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IRS May Bankrupt Katrina Businesses

By Stuart M. Horwitz  Posted by Rob Kall (about the submitter)     Permalink
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In 2006 many small and medium sized businesses will feel the second wave of Katrina; thanks to the IRS and Congress. Congress scrambled to adopt the Katrina Emergency Tax Relief Act which purports to give individuals and businesses five years to reinvest any insurance proceeds they receive, without incurring a tax. While the supporters of the tax bill continue to point to individuals and small businesses as the primary parties benefiting from the act, the main benefactors from this act are large C corporations and wealthy individuals with expensive vacation homes.

The group that is most in need of deferment of gain from insurance proceeds is small to medium sized businesses formed as limited liability companies (i.e. LLCs), partnerships or subchapter S corporations (S Corps). However, what Congress and the IRS are not telling you is that there are additional rules governing these types of entities. These rules may make the new act meaningless to such companies. Any such business that receives insurance proceeds this year may have to recognize a gain on the payment of their debt. This could bankrupt many businesses.

While the Katrina Act provisions pretend to extend the period of non-recognition of gain to five years for individuals and businesses damaged from Hurricane Katrina, they could have extended this period to 50 years and LLCs, S Corps and partnerships could still face a tax this year. Under Section 752(b) of the Internal Revenue Code "any decrease in a partner's share of the liabilities of a partnership ... shall be considered as a distribution of money to the partner by the partnership. " In English, if the company receives the insurance money and pays off the bank (i.e. because the bank has a lien against the assets) in year one, and doesn 't take out new equivalent debt until the following year, the members of the Company incur a tax.

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If the law is left in its current state, C Corporations (i.e. the Fortune 1000) will benefit handily. Any C Corporation that receives insurance proceeds this year will have five years to turn the insurance proceeds into property before recognizing gain.

Similarly, wealthy individuals will also benefit because they now have five years before they must convert their proceeds into property. This allows wealthy individuals more time to decide where they want to rebuild their new vacation home. "Regular " people did not need an extension of Section 1033. Section 121 of the Internal Revenue Code provides for a $500,000 exemption of gain on the sale of a principal residence, so a "deferral " is not necessary in this case.

There is an inequity taking place among C Corps, S Corps, LLCs and partnerships that needs to be resolved. Congress attempted to aid regular businesses with the Katrina Emergency Tax Relief, but the results are misguided. It is unusual that Congress would intend to benefit large C Corporations and wealthy individuals and leave small to medium sized business owners in an untenable situation. Both the Treasury Department and the IRS are well aware of this problem and have affirmatively declined to fix it. All Congressional co-sponsors of the Katrina legislation have been made aware of this problem but have failed to even contact the author of this article.

Congress has the opportunity to make a technical correction to the Tax Legislation and benefit small and medium sized businesses that have had their livelihoods destroyed, be they in Louisiana or in New Hampshire. Trent Lott has stated that he intends to pass longer-term incentives to ensure businesses on the Gulf Coast can rebuild. A technical correction to Section 1033 is a good place to start and would circumvent the "rhetoric " that may arise once people learn that Senator Lott will benefit with a five year deferral on rebuilding his gulf coast home (possibly forever if proper planning is done); whereas many businesses will end up paying phantom income taxes and be ruined.

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Stuart M. Horwitz, the founding member of The Horwitz Group, LLC, has over 20 years of corporate, tax, estate, probate and ERISA planning experience. He has worked for several large firms in Cleveland and Akron, Ohio including Kohrman Jackson & Krantz, Roetzel & Andress and Frantz Ward. He has a BSBA in Finance from The Ohio State University, a JD from The Ohio State University Law School and an LLM in Taxation from the Georgetown University School of Law. He has an AV Rating, the highest rating for attorneys as designated in Martindale- Hubbell. Stuart can be reached via e-mail at
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