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IOWA WILL CUT YOUR HOLDING PERIODS INTO LITTLE PIECES

June 16, 2006

Iowa has an unusual tax break for capital gains on business property held for a long time. You don't have to pay Iowa taxes on certain capital gains from the sale of business assets if you have both

1. Held the property for 10 years, and
2. "materially participated" in the business for 10 years.

This week the Iowa Department of Revenue ruled that if you buy your interest in the business in pieces, your holding period is also measured in pieces, and only the pieces held for 10 years qualify for the capital gains break.

THE COLOR CONVERTING SAGA

Chandrakant Shah began working for Color Converting Industries, an S corporation, in November 1978. He first acquired an ownership interest in the business in 1983. The S corporation later contributed the assets of the business to a limited liability company, Color Converting LLC; the S corporation continued in existence as an owner of the LLC.

He acquired additional interests in 2001 by setting up a new S corporation to buy additional interests in Color Converting LLC. At this point he had interests in two S corporations owning interests in the same LLC.

When the business sold its assets in 2003, the gain was taxed on the returns of its owners, including Mr. Shah. Mr. Shah claimed the Iowa exemption for all of the capital gain passing through to his 1040 through his two S corporations. The Department disagreed:

Because Protesters seek a deduction for capital gain resulting from the sale of their entire interest in the business, and not merely a portion of the interest, the period of time that Protesters held that interest is relevant. The Department does not dispute that the portion of the sale representing Protesters’ interest in the business that was acquired in 1983 meets the requirements of 422.7(21). Protesters maintained an ownership interest in the business despite the fact that the business entity changed. At the time of the sale of the business, Protesters held this interest in the business for more than ten years and materially participated in the business for more than 10 years. Protesters contend however, that because the capital gain from the sale of their interest acquired in 1983 qualifies for the capital gain exclusion, that the property interest acquired in 2001 should also qualify for the exclusion.

Iowa enacted new holding period legislation this year that applies federal holding period rules to the capital gain exclusion. As federal law would treat the two interests acquired as having their own holding periods, the Iowa holding here likely would have been the same under the new law.

Link: Iowa Letter of Findings dated February 8, 2006

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