Our tax laws make a distinction between income and losses attributable to capital assets. The distinction draws a line in the sand. Assets that are capital produce capital gain and losses. Other assets do not.
This in turn has a number of other impacts, such as on the timing of when income and losses are recognized, what tax rates apply, etc.
The court recently considered this distinction in Schwartz, v. United States, No. 17-cv-5914 (E.D.N.Y. 2021), in the context of a net operating loss. The question was whether the loss was an ordinary (business) loss or a capital (investment) loss.
The capital vs. ordinary distinction can be a close call in some cases. This court case shows just how difficult this distinction can be given the right facts.
Facts & Procedural History
The taxpayer was retired. He invested several million dollars into two entities that were organized to finance films. While not discussed in the court case, we assume that the entities were intended to generate film tax credits for the taxpayer.
The agreements provided that the taxpayer would be paid $60,000 a year for management services, but the evidence suggested that no services were provided and the $60,000 was never paid.
The film finance entities ended up in bankruptcy. The taxpayer reported a loss on his 2010 tax return for his investment in these entities. He also filed amended returns to carry the loss back to 2008 and 2009.
About Net Operating Losses
A net operating loss refers to the situation where expenses exceed income. In tax terms, this means deductions exceed taxable income.
Net operating losses offset income in the current year. They generally do not offset capital gain income, which consists of investment income. Capital losses offset capital gains (there is an exception for up to $3,000 of ordinary gain).
Historically net operating losses that were not used in the current year, were able to be carried back to prior years. This allowed taxpayers to request refunds of tax paid in the prior years. Net operating losses that could not be used in the prior years would then carry forward to future years–20 years to be exact.
The Tax Cuts and Jobs Act (“TCJA”) changed this starting in 2018. It eliminated the loss carryback for most types of net operating losses (there are exceptions for losses due to disasters, etc.). Instead of carrying back losses, net operating losses carry forward indefinately. Congress imposed some limitations on the amount of net operating losses that can be taken each year.
The Cares Act basically reversed the TCJA changes for net operating loss carrybacks prior to 2021. The court case that is the subject of this article deals with tax years that pre-date the TCJA and Cares Act years. Since the Cares Act reversed the TCJA, the rules in the court case that is the subject of this post is still relevant today. It will also be relevant if/when the TCJA rules sunset in 2025.
Net Operating Loss vs. Capital Loss
This brings us back to this case. The court considers whether the taxpayers loss resulting from his film financing entities can result in a net operating loss or it results in a capital loss.
As noted above, if the loss is a net operating loss it can be carried back to prior years and it can offset ordinary income from the prior years. If the loss is a capital loss, it cannot be carried back and it cannot offset items of ordinary income, generally.
In this case, the taxpayer was both employed by the film financing entity and he invested in the entity. The employment activities suggest that his interest was ordinary in nature, as wages paid by a business are ordinary income. The investment in the entity suggests that his interest was capital in nature, as an investment in an entity is a return of capital.
The court focused on the taxpayer’s employment situation. The evidence suggested that he was not really an employee. The court noted that:
Swartz was a passive investor who lacked any control over the LLCs’ assets or business. Swartz admitted in the purchase agreements that he was acquiring the membership interests for “speculative” “investment purposes,” and did not indicate that he was joining a partnership. ECF No. 54 ¶¶ 11, 14; see ECF Nos. 51-2, 51-3, 51-5. He “was not the manager of either entity” and lacked “any control over how” CT1 or Alliance Film “spent the money that he had invested.” ECF No. 54 ¶¶ 19, 23, 26; see also ECF No. 51-6 at 15. Indeed, Swartz testified that he never received any financial reports from the LLCs and was ignorant of their financial problems until a bankruptcy petition was filed against CT1 in March 2010.
Absent a bona fide employment relationship, the court found that the taxpayer was an investor in the film financing entity. The result was that his losses were not net operating losses that could be carried to prior years to offset ordinary income in the prior years.
This case shows that net operating losses should be carfully considered. The rules are nuanced and, with advanced tax planning, one may be able to achieve their timing goals. This is particularly true when the taxpayer is planning for a highly speculative transaction that has a higher than average chance of creating a tax loss. Advanced tax planning can help ensure that the loss is absorbed timely. Ultimately, this can help eliminate tax penalties and interest that may be triggered if the taxpayer tries to take the loss in the wrong tax period.