Discussion Questions

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I:9-1

Chapter I:9

Losses and Bad Debts

Discussion Questions

I:9-1 The closed transaction doctrine states that a realized loss must be evidenced by a completed transaction or identifiable event. This doctrine exists to prevent taxpayers from recognizing a loss as a result of fluctuating prices prior to the disposition of the property. This is,

of course, different from the economic concept for realized loss. p. I:9-2.

I:9-2 The amount of the deductible loss when property is disposed depends on (1) the type of property, (2) the manner in which the taxpayer uses the property, (3) the basis in the property, (4) the amount realized upon disposition, and (5) the way the property is disposed. pp. I:9-2 and I:9- 3.

I:9-3 In order to deduct a loss on worthless securities, the taxpayer must first establish when the security actually became worthless. The deduction is only available in the year the security becomes worthless. Once this is determined, Sec. 165(g) provides that the loss incurred is treated as a loss from the sale of a capital asset on the last day of the taxable year. Because of the limitations imposed on the deductibility of capital losses, this may severely restrict the current tax benefit to the taxpayer. Under certain circumstances, if a domestic corporation holds worthless securities in an affiliated corporation, the loss to the domestic corporation is treated as having arisen from a sale of a noncapital asset. This makes the loss an ordinary loss. In order for this exception to apply, two requirements must be met: (1) the domestic corporation must own at least 80% of the voting power of all classes of the affiliated corporation’s stock and 80% of the total value of the stock, and (2) more than 90% of the affiliated corporation’s gross receipts for all its taxable years must be from nonpassive income. pp. I:9-3 and I:9-4.

I:9-4 If the worthless securities consist of securities of an affiliated corporation held by a domestic corporation, the loss is treated as an ordinary loss rather than a capital loss. For this exception to apply the domestic corporation must own at least 80% of the voting power of all classes of the affiliated corporation’s stock and 80% of the total value of the stock. Additionally, more than 90% of the affiliated corporation’s gross receipts for all its taxable years must be from nonpassive income. (i.e., sources other than dividends, interest royalties, rents, annuities, and gains from the sale or exchange of stock and securities.) pp. I:9-3 and I:9-4.

I:9-5 To have a capital loss, (1) there must be a sale or exchange and (2) the transaction must involve a capital asset. For example, the loss from the destruction of a capital asset is an ordinary loss and not a capital loss because there has not been a sale or exchange. Furthermore, a loss on the sale of inventory is ordinary because inventory is not a capital asset. pp. I:9-4 and I:9-5.

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I:9-6 In order for stock to be considered Sec. 1244 stock, the following requirements must be

met:

• The stock must be owned by an individual or a partnership.
• The stock must have been originally issued to the individual or to a

partnership in which the individual is a partner.

• The stock must be stock in a domestic corporation.
• The stock must have been issued in exchange for cash or property other than stock

or securities.

• The corporation may not have derived over 50% of its gross receipts from passive

income sources (i.e., sources other than royalties, rents, dividends, interest, annuities, and sales or exchanges of stock and securities) during the immediately preceding five taxable years.

• At the time the stock is issued, the amount of money and property contributed to

both capital and paid-in surplus may not exceed $1 million. p. I:9-5.

I:9-7 Losses on the sale or worthlessness of Sec. 1244 stock are deductible as ordinary losses up to a maximum of $50,000 per taxable year ($100,000 for married taxpayers filing a joint return). Any excess loss for the year is a capital loss. Gains on the sale of Sec. 1244 stock are

capital gains. p. I:9-5.

I:9-8 Under Sec. 267, a loss on the sale of investment property between an individual and a controlled partnership or corporation (the individual owns more than 50% of the partnership or corporation) is disallowed. The individual and the controlled entity are deemed to be related parties, and therefore, the loss is disallowed. If the loss were not disallowed, the individual would be able to create a tax loss and still retain economic control of the property. The same reasoning applies to the wash sale provisions under Sec. 1091, where losses on the sale of stock or securities are disallowed if the taxpayer purchases substantially identical stock or securities within 30 days before or 30 days after the sale. Furthermore, under Sec. 351, a loss realized on property transferred to a controlled corporation in exchange for stock or securities of the corporation is deferred. Pursuant to the like-kind exchange rules of Sec. 1031, losses realized on

exchanges of like-kind property are also deferred. p. I:9-6.

I:9-9 a. A passive activity is any trade or business in which the taxpayer does not materially participate. A passive activity also includes any rental activity that is not a trade or business.

• Individuals, estates, trusts, closely held C corporations, personal service

corporations, and certain publicly traded partnerships, are subject to the passive loss limitation rules. The purpose of the passive loss rules is to prevent certain taxpayers from offsetting their portfolio and active income with losses generated in passive activities. pp. I:9-10 through I:9-12.

I:9-10 a. A closely held C corporation is a C corporation where more than 50% of the stock is owned by five or fewer individuals at any time during the last half of the corporation’s taxable year.

• A closely held C corporation may offset its passive losses against its active

business income but not its portfolio income. Individuals and personal service corporations may not offset either their active or portfolio income with passive losses. pp. I:9-12 through I:9-14. 2 / 3

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I:9-11 A taxpayer’s material participation in an activity is determined separately for each activity. Furthermore, suspended losses are deductible only upon the complete disposition of the passive activity. Also, the rental losses allowed under the special real estate exceptions must not be mixed in with losses from other types of passive activities. For these reasons, it is critical to identify exactly what constitutes an activity. pp. I:9-10 and I:9-11.

I:9-12 a. Under the Regulations, different business operations may constitute one or more activities, depending upon all the pertinent facts and circumstances. The facts that are given more

weight in this determination include:

• Similarities and differences in the types of business • The extent of common control • The extent of common ownership • The geographical location, and • Any interdependencies between the operations (i.e., the extent to which they purchase or sell goods between themselves, have the same customers, are accounted for with a single set of books, etc.)

Generally, taxpayers have a good deal of flexibility in identifying how operations are to be combined into activities based on these facts. However, once this determination is made, taxpayers must be consistent from year to year.

• In general, a business operation and a rental operation cannot be combined into

the same activity for purposes of the passive activity loss rules. However, if the business operation and the rental operation are situated at the same location and the business operation is insubstantial in comparison to the rental operation, or vice versa, the two may be combined into one activity. The Regulations do not define what constitutes insubstantial. p. I:9-10.

I:9-13 a. No. The rental unit qualifies as a real property trade or business with respect to

Laura. This is the case because she meets the following requirements:

• The rental unit is Laura’s only business and she spends over 750 hours

during the year managing and caring for the rental unit.

• Because Laura is the sole manager of the unit, she meets the material

participation requirement.

• More than 50% of Laura’s personal services for the year is spent in this

real estate business.

• Yes. The lab is a passive activity with respect to Kami. A business activity is

passive with respect to a taxpayer if the taxpayer does not materially participate in the activity.In order to materially participate, the taxpayer must meet one of several tests:

• The individual participates in the activity for more than 500 hours during

the year.

• The individual’s participation in the activity for the year constitutes

substantially all of the participation in the activity by all individuals, including individuals who do not own any interest in the activity.

• The individual participates in the activity for more than 100 hours during

the year, and that participation is more than any other individual’s participation for the year.

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