the life period of the asset.

[Corduroy Frog]

Leasehold Improvements

As an example leasehold improvements such as fixed partition walls in a leased building is written off to "expense" in the year when the business is no longer leasing and using the building.

The only basic difference in GAAP vs tax treatment is usually the life period of the asset.

Jack, if what you say is true, I must be losing my mind. Are not leasehold improvements eligible for annual depreciation as opposed to waiting until the end of the period?