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THIS INVESTMENT IS REALLY UNDERWATER

April 04, 2006

When life hands you lemons, it's the American way to try to make lemonade. When your investment is a lemon, it's tempting to try to use the tax law as a sweetener. Especially when the water is already added.

NO INDOOR POOL

Sealodge International, Inc. operated an underwater hotel in Key Largo, Florida. Not insolvent; I mean really underwater. Originally designed to house ocean researchers, it was put into service as a novelty hotel in 1986. No word on how the valet parking worked.

Running an underwater hotel has to have its financial clallenges. From 1990 to 1994 it lost annually amounts from $5,434 to $21,067. In 1994, the owners of Sealodge decided it was lemonade time. The owners sold their stock to a not-for-profit entity, the Maine Resources Development Corporation.

Ian Koblick, owner of 45% of Sealodge, sold his 45% interest to MRDC for $90,000. It appears that he had about $50,000 invested, and a fair amount of time. He made his lemondade the following April 15 when he claimed on his tax return that the stock that he sold to charity for $90,000 was actually worth $900,000, and that he was entitled to a charitable deduction for the $810,000 difference. The IRS disagreed, and the issue ended up in Tax Court.

NOT VALUED ON CASH FLOW

In valuing a going business, you normally place a value on future cash flows. Tax Court Judge Goeke didn't look at it that way. The court decided that replacement cost was the place to start in valuing the company, and he decided that number was about $1,060,000. He then multiplied that by 45% to reflect Mr. Koblick's interest.

IS IT A "MINORITY" WHEN EVERYONE IS IN CAHOOTS?

In a reversal of the usual arguing positions seen in estate tax valuations, the IRS said a 22% valuation discount was warranted to reflect lack of marketability and a minority interest. The Court decided that only a 6% discount was warranted because the shareholders all donated their interests to the non-profit at the same time in a plan.

BUT IRS WINS ANYWAY

While the owners won the valuation argument, they lost the battle. The Court's replacement price was about $3 million less than that argued by the taxpayer; combined with the 6% discount, the value of the stock ended up at an amount even lower than the IRS determined. The value of the donated stock was pegged at $429,300; when reduced by the $90,000 paid by the non-profit, the charitable deduction ended up at $339,300.

NOT A BAD DEAL, THOUGH

Even at $339,300, that translates into a federal tax savings of up to $135,000 at the 39.8% rate then in effect. Combined with the $90,000 that the charity actually paid, Mr. Koblick pocketed up to $225,000 on maybe a $50,000 investment. As lemonade goes, it could have been a lot more sour.

Cite: Ian G. and Tonya A. Koblick, T.C. Memo 2006-63.

I think they could still make money if they fixed it up like Captain Nemo's place:

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