Case — Stock Basis

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TL Case Summ

THE QUESTION

Does rescission of a loan agreement reduce stock basis?

THE DISPUTE

Taxpayer Says: His cost basis in the stock includes the original debt amount.

Internal Revenue Service Says: The cost basis should be reduced to reflect the outcome of a lawsuit that limited his actual cost.

THE LAW

From Internal Revenue Code Section 1001(a): Gain or loss from the sale or other disposition of property reflects the difference between the amount realized and the property’s adjusted basis.

From Internal Revenue Code Section 1012: Basis is generally the property’s cost, adjusted as determined under section 1016.

From Internal Revenue Code Section 1016(a)(17): In the case of an S corporation, adjustments to basis include adjustments required under section 1367.

From Internal Revenue Code Section 1367(a): Generally, a shareholder’s adjusted basis in S corporation stock is increased for items of income passed through to the shareholder under section 1366(a)(1) and decreased (but not below zero) by losses and deductions passed through to the shareholder under section 1366(a)(1).

From Federal Tax Regulation 1.102-1(a): “Cost” is any “amount paid for such property in cash or other property.”

From Commissioner v. Tufts, 461 U.S. 300, 307-308 (1983): Cost generally includes promissory notes issued in exchange for property.

From Lemmen v. Commissioner, 77 T.C. 1326, 1348 (1981): Although cost basis generally equals the price paid for property, irrespective of its actual value, this rule might not apply “‘where a transaction is based upon ‘peculiar circumstances’ which influence the purchaser to agree to a price in excess of the property’s fair market value.'”

THE CAUSE OF THE DISPUTE

Your basis in stock you purchase is generally the amount you pay for it in cash and other property, including amounts you borrow. If you’re the owner of an “S” corporation, your basis also includes corporate income and losses passed through to you from the corporation.

In this case, the taxpayer was president of an S corporation. In 1999, he exercised an option to purchase 500,000 shares of the corporation from another shareholder for $212,334. He also purchased 1,477,859 shares of stock from a third shareholder for $5,842,606, and executed a promissory note in that amount. The note, plus interest, was due May 5, 2000.

The note was revised prior to any payments, and the revised terms called for $3 million to be paid on June 14, 2000, with the balance due in three annual installments of $1,009,367.

The company paid the initial $3 million, and made additional payments of $2,353,624 between October 2000 and June 2002. All the payments were made directly to the loan holder, and treated as advances from the company to the taxpayer.

In 2002, before any of the advances were repaid, the taxpayer sued the company, seeking to have the balance of the advances cancelled. He claimed he’d entered into the second stock purchase at the company’s request, and that the stock had been overvalued.

In December 2002, the taxpayer entered into an agreement with the company. The agreement stated the true economic value of the shares at the time of purchase was $1 million, and that the balance in the “advances” account would be reduced to that amount.

In 2005, the taxpayer sold all of the shares for $3 million. He reported basis of $4,502,519, which was his cost basis of $6,054,940 less adjustments for the application of shareholder basis rules (see code section 1367 rules in “The Law” above).

While not disagreeing with the shareholder basis adjustments, the IRS says the taxpayer’s cost basis was actually $1 million due to the settlement agreement with the company. The IRS argues the loan from the company was related to the purchase, and that the judgment relieved the taxpayer of all but $1 million of the principal amount of the loan.

The taxpayer says the two transactions are separate, and should be treated separately.

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THE COURT’S DECISION

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HL Carpenter, an experienced investor and a CPA, specializes in reader friendly articles on taxes and investing for individuals and small businesses, and publishes two newsletters: Taxing Lessons and Top Drawer Ink. Visit TaxingLessons.com and HLCarpenter.com.

This information should not be considered legal, investment or tax advice. Taxing Lessons and Top Drawer Ink Corp. do not provide legal, investment or tax advice. Always consult your legal, investment and/or tax advisor regarding your personal situation.

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Sorry, wrong answer :(
Right answer!
For the IRS. The economic reality of the transactions in question, viewed in their totality, was that the taxpayer agreed to purchase the shares as an accommodation to the company, with an understanding that the company’s funds would be used to pay the nominal purchase price. In the final analysis, the taxpayer neither paid, nor was he obligated to pay, more than $1 million for the shares. In these circumstances, we agree the taxpayer’s cost basis in these shares was $1 million.
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