KC, JAINEN, Tax help needed

[michaelmars]

jewelry wholesaler "S" corp, the company owed shareholder $500,000. since there was no cash he took $500,000 of diamonds [for this purpose assume cost=market value]. i debit shareholder loan and credit inventory. the problem is the cost of goods sold. the change in inventory should not affect the p&l. irs says if you have a loss, disaster etc and if you don't want to flow it through cgs and affect the p&l you should adjust opening inventory for the amount of the loss. i want to do the same thing, so that my gross profit percentages etc remain intact.

what do you think?

i know i could show it as a sale for cost and use the receivable to offset the stockholder loan but that affects sales tax as well as liability insurance.

[RoyDaleOne]

May I ask what the inventory cost of the diamonds is?

That is does cost=fmv is that

1. wholesale fmv or,

2. retail fmv?

The reason I ask is to determine if there is a profit to the corporation or not in making such payment.

[michaelmars]

good question, since they are wholesalers i assume that is the fmv we are talking about.

[RoyDaleOne]

With the inference that the diamonds are being removed from inventory at their inventory cost, the reduction of the opening inventory could be correct. This is because the reduction in the inventory is the not results of a sale, and therefore, the inclusion of the such costs in cost of goods sold would not be necessarily be correct by definition.

"Merchandise withdrawn from sale. If you withdraw merchandise for your personal or family use, you must exclude this cost from the total amount of merchandise you bought for sale. Do this by crediting the purchases or sales account with the cost of merchandise you withdraw for personal use. You must also charge the amount to your drawing account."

Applying these instructions should result in the same answer.

The instruction get there by reducing "purchases" for the current year for the amount withdrawn.

Ignore the part of personal or draws etc.

[michaelmars]

I agree with you but the case here is that there are no current year purchases, thus i want to reduce opening inventory to match the remaining inventory on the books [no purchases or sales in 2008] the irs says to do this when you have a disaster or theft but the effect is the same here, a reducition of inventory with no c/g/s/ effect.

[kcjenkins]

I see no problem with doing it that way, as long as they have some documentation for the FMV of the inventory transfered. Although I could imagine some state sales tax auditor taking the position that this is in fact a 'sale', and is subject to sales tax, unless the shareholder has a retail permit, and is taking the diamonds for resale.

[RoyDaleOne]

There is no need for FMV of the inventory, there is a need for the cost of the inventory.

The inventory is being taken as payment on debt the Company owed.

This is not a sale, more like, deed in lieu of foreclosure.

Did I miss that there were no purchases in the original post?

[michaelmars]

no purchases in the current year, the inventory is from prior year. and i agree with KC that the big issue is sales tax and liability insurance based on sales. i want to do it as above and my partner wants to show the sale at cost. btw, its a million bucks we are talking about

[kcjenkins]

Well, it's enough money that if you do it your way, and then the state comes back and says, no, it's a sale, you are going to be putting your rear in the pincers. I'd want a legal opinion, to protect myself, before I'd go that way, since there is a strong element of a sale here, IMHO. Even a deed in lieu of foreclosure is recorded as a sale. And when it is inventory that is sold, unless the buyer has a resale permit, it's going to be your ass in the sling if you don't record it that way. It's no different than if he got repaid for his loan, and then used the money to buy the diamonds.

[RoyDaleOne]

Just to clear me head. You saying for example, that a bank that repossesses a vehicle pays sales tax on the repossession, unless, the bank has a resale permit?

[RoyDaleOne]

New York TSB-A-85(36)S:

Section 1141© of the Tax Law provides, in relevant part, that "Wherever a person required

to collect tax shall make a sale, transfer or assignment in bulk of any part or the whole of his

business assets, otherwise than in the ordinary course of business, the purchaser, transferee or

assignee shall at least ten days before taking possession of the subject of said sale. . .or paying

therefor, notifying the tax commission by registered mail of the proposed sale and of the price, terms

and conditions thereof. . . .

Whenever the purchaser. . .shall fail to give notice to the tax commission as required by the

preceding paragraph or whenever the tax commission shall inform the purchaser. . .that a possible

claim for such tax or taxes exists, any sums of money, property or chooses in action, or other

consideration, which the purchaser, transferee or assignee is required to transfer over to the seller. . .

shall be subject to a first priority right and lien for any such taxes theretofore or thereafter determined

to be due from the seller. . .to the state, and the purchaser, transferee or assignee is forbidden to

transfer to the seller. . .any such sums of money, property or chooses in action to the extent of the

amount of the state's claim. Within ninety days of receipt of the notice of the sale. . .from purchaser.

. .the tax commission shall give notice to the purchaser. . .and to the seller. . .of the total amount of

any tax or taxes which the state claims to be due from the seller. . .to the state, and whenever the tax

commission shall fail to give such notice to the purchaser. . .and the seller. . .within ninety days from

receipt of notice of the sale, transfer, or assignment, such failure will release the purchaser. . .from

any further obligation to withhold any sums of money, property or chooses in action, or other

consideration which the purchaser. . .is required to transfer over to the seller. . . .

For what it is worth...

[OldJack]

>>This is not a sale, more like, deed in lieu of foreclosure.<<

Well.. I don't believe there is a foreclosure as such legal procedures have probably not been initiated. I think what is overlooked in this post is the fact that this is a S-corp and not a proprietorship. Removal of inventory as discussed in the IRS publication is with regards to a proprietorship or partnership. Removal of inventory for a S-corp is a distribution/sale of property at fair-market-value just as though it was sold to any customer. Therefore, it is a taxable sale with cost of goods sold and removal of inventory as would be for any sale to customers. The only difference in the transaction is the S-corp debits the debt owed to the shareholder rather than debit a receivable due from the shareholder.

[RoyDaleOne]

A sale of we have for income tax purposes because:

TRANSFERS OF PROPERTY TO SHAREHOLDERS

Williams v. Commissioner, T.C. Memo 1985-201

It is well established that the transfer of assets in satisfaction of indebtedness is equivalent to a sale upon which gain or loss is recognized in the amount of the difference between the basis of the assets transferred and the amount of indebtedness which is canceled. Kaufman v. Commissioner, 119 F.2d 901 (9th Cir. 1941), affg. a Memorandum Opinion of this Court; Rogers v. Commissioner, 103 F.2d 790 (9th Cir. 1939), affg., 37 B.T.A. 897 (1939), cert. denied 308 U.S. 580 (1939), rehearing denied 308 U.S. 635 (1938); Danenberg v. Commissioner, supra; Unique Art Manufacturing Co. v. Commissioner, 8 T.C. 1341 (1947), R. O'Dell & Sons Co. v. Commissioner, 8 T.C. 1165 (1947), affd., 169 F.2d 247 (3d Cir. 1948).

[michaelmars]

wow, generated alot of response and effort on all your parts, thanks everyone and especially Roy for the cites

[jainen]

>>the S-corp debits the debt owed to the shareholder<<

Thank you for making this clear. I was sure the suggestions about inventory reduction were off-base, but I didn't know the right way. As for the sales tax, there shouldn't be any doubt that since the items were transferred to an end user (that is, an individual not in the business of selling to others), normal sales tax must be reported and paid.

It seems to me this scenario has a lot of dangers for a practitioner. I wouldn't get involved without a clear engagement letter, specifying who the client is and limiting the job to the bookkeeping, tax prep, or whatever service is being offered. In particular, I would not recommend any accounting or tax position based only on a shareholder's statements without studying the full documentation of the loan history and inventory tracking. Most disturbing of all is the desire to make an end run around paying for insurance, right when the company is most at risk for it all hitting the fan.

[BulldogTom]

This is just an aside, as I believe you have the right answer above.

But if you proceeded as you originally proposed, I would think that you would have transfered the USE TAX liability to your individual client. I don't know about New York for sure, but I think the laws are similar to that in CA. If an end user aquires goods for personal use that are not exempt from sales tax, and that sales tax was not paid, the consumer must pay USE TAX on the acquisition of that product. This situation normally arises in the purchase of goods from a vendor in a state that does not have sales tax and are brought into the state with a Sales/Use tax requirement. But I think it would apply equally in this case to the transfer of goods to the shareholder.

Just adding an unrelated bit of information to the discussion. I was thinking there was something wrong with the original thought of how to treat it also, but I did not get to the right answer until I saw the other posts. But I was sure there had to be either a sales or use tax in the mix somewhere.

Thanks to all for the information. I have been educated by this post.

Tom

Lodi, CA

[michaelmars]

actually the thought was that the shareholder would try and sell the items personally and that is where the sales tax would get paid, but i see and conceed on all the posts and will discuss the transaction with the client as a sale. the issue of not paying insurance on this is because its unlikely the sole shareholder will sue the corp for receiving faulty merchandise etc.

[samingeorgia]

It's unlikely that anybody is going to keep $ 500K in diamonds for personal use. If the shareholder is going to try and resell the diamonds on his own, shouldn't he get a resale certificate from his state tax authority, thus making this transfer a resale exempt from sales or use tax? Won't he have to charge sales tax when he sells the product to an end-user, or be making an exempt sale if he sells to a retail jeweler? It seems to me that the shareholder has created a proprietorship business, which needs to register and file sales tax reports.

BTW, even though sales and use tax rules vary from state to state, all 50 states are getting hungrier / greedier for money.

[kcjenkins]

Yes, that was exactly my point. Sam. And Roy. to your comment about "You saying for example, that a bank that repossesses a vehicle pays sales tax on the repossession, unless, the bank has a resale permit?" That is not what I was saying, because that is a very different situation. If you have a lien on the diamonds, and you repossess them, that is very different, legally, from making an unsecured loan, and taking inventory to settle the debt. For the loaner, it's pretty much the same RESULT but for the borrower, it's a barter sale, if it transfers inventory to pay off a debt.