Business Structure Apparent Conflict

Client stated that they invested a total of $12k (as a passive investor) in a local restaurant that has since closed permanently. I asked the client whether this was an equity investment or debt. They stated that they’d get 10% of gross sales. I told them that this sounded like an equity investment and if this were a partnership or S Corp, they should request a Schedule K-1 from the individual who organized this business.

They requested a K-1 from this individual and the individual told them “because I’m a sole proprietorship/LLC and the business isn’t an S corp or partnership, that we don’t need to issue a k-1”. Because the investment sounded like an equity buy-in to the business, I asked my client to forward a copy of the agreement for review.

The top of the agreement says “SHARE PURCHASE AGREEMENT” and it refers to the business as a “corporation” and the new investor as a “stockholder” and in exchange for $12k, the stockholder would get two shares and another provision states “Dividends of 5% of gross sales per share will be distributed on the 5th of each month”.

After review of this agreement, this business at a minimum is clearly NOT a single-member LLC disregarded for tax purposes. The verbiage makes it seem like it’s either a C Corp or an S Corp, but may even be a partnership if they never actually elected corporate status. I asked them if this contract was drawn up by an attorney because of the many apparent conflicts with this agreement. They said no, which is no surprise here.

Therefore, my question is, if the client had never elected corporate status, does the fact that this contract refers to the business as a “corporation” make the contract void? If so, does this automatically also disqualify it from being considered a partnership too? Aside from the legal implications, how does this agreement (that clearly has many flaws) affect how to report this for tax purposes? Anyone had any similar situations?

Anyone had any similar situations?

Sure, these things are not uncommon. Sometimes people promise investors x% of a business, but when added up, it equals more the 100%. LOL.

You will not get a K1. So forget about that. As to 1244 treatment, I’d forget about that too. We’re left with a profit-motivated transaction, so write it off as a capital loss, would be my advice. I’d probably pass on any abandonment ideas.

P.S. Small investments rarely pay off. It’s an indication of boot strapping and capitalization level is usually misguided, as put forth by an unsophisticated investee. Add in that this is a restaurant and nothing here is unsurprising. The language in the agreement only confirms these well-known general truths. If you want to give your client some important advice, tell him to never do this again.

I assume your client has no desire to pursue return of his investment.

This situation gives you a lot of reporting flexibility. I'd be biased toward a story that generates an ordinary deduction, e.g., theft.

As to investment advice, stay in your lane.

This situation gives you a lot of reporting flexibility. I'd be biased toward a story that generates an ordinary deduction, e.g., theft.

One of the requirements of a theft loss is that the taking be illegal under applicable law. I'll heard plenty of embellished stories before but...

I agree with Jeff. Investment motive. Capital loss. Move on, don't worry too much about all of the conflicting documentation, that stems from both the operator and your client being unsophisticated in these matters, and being too cheap to get good advice.

That was a cheap lesson for your client. I'm glad it was only $12k. Investment/capital loss. This is not worth spending time on to stretch to a different conclusion anyway.

Thank you all for the insight here. So do you all believe this should be reported as a “nonbusiness bad debt” whereby the deduction is reported as a short-term capital loss and an explanation is provided regarding the bad debt or just report this is if it was actually a stock sale with no attached statement?

I was hoping to get a K-1 (if this was indeed an S Corp) since this may have been reportable as a passive ordinary loss and if the activity was disposed of before the end of the year, they could offset the entire loss against other ordinary income. They currently have already maxed out the $3,000 capital loss limitation for this year so reporting it this way would yield no current tax benefit. But sounds like this is an unfortunate consequence to an unwise investment.

I assume your client has no desire to pursue return of his investment.

The client actually stated that this individual wanted to try to pay them back “eventually” but that they don’t believe that will ever occur. So they are more concerned about the tax deduction. But if this is being reported as a capital loss, because it’s not currently considered totally worthless (since there is a slim chance that they get paid back), should they even report this now or should they wait until it’s been determined that this is completely worthless?

Operator implies it was some kind of debt with his language, and your client isn't in the T/B of lending. Agreement states it's stock in a corp. Both of those are capital assets. Capital loss.

You're spinning your wheels trying to stretch this to ordinary loss treatment IMO. What marginal tax bracket is your client in? I'm assuming max, surely not the 20s or below for you to dig this much?

As to investment advice, stay in your lane.

This is in his lane. A $12k investment. Usually those never pan out for the cited reasons. In a (small, local presumably) restaurant. Usually those don’t pan out either. (Restaurants are tough, and involve cash, and people always steal. The fact that your client would be passive makes me hesistate as well). And had we known about the “agreement” prior to it being finalized, that would have been the third strike.

In any case, it’s facts and circumstances. And in this case, I would have been pretty hardcore about advising the client not to do it. In other cases, I might not be so pushy, but I would certainly speak loudly about the risks.

Here’s another idea for you: When it comes to evaluating small business investments, some folks are very astute, sharp, knowledgable and wise. They are typically well-educated and have had prior small business success. They often have a grasp of accounting, financial statements and even legal matters. And they know a bullshitter when they see one. They don’t need my help in small business investment evaluation. In other cases, we have an unsophisticated client, who isn’t so well-versed in what it takes for a small business to be successful. This group may very well make some very bad small business investment decisions. For these folks, I say, “Tell the promoter you don’t make these decisions. Tell the promoter to call me, your CPA.” One of the first things I ask about is past history with successful business ventures. I want to see his resume, where’s he’s worked and what he’s done. I also like to see the educational background. I want to know where his kids go to school. I want to know where he lives. And I want to see a personal financial statement of the promoter. That right there usually nips things in the bud. If some guy, say age 50, is coming to my client asking for an investment, I want to see how successful he’s been in his own financial life. That guy has had 30-years to save and be successful. And if promoter is 40, he’s had 20-years to save and be successful. In effect, I want to know about the promoter/management team. Two things make a great business: The idea and the execution. The former is easy. The latter isn’t. So I want to do a deep dive into how I think the execution will play out, which is predicated on what we think about the guy who is coming to the client asking for money. And I also want to know how passive or active my client will be. And I want to know who will control the checkbook.

This is a real value add.

Agreed. This was certainly an unwise investment. This was a new client and had I known about this in advance, I would have likely advised against it as well. The operator of the restaurant was a veteran so that may have played a role in their decision to invest.

Operator implies it was some kind of debt with his language, and your client isn't in the T/B of lending. Agreement states it's stock in a corp. Both of those are capital assets. Capital loss.

True, both are capital assets but nonbusiness bad debt is reportable as a short-term capital loss (regardless if held over 1 year) and necessitates the attachment of a statement explaining the situation. A worthless security on the other hand can be short-term or long-term in nature. Regardless, if there is a possibility that the operator pay them back in the future, it’s probably going to be best not to report anything for tax purposes until it has become totally worthless.

You're spinning your wheels trying to stretch this to ordinary loss treatment IMO. What marginal tax bracket is your client in? I'm assuming max, surely not the 20s or below for you to dig this much?

Effective tax rate between Federal and state is about 29% so this deduction has the potential to save about $3,500 in total taxes depending on how it’s reported. But I’m okay with not reporting this as an ordinary loss if that’s what’s recommended here. It’s just that if this WERE handled properly, the taxpayer should probably get a K-1 for this reporting it as such.

I try to avoid giving investment advice and think preparers should do the same.

I try to avoid giving investment advice and think preparers should do the same.

It’s not that simple. And perspective is a big part of it. Your perspective is from an attorney’s standpoint, likely with sophisticated, higher net worth clients. And those client may have a bit of business and small business investment experience.

Now look at the people who post on this board. Most have a different perspective and a different type of clientele. You know, unsophisticated clients. Like the one in this thread. $12k is likely a lot of money to that client. To steer that client in the right direction is a big value-add. We wouldn’t be talking about saving the client $3k in taxes. We would have instead saved him $12k. Some of us accountants have a lot of experience, having seen a lot of things and have pretty good judgements about things, inlcuding people. To cast that good judgement aside is a waste and doesn’t best serve the client in many cases.

There was even a post the other day where some client making $60k a year had to withdraw that much from her IRA to make a down payment on a new $400k home…tax, 10% penalty, repayment of PTC, reduction of IRA growth. Not to mention, a high interest rate on the loan. I wonder how much the furniture will cost? And don’t forget the monthly bills. Yes, she gets child support, but when will that end? This was very likely a short-sighted, and highly questionable, financial decision. She was clearly stretching. Sometimes stretching leads to harder work and higher pay (especially if self-employed). So sometimes, it’s not a bad move. But sometimes it does nothing but cause stress. We’ll see how long she lasts in that house. If this was my client, and I knew what she was doing, there would have been a long conversation about it, whether or not the purchase had the blessing from her financial advisor (if there is one). And sure, I wouldn’t be opposed to talking it through with the financial advisor (if there is one).

If a client is sophisticated, fine. If someone isn’t, you’re doing your client a disservice. A practitioner has to use their judgement in advising a client on something like this. I will also submit, that, in my judgment there are certain “newly wealthy” folks that make pretty bad financial decisions. In a lot of cases, these folks have risen to a new financial level, but unfortunately, heightened sophisication often doesn’t quickly follow. That’s human nature, but nonetheless true. The least we can do is point it out to folks in this category.

So, all in all, I disagree with Gator’s blanket “avoidance” approach…especially for clients that could use some good judgement, including a second opinion. But in a lot of cases, people don’t even get a first opinion

Effective tax rate between Federal and state is about 29% so this deduction has the potential to save about $3,500 in total taxes depending on how it’s reported.

There's more than one return at play, though. If it's a capital loss, all else equal, the unused capital losses will be taken over 4 years so the client will still get the $3,500 in total taxes saved. Of course, it will be realized over a couple years and with a small discount due to time value of money, but the client will still be saving the taxes.

I try to avoid giving investment advice and think preparers should do the same.

As tax professionals, we are not experts on investing but we have seen enough sausage being made that we can provide a perspective. I get questions all the time from unsophisticated clients and, although I would not make specific recommendations on specific investments (for or against), I'm willing to have a reasonable discussion about the basics of the investment. A common one I get is gold, and I can talk about some of the pros and cons for gold as an investment, and another example was when I was getting the questions about AMC and the other meme stonks a couple years ago. I'm not going to say "no" or "yes" to whether a client should choose a specific investment, but I think it's fine to give some background on the investments as a general course of discussion.

This situation of a $12,000 investment in exchange for 10% of the gross sales of a restaurant is something we can absolutely help our clients think through. The return to the investor under these terms would be a huge expense to a restaurant, which already has thin margins, such that the restaurant would probably be better off taking a loan from the mafia. So why is this business offering investments at such bad terms? And why are you, my client, the person who has been given the opportunity for such an amazing set of returns?

In this situation, I wouldn't be providing investment advice, but I sure as hell would be willing and able to get my client to think through their choices.

This situation of a $12,000 investment in exchange for 10% of the gross sales of a restaurant is something we can absolutely help our clients think through. The return to the investor under these terms would be a huge expense to a restaurant, which already has thin margins, such that the restaurant would probably be better off taking a loan from the mafia.

Exactly. Even a proven restaurateur, one with a track record of success and ability to execute would have difficultly paying 10% of gross to an investor each month and remaining solvent. The net margin in the restaurant industry is not high.

Illustrating that for the client might mean this investment/loan/whatever would never get made and the client would be better off for it.

To Missing Donut…exactly. I’m not gonna answer questions like, “How much of my portfolio should be in foreign small-cap stocks,” but I’m more than happy to vet out the details surrounding some small business deal and give my opinions on those people promoting it. And I will often start that conversation even without being asked. Unsophisticated people often do not have great sounding boards. Their friends and family are typically just like them. And the financial advisors for these people are often not all that savvy either. They at least need one sound opinion. And, as predictable as it may be (because of their lack of sophistication), they don’t know enough (or bother to) ask for an opinion. They just do it. Often, after a real rosy sales pitch.

There’s a lot to these conversations and decisions, including what the client thinks. Sometimes a guy will say, “Jeff, I’m just trying to hit a home run with this deal. I’m well-prepared to lose my $12k.” Fair enough. But in other cases, it might be, “This $12k is gonna really strap me, but I think it’s a real safe and sound investment.”

This discussion is about the practical vs the ideal. It should be in the PFZ.