Joe Kristan is a CPA at Roth & Company P.C.
Judging by income tax law alone, Congress seems to think that "The Sopranos" provides the standard business model for family financial transactions. The tax code is full of special rules that punish transactions between family members, on the assumption that they can't do business without trying to pull a fast one on their tax filings. You can't accrue a deduction to a cash-basis relative, for example, and you can't deduct a loss on a sale to family
A Kansas City entrepreneur recently learned about another related party rule, good and hard.
Gary Fish started a successful tech company, FishNet Security, described on its website as "the No. 1 provider of information security solutions that combine technology, services, support and training." From 1998 the company was operated as an S corporation, a common tax structure under which the earnings of the corporation are taxed directly on the owner's 1040.
In 2004, he got an opportunity to get some cash out of his investment. While the technical details were a bit convoluted, for tax purposes it came down to having his S corporation contribute the operating business to a new corporation; a private equity group contributed cash. Mr. Fish received some stock in the new corporation, along with $9,698,699 of the private equity cash.
The formation of a new corporation is normally tax-free. Internal Revenue Code Section 351 allows taxpayers to exchange appreciated assets for stock without recognizing gain, as long as the contributing parties own 80% or more of the company after the transaction. But the tax law triggers taxable gain to the extent a taxpayer receiving stock also receives "boot" -- cash or other non-stock property -- in the deal.
As with many tech companies, the value of the business was mostly in its intangible assets -- its "goodwill." The new corporation was treated as buying goodwill. The tax law says purchased goodwill can be amortized for tax purposes over 15 years. And here is where things went bad for Mr. Fish.
When "goodwill" is sold, the tax law normally treats it as a capital gain. An obscure part of the Code, Section 1239, can change that result. If you sell anything that can be depreciated or amortized to a related party -- things like machinery, buildings, and, yes, goodwill -- Section 1239 makes the gain ordinary. The idea is to prevent a taxpayer from selling something to a relative at reduced capital gain rates and then getting depreciation deductions against ordinary income, which is taxed at higher rates. This would not be very a attractive trick for goodwill, where the capital gain tax is paid right away while the deductions are spread over 15 years, but nobody ever said the tax law has to make sense.
Among the related parties affected by Section 1239 are corporations where a taxpayer owns over 50% of the stock value. While the capital structure of the new corporation was complex, the Tax Court judge determined that Mr. Fish owned more than 50% of the value of its stock. As a result, the $9,698,699 of "boot" gain recognized on the goodwill transferred to the new corporation was ordinary income, not capital gain.
In 2005, capital gain was taxed at 15%, while the top ordinary income rate was 35% (current rates are 20% and 39.6%; if the Obamacare surtax applies, both rates are increased by another 3.8%). Using those rates, Section 1239 increases Mr. Fish's federal tax bill on the gain from $1,454,805 to $3,394,545 -- $1,939,740 of unhappiness, if it isn't overturned by a higher court.
Does this mean you can never do business with relatives without, er, sleeping with the fishes, tax-wise? No. But, like Tony Soprano, you need to be very careful doing so. You should work very closely with your tax advisor when engaging in finance with friends and family, including friendly family-owned businesses. Mr. Fish could give you about $1,939,740 reasons why.