Wash Sales Rules and Potential Merger; "Sweat Equity" Issues

This column, in slightly different format, originally appeared in The San Francisco Examiner Newspaper, August 20, 2000.

Copyright 2000  Robert L. Sommers, all rights reserved.

Question:  If I sell my AOL stock at a loss and purchase Time Warner stock within 30 days, may I deduct the loss or would this be considered a "wash sale" due to the pending merger of the two companies?

Answer: Yes, you should be entitled to deduct the loss. The wash sale rule applies if you sell stock for a loss, then purchase within 30 days stock which is "substantially identical" to the stock you sold. In other words, you cannot deduct a loss from the sale of stock if, within the time period beginning 30 days before the sale and ending 30 days after sale, you purchase, or enter into a contract or option to purchase, substantially identical stock.

For example, if you sold your AOL stock for a loss and then repurchased AOL stock within 30 days, you are not permitted to claim the loss, since you acquired stock in a substantially identical company within 30 days.

The substantially identical test is based on the identity of the company, not the mere similarity of business operations, according to the Tax Court.

In your case, it depends on whether Time Warner is substantially identical to AOL. Since Time Warner is a large, diversified company in the publications and communications business, whereas AOL, in general, is an internet service provider, the wash sale rules should not apply because the companies are not substantially identical. Also, it is not certain the merger will transpire.

Question: If an investor contributes money to a new venture, and I receive stock for my "sweat" equity, am I liable for taxes on my stock?

Answer: Yes. This situation usually arises when investors contribute money toward a new venture, while other investors receive stock in exchange for working in the company.

For example: Assume you have a great idea for a company and you convince an investor to contribute $1,000,000 for a 50% ownership. You contribute $10,000 to the venture and will work full-time on the project for a small salary. You own the remaining 50% of the company. Under our tax laws, you’ve received compensation in the form of stock worth $505,000 (the company is worth $1,010,000 and your share is 50% = $505,000) and will pay income taxes as though you were paid in cash. IRS looks at what would happen if the company liquidated the next day. In your case, you’d be entitled to 50% of the proceeds or $505,000.

This result can be avoided if the money investor contributed $10,000 and then loaned the company $990,000, provided his loan will be paid in full before you each are entitled to receive profits. In this case, your interest is limited to your share of money invested, plus 50% of the venture’s future profits. Note: In general, receipt of an interest in future profits is not currently taxable to you. Of course, you’ll pay tax on your share of future profits when they are generated by the venture.

Another alternative: If the investor receives a preferential distribution of the first $990,000 from the venture, then you will have no compensation income because if the company worth $1,010,000 liquidates the next day, you will only receive your original investment of $10,000 ($990,000 of the $1,010,000 goes back to the investor and the $20,000 balance is split evenly).

Note: Using an S corporation in this context can be dangerous. An S corporation is allowed only one class of stock. Allowing the investor a preferential distribution of proceeds will be considered a second class of stock.

Question: As a self-employed musician, I purchased a saxophone this year. May I expense (write-off the entire purchase of) the saxophone?

Answer: Yes, as a self-employed musician, you may expense up to $20,000 of tangible personal property purchased in 2000 and used in your business. You make the election on Form 4562.

Note: This benefit is reduced, dollar-for-dollar, for purchases exceeding $200,000 in a year. Example: If you purchase property worth $205,000, then only $15,000 may be expensed.

Employees who itemize deductions make this election on Form 2106, as an itemized miscellaneous expense. Note: The deduction for all itemized miscellaneous expenses must exceed 2% of adjusted gross income.

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All contents copyright 1995-2003 Robert L. Sommers, attorney-at-law. All rights reserved. This internet site provides information of a general nature for educational purposes only and is not intended to be legal or tax advice. This information has not been updated to reflect subsequent changes in the law, if any. Your particular facts and circumstances, and changes in the law, must be considered when applying U.S. tax law. You should always consult with a competent tax professional licensed in your state with respect to your particular situation. The Tax Prophet® is a registered trademark of Robert L. Sommers.