Friday, November 25, 2011

What's It Worth To Say Your Wine is From Long Island ?

CCA 201040004

This was originally published on October 29th, 2010.

One of the greatest sources of tax controversy is whether something is depreciable (in the case of intangible assets we say amortizable.)  Land is one of the primary examples of non-depreciable property.  So if someone comes up with a way to write off even some of the cost of land it is worth paying attention to.  Land is by it's nature non-fungible, but frankly some land is more non-fungible than other land.  At the most extreme end of this non-fungibility is land that you grow grapes on to make wine. 

It so happens that my favorite beverage is Mountain Dew.  The various chemicals that go into making it can come from just about anywhere and they probably do.  It doesn't work that way with wine.  There is something called the Napa Declaration on Place.  It is a bunch of "Whereas's" like :

Whereas, it is generally acknowledged that there are a handful of truly extraordinary places on earth from which great wine is consistently produced.

finishing up with :

Therefore, be it resolved that we, as some of the world’s leading wine regions, join together in supporting efforts to maintain and protect the integrity of these place names, which are fundamental tools for consumer identification of great winegrowing regions and the wines they produce.

I was kind of vaguely aware of this, but I always thought it had to do with that weird country where they eat snails and think Jerry Lewis was a good actor.  It turns out that the same thing goes on in the United States..  A geographic region can be designated an American viticultural area (AVA), by the Alcohol and Tobacco Tax and Trade Bureau (“TTB”) of the United States Department of the Treasury.  Once that happens you can't put that place name on the wine bottle label unless 85% of the grapes come from that region. 

The Chief Counsel has determined that the designation is a "license, permit, or other right granted by governmental unit and isn't interest in land". This makes it an intangible asset covered by Section 197, which means it can be amortized over 15 years.  This is a taxpayer friendly ruling, so I am inclined to like it, but it is really a little challenging to wrap my head around.  You buy some land in Napa Valley or Mendocino or, I kid you not, Long Island  (Check the list)on which grapes grow and you get to allocate some of the cost to the right to stamp Long Island on the label and write that portion off over 15 years.

The Chief Counsel noted a problem with the ruling:

We have concerns about how a taxpayer would value the right to use an AVA designation. It is unclear whether the value of the right to use an AVA designation attaches to an acquisition of a particular vineyard within an AVA. The benefit in value from the right to use an AVA designation accrues to all land whose highest and best use is as a vineyard within such designated viticultural area. Consequently, all of the closest comparable vineyards share the same intangible benefit thereby making an appraiser's determination of the increment of value assigned to the intangible benefit and finding comparable vineyards outside of the particular AVA factually difficult.

My study of labels is limited to making sure that I don't make the mistake of buying Diet Mountain Dew, a wretched tasting concoction often hazardously located adjacent to the good stuff.  I would hazard a guess though that stamping Southeastern New England on your wine bottles is not going to make them fly off the shelves and that there are probably very few AVA designations that have any value.

Nonetheless the concept is very interesting.  There have been discussions about whether the names of landmark buildings might be separate intangible assets. Do the owners of the Empire State Building get royalties on all the little chachkies that are shaped like their building ? That would seem to have the makings of a 197 intangible.

Chief Counsel Reiterates Dependency Option for Same Sex Couples

CCA 201040012

This was originally published on October 29th, 2010.

I am always on the lookout for anything that might be relevant for my mythical clients Robin and Terry, a couple of indeterminate gender and marital status, whose role in life is to help me avoid awkward pronoun problems.  I introduced them in my post on CCA 201021050, which calls for income splitting for California domestic partners.  They also appear in my post on Gill v OPM, which declared a portion of the Defense of Marriage Act unconstitutional.  Incidentally the Justice Department filed a notice of appeal in Gill.

A CCA, by the way, is a Chief Counsel Advice.  Here is the meat of the latest CCA bearing on Robin and Terry :

The issue raised by the agent was discussed here in the National Office and with Treasury in connection with the development of Notice 2010-38. The conclusion reached at that time is that the FICA and FUTA provisions relating to “dependent” aren't really definitions in the sense of an exclusive meaning. They're instead worded to say “dependents” “include” an employee's family members. They do not preclude the possibility that other individuals could also be dependents for purposes of the FICA and FUTA exclusions.

When the issue was discussed in connection with Notice 2010-38, we viewed the PLRs (e.g., PLR 200339001 and PLR 200108010) as expanding the group of dependents described in the FICA and FUTA regs to include individuals who are dependents under section 152. Therefore, even though the PLRs can't be relied on by taxpayers other than those who got them, it is Counsel's position that a domestic partner who is a dependent of an employee under section 152 is also a dependent for purposes of the FUTA exclusion. Thus, the value of the health coverage for the domestic partner isn't FUTA wages.

In order for someone to be your dependent you must meet three tests - relationship, support and gross income.  One of the possible relationships is "member of your household" (with the quaint caveat that the household composition not violate local law).  So if Robin provides more than 1/2 of Terry's support and Terry's gross income is below the threshold (currently $3,650) Terry can be Robin's dependent.  This will qualify Robin for the more favorable head of household rates and exempt from payroll and withholding the health benefits that Robin's employer provides to Terry.  To be someones dependent for medical purposes, however, does not require that you meet the gross income tax.  So Terry could have substantial income and still be a dependent for purposes of the medical benefit exclusion.

An interesting question is what is going to happen to California domestic partners who have benefited from this technique.  Thanks to CCA 201021050 Terry will now be taxed on 1/2 of Robin's income and presumably will no longer qualify as a dependent.  I can hear somebody howling "That doesn't make any sense."  The answer to that is that making sense is not a requirement.

You Should Wear Shoes in Tax Court But Don't Bring the Box

Thomas F. Hale v. Commissioner, TC Memo 2010-229

This was originally published on October 27th, 2010.

Over 500 years ago Fra Luca Bartolomeo de Pacioli published a text book Summa de arithmetica, geometria, proportioni et proportionalita.  Included in the text book was a description of the methods that Venetian merchants used to keep accounts.  The method, known as double-entry became remarkably popular.  During the 1980's a product known as Quicken tried to abolish double entry to the delight of many small businesses and the consternation of the world's accountants.  The makers of Quicken, thankfully, came out with Quickbooks.  Now double entry is there behind the scenes.  Not as many people have to learn it anymore.

Even before computers became fairly pervasive, there were people who didn't want to learn double entry.  I used to think that was odd, but then I realized that other people didn't break license numbers down into their prime factors while driving, so maybe I was the peculiar one.  If such a person needed to do record keeping there was a solution.  We used to call then "Dumb" books, but after I studied them some, I came to admire them.  I only once saw somebody work the whole system thoroughly, but they did work.  One-write was probably better, but Dome books worked.  So I am glad to see that they still exist and can be purchased from Amazon.

Thomas Hale might have been well advised to purchase a Dome book.  Thomas Hale was a professor at Idaho State University, an attorney and a landlord.  God bless him, I can see why he never got to double entry.  The IRS claimed that he understated his rental income and legal fees and claimed unsubstantiated deductions for 2003, 2004 and 2005 assessing tax deficiencies totaling over $60,000 and penalties over $10,000. Professor Hale petitioned the tax court. Things did not go that well.

 At trial, petitioner introduced into evidence approximately 317 pages of uncategorized photocopies of receipts, canceled checks, invoices, and similar documents. He also offered copies of Federal and State tax returns that he had submitted to respondent during respondent's examination. He made no attempt to tie that evidence to respondent's adjustments underlying the deficiencies in question. At the conclusion of the trial, we set a schedule for briefing and provided petitioner with detailed instructions as to the form and content of briefs, directing him to Rule 151(e), which addresses that subject. In particular, we cautioned him to set forth in response to each adjustment made by respondent the facts in evidence that he believed supported his claim that respondent erred in making that adjustment. Petitioner failed to file any brief.

I must admit that I have not studied Rule 151(e).  This case, however, should not have gotten beyond the agent level without categorizing the various receipts and cancelled checks and tying them to the tax return. That appears to be what the Tax Court was looking for.

 In support of his claim that his only income was what he reported on his return and he has adequately substantiated all of his deductions, petitioner offers us what amounts in effect to a shoebox full of papers. Petitioner has ignored our specific instructions that he link his evidence to respondent's adjustments. We need not (and shall not) undertake the task of sorting through the voluminous evidence petitioner has provided in an attempt to see what is, and what is not, adequate substantiation of the items on petitioner's returns

Professor Hale taught European history.  Europe has had an awful lot of history so his unfamiliarity with Fra Pacioli's contribution might be understandable.  A Dome book would have done the trick for him though.  Another possibility might be the deduction summary guides offered by a much more seasoned tax blogger than myself. Robert Flach still prepares tax returns by hands distrusting the "flawed software" that most of the rest of use. 

What you can't tell from reading the case is to what extent Professor Hale was denied deductions that would have been legitimate, if they had been substantiated. Assuming they were significant, he could have saved himself quite a bit by engaging a tax professional at some point in the process.

FLP Good for the Family Business - But Maybe not the Family Jewels

JOHN W. FISHER and JANICE B. FISHER, Plaintiffs, v. UNITED STATES OF AMERICA, Defendant.09/01/2010

This was originally published on October 25th, 2010.

The family limited partnership is a fairly robust estate planning tool.  It has been under attack for some time, but generally stands up pretty well.  The IRS objection to it is understandable.  Somehow it seems that taking a bunch of stuff and putting the stuff into an entity should not produce a whole that is of lesser value than the sum of its parts.  It makes one wonder whether intellectual integrity is a key element in successful tax practice.  On a really bad day it makes one wonder whether lack of intellectual integrity might be a requirement.

The Fishers formed a Limited Liability Company (LLC) called Good Harbor Partners LLC.  Its principal asset was a tract of undeveloped land that bordered Lake Michigan.  In 2000, 2001 and 2002, they gave 4.762% interests in the LLC to each of their children. The Good Harbor operating agreement has significant restrictions on the transferability of interests.  The IRS argued that the restrictions on transferability should not be considered because the LLC did not constitute a bona fide business arrangement.  The court agreed stating :

The facts of this case are analogous to those in Holman . There, two donors created a limited partnership, funded it with common stock from a publicly traded company, and gifted limited partnership shares to their children. 601 F.3d at 765. There was no evidence indicating that the partnership employed a particular investment strategy or that the donors were “skilled or savvy investment managers whose expertise [wa]s needed or whose investment philosophy need[ed] to be conserved or protected from interference.” Id. at 770, 771. The donors retained exclusive control of the partnership, and their children could not withdraw from the partnership or assign their interests unless certain transfer conditions were met. Id. at 766. The Eighth Circuit affirmed the Tax Court's conclusion that the restrictions upon the children did not serve a bona fide business purpose because the partnership was not a ““business,” active or otherwise.” Id. at 770. In so holding, the Holman court distinguished a line of cases where active, ongoing business interests were preserved by the transfer restrictions at issue.See, e.g., id. at 771 (“The underlying assett in [Estate of] Bischoff [v. Comm'r, 69 T.C. 32, 39–40, 1977 WL 3667 (1977)] was a pork processing business organized, controlled, and managed by three families who sought to assure their continuing ability to carry on their pork processing business without outside interference, including that of a dissident limited partner.”).

This case is troubling in that there doesn't appear to be any of the sloppy execution that is common in failed family limited partnership.  It appears to call into question the use of this technique in the case of a single asset that does not have business characteristics.

Bring A Gun To School But You Better Have Insurance


This was originally published on October 20th, 2010.

God made the angels to show Him splendor, as He made animals for innocence and plants for their simplicity. But Man He made to serve Him wittily, in the tangle of his mind.

The material for my posts comes mostly from scanning the original source documents in RIA's Checkpoint tax research service.  It is a habit I developed long before I started blogging.  My main focus is looking for things that might be of some relevance to my client base.  I could not, however, pass something up called Thomas More Law Center v. Obama.  I had a brief delusion that I might get ahead of the crowd, but there is already a lot of commentary out there on it.

The case is a request for an injunction against the implementation of the part of the Health Care Reform Act that calls for a tax on people who don't buy health insurance.  The tax is scheduled to go in effect in 2014.  Clearly we are dealing with a group of people who care about principles.  How can you get excited about a tax that doesn't go into effect for a couple of years?  A lot can happen between now and then.  I guess the name of the organization clues you in that they care about principles.

The decision goes into a lot on whether they have standing.  It seems that all the worrying they are doing about the extra money they have to pay in 2014 was enough to give them standing.  So they got into the merits of the case.  Basically, it is about Congress having the power to force every to buy insurance.  The power comes from the right under the Constitution to regulate interstate commerce.  The Thomas More guys think that that is a bit of stretch.

The crux of plaintiffs' argument is that the federal government has never attempted to regulate inactivity, or a person's mere existence within our Nation's boundaries, under the auspices of the Commerce Clause. It is plaintiffs' position that if the Act is found constitutional, the Commerce Clause would provide Congress with the authority to regulate every aspect of our lives, including our choice to refrain from acting.

The court notes that in analyzing whether Congress has the power to regulate something under the Commerce Clause, their role is a modest one :

The court need not itself determine whether the regulated activities, “taken in the aggregate, substantially affect interstate commerce in fact, but only whether a “rational basis” exists for so concluding.”

I translate that to "We don't have to agree with you as long as we don't think you're crazy for thinking it."

They note that the Supreme Court  has placed some limits on the scope of the Commerce Clause.  Notably :

Far from permitting the Commerce Clause to provide Congress with unlimited power to regulate, the Supreme Court has, in fact, placed limits on its reach. The Court was asked to review Congress's power to enact the Gun-Free School Zone Act of 1990 which criminalized possession of a gun within a statutorily defined school zone. United States v. Lopez, 514 U.S. 549 (1995). The government argued that possession of a firearm in a school zone may result in violent crime, which can be expected to affect the national economy in several ways. First, the costs of violent crime are substantial, and via insurance those costs are spread throughout the population. Second, violent crime reduces the willingness of individuals to travel to areas that are perceived to be unsafe. Finally, the presence of guns in schools threatens the educational process, which will result in a less productive citizenry. The government concluded that these adverse effects on the nation's economic well-being gave Congress the power to pass the Gun-Free School Zone Act under the Commerce Clause. The Lopez Court held that Congress could not “pile inference upon inference” to find a link between the regulated activity and interstate commerce.

The health care mandate apparently does not require a similar stretch

There is a rational basis to conclude that, in the aggregate, decisions to forego insurance coverage in preference to attempting to pay for health care out of pocket drive up the cost of insurance. The costs of caring for the uninsured who prove unable to pay are shifted to health care providers, to the insured population in the form of higher premiums, to governments, and to taxpayers. The decision whether to purchase insurance or to attempt to pay for health care out of pocket, is plainly economic. These decisions, viewed in the aggregate, have clear and direct impacts on health care providers, taxpayers, and the insured population who ultimately pay for the care provided to those who go without insurance. These are the economic effects addressed by Congress in enacting the Act and the minimum coverage provision.

The main reason for venturing to the very edge of this blog's field was for the literary/pop culture quiz opportunity afforded by this case. Whoever, can identify the leading quotation gets to claim the invaluable prize of specifying a future topic ?  It happens that it is one of my favorite quotations.  I expect this to be so easy that I was thinking about excluding Xavier graduates from the competition, but they can go for it too.

Debit by the Window - Credit out the Window

KRAUSE v. U.S., Cite as 106 AFTR 2d 2010-5382, 10/12/2010

This was originally published on October 18th, 2010.

There is an old joke about a CPA who used to come to work everyday, open his desk drawer and look at a slip of paper.  After he retired someone found the slip of paper and saw written on it "Debits by the Window - Credits by the Door".  If he went to law school and started doing Son of BOSS deals, he would have had to change it to something more in line with the title of this post.
My readers, who may well number in the scores, vary in their degree of tax geekiness.  Those of you who come here out of friendship or because I have grovelled may want to just click on a few ads and move on, because this is one of those points that is a stretch for me.  I feel I must comment on this synchronicity.  My last two posts have been about Fidelity International Currency.  The rather long decision was issued in May.  It disallowed two partnerships which had been used by EMC founder Richard Egan to shelter capital gains from the sale of stock and ordinary income from the exercise of non-qualified options.

The decision was amended on October 6 to indicate that penalties would apply.  Talk about waiting for the other shoe to drop. The Egans had already put up the 60 million or so in tax.  Somehow I doubt they had been counting on the refund they were suing for to do their Christmas shopping.  So the October 6 amendment might be what they were really sweating out.  If the judge had wanted to make life even more difficult he would have waited until January.  Mr. Egan died in August 2009 making the extended due date of his estate tax return fairly imminent.  Presumably the penalty will go in as a debt of the estate.

In my post I indicated that since this was a partnership case, I was leaving it to the tax litigators as to whether that really was the venue for deciding individual penalties.  Next time I take a break from October 15 returns and start crawling through decisions I find the case of J. Winston Krause.  Mr. Krause was a tax attorney and CPA who built his own Son of BOSS shelter.  I have to wonder if he has two sides to his personality. Right now the CPA side is yelling "Language of 752, language of 752 - I knew it couldn't work.  The entry didn't balance.  You can't get all that basis without crediting something."  The tax attorney side has answers. I can show you an example of a CPA making beautifully balanced entries that make no impression on judges, who are lawyers.

Mr. Krause's partnership did not fight the disallowance of the Son of BOSS losses.  He paid the assessed tax, penalty and interest and then sued for refund of the penalties.  Mr. Krause, not being a high tech billionaire. "only" has about $112,000 in penalties. (I have a rule that the word "only" should not be used in connection with sums of money greater than four dollars, but I'm relaxing it in light of the Egan's 20 million plus penalty).  In arriving at its ruling he court goes into a discussion on the partnership provisions of TEFRA. (Tax Equity and Fiscal Responsibility Act of 1982).  The partnership provisions of TEFRA are a more subtle part of the war against tax shelters than passive activity loss rules of the Tax Reform Act of 1986.  Without them each parter in a partnership could litigate the same transactions in tax court.

To avoid duplicative litigation stemming from the tax treatment of partnerships, Congress enacted TEFRA, which creates a unified procedure for determining the treatment of partnership tax transactions. TEFRA requires the differentiation between the tax treatment of partnership-level and partner-level items.Id . § 6221. Partnership items include all items of “income, gain, loss, deduction, or credit of the partnership,” along with “optional adjustments to the basis of partnership property pursuant to an election under section 754,” and “the accounting practices and the legal and factual determinations that underlie the determination of... items of income, credit, gain, loss, deduction, etc.”

The penalties assessed under the FPAA were directly attributable to the fraudulent $2.79 million loss KAAS alleged it incurred when it sold its Canadian currency. This loss, which passed through to Krause Holdings and then to Krause, occurred because of the overstated basis KAAS had claimed in the Canadian currency due to an earlier basis election. Thus, the penalty related to basis, basis adjustments, and losses, all of which are considered partnership items under § 6231

 Further, the refund sought by Krause relates to penalties and penalty-related interest that are associated with partnership-level items, both of which are in and of themselves considered partnership-level items. I.R.C. §§ 6221, 6230(c)(4). In this regard, the Code is clear: these are items that must be contested before the IRS finalizes an FPAA. The district court did not err by concluding that it could not consider Krause's refund claims.

So if this decision holds, the Egan family might be able to appeal the Fidelity decision, but they won't get to have a fresh hearing on the penalties when they are assessed against the individual returns.

Welcome to the Sausage Factory - RTFI

This was originally published on October 15th. 2010.

It's always a disappointment to me when something I get excited about turns out to be old news.  Such was the case with Fidelity International Currency which was the topic of Wednesday's post.  The decision, issued October 6 was an amendment of a decision issued in May.  I must admit that I have not done a word for word comparison. but skipping to the end I found that in the section headed "The Court does not reach the following issues":

(4.) Whether specific accuracy-related penalties should be assessed against any member or partner of Fidelity High Tech or Fidelity International

was dropped in the amended finding.

In the conclusion section we find added

(6.) The following accuracy-related penalties are applicable to any understatement of the income tax liability of Richard Egan arising from the treatment of the Fidelity High Tech and Fidelity International transactions on the tax returns of those entities for the years 2001 and 2002.
(a.) a 40% penalty for gross valuation misstatement pursuant to § 6662(a), (b)(3), and (h);

(b.) a 20% penalty for substantial valuation misstatement pursuant to § 6662(a) and (b)(3);
(c.) a 20% penalty for substantial understatement of income tax pursuant to § 6662(a), (b)(2), and (d)(2)(A); and
(d.) a 20% penalty for negligence or disregard of rules and regulations pursuant to § 6662(a) and (b)(1).

The penalties are alternatively, and not cumulatively, applied
There are some complex court jurisdiction issues in this case, which don't interest me an awful lot.  The Egans put up the estimated amount of tax that would be assessed if the partnership determination was upheld rather than go to Tax Court.  The penalties discussed above are not the partnership's penalties.  So I suppose there is some question as to whether the court is supposed to be ruling on them, particularly since they are not yet assessed.  Whether Mr. Egan's executors can go to tax court over the penalties is a question for the tax litigators.
The two primary emotions I experience in my wanderings through the ever expanding body of primary source tax documents are compassion and schadenfreude (Curious that you have to go to German for that term.) Mr. Egan certainly doesn't need my compassion, but I do think it is sad that he was vilified in the media as a tax cheat in the final year of a life of high achievement.  I think it would be tasteless and unprofessional to express schadenfreude with respect to any of the professionals involved in this debacle.  I will, however, single out one for a special type of compassion.  It is the "There, but for the grace of God, go I" variety of compassion.  You see there is  not very far distant alternate reality in which the Egans upset with their maltreatment by KPMG decide that leaving the warm embrace of a well established regional firm like O'Connon and Drew was a mistake.  Maybe there are some other firms in their region of similar size to O'Connor and Drew with somebody who knows about partnerships and tax shelters.  In that dystopia, the odds that this nightmare could have ended up on my desk are far from remote.  Thankfully, the Egans decided to stay national.  So my sympathy goes to Ron Wainwright of RSM McGladrey who got to sign the returns that KPMG wouldn't sign without disclosures that the tax attorneys said were not required.

In my previous post on this issue I analogized the people in the national firms who believed tax shelters still worked to isolated detachments of Japanese soldiers who were probably more prevalent in TV sitcoms than in real life in the fifties and sixties.  Implicit in this analogy is analogizing the Tax Reform Act of 1986 to the atomic bomb.  This may seem irreverent, but what can I say it's a metaphor.  And it is a pretty good one because tax shelters had already been dealt very heavy blows and might have went down anyway.  So in this elaborate metaphor Section 465, the at-risk rules, plays the role of ComSubPac, which sunk all the Japanese merchant ships. 

At any rate to explain my own role in the world of tax shelters in similar terms it is necessary to switch sides.  In this metaphor the Tax Reform Act of 1986 is the blitzkrieg.  My part of the tax shelter world, low income housing, was like Vichy France.  Our deals that were still in their pay in period were granted transitional relief.  Somebody told me that the fiscal trade-off for that was fiscal years for S corporations. Not a good trade from my viewpoint. We got a whole new credit, which meant all the new deals had to be redesigned and kept on trucking.  People capitalizing low income housing without much upside beyond the tax benefits was the way thing's were supposed to be.  This particular metaphor really sucks because it makes the national guys the Maquis and me, well never mind its a metaphor.  Basically we had to learn all the aggravating stuff in the 704(b) regulations and whatever other collateral damage the war against tax shelters did to Subchapter K, but we didn't have to hide in the woods while we were preparing returns.

I experienced this difference in world views in the mid-nineties when I was on the AICPA Tax Division's Partnership committee.  (Hey it really impressed somebody on our peer review team once).  When discussing some particularly arcane regulation a couple of the national guys indicated that they would be just as  pleased if it stayed unclear.  I must say that was exceptional.  Generally the committee was striving for clearer regulations.  I also remember that the anti- abuse regulations (1.701-2) were more or less hot off the presses at the time of our meeting.  There were a lot of bent out of shape people.  I, on the other hand, just looked at example 6 Special allocations; nonrecourse financing; low-income housing credit; use of partnership consistent with the intent of subchapter K and decided that there was nothing to worry about.

The Fidelity opinion got into the real nitty gritty of return preparation.  The transaction I explained in my previous post was executed by a partnership called Fidelity High Tech.  There were three partnership returns covering two years.  The reason for the extra return was that the plan required a "technical termination" meaning that a change in ownership created a new partnership for income tax purposes.  The "new partnership" was able to apply basis created by what a simple minded accountant like myself would see as an unbalanced entry to EMC stock the Egans had contributed to the partnership.  In a nice bit of presentation work, they got Mellon Bank to present a capital gain (loss) schedule which incorporated the new basis.  That can be a real challenge.  The court mentions that they didn't file form 8275, but they had an opinion that there transaction was somehow different.  What I see as the real "gotcha" is this:

 Because Fidelity High Tech did not use cash cost to compute the stepped-up basis, it was required to attach an explanation to Schedule D. No such explanation was attached.  An adequate explanation, as required by the instructions, would have included disclosure of the underlying transaction that resulted in the purported stepped-up tax basis used by Fidelity High Tech.

Back in the good old days, when we did returns by hand, my favorite review note was. RTFI - Read The Instructions.  I really think that if I had been sweating this return out, I would have caught that.  There would have been some sort of explanation.  Likely it would not have been sufficient, but if you look at the revenue procedures on adequate disclosure (e.g. Rev Proc 2010-15), sometimes thoroughly filling out the form is what does the trick.

It's Over


This was originally published on October 13th, 2010.

For some time, I have been of the belief that the Tax Reform Act of 1986 killed tax shelters.  I'm still pretty much of that opinion.  When I find a case like Fidelity International Currency Advisors A Fund, LLC, which was just issued by the US District Court for Massachusetts last week (amending their previous May findings in the case), I'm reminded of a trope that would pop up on television series in the 1950's and 1960's. One or more Japanese soldiers on a remote island have to be convinced that they have lost the war and can go home now.  Gilligan and the Skipper had to deal with the problem in Episode 16 and Ensign O'Toole and the Appleby ran into it in Episode 6. 

Fidelity International has local gossip value too it I guess, but not because it has anything to do with the Boston firm that runs mutual funds.  The name is not a coincidence either, but that's part of the story.  The tax matters partner of Fidelity was Richard Egan, recently deceased.  He was one of the founders of EMC, which has its headquarters in Hopkington, MA. He was also the US Ambassador to Ireland, which, is in part, what led to this drama.

This case will likely merit more than one post.  Actually there are probably a couple of good novels in there, but for now I will explain one of the transactions and comment on the feature I find most intriguing.  Mr. Egan owned approximately 25 million shares of EMC, which traded at over $100 per share (Back then at the dawn of the millennium it was a well established law of nature that EMC stock could only go up).  His basis was approximately two cents per share.  Given that he founded a company noted for memory storage, it would have not been reasonable to try invoking the Steve Martin Rule  (That is not pay the tax and say "I forgot").  So he and his son Michael, who ran his family office, consulted with an attorney and some national firms. They wanted to find a way to eliminate capital gains and also shelter the income from the exercise of non-qualified stock options.  In this post I will comment only on the former.

The plan for eliminating capital gains works like this.  You write a very large option which entitles you to receive a large premium.  You use that premium to buy a very similar option.  When it unwinds you will most likely have a loss, particularly after fees, but not a very large loss relative to the notional amount of the options.  Get ready for the magic and if you are passionately attached to double entry remain calm.  Form a partnership and contribute these two contracts to the partnership.  Slowly.  Carefully.  One at a time.  First there is that option you bought for say 150,000,000 (Never mind where you got it from).  That's easy.  Your basis is 150,000,000, the partnerships basis in it is 150,000,000.  Increase your basis in your partnership interest by 150,000,000.  You probably want to take a break.  Now you've got that other thing.  The option that you wrote.  Well you got a lot of money and it seems like it could require you to pay out a lot of money.  In some ways it seems like a liability.  But remember this is a partnership.  You need to check Section 752.  Well something that you maybe have to pay isn't going to pass muster as a liability under 752.  So now you are done.  Your basis in your partnership interest is 150,000,000.

Now you put in your stock in Bigco which is worth 150,000,000 and has effectively zero basis.  After those options sort themselves out for some relatively negligible effect, you are ready for your next step.  You contribute your partnership interest into an LLC and make a 754 election.  You now have to allocate your basis in your partnership interest among the assets of the technically new partnership.  Your basis is still 150,000,000 and the only thing to allocate it to is the Bigco stock.  So now your partnership has basis in your Bigco stock.  It can sell it at a small gain or no gain or, as worked out in this case, a loss.  Mr. Egan's minions needed to put more and more EMC stock into the partnership to take advantage of all the shelter they had bought as the price of EMC collapsed.

There is something really really neat about this plan that I couldn't emphasize if I was presenting it to you as a client.  You see I am a member of the American Institute of Certified Public Accountants and thereby subject to its Statements on Standards for Tax Service, which were issued around the turn of the millennium.  Among the things I can't do is recommend a tax position that "Exploits the audit selection process of a taxing authority."  But since you and I are just pals and I am certainly not recommending this position I can tell you the really neat thing about it.  If it works as planned, you never have to put a really big ugly looking negative number anywhere on any return you file.  The basis that you created, as if by magic, enters into computing the gain or loss on your sale of Bigco stock.  If Bigco stock behaves like everybody thought EMC stock was going to behave it means you will be reporting a gain.  Just not as big a gain.  No tax shelter here just a hard working high tech billionaire paying more taxes than most people.

The only thing wrong with the plan is that creating basis out of thin air doesn't even make good nonsense.

This brings me to the part of the case I find most interesting.  The low reporting profile of the transaction was a big attraction.  What amazes me is how big a paper trail the advisers created discussing the low reporting profile of the transaction.  Stephanie Denby, an attorney, wrote in a memo to Mr. Egan:

. The IRS is certainly aware that these transactions are out there. They have implemented new reporting requirements to try to stop these transactions. To date new reporting requirements have focused solely on C corporations. Although, they could have easily applied similar restrictions to individuals, they have failed to do so.

These transactions clearly take advantage of “loopholes.” The reporting is consistent with tax law although the results are unintended. The promoters will provide tax opinion letters to avoid penalties if audited. It appears that there is a very low chance that these transactions would ever be picked up by the IRS. The promoters I have talked to have not had any audits

Secondly, some of the transactions focus on generating basis as opposed to capital loss. Basis is more discrete [sic] and less likely I believe to cross the IRS radar screen.

You see that's the neat part that I couldn't use to recommend the deal.

She also investigated insurance for the plan then sent an e-mail to James Reiss, CFO of Carruth Associates, Mr Egan's family office :

Marsh &; McLennan does not issue insurance for “transactions with no economic purpose other than the tax benefits.” I think if we pursue this and get rejected, we would be creating a bad trail. Accordingly, I think this is not something to pursue. Let me know if you agree.

Mr. Reiss responded

They probably help insure “straight” transactions. What fun is there to that? I agree with your comment.

The search went on.  Eventually Ms. Denby prepared a comparison of various methods being promoted by national firms rating them positively or negatively based on various attributes including :

Denby also rated and commented with respect to the manner in which the tax loss was generated, noting a plus if the transaction was “harder for [the] IRS to find” and a minus if the transaction was “easier” for the IRS to find

Denby also rated and commented with respect to their complexity, noting a plus if the complexity of the structure made it harder for the IRS to “unwind” or “pick-up” and a minus if the simplicity of the structure made it easier for the IRS to trace.

Ultimately they went with a plan being promoted by KPMG.  As part of the deal KPMG would prepare the returns.  Unfortunately, the landscape shifted between the time of the committment to the transactions and the filing of the affected returns.  KPMG decided that the transactions did need to be explicitly disclosed.  This was upsetting:

On August 30, 2002, Stephanie Denby sent Reiss and Shea a proposed draft letter to Tim Speiss at KPMG. (Ex. 3429). The letter stated that Denby was “astonished” that KPMG would not sign the tax return without a disclosure statement, and that she found the firm's position “shocking” and “untenable,” as well as “a breach of KPMG's fiduciary duty and patently unprofessional.” In her cover e-mail, she wrote that “it would make sense to send out [the letter] after we have confirmation that [Speiss] has purged his files.”

So they fired KPMG and got McGladrey to prepare the returns.  I have never seen a case go into as much detail on the minutiae of return preparation.  I'm hoping to write more on it in the weeks to come. 

The end result of the case was to blow up the transaction and subject it to a 40% gross overstatement penalty.  All the lesser 20% penalites were also found applicable, but they are not cummulative.  The letters from attorneys saying that positions were reasonable and disclosure was not required were of no avail.

When this case was announced in the media earlier this year there was some villification of Mr. Egan, which I really think was misplaced.  Mr. Egan was part of the team of people that helped put men on the moon.  His team of adivsers believed that there were geniuses in the national firms that had figured out a legitimate capital gain strategy.  In retropsect, it is easy to say that they should have realized the game was up when KPMG told them they had to disclose.  That was like the real life case of Second Lieutenant Hiroo Onoda on Lubang Island in the Philliphines.  When his former commander Major Taniguchi told him the war was over he came out of the jungle with his rifle, 500 rounds of ammo and some hand grenades.  It was 1974.  He was lucky not to have a letter from a law firm to contradict him.

Sauce for the Goose

Donald J. Byk v. Commissioner, TC Summary Opinion 2010-137

This was originally published on October 11th, 2010.

Some things are disturbing.  Other things are heartening.  Occasionally I encounter something that is both.  Such is the case of Donald J. Byk.  Tax court summary opinions are the reality TV of the system.  Taxpayers who prepare their own returns according to their own notions get a chance to tell it to the judge.  Frequently they end up seeming - well kind of lame.  I'll point these cases out from time to time, like the fellow who claimed 96,000 business miles in his part time activities. "Anytime you're moving, you're in business."  There is nothing particularly disturbing about them or heartening either of course.

What I do find disturbing is when the IRS is really lame.  Byk v Com. is an appeal from a collection due process hearing.  Here is how it came about.  Sometime in 2007, Dr. Byk,  a dentist, received a notice that his June 30, 2000 Form 941 payroll return had not been filed.  His accountant, as luck and foresight would have it, had a copy of the return.  Said copy was sent to the IRS to show that the Form had in fact been filed.  The IRS treated the copy as an initial filing and assessed the reported tax and interest and penalties.  They sent Dr. Byk a notice of federal tax lien.

Dr. Byk responded with Form 12153.  Form 12153, you may discern from the large number is a relatively recent addition to the pantheon of tax forms.  It is the result of the IRS Restructuring and Reform Act of 1998.  The title of the form is Request for  A Collection Due Process or Equivalent  Hearing.  I'm tempted to say that there are two types of tax practitioners.  One is not familiar with Form 12153.  The other isn't familiar with any of the other forms except Form 656 (Offer in Compromise).  The point is that the IRS has a system for determining what your tax is, in which you cooperate to a greater or lesser extent.  Once that determination is made, there is a fairly distinct system for actually collecting that amount.  The latter group, collections, can be sensitive to the fact that you can't get blood from a stone, at least not quickly, but they are generally not well attuned to the notion that you might not actually owe the money

So Dr. Byk's collection due process hearing, conducted by telephone was fairly perfunctory.  The resulting notice stated :

Collection followed all legal and procedural requirements and the actions taken or proposed were appropriate under the circumstances

The 1998 Act not only created the right to a hearing, it also provided that the hearing decision could be appealed to tax court.  That was Dr. Byk's next step.  I'm going to be quoting from the case some so its important that you keep track of the players.  Dr. Byk is the petitioner.  The IRS is the respondent. 

The parties' confusion is understandable; the relevant timeline and tax amounts have been reconstructed using photocopied forms, computer screen printouts, and dot-matrix printouts of tax account balances. Many of these records have no supporting explanation (and therefore are inscrutable to any non-employee of the IRS)

Respondent apparently relied upon transcripts for petitioner's general dentistry business and his corporation that respondent was unable to fully explain to either petitioner or the Court. The Court questioned respondent about entries in the transcripts, specifically asking about entries concerning nonfiling of returns.Respondent agreed with the Court that the Internal Revenue Service routinely offers a transcript documenting the nonfiling of a return or a Form 3050, Certification of Lack of Record. No such documentation was provided.  No explanation, other than for two codes, was given to decipher the numerous symbols and codes in respondent's transcripts. Petitioner testified that he did not understand the letters and numbers that make up the code in respondent's transcripts.  To complicate matters, respondent's witness could not explain to the Court many of the codes and acronyms referenced in the transcript.  Respondent simply asserted, on the basis of the incomplete testimony of his witness, that petitioner's Form 941 for that tax period was not filed until 2008

Petitioner supplied an apparent copy of a Form 941 from his accountant that respondent had requested. Petitioner asserts that the original return was properly filed and the reported tax liability timely paid. The issue of petitioner's filing a Form 941 raises questions about the validity of respondent's determination and an irregularity in the assessment procedure.

The court did not bother to remand the case back to appeals given the amount of time that had passed.   The IRS behaviour in this case is rather disturbing.  My bet would be that Dr. Byk did in fact file his second quarter 941 near the dawn of the millennium.  Either way the IRS looks really lame, though, not being able to explain the codes on documents that they introduce as evidence.  On the other hand it is heartening to know that the tax court is there for us in this situation.

I'm sure there must be somebody working on a financial MMORPG.  The government monsters will have liens and levies and all sorts of other nasty stuff to cast.  If you are playing a dentist or any other such tax paying character you'll be sure to have some 12153's in your potion stash. 


They Also Serve

James F. Moss, et ux. v. Commissioner, 135 T.C. No. 18, Code Sec(s) 469; 6662.

This was originally published on October 8th, 2010.

God doth not need
Either man's work or his own gifts. Who best
Bear his mild yoke, they serve him best. His state
Is kingly: thousands at his bidding speed,
And post o'er land and ocean without rest;
They also serve who only stand and wait

So this is another post about a development in the passive activity loss rules.  The rules require us to group our trade or business activities into different buckets depending on our level of participation.  Losses in the passive activity bucket can be used against gains from passive activities, but a net loss is suspended until the related activity is fully disposed of.  A special feature of the rules is that rental activities are "per se" passive.  Persons who are in real estate trades or businesses can be exempted from this "per se" passive rule.  They may need to make a special election to take advantage of this benefit.

I've discussed the election in a previous post.  I've also discussed the biggest problem, people have, which is proving how they spend their time. James Moss has introduced a new angle.  Mr. Moss worked full time at a nuclear power plant.  The total hours worked at this job for 2007 came to 1900.  Included in his work hours were 200 to 300 hours of "call out" or "standby time".  Apparently, this was time where he had to be ready to go in, if they needed him.  Maybe it was the days when Homer Simpson was working alone, but I'm pretty sure that's a different power plant.

Mr. Moss also rented out some property that he owned.  There was a four unit apartment building and three single family homes.  He apparently kept meticulous track of his time. (His "day job" involved planning the maintenance activities of a nuclear power plant, so the habits there may have carried over).  He spent 507.75 hours working on his properties and 137.75 hours travelling two and fro for a grand total of 645.50 hours.  The court noted that the IRS did not say that Mr. Moss failed to make the election to group his properties, so they figured he must have.

You guys who know all the answers, I need you to slow down here.  Mr. Moss has done better than most real estate exception wannabees in tax court.  The court isn't calling his time records a ballpark guesstimate and they are giving him credit for the election.  It doesn't make him win, but he deserves a cheer.  Sadly, one of the necessary, though not sufficient, conditions is that you have 750 hours in a real estate trade or business.  So by his own meticulous records Mr. Moss loses.  He has another argument, though.  All the time that he wasn't working at the power plant, he was "on-call" for his tenants.  That should easily put him over the 750 hours.  OK wise guys.  He actually has to beat 1900 hours, because another condition is that you spend more time in real estate than anything else.  Well by my reckoning the "on-call" theory could be another 6,000 hours.

Sadly the tax court wouldn't buy it.  So he has to pay the tax.  He also got hit with an accuracy related penalty.  He proffered two arguments.  The first was that the penalty should be waived, because the IRS mistreated him.  Sadly we don't get the details.  The other was reliance on his CPA, but it is indicated that he did not tell his CPA how many hours he worked. 

First reader to identify the poem above can chose the topic of a future post.

Owe It to You or Cheat You out of It

Carolee F. Argyle v. Commissioner, TC Summary Opinion 2010-129

This was originally published on October 6th, 2010.

Time for another lesson on not reflexively filing joint returns.  Carollee Argyle was turned down for innocent spouse relief on her tax debt from the 2002 joint return she filed with her then husband, James Newkirk.

Early in 2002 both Ms. Argyle and Mr. Newkirk were laid off from their jobs with AT&T.  Mr. Newkirk withdrew $144,205 from his pension during 2002.  They ended up selling their home in Florida and buying a new home in Utah.  Between this and that and the other thing, the pension money pretty much went.  When it came time to file their 2002 tax return, there was a balance due of $27,539.  Neither of them paid it.

The couple divorced in 2006.  (This being a Tax Court Summary decision we are left to fill in the intervening drama in our imagination).  The divorce agreement indicated that any debts incurred during the marriage should be the responsibility of the one who incurred the debt.  The agreement did not address the unpaid tax.

It may well be that the storm clouds of marital dissolution were not on the horizon in 2003, so my previous post on this issue would not seem relevant.  Nonetheless filing separately should have been considered. Presumably the liability on two separate returns was greater than the joint liability.  Does that really matter though ?  I have a theory that all amounts greater than you can conceivably pay will end up being equal to what somebody else thinks you can afford to pay.  Maybe another couple would have seen a way to pay the $27,539, the Newkirks did not.  By filing a joint return they were telling the IRS to get as much as it could up to $27,539 from both of them.  Had they filed separate returns they would have been telling the IRS to get as much as it could up to say $40,000 from Mr. Newkirk.

Here is the interesting wrinkle.  If it turned out that between both of them they could actually come up with $27,539, they could amend to a joint return at that point.

Filing a timely return even though you don't have the money to pay the tax is definitely the right thing to do.  When you are filing such a return, think before you make it a joint return.  If you are the part of the couple who doesn't have the income think three times.

The Mills of the Gods Grind Slowly

IN RE: BRYEN, Cite as 106 AFTR 2d 2010-5835, 08/13/2010

This was originally published on October 4th, 2010.

There are a number of sayings that I have accumulated over the course of my business career.  Some I have even coined myself.  An example of the latter is what I perceived to be the essence of business wisdom that my first managing partner, a second generation CPA, had distilled from perhaps a century of family public accounting experience (counting his father and his brother).  "Money coming in is good.  Money going out is bad."  In my callow youth, I thought of that as ironic.

A real favorite, which I did not coin, is the saying "It is better to be lucky than good." (There is a contra saying that states a strong positive correlation between luck and hard work).  A corollary is the observation "There but for the grace of God, go I."  (Joan Baez says "fortune", but I don't find that as poetic.)  That is what I reflect on contemplating the fate of Bruce Bryen, a fellow CPA.
Like Mr. Bryen, I devoted a significant part of my early professional career to tax shelters.  I was fortunate in two regards.  The first was that the tax shelters that my firm was involved in were quite legitimate.  Shelters were attacked on a variety of grounds, one of which was that there was not a real desire for an economic return exclusive of the tax benefits.  The "for profit" requirement was, however, relaxed in the case of tax shelters designed to promote low income housing, since Congress wanted people to put money into low income housing without expecting to get large economic returns or any economic return at all as it often turned out.  My other piece of luck, if you might call it that, was not making enough money prior to 1986 to be tempted to buy any of the things myself.

Mr. Bryen became involved with "employee leasing" shelters.  This was a type that escaped my notice in what turned out to be the waning days of real tax shelters.  I may not appreciate the fine points, but the deals worked something like this.  A partnership borrowed money from an operating company.  The partnership then hired all the people who worked for the operating company and leased them to the operating company.  The lease payments were deferred and the partnership was on the cash basis. When the partnership switched to the accrual basis it adopted a four year spread.   The thing about a shelter like this is that it was pure deferral.  Real estate held out the promise of conversion.  That is that the income when it turned around on you would be a capital gain.  Regardless, Mr. Bryen and his father, also a CPA, did quite a few of these deals.  The IRS ended up making a project out of it.  Finally, in 1996 one test case was heard with the decision to be binding on over 120 cases.  Bealor v. Commissioner, 72 T.C.M. (CCH) 730, 1996, as you might guess found that the employee leasing arrangement was a sham.  Among the facts noted was that the original "loan" by the corporation to the partnership was handled by a check that never was introduced into the banking system.

So this is all ancient history.  These were cases from 1980 - 1988.  The particulars aren't all that interesting because there are several law changes that would kill these deals as shelters even if they were respected.  That's not what this story is about.

What happened after the Bealor decision is where it gets interesting.  Given this whole test case concept you would think that Mr. Bryn would have gotten a bill sometime in 1996 or maybe 1997.  That's not what happened.  Here's what happened :

Once the Bealor Decision was final, the Debtor knew that he would be subject to additional tax liability and that the IRS would send him notice of the amount the IRS believed that he owed. While the Debtor knew that he also would be subject to interest and penalties, he did not know, at that time, the precise amount of additional tax that ultimately would be assessed.

For approximately five (5) years after the Bealor Decision was issued in 1996, the Debtor did not receive any communication from the IRS regarding the specific amount of his additional tax liability.

 On June 27, 2002, the parties' negotiations culminated in the Debtor signing three (3) stipulations with the IRS  All three (3) stipulations stated that the Debtor owed taxes due to substantial underpayment attributable to tax motivated transactions.

The total tab tax and penalties was $2,808,444.  Then they added the interest.  That brought the total tab to $13,556,124.82. Mr. Bryen's total payments on this obligation were exactly 0.  The court noted that in the years from 1996 to 2003 Mr. Bryen's income ranged from the mid sixties to as much as $190,000.  In 2004, when he filed for bankruptcy his projected annual income was $125,000.  He listed 23 million dollars in debts of which 19 million was due to the IRS.  (I don't know how it got from 13 to 19.  It probably doesn't matter).

The court describes Mr. Bryen's lifestyle during this period in what to me sounds like a critical tone. He spent as much as $25,000 on travel in some years and shared the expenses of a beach house owned by his girl friend, whom he subsequently married.  They spent $5,000 on their wedding the cost being evenly split between them. 

I have this real mental split about how I respond  to amounts of money.  I have a rule with my kids that they can't use the word "only" in conjunction with any sum of money greater than four dollars (My kids are 17 and 21, by the way).  I've not had a particularly onerous life, but as a teenager living with my mother, I was technically below the poverty line.  When I was in VISTA, I used to consider how many cans of tuna fish I had to be a significant portion of my net worth.  To this day, I get a warm fuzzy feeling when I open the cabinet and see 10 or more cans of tuna fish. So I understand the perspective that sees Mr. Bryen living real high during that period. On the other hand I've lived in a business world not that far removed from Mr. Bryen's where an income of $150,000 might be referred to as a buck and a half.  The court is criticizing Mr. Bryen because he didn't live a frugal lifestyle for the five years that the IRS spent dithering after they won the Bealor case.  The thing is that you could have teamed up Suzie Orman and my mothers friend "Aunt" Melba, who would mix four cans of water with the frozen orange juice, to run Mr. Bryen's life while he was waiting for the hammer to fall  and he might have been able to save up something like $300,000 or so.  In which case he would have owed more than he could ever conceivably pay.  Choosing instead to live a less than frugal lifestyle he ended up owing more than he could ever conceivably pay.

The court did not say how much of a payment would have made a difference, but since he paid nothing and lived high on the hog for those five years, his debt was not discharged in bankruptcy.  I'd love to have some comments from people who work with collections as to how they think this drama will play out from here.

Clock is Ticking On Amending Returns of Same Sex Couples

This was originally published on October 2nd, 2010.

Taxpayers who extended their 2006 returns have until October 15, 2010 to amend.  In a previous post, I discussed at some length the Gill decision.  Under the Defense of Marriage Act, same sex couples are not considered to be married for purposes of federal law.  The Gill decision found that a significant portion of DOMA is unconstitutional.  Among many other things, the Court ruled that couples married under Massachusetts law should be entitled to file joint federal income tax returns.

This will generally be more beneficial to the extent that there is a difference in the couples income.  For example if Robin and Terry each make $100,000, they will likely be better off single.  If Robin makes $200,000 and Terry makes nothing a joint return will produce a lower tax.  The way various exemptions, phase-outs and limitations work, though, makes any general rule like that of limited applicability.  If, for example, Robin had disallowed investment interest and Terry had investment income, a joint return might producing savings even if their incomes were equal.  They only way to tell for sure is to run the numbers.

As I have pointed out in another post, the decision to file a joint return is not just a numbers exercise.  Joint returns create joint and several liability.  The Gill decision applies to couples who are married under state law.

You Don't Need a Matchmaker at the Family Reunion

This was originally published on September 29th, 2010.

I have these silly rules that I make up and then go ahead and break all the time.  One is to not use the word only in association with any sum of money greater than $4.00 (Yes there is a decimal point. Four dollars).  Another is to rule out of the discussion the concepts of "making sense" and "being fair" when discussing what the tax rules actually are.  I compound this latter rule by not paying much attention to theories about what the tax laws should be.  This comes from some hard experience I had in 1987, trying to keep straight what actually made it into the Tax Reform Act of 1986 as opposed to the "Treasury II Proposals". 

I somewhat relax the "making sense" and "being fair" proscriptions for purpose of enunciating one of my general rules of tax planning.  "Any clever idea you have has been thought of and probably ruled against."  An extension of this is that most of the thing that you think don't make sense actually do make sense.  They are there to squelch an abusive transaction dreamed up by someone even more clever than you are.  All of this is just me apologizing for saying that the Eleventh Circuit's decision in Ocmulge Fields v. Com (106 AFTR 2d 2010-5820) makes sense.

The case concerns like-kind exchanges, a topic which I discuss here and  there.  At issue is the application of the related party resale rules.  Suppose you owned two companies (Call them Highoco and Lowco)and each one owned a piece of real estate worth $1,000,000.  Further suppose that the basis of one property (High-B)was $900,000 and the other (Low-B) was $100,000.  Along comes buyer who perversely is willing to pay $1,000,000 for Low-B, but has no interest in High-B.  Wouldn't it be nice if you could move the basis in High-B over to Low-B ?  Well you can.  Highco and Lowco can do a like-kind exchange.  Highco's basis in Low-B will be $900,000, its basis in the property that it surrendered.  Clever.

Unfortunately, if Highco disposes of Low-B within two years of the exchange Lowco has to recognize gain.

There is another set of rules involving like-kind exchanges.  Since the person that has the property you want is rarely the person who wants your property many exchanges use qualified intermediaries.  The qualified intermediary receives the money from the sale of your property and uses it to purchase another property.  You have 45 days from the date of sale to identify the target property and you must receive it within 180 days of the sale (If the sale is later in the year you may have to extend your tax return in order to have the full 180 days).

Ocmulgee Fields Inc decided that they should go the qualified intermediary route. The hired Security Bank of Bibb County to serve as qualified intermediary. The bank received the proceeds for the sale of Ocmulgee's property known as Wesleyan Station to the McEachern Family Trust.  Ocmulggee then searched high and low for a replacement property.   They used up all of six days. Finally they identified a Barnes and Nobles.  It just kind of happened, sort of by coincidence, that the Barnes and Nobles was owned by a company named Treaty Fields.  Come to find out, Treaty Fields was pretty much owned by the same people as owned Ocmulgee.

Seems like since they already were acquainted with one another, they did not really need a qualified intermediary.  Just as well they used one, though, since it got them out of that nasty related party resale rule.  Well that's what they thought.  It's not what the IRS thought, though.  And the Tax Court and the Eleventh Circuit agreed with the IRS.  Treaty Fields, surprise, surprise, had higher basis in the Barnes and Nobles than Ocmulgee had in the Weslyan property.  But that's not all.  Ocmulgee was a C corp and Treaty Fields was a partnership.

I would have been awfully upset if Ocmulgee won this case.  Not because I root for the IRS.  I would have been upset at myself for not telling my own clients about such an obvious end run around the related party resale rules.  The resale rules have this nice little ending (1031(f)(4)), which disallows any exchange which is a part of a transaction or series of transactions to avoid the purposes of the resale rules. It reads:

This section shall not apply to any exchange which is part of a transaction (or series of transactions) structured to avoid the purposes of this subsection

Read by itself, it doesn't make a lot of sense.  What it says is that you can't fix a bad exchange by throwing in a couple of extra seemingly good ones.

Shoemaker's Children

WALLIS v. COMM., Cite as 106 AFTR 2d 2010-5755, 08/11/2010

This was originally published on September 27th, 2010.

Many tax professionals practice as partners in partnerships.  So you would think the tax aspects of professional partnerships would be pretty well worked out.  Think again.  When I think about thoroughly applying 704(c), for example, to an ongoing professional firm that has partners coming and going, I get a headache.  Thus, I can't really say I am shocked, shocked that a tax attorney couldn't prevail on the proper treatment of the guaranteed payments from his own partnership, but I'd still like to give you some comments on Wallis v Com. (106 AFTR 2d 2010-5755).  I'm not sure if my motivation is compassion or schadenfreude.  Since it's a tax attorney rather than a CPA it's probably schadenfreude.

Donald Wallis was a partner in the firm Holland & Knight. Under the partnership agreement he was awarded something called Schedule C units for each year of service.  When he withdrew from the partnership in 2003 he had a capital account of  $98,161.75 and $240,000 in "Schedule C" units.  In 2003 he began receiving quarterly payments of $28,180.15.  $20,000 of each payment was with respect to "Schedule C" payments and the the balance toward his capital account.  In 2005 the partnership sent him From 1099-MISC in the amount of $80,000 and deducted the payment to him in computing its taxable income. 

In preparing his 2005 return Mr. Wallis did not report the $80,0000 at all.  He subsequently abandoned the theory that the payment was non-taxable and took the position that it was in exchange for his partnership interest and should be accorded capital gains treatment.  The 11th circuit sustained the tax court in treating the payment as ordinary income and allowing an accuracy related penalty to be charged.

The argument about the penalty was the most interesting.  The court cited Section 6662 which requires you to be consistent with a partnership's treatment of transactions unless you notify the IRS that you are being inconsistent.  The notification is done by attaching Form 8082 which has the apt title of Notice of Inconsistent Treatment.  Mr. Wallis argued that since he didn't have a disagreement with his K-1, which apparently did not include the payment but rather with the 1099-MISC, the consistency requirement didn't apply.  The court was unsympathetic:

Section 6222 provides a means for a partner to inform the IRS when his own treatment of a partnership item “is (or may be) inconsistent with the treatment of the item on the partnership return.” 26 U.S.C. § 6222(b)(1). Given that Donald Wallis has 35 years of experience as a tax lawyer, the Tax Court reasonably could conclude that Wallis should have been aware there were inconsistencies between (1) his not reporting the Schedule C payments at all to the IRS and (2) the income Form 1099 he received from H&K. See Treas. Reg. 1.6664-4(b)(1).

The Wallises argue that they had no obligation to report under § 6222 because their inconsistency was with H&K's Form 1099-MISC, not with H&K's 2005 return. Nonetheless, § 6222 requires partners to report even possible inconsistencies to the IRS if they wish to treat partnership items differently on their own return from the partnership's return. And, Wallis's receipt of the Form 1099-MISC should have alerted him that the Schedule C payments would be reflected as deductions on H&K's partnership return. Rather than alerting the IRS to Wallis's (now-abandoned) theory that the payments did not represent taxable income, the Wallises made no mention of the Schedule C payments when they filed their return. Under the circumstances, the Tax Court did not clearly err in finding that the Wallises did not have reasonable cause for the underpayment or act in good faith with respect to it.

It is interesting to note that the instructions Form 8082 state "... you generally must report items consistent with the way they were reported to you on Schedule K-1."  It goes on to state, however, that you should report "any inconsistency" between your tax treatment and the way the partnership reported on "its return".  Presumably Mr. Wallis didn't see the H&K return, but apparently the 1099-MISC was supposed to be enough of a clue.

Joint Extension Payments

This was originally published on September 24th, 2010.

CCA 201035023 highlights one of the problems that arises from routinely filing joint returns and then shifting to a separate return.  The IRS received Form 4868 (Extension request) from a couple along with a payment.  The couple did not, however, file a joint return.  Therefore the payments were allocated in accordance with regulation 1.6654-2(e)(5). Please be patient here.  Readers of this blog number in the scores and not all of them have memorized the regulations - yet.  The payment was therefore apportioned based on the taxpayers gross tax liability.  When husband got wind of this he requested that the portion applied to wife be allocated to him since he was the source of the funds for the payment.  He cited the MacPhail case (96 AFTR 2d 2005-6066). 

The IRS noted that the MacPhail case concerned a refund not the application of an estimated payment.  (In MacPhail all payments on a return were made by wife's family partnership.  The business that the husband and wife ran together produced only losses.)  So they are sticking with the application of the extension payment. 

It's not unusual for the need to  make estimated or extension payments to be generated more by one member of the couple than the other.  I have a mythical couple called Robin and Terry who's function is to help me with awkward pronoun problems.  For purposes of this discussion Robin is a partner in a law firm and Terry is an employee of a high tech company.  Robin gets a monthly draw of 6% of total guaranteed pay and quarterly draw payments of 7%.  The latter are used to make estimated tax payments.  Terry of course has withholding.  If things ever get rocky for this couple Robin could be in a tricky position.  Terry's withholding is Terry's, but absent an agreement Terry would be entitled to a share of Robin's estimated tax payments. 

It's not unusual for family businesses or trusts to make estimated tax payments for beneficiaries or family owners.  Controllers or trustees charged with that responsibility would be prudent to make those payments as individual, not joint, estimated tax payments.  Whoever was making the payments on behalf of Sarah Crane (Angus MacPhail's ex-spouse) probably wishes they had followed that course.

Short Note on Purging Earnings and Profits

This was originally published on September 23rd, 2010.

I recently wrote on a strategy for old C corporations with appreciated properties.  The idea is to make an S election and wait out the built-in gains period.  Among the provisions of the Jobs Act which just passed the House and is now awaiting signature is a shortening of the period to five years.  This is a lot less than 10, but it is still greater than 3.  So a corporation that cannot rely on having active income will still want to purge its earnings and profits before the favorable rate on dividends goes away.  The shortening of the recognition period makes this strategy much more viable.

I need to thank Jeff for pointing out that the shortening of recognition period is not a permanent provision.  Someone electing in 2011 still faces a 10 year period.  The period was shortened to seven years for sales in 2009 and 2010.  We can't count on the shorter period sticking for someone who elects in 2011.

OOPS I Should Have Had A LLC

Randy M. Javorski, et ux. v. Commissioner, TC Summary Opinion 2010-136

This was originally published on September 22nd, 2010.

I try to cultivate humility.  I have several people who assist me in this most notably my children.  And I do plenty of things to be humble about.  I mention this because I reread the Javorski case after coming up with the flippant title to the post.  I noticed that the company involved was a Canadian company, so there may have been practical cross-border issues that dictated the structure that they used. 

Nonetheless, the tale of woe in this case is a great illustration of the benefits of an LLC structure.  Randy Javorski was a manufacturer's rep for several lines of furniture and lighting.  He had long wanted to own his own furniture store.  In 2002 he formed Lucca Interiors, Inc with Stephan Eberle.  Mr. Javorski contributed $150,000 in exchange for a 49% ownership position in Lucca.  Mr. Eberle received the balance of the stock in exchange for his services.  Besides its own profit potential Mr. Javorski would also benefit from having Lucca as a customer.

Lucca was not profitable.  Mr. Javorski exhausted one line of credit and then another in making advances to allow Lucca to fund its operations.  Design Institute of America, one of the lines that Mr. Javorski represented, held him accountable for Lucca's failure to pay its bills promptly, creating more pressure for Mr. Javorski to advance funds.  In total Mr. Javorski put $382,000 into Lucca.

Lucca was unsuccessful and went into bankruptcy in 2005.  Mr. Javorski did not put in a claim, but it was conceded that he would not have received anything if he did.  The controversy in the case was the nature of Mr. Javorski's loss.  He was arguing for bad debt treatment in 2005.  The IRS said a capital loss in 2006.  The advances were not well documented as loans so the Court went with the IRS on characterization.

What would have happened if this were an LLC ?  The entity's operating losses would have been 100% allocated to Mr. Javorski (loss allocations to Mr. Eberle would not have had substantial economic effect).  It is possible that the losses would have been suspended depending on how much time Mr. Javorski spent on the enterprise and whether it would have been permissible to group it with his manufacturer's rep activity (possibly not).  Even if the losses were suspended, they would have been allowed in full since the bankruptcy would have been a total disposition.

Now we just have to hope that Mr. Javorski has some good returns in the stock market to use up that capital loss carryover.  Maybe next year.

Blast From The Past

This was originally published on September 19th, 2010.

Tax court summary opinions frequently feature taxpayers bringing fairly lame arguments forward.  Like the couple who managed to log 90,000 miles, because whenever they were out and about they were in business.  We should expect higher standards from the IRS.  So it is a little disturbing to witness the IRS being lame.  On the other hand, taxpayer victories in the tax court help us continue to have faith in the system.

Dennis W. Gaffney v. Com (TC Summary Opinion 2010-128) concerns cancellation of indebtedness income.  Accountants understand cancellation of indebtedness income, because they think in double entry.  Some of them think there is a big balance sheet in the sky.  If somebody writes something off without somebody picking up income the fabric of space time will become disturbed.  They can be extremely disturbed by asymmetrical results.  Personally I put taxing debt discharge income in the same category as the GAAP going concern qualification.  It's kicking somebody when they are down.

The exact year that you recognize income is always an important issue, since your tax is an annual computation.  It is particularly significant with COI income though, since COI income is excludable to the extent that you are insolvent.  One has to wonder why anybody would be cancelling your indebtedness for you when you are not insolvent.  The Gaffney case is all about timing.

The Gaffneys had lived in Hawaii, but because of some business disputes they found that they had to abandon their residence and in 1993 they moved to Carefree, Arizona.  Apparently there is something magical in that towns name.  In 1994 the Bank of America foreclosed their Hawaii home and in 1995 obtained a deficiency judgement in the amount of $90,845.  News of these events did not make it to the Gaffneys who were at least free of those cares in Carefree.  In August of 1995 they moved to Cave Creek, Arizona where they continued to have mailed forwarded from their former Hawaii residence.  No news of the foreclosure or deficiency judgement reached them there either.  In 1998 they moved to Oregon.

In 1996 Mr. Gaffney had settled a dispute with the insurer of his business and paid off his various creditors.  He was not aware of the judgment by Bank of America and they were not involved in the settlement.  The problem may have been related to the fact that BOA attributed the loan deficiency to Thomas Gaffney, who according to BOA had the same address and social security number as Dennis Gaffney, who is apparently unacquainted with his fiscal doppelganger.  BOA finally gave up collection action in 2001.  Their last activity was the creation of an asset profile on Thomas Gaffney in April of 2003.

There must have been a BOA accounting minion troubled by perturbances in the big balance sheet in the sky.  In 2006 they issued a 1099-C to the mysterious Thomas using Dennis's social security number and 1998 address.  What the IRS brought to the tax court was the 1099-C and a letter from Bank of America saying that they had reviewed the file and that the amount of discharge was correct and had occurred in 2006.

The court was not impressed.  There was a discussion of when the discharge may have occurred.  The argument for 1994 was fairly strong, but it wasn't really necessary to make an exact determination.  The important point was that whenever the discharge occurred it was well before 2006.

Incentive to Innovate

This was originally published on September 19th, 2010.

I attended the Mass Innovation Night Wednesday  It is a pretty neat event. Neuron Robotics   is making a central control unit to use in robot applications.  Another neat start up was Isabella Products which has a picture frame with a linked e-mail address.  I really wish my mother was still around.  I would definitely have gotten her one.  I was chatting with an attorney who does a lot of start-ups and I was really surprised to find that he wasn't aware of the special tax treatment available for patents.  It's not the first time that I've run into so I thought it might be worth a blog post even though I haven't noticed any striking developments in that area.

Code Section 1235 applies to inventors and their financial backers.  It allows capital gains treatment on payments in exchange for the transfer of a patent even if the payments are over a period of time or contingent on the use of the property.  An analogy that can be used for distinguishing capital transactions from ordinary income is that of a tree and its fruit.  If you sell the tree that's a capital transaction.  If you sell the fruit that is ordinary income. This distinction and the ways that  people try to confound it are sources of much tax complexity which I will discuss from time to time. There is an assumption that when payments for property are spread over time, some portion of the payments represent compensation for the time value of money (which used to amount to something).  Another principle is that things that you create yourself are not capital assets in  your hand.

Code Section 1235 suspends both these principles when it comes to compensating inventors.  Payments that qualify under 1235 are 100% capital gain even though long deferred and the relief is targeted to the creators.  The requirements for 1235 treatment are that the taxpayer be a "holder", which is either the inventor or someone who acquired all rights from the inventor before the invention is reduced to practice.  The inventor can transfer rights even before patents are issued and still qualify for capital gains treatment.  In one case the courts allowed 1235 treatment for the sale of patentable designs even though no patents were ultimately applied for.

In order to qualify for the treatment the sale must be of all substantial rights in the patent or an undivided interest in all the substantial rights.  This might create a significant business issue, since a sale that is restricted to a particular industry or geographic area will not qualify.  I think it is possible that 1235 is not thought about a lot, because the end game of a lot of start ups is the creation of a public company or being taken over by one.  I think this is what accounts for the strange popularity of C corporations.  Nonetheless, it can be a great benefit in the right circumstances and should not be neglected.

Time to Purge C Corporations

This was originally published on September 15th, 2010.

Generally in this blog addresses specific developments - a tax court decision or a private letter ruling for example - issued in the last few months.  I'm celebrating entity extended due date (one of the four major holy days in the tax nerd religion) by pointing out a major planning opportunity.  It requires action before December 31 and if applicable may require significant study, so the time to start looking at it is right now. 

Are you involved in anyway with a C corporation with significant appreciated assets ?  A youngster might wonder how such a thing came to be.  Well have you ever noticed that when you see a copy of the Code it says Internal Revenue Code of 1986 ?  Did you ever wonder what it was like before that ?  Under the Internal Revenue Code of 1954 that is.  Individual rates were much much higher.  The maximum individual rate was 70% (and that was down from higher levels).  There was a special maximum rate on earned income of 50%.  The first 50,000 of corporate income was taxed at significantly lower rates.  Prior to the Tax Reform Act of 1969 it was possible to have multiple corporations with common ownership take advantage of this feature.  (That is getting before my time.)

The neat thing that you could do back then was sell the assets of the corporation in a complete liquidation without recognizing gain at the corporate level.  The proceeds were then distributed to the shareholders who had capital gains treatment.  Eliminating this feature, sometime referred to as the General Utilities doctrine, was one of the biggest changes in TRA 1986, which is really saying something.  To prevent people getting around the gain recognition by a last minute S election, the S corporation built in gain tax was created.  If in 1985 you had a C corporation the thing to do was to look at it closely and see if there was a reason to not make an S election.  Over the years I've encountered a few instances of C corps that really should have converted in 1985.  I suspect there are probably a few still kicking around. As a matter of fact, I just read about one in the case of Estate of Marie J. Jensen, et al. v. Commissioner, TC Memo 2010-182.  The decedent had owned stock in a corporation that owned real estate, a moribund summer camp.  In valuing the stock interest the estate was allowed to deduct the capital gains tax that the corporation would have to pay if the real estate were sold.  Now I wouldn't want to deprive the Jensen estate of its discount, but there is a strategy that an entity like that might consider.

The built-in gains tax (Section 1374) only applies to the appreciated value of the real estate at the time of the S election. (I know you don't think that there is any such thing as appreciated real estate anymore, but you have to remember we might be talking about something a corporation purchased in 1957.)  So any future appreciation will not be subject to double taxation.  More significantly the built-in gains tax only applies for ten years.  (Well maybe I should not have used the word "only" there.)   So imagine you have inherited Oldco, Inc, a C corporation, which owns land worth $10,000,000.  Your basis in the stock is $5,000,000.  The corporations basis in the land is $500,000. 

If you can take a long view an S election can solve the double tax problem.  You have to be able to wait out the ten years, though.  An installment sale will not do the trick.  A like-kind exchange will.  I have written here and there about the perils of like-kind exchanges, but there is no question that they can be a fantastic wealth building device.  The owners of Oldco, Inc would have to do a really bad job in selecting a target property to make them wish they had just paid the taxes.  A likely strategy would be property that is triple net leased to a credit tenant.  You always wanted to own a Walgreen's right ?  So now Oldco, Inc without incurring any tax is flowing through $800,000 of rental income to its shareholders subject to a single tax.  The built in gains tax taint has transferred from the raw land to the Walgreen's, but it will go away in 10 years and nothing prevents you doing another like kind exchange.   Everything would be great except that now you have an S corporation with excess passive income(Section 1375).  So your $800,000 is subject to double taxation.  And you are not going to be able to wait out the ten years, because if you have excess passive income for three years running your S election is revoked.  The two sections 1374 and 1375 sit their like Scylla and Charybdis waiting to devour you (I leave it to one with better classical training to decide which section is Scylla and which Charybdis).

There are at least two approaches to solve the problem.  One is to make sure that Oldco Inc has active business income at least three times as great as its passive income.  I could go on at length about this strategy.  It could work, but it has the danger of creating a tail wagging the dog type of problem.  I will note, though, that rental income which is passive for purposes of the passive activity loss rules might be considered active for purposes of the S corporation tax on excess passive income.  Conceivably you might solve the problem by swapping your triple net Walgreen's for a strip mall, but there is another solution. Section 1375 applies to S corporations that have excess passive income and accumulated earnings and profits.  If Oldco, prior to making its S election, distributes its accumulated earnings and profits it will be not be subject to the tax on excess passive income.

Why is this timely ?  Under current law dividends are taxed at 15%.  So Oldco's purging of its accumulated earnings and profits may be much less expensive if it is accomplished in 2010.  Assuming Oldco is really on the old side determining what the amount of its earnings and profits is may turn out to be a non-trivial question.  As Biker and Eustice note :

To compute a corporation's earnings and profits is often no simple task, especially if the corporation has gone through a series of reorganizations or other adjustments. It may be necessary to decide how a transaction occurring many years ago should have been treated under a long-interred statute because of its effect on accumulated earnings and profits; and, because there is no statute of limitations governing the effect of prior transactions on accumulated earnings and profits, it is advisable to retain corporate records permanently.

There may be a host of other problems to solve including, most likely, stubborn inertia.