Question

Research Problem 2. Five years ago Bridget decided to purchase a limited partnership interest in a fast-food restaurant conveniently located near the campus of Southeast State University. The general partnerof the restaurant venture promised her that the investment would prove to be a winner. During theprocess of capitalizing the business, $2 million was borrowed from Northside Bank; however, each of thepartners was required to pledge personal assets as collateral to sa±sfy the bank loan in the event thatthe restaurant defaulted. Bridget pledged shares of publicly traded stock (worth $200,000, basis of$75,000) to sa±sfy the bank’s requirement.The restaurant did a good business un±l just recently, when ²agrant health code viola±ons werediscovered and widely publicized by the media. As a result, business has declined to a point where therestaurant’s con±nued existence is doub³ul. In addi±on, the $2 million loan is now due for payment.Because the restaurant cannot pay, the bank has called for the collateral provided by the partners to beused to sa±sfy the debt. Bridget sells the pledged stock for $200,000 and forwards the proceeds to thebank. Bridget believes that her share of the restaurant’s current and suspended passive losses can o´setthe $125,000 gain from the stock sale. As a result, aµer ne¶ng the passive losses against the gain, noneof the gain is subject to tax. How do you react to Bridget’s posi±on?

Answer 1

Solution:-

How do you react to Bridget’s position:-

The tax issue underlying the problem Bridget faces is whether the gain on the disposition of the publicly traded stock constitutes portfolio income or passive income. If classified as passive, it could be offset by current and suspended passive losses from the restaurant partnership. However, if it is treated as portfolio income, the entire $125,000 gain is taxed, while the current and suspended passive losses remain unused.

Sec. 469(e)(1)(A)(ii)(I) and Temp.Reg. § 1.469–2T(c)(3)(i)(C) provide that portfolio income includes gain from property that is not derived from the ordinary course of a trade or business and that produces portfolio income. This definition generally includes property of the type included in an individual’s stock portfolio. However, Bridget is apparently taking the position that because the sale of her stock is related to and required because of her interest in a passive activity, the gain is derived from the ordinary course of a trade or business and available to absorb passive losses. This position seems to be supported by Reg.§ 1.469–2(c)(2)(iii)(A) and Temp.Reg. § 1.469–2T(c)(2), which state that such gain is passive if the property sold was used in the passive activity for at least 24 month sending on the date of disposition. Essentially, Bridget maintains that pledging the stock as collateral made it used by the passive activity. Consequently, a conversion from an investment asset to an asset used in a trade or business occurred.

In Howard V. More [115 T.C. 125 (2000)], a taxpayer used a personal stock portfolio, which had been pledged to guarantee losses from a passive activity, to satisfy losses incurred by the passive activity. The task of the court in More was to reconcile the apparent contradiction between the specific rules of § 469(e)(1)(A)(ii)(I) and Temp.Reg. § 1.469–2T(c)(3)(i)(C), which provide for portfolio treatment, and the general rules of Reg. § 1.469–2(c)(2)(iii)(A) and Temp.Reg. § 1.469–2T(c)(2), which provide passive treatment. In this case, the court treated the disposition as producing portfolio income because the stock originally was acquired for investment and only later pledged and used to satisfy an obligation of the passive activity. In the court’s view, the pledging and subsequent use of the investment assets did not convert them into assets used in a trade or business [i.e., the gain was not from “investments made in the ordinary course of business” as defined in Temp.Reg.

§ 1.469–2T(c)(3)(ii)]. Although the facts in More involve an investor in the insurance industry rather than the restaurant industry, the court’s conclusion would likely be applicable in Bridget’s situation.Therefore, based on More, Bridget’s position does not appear to be valid and the $125,000 gain will be treated as portolio income. As a consequence, all of her gain is Taxable and none of The passive loss from her restaurant investment may be deducted in the current year.