Tax Update Blog: Permalink

« Previous · Tax Update Blog Home · Next »

IOWA'S REALLY LONG-TERM CAPITAL GAIN DEDUCTION

February 20, 2004

Some states offer easy tax-free treatment to those wishing to sell their businesses. If you make good in, say, Nevada, and sell your business to enjoy a life of ease after only a year or two, you pay no state income tax - there isn't one.

In Iowa, you need to be made of sterner stuff.

Iowans who "materially participate" in a business for ten years or more incur no Iowa tax on capital gains on the sale of business assets, or real estate used in the business – but only if they have also “held” the property for 10 years. Taxpayers get this “capital gain deduction” in computing their taxable income. Two recent rulings show how the Iowa Department of Revenue enforces these stern “10 x 10” requirements.

Sternly.

TRANSFER OF BUSINESS REAL ESTATE STARTS NEW HOLDING PERIOD

Mr. Hartrick requested a ruling on whether he met the “10 x 10" requirement for deducting capital gain.

The ruling lays out the facts:

Taxpayer materially participated in his business, an S corporation (“A”), for over 20 years. “A” owned the building from which it operated until late 1993, when it burned down. The facility was rebuilt on the same site and was reoccupied by the same business in the spring of 1994. At that time, the owners of “A” set up a separate S corporation (“B”) to buy the building from “A.” The building was rented back to “A.” The taxpayer was a 50% owner in both “A” and “B.” The business building was sold in April 2003.

What a worthy taxpayer: toiling 20 years in the state, stoicly rebuilding after a disastrous fire -- surely the state graced the sale of the building with tax exemption...

Sorry. The Department found that the transfer of the rebuilt property in 1994 to another S corporation with identical ownership started a new holding period, of which only nine years or so had run. No capital gain deduction for you, short-timer!

SOME TRANSFERS TO CORPORATIONS ARE OK

Mr. McCabe claimed the capital gain deduction on a farm inherited from his mother. The Department initially rejected the deduction, but relented after the taxpayer protested. The Department's response to the protest set our the facts:

The facts of this Protest are that Mr. McCabe’s mother passed away on April 14, 1987 and his father on August 8, 1987. Mr. McCabe inherited a share of farm land from each of his parents. In both parents’ cases, land was deeded in shares to several individuals as tenants in common with the transfer of title occurring from the estate in 1989. In 1990, the same land was deeded to ALMC Farm Inc., an Iowa S corporation. Protester received shares of stock in ALMC in exchange for the land. The transfer to the sub-S does not affect the deduction… In early 1999, ALMC sold the land to Ronald Gehling, an unrelated party.

The statement “the transfer to the sub-S does not affect the deduction” seems out of place in light of the harsh Hartrick result. The only obvious distinction between the Hartrick and McCabe facts is that Mr. Hartrick “sold” land between S corporations, while Mr. Mcabe transferred is shares “in exchange for stock,” apparently in a tax-free transaction.

So tax-free transfers are ok? Well, not necessarily. The Department informally tells us that the McCabe transaction passed muster because all of the farm business was transferred, while the Hartrick taxpayer only transferred the real estate, leaving the rest of the business in the old S corporation. The Department may have approved if an entire trade or business was transferred in Hartrick.

WHAT IT MEANS

Iowans need to consider whether a business restructuring will reset the 10-year holding period clock. A transfer of a whole business appears safe, at least when it is a tax-free transfer. Taxpayers considering transfers of less than a whole business, even in a tax-free transaction, should consider getting the deal blessed in writing by the Department if they don’t want to restart their 10-year clock. Taxpayers contemplating a taxable transaction before the 10-year clock runs definitely should pause and reconsider.

WHAT ELSE IT MEANS

Taxpayers should be able to know whether they are restarting the 10-year clock without having to ask the Department of Revenue. The Department should adopt a straightforward way of measuring the holding period of business assets. We humbly offer the following suggestions:

-A tax-free incorporation, merger, or corporate division should not restart the holding period.

-A tax-free contribution to or distribution from a partnership, or a tax-free partnership merger or division, should not restart the holding period.

-It should not matter whether an entire business is transferred.

-Death, gifts, or taxable transactions should restart the holding period.

-Transfers between spouses should be disregarded.

With these guidelines, or something similar, taxpayers could arrange their affairs knowing how their transactions will affect their eligibility for the capital gain deduction.

      Bookmark: del.icio.us • Digg • reddit