After Tax Payment of Loan Principal - A Trap For the Uninitiated

 

            The payment of loan principal with "after tax cash flow" is a common trap for many businesses, both large and small.  Here is a case where a poor tax decision caused significant hardship.

 

Principal Payment of Debt Is not Tax Deductible

 

            The problem can be difficult to understand until one is exposed to it first hand.  Specifically, in order to pay the principal portion of a loan, a business must generate cash flow.  The problem arises when every $1.00 of earnings is needed to pay $1.00 of principal on a loan (which is not deductible,) and the partners must pay income and self employment taxes at a rate of 30% to 49% dependent upon one's tax bracket. 

 

            After tax, that only leaves 48 to 70 cents available to make the principal payment.  Or computed another way, one must earn $1.43 to $1.96 to net $1.00.  According to the partnership 2014 tax return, $17,215 was paid down on mortgages.  The pre-tax cash flow necessary to net $17,215 then must have been between $24,600 and $33,700.  Over the course of many years, this results in a very material taxation effect.

 

Matching Principal Payment with Depreciation Deductions

 

            One solution to this problem is to match principal reductions with the associated depreciation deduction on the assets acquired.  However, here is where the problem lies with many businesses, the implementation of a buy out without a resulting depreciable asset.

 

Poorly Planned Partnership Buy Out Arrangement

 

            In general, income tax laws are structured to treat purchases and sales symmetrically; the Sellers pick up income and the Buyers deduct, through depreciation and amortization, the purchase price.  

 

            However, when it comes to intra-family purchases and sales, the aspect of paying tax on the sale side frequently becomes the indirect burden of the buying side of the family. With such pressures, shortsighted decision making and transaction design can cause serious hardship.

 

            In the partnership tax arena, a tax election is generally required as well as special transaction structuring (partner level purchase and sales versus partnership level redemptions).  Also, here in New Hampshire one could shortsightedly avoid NH Business Profit taxes at the cost of no Federal and no NH depreciation deductions. 

 

            The following analysis of such a decision follows and assumes that the Sellers:


 

            In order to measure materiality of the depreciation benefit, one needs to determine the depreciable lives of the assets acquired.  That would normally be based upon the sale price allocated as negotiated and disclosed in the purchase and sales agreement between Buyers and Sellers, or if none (which would not occur to a client of ours who consulted with us in advance), based upon an allocation of the purchase price to the fair market value of assets acquired as governed by IRC Section 1060.  In this regard, be aware that land is not depreciable.  For those who implement purchase and sales agreements without consulting an expert, or employee the same representative on both sides of the transaction design and negotiation, are inviting trouble. 

 

            The allocation of a sales price is an art form unto itself, with material consequences routinely ignored by real estate agents as well as some professionals.

 

            DSB&Co routinely disagree with the tax advice not to record the assets acquired with no plan to depreciate them for the following reasons:

 

  1. In general, income tax "follow the money" affects; the Sellers received the proceeds and thus are liable for both Federal and NH income taxes.  Unless there is a purchase and sales agreement provision to the contrary, the Sellers cannot simply shift those taxation burdens onto the General Partnership and its remaining partners.

 

  1. Assuming the Sellers reported the sale to the IRS and State of NH, there would be no 2nd amount of tax due by the partnership. 


  1. The State of NH's Department of Revenue has been assessing Sellers who sell real estate with business interest located on them.  Even in a situation where the Sellers are nothing more than passive landlords of vacant commercial land, the State has and continues to pursue those taxpayers. 

 

We find it unimaginable that a Sellers' realized income from the sale would not be report to the U.S. Treasury, to their State of residency (wherein an income tax credit would be allowed for out of state taxes) and to the State of New Hampshire.

 

The State of NH routinely flags for audit, partnerships that elect to record partner acquired assets on its books through a so called Section 754 "step-up" election.  That does not mean a 2nd NH tax is due.  However, to the extent the Sellers did not file a NH Business Profits tax return recording the sale, there exists a question as to whether or not that election would cause the business, and its partners, to become liable on the Sellers' income.  A legal opinion is needed in this regard.  In addition, a business with a long operating history may possibly incurred a prior step-up, a question whether a search of all those tax returns was undertaken to determine if an undisclosed IRC Section 754 election, enacted in 1954, is in fact already in place.

 

  1. It is necessary to know whether the Sellers met their obligations to the State of NH and we recommend simply asking them (as opposed to reporting them.)

 

  1. Clearly the time to be handling this issue was during the negotiation of the purchase and sales agreement, but no later than when the applicable tax returns were filed.  The worse time is now years after the fact, but when feeling the sting of the decision not to elect to step up the tax cost basis of assets.  Due to the complexity of our tax laws, Congress has enacted mitigating provisions.  However, such provisions will lapse after 3 years (6 years for certain purposes if an undisclosed IRC Section 754 election is in effect as hypothesized in item 4 above,) which is the statute of limitation on correcting errors and omissions to the extent permitted by the IRC and regulation.  Though outside the scope of research for this letter, it is likely that mitigation avenues are now closed, however we noted that the capital account transfer of just under $1 million was reported on the 20XX tax return, not the year of acquisition, 20XX-1.  Consequently, the avenues available now to resolve this depreciation deduction issue and undo the damage may be limited to a partnership level termination transaction wherein for tax purposes the organization is reformed.  We do not have enough facts to make such a determination if such a technique would be available in your situation.

 

  1. Partnership taxation is the most complex of Federal income tax schemes.  For example, the failure of the partnership to make an IRC Section 754 election can literally result in double taxation of the same asset acquired under IRC Section 743(b) with a resulting capital loss offset (limited to $3,000 per year.)  This occurs because where there is no step-up to the basis of the asset at the partnership level, the asset when sold in the future will have a larger gain on sale, i.e. exposure to double taxation.  Had an IRC Section 754 election been made, the Federal gain would have only been allocated to the Selling partners. 


  1. The unique nature of a general partnership formed by tenants-in-common owners, is that it can be very difficult to separate, as tax law attempts, the business represented by one's capital accounts and the underlying real estate engine which drives cash flows.  A partnership is an association of two or more persons who organize as co-owners to carry on a business for profit.  Using this tax law principle, the acquisition might have been treated as a new additional entity, for example just between father and daughter, wherein the asset acquired would have been booked and depreciated along with a revenue sharing arrangement with the operating entity/partnership.  

In your CPA firm's experience, what is the most material overlooked deduction in the estate, gift and trust income tax area

If you have any questions, do not hesitate to contact the professionals at Dana S. Beane & Company, P.C.

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