AGAIN, IT'S BETTER TO LOSE by C. David Anderson

Here is another illustration that taxes are so complicated that it’s hard to understand whether it’s better to win or lose until you do the numbers carefully.

A client had a massive operating loss in the 2008/9 Great Recession and got a large refund by carrying the losses back to profitable 2004/5 years.  This carryback refund got pulled into the IRS special examination program for wealthy taxpayers.

The IRS decided that the client acted more like a passive investor in the business, not like an active manager.  As a result, the losses were “passive losses,” which can only be carried forward, not backward.  Therefore, the refund from the carryback to earlier years had to be repaid.

We thought that the client was in fact quite active in the business, but a lack of email records made this hard to prove to the examiners.  We wound up having to take our argument for a carryback refund to Appeals.   

While in Appeals, we started to think hard about what would happen if we lost the case, besides having to repay the carryback refund.  The natural reaction was to fight the immediate tax from surrendering the carryback refund. 

The main effect of conceding that the losses were passive, however, was that the losses were still allowed but could only be carried forward to later years, and that the losses could only be used against future passive income.  This need for future passive income was a potential problem, because we still thought the client was an active investor. 

By digging deeper and doing the numbers, we realized that the client would actually be far better off if he could use the carried-over passive losses in the future years!  This is because the tax rate in the carryback years, 2004/5, was around 35%, while the tax rate in the future years, after 2010, was more like 43%.  Therefore, the savings from claiming the active loss carryback was quite a bit less than the benefit of carrying the losses forward to the again-profitable years after the Great Recession.  An additional benefit was that California freely allows carryovers of passive losses but restricts carryovers of active losses.

Now the worry was that the IRS might change its position in the later years and argue that the client was actually “active” – so that future income was active and couldn’t be offset by carried-forward passive losses.  The IRS is certainly capable of taking whichever side of the active/passive issue that maximizes the tax at the time.  Hmmm.

We decided this risk was worth taking, since the client actually became less active once the business no longer faced the insolvency risks of the recession years.  Also, we believed that, once the IRS reached a formal finding that the client was a passive investor, it would continue to follow this position as long as the facts didn’t show greater activity in the later years.

Bottom line – we realized that we could concede the audit disallowances in Appeals and be way ahead.

Takeaway – tax calculations are so complicated that sometimes it is hard to tell if you are winning or losing.  Dig deeper to determine all of the consequences of an IRS determination.  Get out your spreadsheets!