Maximizing Bad Asset Losses
Determining the desirable treatment takes some thought
Although the Tax Code is not overly complex in its approach to deductible losses, careful planning is a must to maximize their effect on a business return. The basic rule of thumb in structuring transactions that might lead to a loss is that ordinary losses are good, while capital losses are not so good.
“You’re better off from a deduction standpoint to have an ordinary loss where you can offset ordinary income than to have a capital loss that has limits on what can be claimed, particularly if it’s the only loss you have for that year,” said Roger Harris, president of Padgett Business Services.
“There are all types of transactions that can be one or the other,” he said. “For corporations, the current-year deduction for a capital loss is allowed only to the extent of capital gain, with the possibility of carrybacks and carryforwards, while ordinary losses have a better chance of being fully deducted in the year that they are incurred.”
“In C corporations, once you get to zero you have eliminated the loss for that year, but ordinary losses can be carried forward or carried back. In a pass-through, the ordinary loss can be used to offset salary or other business income. So in an S corporation or another pass-through, the ordinary loss can be carried over to the personal return and used to offset any other ordinary income, whereas a capital loss is limited to $3,000,” he continued. “Capital gains have limited deductibility and can only be deducted against other capital gains, whereas ordinary income has greater opportunities to be deducted currently and can be claimed against more types of income. In a perfect world, you want capital gains and ordinary losses. Of course, there are rules, and you don’t get to pick.”
Nevertheless, in the case of bad assets, there are things you can do to help your client get an ordinary loss, according to Brett Beveridge, CPA, special counsel in the Atlanta office of Chamberlain Hrdlicka.
Beveridge cited the Madoff case and Santa Fe Pacific Gold as two examples where the desirable ordinary loss treatment was not a given. “In general, a loss of an investment from an open market purchase due to fraudulent activity is treated as a capital loss,” he noted. “However, a theft loss is not a capital loss. The IRS, after public pressure, issued a favorable revenue ruling holding that a loss from a Ponzi scheme similar to Madoff’s was a theft loss,” he said.
In Santa Fe, the taxpayer paid a $65 million termination fee. “The IRS argued that the fee should be capitalized and not amortized. The Tax Court held that the fee was deductible under both Code Sections 162 and 165,” said Beveridge. Read more on Accounting Today.