Powell v. IRS, T.C. Memo. 2014-235 (Nov. 17, 2014).
Monday’s Powell v. IRS is yet another small business case (S Corporation) in which many tax incentives were at issue. Code sections 162 (trade or business expenses), 166 (bad debt deduction), 1001 (capital gains), 1372(employee benefits in an S Corp), and many more are discussed in the case. As no new legal interpretations are offered in this Memorandum Opinion, it is a good read for any small business owner.
The discussion of 162 trade or business expense deductions (beginning on page 7) is particularly instructive for new business owners. New enterprises cost a lot of time and money in the start-up phase. Code sections 162 and 212 account for the costs of doing business by creating deductions for “ordinary and necessary expenses paid or incurred during the taxable year in carrying on a trade or business.” Powell, at p. 7. Most notably, “A taxpayer is not carrying on a trade or business under section 162(a) until the business is functioning as a going concern and performing the activities for which it was organized.” Id. at p. 7. These deductions mean that Congress only taxes the new money-the profit.
In this case, the Powells had a Virginia S Corporation in the petroleum industry. They began a side business in North Carolina for growing and selling beer hops. The Powells purchased some land, unsuccessfully grew and sold hops, and sold the land a substantial loss. Powell, at p. 4. They attempted to deduct (on a 1040 Schedule C) related to their beer hop growing business. Id. at p. 8. The IRS denied that this was a proper use of the 162 deduction because the taxpayers were merely preparing to engage in business, but not actually “carrying on” a business at that time. Although Mr. Powell had purchased realty, incorporated his business for this purpose, planted some hops, and contacted buyers, the Tax Court agreed that he was not actively engaged in a trade or business because it wasn’t conducted with sufficient continuity and regularity. Id. at p. 9.
Cavallaro v. IRS, T.C. Memo 2014-189 (Sept. 17, 2014).
The legal formalities of business entities and modern wealth transfer techniques must be understood and respected to minimize tax exposure when structuring wealth transfers between generations. The case of Cavallaro v. IRS, published by the Tax Court last month (September 2014), demonstrates the potentially dire consequences of failing to recognize the legal significance of new business entity formation and properly planning for the transfer of wealth between generations. There, the patriarch (Mr. Cavallaro) embodied the American small business dream—a trade school graduate who could barely read, but who formed a family tool-making company (Knight Tool Co.) which was eventually so successful that it supported his family, created the impetus for his three sons to go to college, and eventually provided professional employment opportunities for he and his family members. Id. at pp. 6-8.
As an adult, the youngest of the Cavallaro sons assisted his father and the Knight engineers in developing a new liquid-dispensing machine, the CAM/ALOT. Id. at pp. 9-10. The liquid-dispensing machine eventually became the bread and butter of Knight. Id. at pp. 11-12. But Mr. and Mrs. Cavallaro decided to refocus their company on tool making again in the late 1980s. So their sons, led by Ken Cavallaro (the oldest), were allowed to use the CAM/A LOT as the core product of a new corporation—Camelot Systems, Inc. Id. at p. 13.
At the time, the family thought a transfer of the CAM/A LOT had been successfully and informally made such that that Mr. Cavallaro and his old company—Knight—could continue to shepherd his sons and their new company—Camelot—without the formalities required of arms-length transaction. The fallacy of that assumption had real, if still unknown, consequences at the time. The implications of the attempted 1987 transfer finally manifested themselves in 1995 when the family attempted a tax-free merger of Knight Tool with Camelot (presumably under IRC § 368). When the dust settled, Mr. and Mrs. Cavallaro (who had formerly owned 100% of Knight and its intellectual property) ended up with 38 shares (19%) of the surviving Camelot Corporation; their sons equal shares of the remaining 162 (81%). Id. at pp. 32-33. This kind of ownership transfer is a red flag for the IRS and tax planners.
The error lay with the legal experts who failed to recognize the tax implications of the 1987 transaction. Specifically, a diligent search should have been conducted regarding the ownership of the CAM/A LOT technology in 1987, which was the most valuable item changing hands. See Id. at p. 55. Only then could proper planning avoid triggering the income or gift tax between 1987 and 1995 with the help of appropriate wealth-transfer tools.
The mistake was practical more so than legal. Good attorneys treat the factual details of their work with the utmost respect. With proper diligence, the law can be correctly applied to the facts. With good evidence at one’s disposal, there are many appropriate practical and legal mechanisms by which such a wealth transfer such as this is possible. Assuming Mr. and Mrs. Cavallaro could have continued operating Knight from 1987 to 2014 instead of participating in litigation, there would have been an additional 27 years to structure and execute a wealth transfer plan that would, at the very least, have reduced the $13 million tax bill they now face. The best way to do this, that also existed in 1987, would have been by means of an Employee Stock Ownership Plan (ESOP).
ESOPs allow business owners to reduce their proportionate investment in their company and build a diversified portfolio of other assets (like regularly traded securities) without immediately triggering gains that suck much-needed cash out of their going business concerns. This incentive could have been utilized here if Knight Co. had set up an ESOP trust. The Cavallaro parents could have designated themselves as the initial ESOP trustees. From there, a bank loan to the ESOP could have been used to purchase a large portion of the Cavallaro parents’ stock (say 30%). To receive preferable tax treatment, he Cavallaros would have also had to reinvest the money they received from this transaction into a diversified portfolio of stocks and bonds in U.S. companies. As such, a properly structured and qualified ESOP would have allowed the Cavallaros to avoid recognizing income tax gain on the sale until the replacement securities were sold. At the same time, Knight could have begun making tax-deductible contributions to the ESOP to repay the loan. Ultimately, the three Cavallaro sons could have continued working for Knight and developing the CAM/ALOT technology under the supervision of Mr. Cavallaro. The sons would also have benefitted from their respective interests in the ESOP at retirement, disability or death.
Although additional planning and structuring would be needed so the Cavallaro boys’ families could reduce income and gift/estate taxes when the sons ultimately received money from the ESOP, even a small reduction in the taxable amount transferred between two separate companies (30% in this example) of the $29.6 million (see p. 46) trapped within Knight would have greatly improved the tax positioning of the Cavallaros as it was ultimately determined to be in this case. Moreover, the use of modern gift and estate tax exemption and deduction amounts could have been further used to reduce the tax bill. In short, modern small and moderate sized business owners need to pay attention to wealth structuring and tax planning from early on in their careers to proactively reduce or eliminate unexpected future tax bills.
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