Origin of Claim?

Technical topics regarding tax preparation.
#1
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I'm dealing with the wife of a deceased taxpayer. The details are a little fuzzy since he didn't share this investment with us or his wife, but this is the background I was able to gather from the attorney involved:

Back in 2007, the taxpayer invested $90k for an interest in an LLC. The LLC borrowed about $3 million to build apartments. He signed personally along with the other investors. When the LLC couldn't pay it back, they went to the investors. According to the attorney I spoke to, he had a chance to settle, but received bad legal advice from another attorney. Apparently he was told not to worry since the investment was in another state. In 2012, the lender successfully entered a judgement against the taxpayer for the $3 million (he was the only remaining investor who didn't settle). In early 2017, the taxpayer and spouse had over $500k debited from their joint checking account as part of the judgement. A few months later, the taxpayer died. His spouse spent about $400k in legal fees related to case, resulting in a settlement where no further money was due.

The legal fees were related to the initial investment, but they were to prevent the lender from receiving the full judgement. I'm thinking any deductions related to the legal fees are capital since they're connected to the LLC interest. I'm not sure about the timing and which year(s) I should claim the capital loss. I'm assuming it would include the $500k debited and the $400k legal fees. She spoke to a CPA who believed she might be out of luck since the statute was up on the $90k loss. Any insight is appreciated.
 

#2
makbo  
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When did the LLC terminate? And didn't the other investors who settled reduce the $3 million liability? And is there CODI here? And if a capital loss belonged to the spouse, isn't it lost after the year of death?

Just asking for clarity's sake, I don't have real insights here.
 

#3
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What share of the LLC capital and loss interest did the taxpayer have? Was the LLC taxed as a partnership or S-Corp? If partnership, did he include his share of the $3 million liability in basis?

I'm thinking if the LLC was taxed as a partnership, the taxpayer should already deducted ordinary losses up to his initial $90k investment and his share of the $3 million loan. Collections up to his share of the debt have no tax effect. Any collections beyond that point are capital losses, because if they had been invested in the LLC and used to pay off the lender, that would have increased taxpayer's basis without a corresponding ordinary deduction. The loss occurs in the year of payment (2017).

The way I understand the origin of the claim doctrine, the legal fees paid have the same character as the underlying transaction, which if my previous paragraph is correct, is investment in the defunct LLC. The legal fees are also capital losses, in the year paid, to the taxpayer or the taxpayer's estate, not necessarily to the surviving spouse.

Cancellation-of-debt income, if any, should also be capital in nature, and should be excludable under IRC 108(e)(2). (In other words, if taxpayer had paid the remaining $2.5 million, it would be deductible [subject to the $3,000 limit] as a capital loss, which would then be offset by the "capital gain" that results from having $2.5 million of debt discharged.)

All of the capital loss belongs to the taxpayer, and does not transfer to the surviving spouse, so I don't think there is any deduction available to the spouse in 2018 and beyond. Capital losses do not transfer to the estate, but I do think that new losses can be generated by legal fees paid by the estate in relation to this case. When the final estate return is filed, these losses transfer out to the beneficiary[ies].
Last edited by MSchmahl on 4-Sep-2019 3:38pm, edited 1 time in total.
 

#4
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Thanks for the responses. It's been really difficult finding information on this. I checked with the TX Secretary of State. The LLC he invested in dissolved by proclamation in 2012. He never received a K-1. I assume if anything was filed, it would be a partnership. Never even considered cancellation of debt. I've got some more homework to do on this, but the legal fees passed through to the beneficiary (spouse) from the final estate return sounds like the only bet. This client was very quick to invest without consulting anyone, so we're left putting the pieces together. I appreciate the responses on here. It's my first post on here and I'm very impressed. Thanks
 

#5
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MSchmahl wrote:What share of the LLC capital and loss interest did the taxpayer have? Was the LLC taxed as a partnership or S-Corp? If partnership, did he include his share of the $3 million liability in basis?


All references in the legal bills I obtained refer to it as a partnership. However, no K1s were issued. I'm going to assume partnerhsip.

I'm thinking if the LLC was taxed as a partnership, the taxpayer should already deducted ordinary losses up to his initial $90k investment and his share of the $3 million loan. Collections up to his share of the debt have no tax effect. Any collections beyond that point are capital losses, because if they had been invested in the LLC and used to pay off the lender, that would have increased taxpayer's basis without a corresponding ordinary deduction. The loss occurs in the year of payment (2017).


I'm going to forget about the $90k. Correct, it would have been deducted, but no K-1s issued - and the taxpayer never mentioned the investment. I'm going to amend 2017 to include the $500k debit to their joint account (while taxpayer was alive) as a capital loss. Am I correct that I'd just enter on 8949 and Sched D as a LT capital loss?

The way I understand the origin of the claim doctrine, the legal fees paid have the same character as the underlying transaction, which if my previous paragraph is correct, is investment in the defunct LLC. The legal fees are also capital losses, in the year paid, to the taxpayer or the taxpayer's estate, not necessarily to the surviving spouse.


After some research, I learned that the legal fees were paid by the wife after the taxpayer died. They were paid from her own funds and funds she inherited, but I'm a little concerned over the nature of the fees. The fees came to about $400k. They included exploring possible bankruptcy, challenging the bank on the actual debit to their joint account, and settling with the bank on a reduced amount. I don't want to push it, but they're all related to the underlying investment.

Cancellation-of-debt income, if any, should also be capital in nature, and should be excludable under IRC 108(e)(2). (In other words, if taxpayer had paid the remaining $2.5 million, it would be deductible [subject to the $3,000 limit] as a capital loss, which would then be offset by the "capital gain" that results from having $2.5 million of debt discharged.)



All of the capital loss belongs to the taxpayer, and does not transfer to the surviving spouse, so I don't think there is any deduction available to the spouse in 2018 and beyond. Capital losses do not transfer to the estate, but I do think that new losses can be generated by legal fees paid by the estate in relation to this case. When the final estate return is filed, these losses transfer out to the beneficiary[ies].


I'm going to file a late 1041 to include the capital losses form the legal fees. Again, is this just a Sched D item, shown as a capital loss? She doesn't have much as far as capital gains, so this will most likely never be used up at $3k loss/year. So the tax benefit right now is not much. I just want to be sure I'm thinking of everything if challenged.
 

#6
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I'm going to file a late 1041 to include the capital losses form the legal fees. Again, is this just a Sched D item, shown as a capital loss? She doesn't have much as far as capital gains, so this will most likely never be used up at $3k loss/year.


Sounds about right. The unused capital losses will be passed on to the beneficiaries on the final 1041 (K-1 box 11) whenever that is filed. Make sure you have plenty of notes to back up the capital loss treatment, because any challenge from the IRS may come for any year the capital loss carryover is claimed.
 

#7
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Appreciate all of your help.
 


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