What is my Cost Basis?

What is my cost basis in certain property and why do I care?  Many people and businesses are not fully aware of their basis in property, do not properly track the basis and may be unaware as to the importance of their basis in property.  The article below has been prepared by a tax attorney to provide information regarding basis.  Please remember, this is not legal advice and it is recommended you consult directly with your tax attorney regarding your specific issues and questions.

You could look at your cost basis as your initial threshold for gain or loss when an asset or property is sold.  Although, not discussed in this article, under certain circumstances you may not be able to recognize a loss, and you may not have recognize gain.  Further, your basis may be adjusted because of certain issues.  Regardless, to calculate basis, you would start with your cost basis.  Generally, the basis of your property is the cost.  You would likely determine cost by the amount of cash paid, debt obligations (loan or promissory note) and other property transferred.  However, it is very important to remember that your cost basis may also include:

  • Freight/shipping
  • Installation and testing
  • Sales Tax
  • Legal and accounting fees
  • Excise Taxes
  • Recording Fees
  • Real estate taxes

For example, say you decide to purchase a piece of equipment for $100,000.  The shipping fee was $2,500 and you paid an attorney $1,000 to draft the bill of sale and related purchase documents.  Your cost basis would thus be $103,500.  Thus, if you sold the equipment immediately thereafter, your threshold for any gain would be $103,500.  If you held the equipment for business use, and depreciated the equipment, this depreciation would lower the cost basis and you would track the adjusted basis of the property.

 

Often when a business is purchased, you purchase all assets and the assets differ.  Thus, how do you report or track the cost basis in the purchase of a business?  When you purchase business assets, you can report the amount paid for each class of assets on Form 8594.  The IRS allocates purchase price in an asset sale between seven classes of assets, which are outlined on the Form 8594 and defined in the instructions and elsewhere.  The business selling the assets would report the sale of the assets on Form 4797 (Sales of Business Property).  Generally, the seller and buyer involved in the asset purchase will agree to the allocation of the purchase price and Form 8594 will be agreed upon and completed prior to closing, perhaps even as an exhibit to the asset purchase agreement.

 

If you have questions relating to your basis in property and tax treatment through the sale or purchase of property, you may want to speak with a tax attorney and/or business attorney.  You can contact The McGuire Law Firm at 720-833-7705 with any questions.

Denver Tax Lawyer

Operating Agreement Invalidating S Corporation Election

Limited Liability Companies (LLC) are a very popular entity choice and structure for new businesses and closely held entities.  An LLC can be formed quickly and has a lot of flexibility regarding members, operations and taxation structure.  It is not rare for an LLC to eventually consider and perhaps decide to be taxed as an S corporation.  Although, an LLC converting to a Subchapter S corporation has benefits, such as potentially reducing self-employment taxes, these benefits may be mistakenly lost if the Subchapter S corporation status is invalidated.  A means by which to invalidate the S corporation status, which is many business owners may not consider is the LLC operating agreement.  Abiding by the LLC operating agreement may cause the entity to operate in a manner than invalidates the S corporation election.  The article below has been prepared by a tax attorney and business attorney to further discuss the risk of losing S corporation status by abiding by an operating agreement.  Please remember this article is for information purposes only, and is not intended to be legal or tax advice.

To properly evaluate how an S corporation could lose or invalidate the S corporation election, it is important to remember how a business qualifies and the requirements for an S corporation.  The qualify as an S corporation, the corporation must:

 

  • Have only allowable shareholders (no partnership, corporate or non-resident alien shareholders)
  • Have only 100 shareholders or less
  • Have only one class of stock
  • Be a domestic corporation
  • Not be an ineligible corporation (insurance companies and other disallowed companies)

Our focus will be on the one class of stock requirement.  The one class of stock requirement requires that all shareholders receive distributions and liquidation preferences pro-rata per their stock ownership.  An S corporation can have a different class of stock for voting rights, but the economic benefits and distributions to the shareholders must follow the ownership percentage, which is directly related to the number of shares each shareholder owns.  Many LLC operating agreements will contain clauses and language that actually require unequal or disproportionate distributions to the LLC members.  Thus, if the distributions are in accordance with the operating agreement, the issuance of disproportionate distributions could lead to the IRS claiming the corporation has multiple classes of stock, and therefore, the S corporation election is invalid.  Treasury Regulation Section 301.7701-(3)(c)(1)(v)(c) states that the S corporation election is valid only if ALL requirements are met.  Thus, an LLC electing be to be taxed as an S corporation should consider removal of certain clauses within the operating agreement relating to substantial economic effect, IRC Section 704 and any other clause that could create disproportionate distributions.  If the S corporation election was lost, the owners may be subject to additional self-employment tax, or the business, if taxed as a C corporation would be subject to tax at the corporate level, and the shareholder level, thus double taxation.

If you have questions related to your choice of entity, taxation matters and internal business documents, it is recommended you speak with a tax attorney and/or business attorney to review the documents, taxation matters and intended tax treatment.

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The Cohan Rule

Individuals or business who have been audited by the Internal Revenue Service may be familiar with the Cohan rule.  The Cohan rule is based upon a court case that may allow a taxpayer an allowance for certain business deductions even if the taxpayer is unable to verify or substantiate certain expenses.  This article has been prepared by a tax attorney at the The McGuire Law Firm to provide additional information related to the Cohan Rule and IRS tax audits.  It is recommended you use this article for informational purposes only and discuss your facts and circumstances specifically with your tax attorney and other advisors.

The Internal Revenue Code requires that a taxpayer maintain certain records for the IRS to allow an expense or deductions.  When a taxpayer is being audited by the IRS, generally the taxpayer must show a receipt, invoice, cancelled check or like item for the IRS to allow the expense that is under audit.  If the taxpayer is unable to provide the necessary documentation, the IRS may disallow the expense or item.  Under the Cohn rule, the IRS or a court may allow a taxpayer reasonable amount of the deductions.  The key issue is, what is reasonable?

The Cohan rule was established through a Court of Appeals case in the Second Circuit in 1930.  Although, the court stated the taxpayer did not have adequate substantiation to verify expenses, the court held the board (IRS) should make an approximation.  In short, the court felt that it was reasonable for the taxpayer to have some reasonable business expenses, and should not be disallowed all deductions due to lack of records.  Thus, under the Cohan rule, a taxpayer can make an argument for an expense deduction to be allowed without proper documentation.

It is important to remember that the Cohan rule does not apply to all expenses.  For example, the Cohan rule does not apply to items whereby Internal Revenue Code Section 274(d) applies.  IRC 274(d) applies to travel expenses, entertainment expenses, gifts and other listed property, and taxpayer must comply with very strict verification rules for the IRS to allow a deduction.

One question that is often asked is, who has the burden of proof in a tax audit?  Generally, the taxpayer will have the burden of proof that they are entitled to the deduction and the additional tax proposed by the IRS is incorrect.  However, under Internal Revenue Code Section 7491(a), the burden of proof can switch to the IRS when the taxpayer produces credible evidence relating to factual issues, complies with requirements and verifies deductions, cooperates with reasonable requests by the IRS relating information, documents, interviews, meetings and maintains records under the Internal Revenue Code.

If you are being audited by the IRS, you may consider representation by a tax attorney.  You can speak with a tax attorney by contacting The McGuire Law Firm.

Deductible or a Capital Expense?

Is an amount paid by a business an expense that is currently deductible, or is it a capital expenditure that should be depreciated,, amortized or depleted?  This issue is one of the most common issues in a tax audit with the Internal Revenue Service, as well as one of the most litigated issues in United States Tax Court.  The article below has been prepared by a tax attorney to provide additional information related to this common issue.  Please remember that this article is for informational purposes, and you should consult directly with your tax attorney and advisors related to your specific issues.

A currently deductible expense is an ordinary and necessary expense that is paid or incurred by the business during the taxable year in the ordinary course of operating the trade or business.  Please reference Internal Revenue Code Section 162.  In comparison, a capital expenditure would be the cost to acquire, improve or restore an asset that is expected to last more than one year.  These capital expenditures are not allowed a deduction, but rather are subject to amortization, depreciation or depletion over the useful life of the property. See Internal Revenue Code Section 263.

That being said, how does one determine whether an expenditure is an expense to be deducted or a capital expenditure?  The answer is, it is a question of fact.  The Courts have applied the principles of deductibility versus capitalization on a case by case basis, and the facts and circumstances of each case will likely determine the outcome.

An example may help illustrate the difference between an expense that would be deductible versus one that would be capitalized.  If a business owner bought certain office supplies such as pens and paper, they would be deductible.  If the same business owner, purchased a building to operate the business, the building would be capitalized.  Let’s look at a different example that might not be as obvious.  Assume a business owns and rents property.  In one property a hole was placed in the wall when a tenant moved.  In another property, the owner decided to replace the walls with new drywall and paint.  It is likely the fixing of the hole in the wall would be deductible as a repair or maintenance, whereas the cost to replace the walls would be capitalized by the business.

One further issue to consider beyond the matters discussed above is that the Internal Revenue Code requires books and records to be maintained to verify and substantiate the expense whether it be a deduction or capital expense.  If the item or amount of the expense cannot be verified and substantiated by the taxpayer, the IRS may disallow the deduction or the capital expense.

If you have questions related to a deduction or capital expense, you can speak with a tax attorney by contacting The McGuire Law Firm.   The McGuire Law Firm offers a free consultation with a tax attorney to discuss your questions and issues.

Denver Tax Attorney