Category: Individuals, Corporations Copyright 1998, The Tax Resource Group. All rights reserved. Telephone 800-578-3498. Internet: www.taxresourcegroup.com Taxpayer (TP) is a substantial shareholder in a corporation (XYZ) which has experienced significant financial difficulties. TP lent XYZ a considerable sum and also guaranteed corporate bank debt, $100,000 of which is still outstanding. XYZ is out of business as a practical matter, and TP has written off the amounts directly loaned to XYZ. TP plans to inject an additional $100,000 into XYZ in exchange for additional shares. The additional shares are intended to qualify under Section 1244. TP thereafter intends to claim an ordinary loss on the shares as allowed by Section 1244. TP is willing to delay the loss under Section 1244 by as much as one year if that will improve his chances of success. The issue is whether the there is precedent in the tax literature for a transaction of the type set forth above. First, the transaction described above appears to meet the technical requirements of Section 1244. Section 1244 stock must meet all the following criteria. 1. The stock must be common or preferred stock. 2. The stock must be issued by a domestic corporation. 3. At the time the stock is issued, the issuing corporation must be a small business corporation as defined by Section 1244(c)(3). 4. The consideration paid by the shareholder on issuance of the stock must be in money or other property not including stock or securities. Under §1244(c)(3), a small business corporation must meet the following requirements at the time of stock issuance. 1. The aggregate contributed capital for the corporation does not exceed $1 million. 2. For the five most recent tax years, ending with the date of the loss, more than 50% of the gross receipts of the loss corporation must consist of items of income other than interest, dividends, rents, royalties, annuities, and sales or exchanges of stock or securities. There is nothing in the facts set forth above to indicate that the contemplated transaction does not meet the technical requirements of §1244; however, given that my understanding of the facts is limited to the rather sparse statement of facts above, I urge you to carefully consider the technical requirements of §1244 based on all the facts and circumstances you can develop based on your relationship with the parties involved. There is one particular requirement that is worthy of note. It seems to be necessary to actually issue new shares in connection with the described transaction. See Section 1244(d)(1)(B). There are cases in which the taxpayer contributed additional capital without the issuance of new shares and the new money was treated as non-1244. The real substance of this research relates to whether precedent exists for the fact pattern described above. Contrary to my feelings when we discussed that matter by telephone, there is indeed precedent which seems squarely on point in this case, and the precedent is extremely unfavorable. There are several cases in which the taxpayer injected capital into an already insolvent company in order to either repay shareholder loans or to satisfy debts to third parties. In two of the cases, Wesley Morgan v. Commissioner, 46 TC 878, and Roland Scott v. Commissioner, 27 TCM 735, the taxpayer lost technically because some requirements of pre-1978 law were not met. These requirements are not relevant today, but the cases are nonetheless damaging because they imply that capital injected into an already XYZ company is outside the scope of Section 1244. The case of Raymond G. Hill, 51 TC 621, is entirely different. In Hill, the court explicitly ruled that capital invested in an already insolvent company is not a true capital contribution eligible for Section 1244 treatment, and the taxpayer's facts in Hill are remarkably similar to those of the present case. I will send the full text of all three cases for your review under separate cover. It seems to me that given the existence of these cases, Hill in particular, TP's chances of success would be practically nil in the event the transaction set forth above were actually consummated and subsequently scrutinized. This is my view irrespective of whether the stock loss is delayed or taken immediately. While it is true that in Hill, the taxpayer invested one day and wrote off the investment one week later, the taxpayer lost because of the facts in existence on the date of investment, not the brevity of the period between investment and loss. Clearly, the near simultaneity of the two transactions hurt the taxpayer in terms of appearances, but it is my view that the result would have been the same if the taxpayer in Hill had waited one year. The fact that the business in Hill was already dead at the time of investment controlled. In the case of XYZ, the business is also apparently dead. Even if the business could be shown to be "more dead" one year from the now, the fact the business is already dead should effectively cut off TP from Section 1244 under the Hill decision. |
