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Question about business bad debts for employee-shareholder

Technical topics regarding tax preparation.
#1
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Hi pros,
I have an interesting situation here with a client and wonder if anyone has seen anything like this before.

The client was a employee-owner of an S corp for about 20 years. His stock in the company was a small percentage and gave him no control. Over the years he was allocated income on his K-1 well in excess of what his distributions were. The S corp also distributed a note to him, probably because the distributions weren't being made pro-rata. Ultimately he realized he was never going to get any of this money and left the company and took legal action. The settlement amount for the stock and the note is a small fraction of what his basis in each were. Sec 1244 is no good here, the company raised more than $1m by issuing stock by the time he was issued his.

It is a bitter pill to swallow for him to have a capital loss after the years of being allocated ordinary income. He won't be able to use the loss for years.

I am looking for any angles that might make some portion of the loss ordinary. I was wondering about the write off of the note and whether it could be considered a business bad debt. Since the note was originally included in income and was in connection with his employment, it seems to me that this is one area that is worth looking into further. I haven't been able to find a clear answer one way or another here.

Thanks in advance.
 

#2
Nilodop  
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Depending on a further development of the facts, there's a reasonable chance of making a good argument that the loss is a business bad debt. You'd need to separate the amount related to the stock vs. the note(s).

Do some research on Corn Products, a famous and important case, and on "dominant motivation" as opposed to "significant motivation", and on "proximate relationship".
 

#3
Chay  
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But in the case of a shareholder-employee, aren't they just engaged in the trade or business of performing services as an employee, as opposed to the trade or business of the corporation itself? That would mean that if the debt is considered business bad debt, the deduction vanishes due to the disallowance of 2% miscellaneous itemized deductions.

How about amending returns and filing Form 8082 with a statement that the corporation had multiple classes of stock and therefore its S election had terminated? That would reduce the taxable amount to whatever distributions were actually received, and they would be taxed at preferential rates. Also fun for your client to watch if the corporation then gets audited.
 

#4
Nilodop  
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That would mean that if the debt is considered business bad debt, the deduction vanishes due to the disallowance of 2% miscellaneous itemized deductions.. I overlooked that fine point. So is there authority somehow to use some other tax principle so as to directly offset the bad debt against the salary income? Or is there no other choice but to treat it as a miscellaneous itemized deduction and therefore wasted?
 

#5
Chay  
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Nilodop wrote: So is there authority somehow to use some other tax principle so as to directly offset the bad debt against the salary income?

We would have to start questioning the character of the payments that were made by the corporation.

Here's an argument:
If, as the company alleges through its continued filings of Form 1120-S each year, the company really is an S corporation, then all shareholders must have had identical rights to distribution and liquidation proceeds. Therefore, we should regard an amount of the total distributions to the taxpayer proportionate to the overall distributions of the corporation as having been in satisfaction of that right.

Here's another argument:
The taxpayer was acting as a creditor both in the sense of being owed wages by the company and in the sense of holding a note issued by the corporation. The company's obligation to repay both types of creditor is equivalent, and so we should regard all payments received as being in satisfaction of debts owed to the taxpayer in the order that the debts were incurred.

And don't forget we can also talk about the position that the company's S election was terminated, which I mentioned previously.
 

#6
Nilodop  
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I was thinking more of the so-called "relation back" concept, but it's just a thought.
 

#7
Chay  
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Whatever happens, it needs to happen at the level of gross income, meaning that what the company listed as "wages" on the W-2 weren't actually all wages. Any deduction we can come up with won't fit into one of the categories enumerated in section 62(a) unless it's a capital loss deduction.

Can the relation back concept accomplish this?
 


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