Business or Nonbusiness Capital Gain?

Taxpayer recognized a capital gain from a distribution in excess of basis from an S-corp that he is active in (not a passive activity). For purposes of computing his 2017 NOL, I'm planning on treating this as a business capital gain since it was derived from his trade or business. I didn't find clear guidance from the code section or the IRS instructions. Could this be considered a non-business capital gain?

Interesting question. I also did not see much guidance on it. Reg. 1.172-3 explains how the calculation of NOLs is affected by capital gains and losses, but does not seem to define business capital gains. Why it matters is sort of described here in the reg.

(2)Capital losses.

(i) The amount deductible on account of business capital losses shall not exceed the sum of the amount includible on account of business capital gains and that portion of nonbusiness capital gains which is computed in accordance with paragraph (c) of this section.

(ii) The amount deductible on account of nonbusiness capital losses shall not exceed the amount includible on account of nonbusiness capital gains.

.

Pub 936 restates it thusly.

Adjustments for capital losses (lines 19– 22). The amount deductible for capital losses is limited based on whether the losses are busi- ness capital losses or nonbusiness capital los- ses.
Nonbusiness capital losses. You can de- duct your nonbusiness capital losses (line 2) only up to the amount of your nonbusiness capi- tal gains without regard to any section 1202 ex- clusion (line 3). If your nonbusiness capital los- ses are more than your nonbusiness capital gains without regard to any section 1202 exclu- sion, you cannot deduct the excess.
Business capital losses. You can deduct your business capital losses (line 11) only up to the total of:
Your nonbusiness capital gains that are more than the total of your nonbusiness capital losses and excess nonbusiness de- ductions (line 10), and
Your total business capital gains without regard to any section 1202 exclusion (line 12).

So it seems it's beneficial to include capital gains as business capital gains so you can include business capital losses (if any) in calculating NOLs. But. it's also beneficial to have nonbusiness capital gains if you want to include nonbusiness capital losses. Just curious - which is your situation?

On whether the c/g you describe is a business c/g, I think yes. No specific authority, just reasoning. So absent a specific authority, maybe treat it however you get the best answer. Oh, my reasoning is kind of like yours. There were business investments and income and deductions and distributions, all in connection with the shareholder's active participation, and all of which directly affected his return. The answer might or might not be different if it were a C corporation, but it's not, so let's not pursue that one.

This is a stretch, but there's a similar issue in cooperative patronage dividends. Well, a bit similar maybe. Really a stretch. It's in Written Determination 8815001.

The third and fourth issues address the question of the proper classification of gain realized from the sale of real and/or depreciable property used in Taxpayer's trade or business. If the gain is properly classified as gain under section 1231, it is necessary to determine if that gain is patronage or nonpatronage gain. ... Rev. Rul. 74-84, 1974-1 C.B. 244 holds that where the taxpayer realizes gain upon the sale of a depreciable asset, that portion of the gain treated as ordinary income under section 1245 of the Code is considered patronage source income because the taxpayer is merely recapturing income that otherwise would have been available for distribution as a patronage dividend. That portion of the gain treated under section 1231 as gain from the sale of a capital asset held for more than six months is considered income derived from sources other than patronage, and thus, does not give rise to a deduction to the cooperative when distributed to its patrons as a patronage dividend. ... CONCLUSIONS

(3) Gain from the sale of depreciable property or real property used in a trade or business is considered gain under section 1231 of the Code.

(4) Section 1231 gain is considered capital gain and as such is deemed to be nonpatronage source income.

It might be, it depends on the facts and circumstances. Business capital gains and business capital losses are gains and losses from the disposition of non-depreciable property that is either “directly related” to, or has a “real nexus” to the taxpayer’s business. There's a good discussion in Crow v. Commissioner, 79 T.C. 541 (1982). https://casetext.com/case/crow-v-commis ... -revenue-1

Thank you nilodop and dave829. The taxpayer doesn't have any capital losses for the year. It would be more advantageous for the capital gain to be considered nonbusiness in order to utilize their non-business itemized deductions when calculating the NOL.

After reading the discussion and analysis in the Crow case I’m of the opinion this is a non-business capital loss. The distribution in excess of basis that created the capital gain is analogous to a partial disposition of the S-Corp stock which, does not meet the “directly related” or “nexus” tests to the business itself and is therefore more accurately viewed as a non-business capital asset which would result in a non-business capital gain. I couldn’t find a case with close fact pattern but in Merrill v. Commissioner (1947) the court ruled that the sale of partnership interest was outside of the business regularly carried on by the petitioner and “not a part of the business of the partnership”.

Except that in your facts he did not sell anything. BTW, is he the sole shareholder of the S corp.?

Yes, he was the sole shareholder and no E&P in the s-corp. True, he didn't sell anything. However, in this context, the distribution in excess of his basis is like a sale of a capital asset. Sec. 1368 "If the amount of the distribution exceeds the adjusted basis of the stock, such excess shall be treated as gain from the sale or exchange of property".

I'm not questioning that it's a capital gain, and I'm aware of how 1368 works. I'm simply saying I can't see a much more closely-related-to-the-business capital gain than your client's. Having said that, I think I already said up above that absent more specific guidance, I'd go the way that best helps my client.

The S corp stock in the hands of the shareholder is a capital asset and not a business capital asset.

Quite possibly, BTJig. Do you have a citation handy?

Arkansas Best

You are misreading the issue in that case https://supreme.justia.com/cases/federal/us/485/212/. It has to do with capital vs. ordinary gain or loss treatment, i.e., the Corn Products doctrine. not business capital gain vs. nonbusiness capital gain (or loss) for NOL purposes.