Warning

ANY TAX ADVICE CONTAINED IN THIS COMMUNICATION IS NOT INTENDED OR WRITTEN TO BE USED, AND CANNOT BE USED FOR THE PURPOSE OF AVOIDING PENALTIES UNDER THE INTERNAL REVENUE CODE OR PROMOTING, MARKETING OR RECOMMENDING TO ANOTHER PARTY ANY TRANSACTON OR MATTER ADDRESSED HEREIN.





Sunday, December 4, 2011

IRS To Stop Lousing Up Short Sales

PMTA 2010-058

This was originally published on PAOO on November 29th, 2010.

For the latest on this see my follow-up post

When I was a kid, my father worked on Wall Street. He was a Senior Order Clerk. I'm not sure whether his job still exists. It was not particularly lucrative, but I got these insights into high finance through the jokes that he used to tell me. Most of them I didn't "get" until I was in my thirties. One of my favorites is the little ditty "He who sells what isn't hissen, buys it back or goes to prison." That was about short sales as the term relates to securities.

The term means something else in real estate. If a property has a fair market value lesser than the mortgage, the secured party might let the property be sold for an amount lesser than the mortgage. This avoids the need for foreclosure. The owner may or may not remain liable for the balance, the discharge of which may or may not be a taxable event. Such is not the topic of this post.

When I was buying a condo, I found that buying property on a short sale tended to be fraught with delay. You would think that the pressure to sell would create pressure to move things along, but the pressure is not sufficient to overcome bureaucratic inertia. Not surprisingly people who have trouble paying their mortgages frequently have trouble paying their taxes. So it is not unusual for a property with an upside down mortgage to have IRS liens against it. In order for the property to transfer the IRS must release its lien.

Typically the first mortgage will have been in place before the IRS filed its liens. So the value of the lien is the lesser of the tax obligation or the taxpayers equity in the property. In the case of a short sale the latter amount is 0. So the IRS should release its worthless lien and let life go on. That is not what has happened though. Even though the IRS is behind the first mortgage, they are, or at least, believe they are ahead of everybody else :

Applications for Discharge Which Include Requests for Payment of Real Estate Transfer Tax....In cases where a filed notice of federal tax lien has perfected the interest of the United States in such property, the Service is asked to issue a certificate of discharge of federal tax lien to allow payment of the state's claim at closing. It is the Service's position that such taxes have no priority status under I.R.C. §6323(b)(6) against the filed notice of federal tax lien. ... Priority of the federal tax lien is defined exclusively in I.R.C. §6323. Under no circumstances will a discharge of federal tax lien be issued for less than the full value of the Service's claim on the equity in the subject property. The transfer tax will not be accorded priority status or treated as an expense of sale. Applications that include such provisions will be rejected.

Under this interpretation, the taxpayer/property owner has to come up with the transfer taxes in order to move the transaction on.


PMTA 2010-058 finds the above interpretation to be erroneous:

We disagree with the conclusion that the designation by the senior lienholder of some of its proceeds to be used to pay real estate transfer taxes in connection with short sales of real property somehow creates an equity interest in the property on the part of the taxpayer. Rather, these are expenses that the senior lienholder agrees to carve out of its priority lien claim as a matter of business prudence in order to facilitate the sale. Because this does not create an equity interest on behalf of the taxpayer that is subject to the federal tax lien, the authority of the Service to issue a certificate of discharge is under section 6325(b)(2)(B), where the interest in the United States is valueless. The Service has no authority under section 6325(b)(2)(B) to require payment of the sum that otherwise would be applied to junior real estate transfer taxes as a condition of discharge. Because the interest of the United States is valueless, the result would be the same even if the senior lienholder was choosing to use a portion of its mortgage proceeds to pay a junior creditor of the taxpayer (such as payment of homeowner's association fees).

Essentially they are saying that the carve-out for transfer taxes is coming out of the banks secured interest and does not create some sort of equity that makes the IRS lien worth something. This document a letter to the director of collection policy (PMTA stands for Program Manager Technical Assistance) was dated September 17, 2010, but only recently came up on RIA. I haven't seen anything else on this so I am making this a bonus post in the interest of timeliness. If you are involved in a short sale that is hanging because of the IRS, it might be a useful reference.

The letter was sent to the Director of Collection Policy for Small Business/ Self Employed. It was copied to Special Counsel of the National Taxpayer Advocate Program, Assistant Division Counsel (SBSE) and Associate Area Counsels for Ft. Lauderdale and Jacksonville. So this may be a problem that is peculiar to Florida although the principle is of general interest.

P.S.
In the comments below you will see feedback from Richard Zaretsky, an attorney specializing in short sales and related matters. He indicated to me that he has had shouting matches with the IRS on this issue. He has a blog dedicated to short sales. I've seen some misinformation on websites that would lead you to believe that an IRS lien will kill the possibility of a short sale. The relevant section of the Code is 6325(b)(2)(B) which indicates a lien with no value can be released and that in determining the lien's value other liens with priority will be taken into account.

Another Round of Miscellany

This was originally published on PAOO on November 29th, 2010.

Original source documents appear in RIA and beg to be shared with my vast readership, Repeatedly they are pulled up and labored on. Time passes and more interesting matters easily transform themselves into full length posts as the promising material slowly begins to wither. Finally it comes to the time to fish or get off the pot. (Pardon my love of deliberately mangling common expressions.) Here are some brief summaries of the posts that go to oblivion unless one of my readers demand that they get the full treatment :

FOUNDATION FOR HUMAN UNDERSTANDING v. U.S., Cite as 106 AFTR 2d 2010-5862, 08/16/2010



This was shaping into a maudlin reminiscence of my father who used to go though this sequence with his hands that started with "This is the church" and ended with "Look inside and see all the people" as he turned his hands over and wiggled his fingers. The point being that the Foundation For Human Understanding failed to qualify as a church, because it didn't have a regular group getting together to worship as a body. It gets into the 14 factors that make a church a church for income tax purposes. It's a little troubling that Jesus and the Apostles would probably have had a hard time passing the test.

UNITED ENERGY CORPORATION v. COMM., Cite as 106 AFTR 2d 2010-6056, 08/27/2010

I was going to title this "The Trouble with S Corps". Probably the biggest deficiency to the S corp form compared to that of partnerships (which includes most LLC's) is that the liabilities of the S corp are not allocated to the shareholders even if they have guaranteed them.

S corps.—income and losses—basis— loans—guarantees—economic outlay—S corp. indebtedness to shareholders. Tax Court decision that shareholders in S corp. and other entities weren't entitled for passthrough loss deduction purposes to increase their bases in S corp. by amount of any of its debt, other than by amount of shareholder ledger debts, was affirmed, based on Court's reasoning that other debt, comprising bank loans or loans with related entities, wasn't “indebtedness of S corp. to shareholders” within meaning of Code Sec. 1366(d)(1)(B) because shareholders made no actual economic outlay in respect to same.


Consolidated returns—interco. transactions and obligations—deemed satisfaction—transfers to controlled corps.—basis—gain—discharge of indebtedness—S corp. indebtedness. Tax Court supplemental decision that new corp. realized taxable gain as result of deemed satisfaction of affiliated S corp.'s shareholder ledger debts, when those debts were contributed to corp. in Code Sec. 351 transaction, was affirmed, based on Court's reasoning regarding operative reg regime/former Reg. §1.1502-13(g)(4) and finding that corp. acquired ledger debts with built-in gain.

MAES v. U.S., Cite as 106 AFTR 2d 2010-6752, 10/13/2010


In this case taxpayer tried to argue that amounts she had reported as alimony were actually disguised child support or alternatively a property settlement. The first argument was based on the fact that amount ran until the year that children turned 20. The agreement did not explicitly reference the children and other evidence argued for alimony. The second argument was based on the fact that agreement did not explicitly state that payments terminated in the event of her death. The requirement was, however, fulfilled because of state law provision which terminates support obligations on death. This case reinforces the point that it is important to have good tax advice in the structuring of alimony.


These two are tax nerd tests. If they seem at all interesting, you are a tax nerd. I sometimes get the impression that in the Chief Counsel's office they spend half their time being confused about TEFRA.


CCA 201034021
A partnership cannot have an affected item in itself. Each partnership year is a separate cause of action whose partnership items are not computationally affected by adjustments to other partnership years. Thus, an amortization for one year will not keep the statute open for other partnership years as “affected items“.
CCA 201033037
That's up to Exam. But its probably unnecessary since we would have to conduct a TEFRA partnership proceeding for any year in which they took excessive deductions to determine the amount, character and allocation of partnership debt, and whether it was guaranteed by each respective partner in that year. These determinations would then be binding for purposes of generating any affected item notices of deficiency limiting loss to basis or at risk for that particular year.

Well that leaves me with enough material to finish out the year. I should be confident that more good stuff will be coming, but you never know.

Smart Grid Experiment Participants Qualify For Income Exclusion

Private Letter Ruling 201046013, 11/19/2010

This was originally published on PAOO on November 27th, 2010.

This merits a brief bonus post. A utility company is engaging in a controlled experiment to determine the effectiveness of a variety of energy saving techniques. They are dividing the sample into four groups:

The first group will be the control group. They will have fixed rate electricity pricing and receive information from monthly electricity bills only. The second group will receive an Advanced Metering Infrastructure (“AMI”) meter. The AMI meter will give hourly electricity pricing and will provide web- based electricity consumption and pricing information. The third group will receive an AMI meter and a PV system. The PV system will allow the home to use electricity that it produces, not through the traditional electricity distribution grid. The forth group will have the AMI meter, the PV system, and a battery back-up energy storage for critical load panel. The panel will allow the home to produce energy with the PV system and store it for use at other times. The PV system and related property provided to customers will be owned wholly by them, and may give rise to increased value to customer's homes.

Under the most general rule of Code Section 61, the installation of the systems at no charge would constitute gross income to the homeowners and in addition to whatever else they were getting they would be receiving a 1099. Code Section 136, however, provides an income exclusion for energy conservation subsidies provided by public utilities. The ruling provides that this particular program qualifies so the participants will not have their sunny savings clouded by a tax bill.

Think Before Filing Joint Returns

Eileen L. Pugsley v. Commissioner, TC Memo 2010-255

This was originally published on PAOO on November 26th, 2010.

I've written before on not reflexively filing joint returns. This case may be a particularly good illustration of the point. It is also one of those stories that illustrates the point that tax problems are frequently the tip of the iceberg of more serious problems. Eileen Pugsley put up with a lot before she divorced her dentist husband, Daniel. She was asking the tax court if she has to put up with being saddled with 6 years worth of unpaid tax liabilities. The tax court indicated that she will.

Doctor Pugsley had been on a long slide due to alcoholism. In 2005, he lost his dental license, because of failure to fulfill his CPE requirement. He continued to practice without a license until 2007 when his practice was shut down by the Ohio State Dental Board. He continued dressing for work and leaving the house each day, but spent the day drinking.

Finally he entered a rehabilitation program. While he was there Mrs. Pugsley found unfiled joint tax returns for the years 1999 to 2003 in a dresser drawer. She called the family accountant who advised her to file them right away. Prior to filing the returns she applied for innocent spouse relief. The IRS turned her down because the returns hadn't been filed. Several months later the returns were filed. She applied again for innocent spouse relief and was denied again. The factors considered were as follow:

(1) is separated or divorced from the nonrequesting spouse,
(2) had knowledge or reason to know that the nonrequesting spouse would not pay the income tax liability,
(3) would suffer economic hardship if relief were denied,
(4) complied with income tax laws in years after the year at issue,
(5) received significant economic benefit from the unpaid income tax liability,
(6) was abused by the nonrequesting spouse,
(7) was in poor health when signing the return or requesting relief,
(8) whether the nonrequesting spouse had a legal obligation to pay the outstanding

The first factor that she was divorced when filing with the tax court was the only factor in her favor. The second factor weighed against her since she should have known that her husband was not capable of paying the tax. The third factor weighed against her :

Petitioner receives $58,000 per year in salary, $1,500 in monthly spousal support, $484.17 in monthly marital asset payments and $240 per month for health insurance payments for her children. Petitioner testified that her monthly expenses are minimal. Petitioner has no dependents though she provides some financial support to her youngest child. Respondent determined that, based on petitioner's spousal support and salary, petitioner had monthly disposable income of $461 that could be applied to the tax liabilities.

The fourth factor also weighed against her :

Respondent's Appeals Office determined that petitioner was compliant with tax laws as of 2008. Petitioner failed, however, to report spousal alimony as taxable income after her separation agreement was executed in September 2009. She also claimed a $5,000 deduction for contributing to an IRA but failed to make the requisite contribution. She alleges to have filed an amended return only after the issue was brought to her attorney's attention, though no amended return was submitted into evidence.

She also lost on the fifth factor, although I have a little trouble understanding this one:

Petitioner spent $300 a month to belong to a tony athletic club and purchased a home for over $500,000. Petitioner also sent her children to expensive private colleges. The facts and circumstances presented strongly suggest that petitioner received a significant benefit from the failure to pay the tax liabilities. This factor also weighs against relief.

I mean what is so great about having Tony in your health club ?

The remaining factors were neutral. She tried to argue that Dr. Pugsley's financial irresponsibility constituted abuse, but that isn't the type of abuse they mean. The Court found his agreement under the divorce decree to pay the taxes of no account since he clearly couldn't pay them in full. He was paying the IRS $1,000 per month.

The final score was 1 favorable factor, 4 unfavorable and 3 neutral. So Mrs. Pugsley has to keep paying the IRS monthly on the debt her husband is responsible for according to the divorce decree.

I don't have all the facts, but I am going to go out on a limb here. I believe it is likely that the decision to file joint returns was a mistake. If I had gotten the panicked call from Mrs. Pugsley, I would certainly not have told her to just go ahead and file the returns. There is a good chance that I would have concluded that she should have sent in Married Filing Separate returns even if they were not required. (This is because a non-signing spouse can be deemed to have consented to a joint return, an issue I previously discussed.)

The problem is that there are really two fairly distinct areas of tax practice. The one that is most familiar and where I spend most of my time involves determining the correct tax and planning the legitimate ways of minimizing it. Included in this is elections such as the election to file a joint return. The other area is collection. In collection matters, the correct amount of the tax is often only of academic interest, if that. What is important in this area is how much they think they can get from you and whether you are acting like a good doobie. Presumably if Dr. Pugsley had filed separately his correct tax would be even higher. However, the benefit of joint filing reduced the tax to an amount that was still higher than what he could conceivably pay. There is a sense in which all tax amounts that can never be fully paid are equal. The joint filing created another source that IRS could collect from namely Mrs. Pugsley's post divorce salary.

It may be that I am being unfair to Mrs. Pugsley's advisers. They may have duly considered separate filing and rejected it for some reason that does not appear in the record of the case. I have practiced enough in this area to know, however, that the decision to file jointly is often made reflexively or is just viewed in terms of tax minimizing. Requesting innocent spouse relief on unfiled returns indicates that there was a fundamental misunderstanding of the two different systems.

Making A List And Checking It Twice

U.S. v. BRIER, Cite as 106 AFTR 2d 2010-5459, 11/05/2010
U.S. v. VAZQUEZ, Cite as 106 AFTR 2d 2010-6970, 11/08/2010

This was originally published on PAOO on November 21st, 2010.

There has been quite quite a bit in the tax blogosphere about the new registration requirements for tax preparers. I have not been weighing in on it. There is some grumbling about CPA's being exempt from the explicit continuing professional education requirements. Frankly, I think that enrolled agents don't get enough respect, so I really don't mind a few brick brats thrown our way. In our defense though I will say we have a 40 hour CPE requirement. My firm provides this to all staff whether they are licensed or not. Much to my chagrin, we are now specialized so tax people will have most of their CPE in tax (I agree with Robert Heinlein that specialization is for insects. On the other hand there wasn't as much to GAAP back in the good old days). I just paid my $64.50 and am awaiting my PTIN. I'm wild and crazy and reckless and figure that anybody who gets a hold of my client's returns is going to want to steal their identity rather than mine, so I never bothered with it before.

I'm talking about this now, because a fairly juicy case has come out. I'm sure some people will argue that it proves we need the new regulations and others will argue that it proves the IRS already has the tools it need. As with many of the things I choose to blog on, I mainly think it is a good story. I doubt there is much crossover between my blog readership and Mr. Brier's customers, but one never knows. They need to be on the alert and perhaps this post will serve as a heads up to some of them.

I don't think I'll ever get over my working stiff attitudes. It doesn't make much sense to over withhold and get yourself a big refund check. It really didn't make any sense at all back in the good old days when money earned interest (I'm sorry anything less than 4% does not deserve to be called interest). Nonetheless, I miss those days. Being a partner in a partnership, I have to make estimated payments and go on extension. I always wrap my first quarter estimate into my extension payment meaning my refund is always applied. The joy of awaiting that envelope in the mail is a thing of the past. Totally irrational financial planning, but it still had a certain satisfaction. One of my disciplines back then was to always put any check other than regular pay in savings. Which is why the attraction of refund anticipation loans totally escapes me.

Nonetheless they became a big business. Refund anticipation loans are a natural outgrowth of certain types of tax preparation businesses, once you get past the underlying financial irrationality. Somebody has, in effect, made a series of small non-interest bearing loans to the federal government. They then pay a usurious rate to get paid back a couple of weeks sooner. I think there is a sub-branch of microeconomics that studies phenomena like this. I'm sure it's not called stupinomics, but that would be a good name for it. Getting seriously into the refund anticipation loan business compounds a problem faced by preparers who are not working in the high end of the business. This problem can be illustrated by a little story.

One Easter I had just gotten off the phone with a client who needed to put together six figures to pay his extension payment. Next I went over my mother's return with her. She was very upset that she owed $150. Explaining to her that she would owe a lot more if she had been 50 and had a salary equal to the state pension and social security that she had received was fruitless. Probably when she was 50 she had gotten a refund. A balance due was a new experience for her. I solved my problem with this "client" quite elegantly. The following year I asked her if it would be OK if I put her return on extension. In her capacity as my mother, she had always had an exaggerated sense of how difficult my life was so she was fine with that. Along with the extension, which I being a CPA,could sign myself, I sent my own check for $300. So when I prepared the extended return there was a refund. I thought the strategy was pretty clever, but don't think you could make a business plan around it. Which brings us to Mr. Brier and Refunds Now Inc.

Mr. Brier started Refunds Now in 2001 preparing approximately 250 returns that year. In 2009 the count was in the vicinity of 8,000. He was hands on in preparing returns early in the business, but has shifted to marketing for the last several years. He seems to have found his niche, given the impressive growth. The court describes some difficulty he had finding himself as a financial professional:


Brier received his undergraduate degree from the University of Rochester and a master's degree in business administration from the University of Rhode Island. Brier began practicing as an accountant in 1987. Brier received his certification as a certified public accountant (“C.P.A.”) in 1991. That certification, however, was suspended in 1999, after Brier entered into a consent order with the State of Rhode Island Board of Accountancy (“Board”). In that consent order, Brier accepted the Board's findings of “unlawful practice of accounting, unlawful use and disclosure of confidential information, and dishonesty, fraud or negligence in the practice of accounting.” His certification has not been reinstated. Brier has also held the designation as a certified financial planner, however that credential was revoked. In June 2003, the IRS notified Brier that he was no longer eligible to practice before the IRS. In 2005, the Rhode Island Department of Business Regulation issued an order barring Brier from associating with a licensed broker/dealer or an investment advisor in the state of Rhode Island. That order was based on Brier's falsification of his application to apply for a license as a broker/dealer. In his application, Brier failed to disclose that his C.P.A. license had been suspended.

You screw up with one board and they're all out to get you. So it goes.

In 2007 the IRS began examining returns prepared by Refunds Now. At trial Agent Christine Stone testified that they found 309 returns where additional tax was due and 2 where the tax was overstated. This was from a sample of 350. You have to have a little perspective here. I imagine that if most returns I have signed were intensively audited, there would be some sort of adjustment if nothing else because of some sort of substantiation problem. We used to have a joke that if you got a no change on an audit that it meant you hadn't been aggressive enough, but the environment has changed. Returns that I sign tend to have a lot of moving parts to them and enough complexity that there will always be something debatable. Knock on wood,I've had mostly no changes the last few years. The "errors" on the Refund Now returns were of a different nature:

(1) the use of incorrect filing statuses to reduce tax liabilities and maximize the earned income tax credit;
(2) the failure to apply the tests to determine whether an individual qualified as a taxpayer's dependent;
(3) the fabrication or manipulation of Schedule C gross receipts for the purpose of maximizing the earned income tax credit or minimizing net taxable income subject to self-employment taxes;
(4) the fabrication or inflation of various Schedule A deductions, such as charitable contributions and/or employee business expenses; and
(5) the fabrication or manipulation of income and expenses on Schedule E.

On examining returns the IRS encountered people who had no idea how items such as charitable contributions ended up on their returns. They also found that returns prepared by Refunds Now were filed under the electronic ID's of other firms, because Refunds Now number had been suspended. There was a pattern of rapidly changing ID numbers. Mr. Brier indicated that this was to keep his competition from getting statistics on his various offices. The IRS and the court seem to have inferred other motives.

The bottom line of this decision is a preliminary injunction against Mr. Brier and several of his minions from preparing returns. More ominous for their clients is the following:

Defendants Michael Brier, Jeffrey Sroufe, Esther Santiago, and Refunds Now, Inc., individually, and doing business under the names RNTS, Inc., FTIRS, Inc., POTIRS, Inc., and IHIRS, Inc., or under any other name or using any other entity, are ordered to provide counsel for the United States, on or before December 15, 2010, a list of names, addresses, e-mail addresses, telephone numbers, and social security numbers of all clients for whom they prepared or helped prepare any tax-related documents, including claims for refunds or tax returns, since January 1, 2004.

They are not done with Mr. Brier. It will be interesting to see how this develops. There is a lot less detail to the case of Marie Vazquez who's operation may have been more modest than Mr. Brier's. She is agreeing that it would be better if she pursued a trade other than tax preparer and will be notifying her former clients of that conclusion. She will also be providing the IRS with a list.




Does Cohan Still Rule ?

This was originally published on PAOO on November 24th, 2010.

COHAN v. COMMISSIONER OF INTERNAL REVENUE, Cite as 8 AFTR 10552, 03/03/1930


If you have been here before you might note that a case from 1930 does not quite qualify as a recent development. I was in Manhattan for a seminar, though, and one of my rituals is to visit the statue of George M. Cohan, the inspiration for the "Cohan rule". The Court gave an excellent rationale for the rule:

In the production of his plays Cohan was obliged to be free-handed in entertaining actors, employees,and, as he naively adds, dramatic critics. He had also to travel much, at times with his attorney. These expenses amounted to substantial sums, but he kept no account and probably could not have done so. At the trial before the Board he estimated that he had spent eleven thousand dollars in this fashion during the first six months of 1921, twenty-two thousand dollars, between July first, 1921, and June thirtieth, 1922, and as much for his following fiscal year, fifty-five thousand dollars in all. The Board refused to allow him any part of this, on the ground that it was impossible to tell how much he had in fact spent, in the absence of any items or details. The question is how far this refusal is justified, in view of the finding that he had spent much and that the sums were allowable expenses. Absolute certainty in such matters is usually impossible and is not necessary; the Board should make as close an approximation as it can, bearing heavily if it chooses upon the taxpayer whose inexactitude is of his own making. But to allow nothing at all appears to us inconsistent with saying that something was spent. True, we do not know how many trips Cohan made, nor how large his entertainments were; yet there was obviously some basis for computation, if necessary by drawing upon the Board's personal estimates of the minimum of such expenses. The amount may be trivial and unsatisfactory, but there was basis for some allowance, and it was wrong to refuse any, even though it were the traveling expenses of a single trip. It is not fatal that the result will inevitably be speculative; many important decisions must be such. We think that the Board was in error as to this and must reconsider the evidence.

I have a special attachment to the Cohan rule, because I am the last person to become a partner in the firm of Joseph B. Cohan and Associates. As young staff when we learned about the Cohan rule we thought it had been named after Joe or perhaps his son Herb. Well it is possible that we had our own variation. Legislation and perhaps technology have eroded the Cohan rule. My visit to the shrine, though, made me want to see how the rule has done in the last year.

Constantine Sakkis, et al. v. Commissioner, TC Memo 2010-256

Both of these deductions are typical of the type of expenses usually incurred with rental property, and are subject to the Cohan rule allowing us to estimate. We must, however, have some basis upon which to make the estimate. Vanicek v. Commissioner, 85 T.C. 731, 742-43 (1985). There is nothing in this record to help us estimate these “triple-net” expenses, so we disallow them. For the interest expense, however, we have a copy of the all- inclusive note which indicates equal ownership of the property by the Sakkises and Tsakoyiases as well as repayment terms for the loan. We find Sakkis credible that the interest rate was kept at 10 percent after the first 10-year period. We therefore allow the entire $11,149.50 as a rental expense on Schedule E.

Sharon L. Griffin v. Commissioner, TC Memo 2010-252

Sharon Louise Griffin worked part time as a videotape operator and technician. But, if her returns are to be believed, she operated nine businesses in her spare time, grossing $2,876,957 during 2001-2003, but ending up in the red each year. She doesn't contest her receipt of income, but disputes the Commissioner's disallowance of her claimed expenses and other deductions.

We need not apply the Cohan rule at all if the evidence presented by the taxpayer is insufficient to identify the nature of or estimate the extent of the expense.

Keith J. Fessey v. Commissioner, TC Memo 2010-191

Section 274(d) overrides the Cohan rule with respect to section 280F(d)(4) “listed property” and thus specifically precludes the Court from allowing automobile expenses on the basis of any approximation or the taxpayer's uncorroborated testimony.


Myrtis Stewart v. Commissioner, TC Memo 2010-184
Taxpayer/longtime IRS examiner/real estate investor was denied claim to deduct as bad debt 2 years of mortgage payments she made on property that co-investor sold without her knowledge in year before those at issue: taxpayer, whose testimony and records were confused and unclear, didn't show that debt became worthless during years at issue, that she sustained some other loss on property, or what her basis was.


Neither the items' fair market values nor their bases can be determined from the record with any degree of certainty. Therefore, we cannot apply the Cohan rule to determine a reasonable allowance for the theft losses. Consequently, petitioner is not entitled to her claimed theft losses, and [pg. 1095] respondent's determinations in that respect are sustained.

Sandra L. Bennett v. Commissioner, TC Memo 2010-114

The documents Ms. Bennett did keep were largely insufficient—even under the Cohan rule, and all the more under section 274(d), where it applies—to substantiate most of the deductions she claims.



Theodore M. Green, et ux. v. Commissioner, TC Memo 2010-109

The record provides no satisfactory basis for estimating the amounts of petitioners' transportation costs that may have been used for trips to the doctor's office as opposed to the hair stylist. Consequently, the Court will not apply the Cohan rule to estimate the amounts of petitioners' transportation costs that may constitute medical expenses.

Mahmoud M. Soltan, et ux. v. Commissioner, TC Memo 2010-91

If a taxpayer establishes that an expense is deductible but is unable to substantiate the precise amount, we may estimate the amount, bearing heavily against the taxpayer whose inexactitude is of his own making (the “Cohan rule”). Cohan v. Commissioner, 39 F.2d 540, 543-544 [8 AFTR 10552] (2d Cir. 1930). The taxpayer must present sufficient evidence for the Court to form an estimate because without such a basis, any allowance would amount to “unguided largesse.” Williams v. United States, 245 F.2d 559, 560-561 [51 AFTR 594] (5th Cir. 1957); Vanicek v. Commissioner, 85 T.C. 731, 742-743 (1985).


Section 165(a) allows a deduction for “any loss sustained during the taxable year and not compensated for by insurance or otherwise.” The Soltans have failed to substantiate the amount or character of any loss. Under these circumstances the Soltans are not entitled to a deduction under section 165(a). Accordingly, we allow no net operating loss deduction to either petitioner for any tax year at issue. We sustain the IRS's deficiency determinations in the notices of deficiency for all of the tax years at issue.




Philip A. Lehman, et ux. v. Commissioner, TC Memo 2010-74

Married couple was denied carryover deductions for NOLs husband purportedly sustained in connection with his tavern-restaurant: taxpayers didn't show that husband actually sustained NOLs in years stated or that such carried over to and were available in years at issue/ weren't absorbed in intervening years. Taxpayers' claims, that husband operated tavern at loss through certain years but that records regarding same were later destroyed by flood, and that as result, their deductions should be allowed pursuant to Cohan rule for estimating deductions despite missing records, were rejected; even Cohan rule required some basis for reasonably estimating taxpayers' claims, which basis was wholly lacking here given foregoing and that only things taxpayers submitted in support of their position were returns, which themselves couldn't establish losses, or self-serving testimony.


Kristine J. Wolfgram v. Commissioner, TC Memo 2010-69

Testimony alone, without corroborative evidence, does not satisfy the requirements of section 274(d), and thus the Cohan rule is inapplicable.

Edralin A. Pagarigan v. Commissioner, TC Summary Opinion 2010-167

An expenditure of $726 seems reasonable for completing a course of study. Nonetheless, the lack of substantiation and the inexactitude are of petitioner's own making. Therefore, to avoid unguided largesse, we hold that under the Cohan rule petitioner is entitled to deduct $363 for the course in 2005, which is one- half of the amount that she claimed

Kelly L. Madsen v. Commissioner, TC Summary Opinion 2010-151

Madsen provided the Court only with worksheets that listed the amounts of work clothes expenses; she did not include any receipts. Her worksheets fail to identify the particular type of each item of work clothing she purchased, and at trial she was able to identify only two items of work clothing as purchased during the tax years at issue. Her testimony thus did not clarify what the items of work clothing listed in the log actually were. But we find her worksheets contain reasonable figures for work clothes expenses and also find her records for the other expense items “more readily lending themselves to detailed record-keeping” to be reliable and accurate within the meaning of the regulation. Therefore, applying the Cohan rule as reflected in the regulation, we hold that she is entitled to a deduction for work clothes under section 162 in the amounts reflected on her worksheets, $797 for 2004 and $1,442 for 2005.

David R. Holland v. Commissioner, TC Summary Opinion 2010-132

At trial, petitioner succinctly set forth his position as well as his understanding of what this case is all about: *** I did run construction. I did have expenses. I don't have records of them expenses, but I did work this construction all year long, and I had the expenses. I don't know of any job that you have no expenses for. Just because I don't have the records of it is what this is all about.

Like petitioner, we are not aware of “any job that you have no expenses for.” But that truism does not abide, because a taxpayer is required to maintain records sufficient to substantiate deductions claimed by the taxpayer on his or her return



Although we found petitioner to be a credible individual, his testimony, standing alone, is no substitute for what section 274(d) demands. Thus, except for the allowance described in the immediately preceding paragraph, we are obliged to sustain respondent's determination disallowing the deduction claimed by petitioner for “Form 2106” and cellular phone expenses.

Expenses Subject to the Cohan Standard


Finally, the deduction in issue includes expenses for work gloves ($550) and safety boots ($150). Neither of these items is subject to strict substantiation; rather, both are subject to the more liberal Cohan standard.


Given petitioner's profession, we can well appreciate that safety boots are a necessity, as are work gloves. But while we understand that work gloves wear out or are misplaced and need to be replaced, $550 strikes us as a bit much, at least in the absence of any documentary evidence. Accordingly, without regard to the 2-percent floor on miscellaneous itemized deductions, see sec. 67(a), we allow $150 for safety boots and $300 for work gloves. See Cohan v. Commissioner, 39 F.2d at 543-544. Respondent's determination to the contrary is not sustained

Asif Hafeez v. Commissioner, TC Summary Opinion 2010-109

A passenger vehicle is listed property under section 280F(d)(4) subject to strict substantiation under section 274(d). The rule in Cohan does not apply to expenses relating to listed property, which generally includes any passenger automobile. Secs. 274(d)(4), 280F(d)(4)(A)(i); Sanford v. Commissioner, supra at 827-828; Seidel v. Commissioner, T.C. Memo. 2005-67 [TC Memo 2005-67]. However, the term “passenger automobile” does not include any vehicle used by the taxpayer directly in the trade or business of transporting persons for compensation or hire. Sec. 280F(d)(5)(B)(ii); sec. 1.280F-6(c)(3)(ii), Income Tax Regs. Therefore the town car that petitioner purchased is not listed property, and the expenses related thereto are subject to the Cohan rule.


Willie J. Moore, et ux. v. Commissioner, TC Summary Opinion 2010-102

I gave Mr. Moore the full treatment in a previous post. Suffice it to say he did not breathe new life into the Cohan rule.

Ian Menzies, et ux. v. Commissioner, TC Summary Opinion 2009-196

The Court believes petitioner incurred unreimbursed vehicle expenses related to his work for Porter and Titan during 2005. However, the Court may not estimate vehicle expenses under Cohan. See Sanford v. Commissioner, supra; Rodriguez v. Commissioner, T.C. Memo. 2009-22 [TC Memo 2009-22] (the strict substantiation requirement of section 274(d) precludes the Court and taxpayers from approximating expenses); sec. 1.274-5T(a), Temporary Income Tax Therefore, we must sustain respondent's Regs., supra. determination.


In Conclusion

The Cohan rule is not dead, but it is of limited use. Ironically, it is in the area that Cohan had difficulty with, travel and entertainment, that it is of no use. It's fine to give your regards to Broadway, but it would be wiser if you kept better records than the famous producer. Perhaps the photo below gives you a more complete picture:




P.S.

Not surprisingly I'm not the first tax blogger to pay a tribute to George. Here is one done a little while ago by Robert Flach of The Wandering Tax Pro.



















A Tisket A Tasket - Your Hedge Fund's in a Basket

AM 2010-005

This was originally published on PAOO on November 18th, 2010.

So today we get to introduce a new acronym. What is an "AM" you ask. Well it is Legal Advice Issued by Associate Chief Counsel. I suppose that doesn't explain the acronym. I'm going to guess Associate Memo. Regardless, it is one of those things that the IRS would just as soon keep to itself, but that you can get in RIA because of that nasty Freedom of Information Act. This particular one gives us advance notice that there is a very clever plan that the IRS does not like one little bit.

The taxpayer a partnership entered into an option to purchase a basket of securities. Nothing too exciting about that. Here is where it starts getting interesting. The basket is being held offshore. They don't give actual numbers, but for the sake of ease I'm going to say that the partnership put up $1,000,000 and a foreign bank put up $9,000,000. The foreign bank then bought the securities that are supposed to be in the basket. When the contract terminates the partnership is entitled to receive $1,000,000 plus the basket gain or less the basket loss. The gain or loss is inclusive of dividends, appreciation, depreciation, interest, expenses etc. If at any point the basket value goes below $9,000,000 the partnership is "knocked out".

Here is the really clever part. What is in the basket ? Whatever the general partner of the partnership says. So the basket is an actively traded portfolio. I would dearly love it if this thing actually worked because it would be a way to avoid having hedge fund K-1's that run into scores of pages. The portfolio manager decides on the amount of leverage transfers the appropriate amount to the foreign bank, issues trading instructions and nothing need be reported till the contract is settled up.

The associate chief counsel does not think that this thing is really an option :

..... it is clear that the Basket Contract, despite its option terminology, lacks the requisite characteristics of an option. In particular, two elements of the agreements between HF and FB are contrary to the typical functioning of an option: (a) the interplay between the Basket Contract's premium, Cash Settlement Amount, and Knock-Out provision, which imposed upon HF costs similar to an obligated buyer and preclude any possibility of lapse; and (b) HF's ability to alter the Reference Basket, through GP, while the Basket Contract remained open, which is inconsistent with the notion that an option on property must reference specific property at a defined price.

The partnership was deemed to be the owner of the "Reference Basket"

Upon application of the factors set forth by the authorities discussed above to the terms of the agreements between HF and FB, it is clear that HF should be treated as the tax owner of the Reference Basket because HF had: (a) opportunity for full trading gain and current income; (b) substantially all of the risk of loss related to the Reference Basket, and (c) complete dominion and control over the Reference Basket.

A memo from the Associate Chief is a long way from definite authority, but it is a head's up that this structure has a target stenciled on its back.

And Another Purge

This was originally published on PAOO on November 17th, 2010.

I was starting to worry about running out of material, but my last ramble through the hottest stuff on RIA indicated that I am well supplied for a while, so I will continue purging those items that I just couldn't seem to turn into a full length post. I thought they were worth sharing when I first saw them though and have looked at them each a dozen or so times since then, so I hate to let them go without a little salute.


Henry A. Williams v. Commissioner, TC Summary Opinion 2010-125

had a fairly messy set of facts. The bottom line is that when it comes to deducting alimony, oral agreements are not worth the paper they are printed on.

Anthony Cicciarella, et ux. v. Commissioner, TC Memo 2010-195 was about medical expenses, but the issue was really just substantiation. The taxpayers had a not unusual amount of lameness, telling the court that they had "researched" the wrong year, but best of all that some of their records were destroyed in a flood. Unfortunately the flood occurred before the records would have been produced. I was going to title the post "Antediluvian".

THE HENRY E. & NANCY HORTON BARTELS TRUST v. U.S., Cite as 106 AFTR 2d 2010-6004

was a good example of an "is what it is" decision. The exempt trust was taxable on UBIT from securities transactions that it had entered into on margin. Trust's attempt to sidestep statute's clear language with claim that UBIT was really meant only to apply in case of unfair competition was off base since statute was clear and didn't limit UBIT in manner suggested.


More Fun For Landlords

was a title of a post I was working on about the extension of 1099 requirements to landlords. The cautionary note that I wanted to make is the language in several IRS audit manuals :

The examiner must be aware of the potential of the information return test work because it can often lead to significant tax dollars which the primary return (corporate, partnership, or individual) may not produce. Large adjustments can be produced through back-up withholding, return penalties, and even on the returns of the payees who were required to report the compensation but did not receive information returns.


If you were supposed to send somebody a 1099, you were supposed to ask them for their social security number of EIN. Since you didn't ask they didn't give it to you. Therefore you should have subjected their payments to back up withholding. It's a nightmare. You can get out of the back-up withholding by getting them to sign a form swearing they reported the income. Good luck.
Rev. Proc. 2010-36, 2010-42 IRB, 09/30/2010

gives taxpayers a special procedure for claiming a casualty loss from corrosive drywall :

An individual who pays to repair damage to that individual's personal residence or household appliances that results from corrosive drywall may treat the amount paid as a casualty loss in the year of payment.

Taxpayers who have a pending claim for reimbursement may deduct 75% of the amount they spend for repairs in the year they spend it. The loss is claimed on Form 4864 and taxpayers should mark "Revenue Procedure 2010-36" on the top of the form.

Joel P. Arnold v. Commissioner, TC Memo 2010-223

I found the IRS and the Tax Court a little mean spirited in this one. The taxpayer worked as a field auditor for the State of Georgia. He was allowed to check out a state vehicle for his work, but if he travelled more than a certain distance he was required to stay over. This would prevent him from going home to his chronically ill son. So he used his own car and claimed mileage which was disallowed. On the other hand they did allow his job hunting expenses, which were based on the same motivation.


ARGYLE v. COMM., Cite as 106 AFTR 2d 2010-6759 10/14/2010



The taxpayer is a CPA, appealing a Tax Court decision, pro se (That means fool for a client). He tried to file as single even though his divorce had not gone through. He was also trying to deduct legal expenses for criminal proceedings for simple assault, the assault being a kiss. Seemed like an interesting story, but ultimately I couldn't make anything much out of it.

Willard R. Randall v. Commissioner, TC Summary Opinion 2010-163

Mr. Randall was entitled to $69,000 in property equalization from his ex-spouse. He offset the amount against alimony that he was required to pay. The IRS wanted to deny the deduction, but the taxpayer won. I was going to title the post "Still Better to Swap Checks", but as I read it more closely I saw that it was possible that check swapping might not have been a viable alternative (e,g, if the property being equalized was illiquid). It does illustrate the principle that your life will be simpler in the long run if you don't skip transaction steps.






The Powder To Blow It Away

Theodore R. Rolfs, et ux. v. Commissioner, 135 T.C. No. 24

This was originally published on PAOO on November 14th, 2010.

We few, we happy few, we band of brothers — joined in the serious business of keeping our food, shelter, clothing and loved ones from combining with oxygen.

As the writer of an award winning blog that has attracted possibly scores of readers, it is to be expected that I will know some celebrities. One of them is the noted science fiction author, John Sundman. What is really impressive about John is that even though he is as advanced in age as I am, he is still a volunteer firefighter. He has given me a great deal of encouragement, so coming on a case touching, however, lightly on firefighting I decided to acknowledge his support.

Theodore Rolfs purchased some lakefront property in 1996. For some time, he pondered exactly what he wanted to do with it. Then his mother-in-law suggested that he build a residence on it to her specifications and exchange it for her residence. He decided that was a good idea and began planning accordingly. There was, however, already a residence on the property. Originally built in 1900, the existing structure could not be made mother-in-law worthy. Mr. Rolfe determined that it would cost him about $10,000 to have it torn down. Then he came up with a better idea.

He wrote to Gary Wieczorek, who was chief of police and also of the volunteer fire department of the Village of Chenequa, where the house was located :

As we have discussed, I would like to donate our house located at 5192 [2] Oakland Road in the Village of Chenequa to the Fire and Police departments of the Village for training and eventually demolition. This letter shall serve as an acknowledgment that it is my intention to donate the house for such purposes. The house is available immediately. If any further approvals are needed please contact me.



Chief Wieczorek had a clear understanding that his department was not the recipient of a new recreational facility. He understood that the house was to be used exclusively for training purposes and that Mr. Rolfs expected that it would be burned down sometime in the first half of 1998. Matters developed in accordance with Mr. Rolf's expectations :

Sometime shortly before February 18, 1998, the Chenequa Police Department used the lake house for a training exercise. On February 18, 1998, the VFD conducted an initial training exercise at the lake house. On February 21, 1998, 11 days after petitioner's letter donating the lake house, the VFD conducted a second training exercise and burned the structure to the ground.


The firefighter training exercises at the lake house allowed the VFD to satisfy monthly training requirements imposed under Wisconsin State law. Chief Wieczorek believed the firefighter training exercises conducted at the lake house were superior to the training exercises otherwise available to the VFD.

Mr. Rolf arranged for an appraisal of his property. The appraiser did a valuation of the property with and without the structure that after standing nearly century went out in a blaze of glory to the edification of the Chenequa Volunteer Fire Department. The appraiser determined that the value of Mr. Rolf's property had declined from $655,000 to $579,000. Accordingly he claimed a charitable contribution of $76,000.

The IRS denied the charitable contribution and asserted a 20% accuracy related penalty. Mr. Rolf filed a petition to Tax Court now claiming a deduction of $235,250, the appraiser's estimate of the reproduction cost of the house. The Service responded by switching to a 40% gross valuation penalty.

The IRS got testimony from a professional "house mover", who indicated that it would have cost on the order of $100,000 to relocate the structure. Given its relatively modest nature and the high cost of land in the vicinity there would not have been anyone willing to pay to relocate it. They also brought on someone from the State of Wisconsin responsible for knocking down houses to make roads who reiterated that this was not the type of house that could be moved somewhere else.

In the end the tax court ruled that Mr. Rolfs was not entitled to a deduction since he had received a "quid pro quo" in the form of the removal of the structure that could not be brought up to mother-in-law standards. Since he had diligently followed all reporting procedures and a similar deduction had been allowed in Scharf v. Commissioner no penalties were assessed.

All in all, the satisfaction of helping the fire department should have been enough for Mr. Rolfs, winning on the deduction would have been icing on the cake. Samuel Johnson said "Every man thinks meanly of himself for not having been a soldier, or not having been at sea." Firefighting had not developed as a profession in his time or I am sure the would have added it. So I will close with a second quotation this one from an office worker's tribute to firefighters :
And when we met them on the stairs
They said we were too slow.
"Get out! Get out!" they yelled at us -
"The whole thing's going to go"
They didn't have to tell us twice -
We'd seen the world on fire.
We kept on running down the stairs
While they kept climbing higher

The collection of unidentified quotations continues to expand. A hint on the leading one is the fictional character also had a great deal of admiration for infantrymen.

Time To Purge The Draft Posts

This was originally published on PAOO on November 12th, 2010.

In case you have ever wondered what the secret is to having a tax blog with conceivably scores of readers, who rarely click on ads, here is how I do it. Whenever I get a chance I scan all the primary source federal tax stuff I have that is available to me through RIA. Federal court decisions, private letter rulings, revenue procedures, chief counsel advice, program manager technical assistance, etc. etc. If something looks promising, I copy it into a draft post. I then work on which ever one the spirit moves me to whenever I get a chance. I've committed to publishing posts on Monday, Wednesday and Friday and have kept up pretty well. The draft posts accumulate at a faster rate than three per week. There are ones that I find kind of interesting, but just don't seem to be able to expand on to have something worth saying.

So in order to keep my draft posts from being cluttered with material that is going stale, I'm going to do a bit of a purge. However, when I first looked at these things, I thought there was something worth sharing, so I at least want to mention them. Once I have done that I will delete them which will make me feel more pressure when I am scanning new stuff, because I am always worried about running out. You can rescue any of these embryonic posts from oblivion by posting a comment.

Martha A. Olson v. Commissioner, TC Summary Opinion 2010-96 is a classic tax court summary opinion, the reality TV of the system. The taxpayers were trying to deduct expenses from a business that they had run several years before. They explained why they hadn't reported the business (a pay day loan operation) in the years it actually operated as follows:

Petitioner did not believe that she needed to report anything from the Checkrite business on the 1996 and 1997 returns because, in her view, she reinvested all the income back into the business; i.e., as customers would make payments against their outstanding liabilities, petitioner would collect the payments and then make additional loans to new or existing customers.

I thought that was kind of amusing and was going to title the post "Consider Taking Accounting 101"

Estate of Marie J. Jensen, et al. v. Commissioner, TC Memo 2010-182 is a valuation case. In valuing a C corporation that owned a moribund summer camp, there was a substantial discount allowed for the potential corporate income taxes on a sale of the property. I gave it a brief mention in my post on purging earnings and profits, since I believe their income tax problem might have been somewhat more manageable than they either thought or at least let on. I haven't felt inspired to give it a full treatment though.


PLR 201016053 is an example of something that is incredibly interesting if you are a total tax geek and rather difficult to make meaningful for a normal human being. Here is the headnote:
:
Self-created customer relationships are severable and distinct asset from acquired customer relationships such that any gain with respect to sale of self-created customer relationships won't be subject to Code Sec. 1245; recapture as result of amortization deductions claimed with respect to acquired customer relationships

I swear if they ever have a machine to test for tax geekiness where they attach and insert all sorts of devices that monitor your reactions and then flash things on the screen that will be one of the things they use. If you just had a WOW - That's really interesting, you are a total tax geek (Maybe some sort of highly specialized business broker just to be open to other possibilities. ). If you just had a WTF (That stands for What The ?) you are a normal human being.

Gordon Kaufman, et ux. v. Commissioner, 134 T.C. No. 9 was about a charitable contribution of a facade easement. The IRS was granted summary judgement on the issue of a deduction for the easement because the property was mortgaged, but it was not granted summary judgement on the issue of the cash contribution that the taxpayers made as part of the deal or their reliance on their accountant to be relieved of penalties. Who knows ? Maybe this case will be back on those two issues.


Gregory J. Bahas, et ux. v. Commissioner, TC Summary Opinion 2010-115 is about the real estate professional exception to the passive activity loss rules. I gave it a brief mention in one of my other posts on that topic. The interesting thing is that I think there is a mistake in it:

Mrs. Bahas misconstrues section 469. Because petitioners did not elect to aggregate their real estate rental activities, pursuant to section 469(c)(7)(A) petitioners must treat each of these interests in the rental real estate as if it were a separate activity. See sec. 469(c)(7)(A)(ii). Thus, Mrs. Bahas is required to establish that she worked for more than 750 hours each year with respect to each of the three rental properties. But, petitioners presented no documents or other evidence with respect to the number of hours Mrs. Bahas worked managing the three rental properties in question. Indeed, the parties stipulated that “petitioners spent less than 750 hours managing the rental properties” in question.

Absent the election, I don't think you need 750 hours in each of the properties. I think you would just have to materially participate in each of the properties. At any rate, I'm beginning to wonder if the actual real estate professionals are beginning to regret that they lobbied for this relief given the number of amateurs that it ends up attracting. Regardless I've probably said enough about Bahas.

Well I guess those five are enough for this post. I still have a decent backlog. If nothing interesting comes out between now and January, I'll be out of material. Not very likely.

IRS More Liberal Than Tax Court on Home Mortgage Interest

Rev. Rul. 2010-25, 2010-44 IRB 571, 10/14/2010

This was originally published on PAOO on November 10th, 2010.

Back under the good old Internal Revenue Code of 1954, interest paid was pretty much deductible. In terms of making life complicated for those not among the ranks of the captains of industry, the one thing that was worse than the passive activity loss rules were the new rules about interest deductibiltiy. Interest expense must be divided into three components trade or business interest, investment interest and personal interest. Trade or business interest is deductible, but might be suspended by the passive activity loss rules (At that point it will have lost its identity as interest and just be part of the loss). Investment interest is deductible, but only as an itemized deduction and only to the extent of investment income, generally (Don't get me started on people who invest in hedge funds that are traders in securities) and personal interest is non-deductible. Of course that's not the whole story. I'm not going to discuss student loan interest. The three broad categories trade or business, investment and personal are all you get when you are only looking at how the money was spent.

Which brings us to residence interest. There are two types. Acquisition indebtedness is used to purchase one or two residences. In addition to tracing the indebtedness to an acquisition of a personal residence the debt must be secured by "such" residence. There is a limit, not on the amount of interest but rather on the amount of indebtedness. $1,000,000 - not indexed for inflation. Then there is home equity indebtedness. The only requirement is that it be secured by a personal residence. If you borrowed money against your house to put into a business you can decide from year to year whether to treat the interest as home equity indebtedness which will give you a sure itemized deduction or trade or business interest deductible in arriving at adjusted gross income (generally better than an itemized deduction) but possibly subject to being suspended if the business is a passive activity. The limit on home equity indebtedness is also a limit on the amount borrowed. $100,000 - not indexed for inflation.

Now suppose you buy a $2,000,000 house putting 20% down. That would give you a mortgage of $1,600,000 and to make the math easy lets say it is at 5%. Further assume that you have no other debt. How much of your $80,000 of interest expense can you deduct ? So you don't have to get a calculator I'll give you two choices - $50,000 or $55,000.

I have to admit that I always thought the answer was $55,000. I thought it was clear enough that I never really looked any further. It turns out, however, that there is a reading of the Code to the effect that interest on home equity indebtedness up to the $100,000 limit is deductible regardless of how the money was spent unless it was spent to purchase a residence. My inability to see that reading must have come from my falling into the "That doesn't make any sense" trap. So what if it doesn't make any sense it is what it is.

There are two tax court decisions with this holding. I went and looked at them and noted that in at least one the taxpayer had made himself obnoxious in nine ways till Sunday so they might have been trying to throw the book at him. Regardless, the Service in this ruling is saying that it will not follow the two tax court decisions on this issue that it won. So if you purchase a house with a mortgage of more than $1,000,000, $100,000 of the excess can be counted as home equity indebtedness.

We Only Wash Losses Here

INFO 2010-0188

This was originally published on PAOO on November 8th, 2010.

I've been sitting on this one for a while. It was issued July 27, 2010. It refers to the flash crash of the stock market on May 6 which caused many stop-loss orders to be triggered some of which resulted in gain recognition. Whoever (I don't think Redacted Text was his real name) wrote to the IRS more or less logically (as if that means anything) thought investors should be able to reestablish those positions with appropriate basis as if no gain were recognized. Here was the response :





Dear [Redacted Text]:
This is in response to your May 20, 2010, letter to Commissioner Shulman concerning the May 6, 2010, “flash crash” of the stock market. You point out that many investors had their holdings sold that day because of stop-loss orders and that, in some cases, these investors realized gains subject to tax. You ask that these investors be allowed to reinvest in the stock sold, that the replacement stock be given the same basis as the stock originally held, and that the investors be excused from recognizing gain.

Stop-loss orders direct a broker to sell a stock at the best price currently available if the stock reaches a specified price. As the result of the speed and scope of the decline in stock prices during the afternoon of May 6, 2010, many stop-loss orders, which are executed as market orders, were triggered. The paucity of bids for many stocks resulted in sales at prices significantly below those of prior trades. Those sales triggered additional stop-loss orders and more stock sales at current market prices. Many investors incurred losses as the result of such sales, although stock prices rebounded significantly thereafter. The dramatic recovery in stock prices was a source of frustration to investors whose stock holdings were liquidated as the result of the execution of stop-loss orders during the market decline. The closing price for many stocks was higher than either the price at which investors' stop-loss orders were triggered or the price realized on the sale of stock as a result of the triggering of a stop loss order.

Reinvestment in securities sold at a loss in some circumstances requires application of the wash sale rules set forth in section 1091 of the Internal Revenue Code, so that the loss cannot be recognized fully for federal income tax purposes. Example: An investor bought 1,000 shares of X Co. stock at $70.00 at the opening of the market on May 6, 2010, and placed a stop-loss order at $66.50 (5% below the cost of the stock). When the stock declined to $66.50, the investor's stop-loss order became a market order. As a market order, the order was executed at $61.00, the best available price. The saleresulted in a loss of $9.00 per share to the investor. If the investor, within 30 days before or after the sale of the X Co. stock, purchased X Co. stock, the wash sale rules would apply to limit or deny deduction of the loss. The amount of the disallowed loss would be reflected in the investor's basis in the X Co. stock purchased within 30 days before or after the sale under the stop-loss order.

On the other hand, there is no similar rule allowing nonrecognition of gain on the sale of stock if an investor purchases replacement stock within a prescribed period. Example: An investor who had purchased X Co. stock on July 20, 2009, at a cost of $40.00 per share had placed a stop-loss order at $66.50 (5% below the closing market price of the stock on May 5, 2010). During the flash crash, the investor's stop-loss order was triggered, and the investor's X Co. stock was sold at $66.50 per share. The investor realized a gain of $26.50 per share on the stock and would be required to recognize the realized gains, i.e., include the gains in gross income, irrespective of whether the investor acquired X Co. stock within a prescribed period, e.g., 30 days, before or after the sale at a loss.

Various nonrecognition provisions in the Code are not applicable. Section 1031 provides for deferral of recognition of gain on like-kind exchanges of property held for productive use in a trade or business or held for investment, but specifically excludes stocks, bonds, and notes from its scope. Section 1033, which provides for deferral of gain if property is compulsorily or involuntarily converted into property similar or related in service or use to the property so converted, or to money, applies only to dispositions resulting from destruction, theft, seizure, or requisition or condemnation.

In sum, absent the enactment of a relief provision by Congress, there is no authority that would allow the Internal Revenue Service to provide for the nonrecognition of gain for stop-loss orders executed on May 6, 2010.

Sorry Red.

Let The Sun Shine In

Private Letter Ruling 201043023

This was orignally published on PAOO on 11/6/10.

I'm going to do this as bonus post, because I don't have the ability to expand on it much. They have figured out a way to make a "curtain wall" of glass where all the windows are, in effect, solar panels. The Service has ruled that even though such a wall is clearly a "structural component" of the building, the entire cost is still subject to the 30% energry credit. That's a great credit, since it is one that can be used against the AMT (The only thing better is a refundable credit).

Inadvertent Termination

Private Letter Ruling 201042010, 10/22/2010

This was originally published on  PAOO onNovember 5th, 2010.

Years ago The Practical Accountant ran a series of cartoons. There would be two guys sitting on a park bench. One appeared to be a distinguished looking business man and the other was, well to use language that is consistent with the artwork, a bum. The latter is always the speaker. Probably the funniest comment, which most people will get was "Read the notes to the financial statements." The really funny one has the less elegantly dressed gentleman saying "There I was sitting on top of the world, when in a thoughtless moment I inadvertently terminated my S election." Well since then, the world has become a more forgiving place at least as it relates to S elections.

Not having to deal with the possibility of an inadvertent termination is one of the several reasons to prefer an LLC, taxed as a partnership, to the S corporation form. I recently mentioned that those remaining C corporations with appreciated property might want to consider purging earnings and profits. This is because an S corporation that has passive income constituting more than 25% of its gross income and accumulated earnings and profits is subject to a penalty tax and if the condition continues for three years, its S status is terminated.

The other advantage an LLC has is the possibility of dividing profits and losses in just about any way you want, as long as the allocations have substantial economic effect. Ironically, this ends up often making the S corporation look better to some, because its single class of stock rule, makes it simpler. You can have an LLC with a single membership class if you want to. Complexity is optional.

So now we get to PLR 201042010. The Company, as it is called in the PLR, has only one class of stock. All shares have the same rights to distributions. They have a very special form of preferred stock though. The shareholder who controlled the checkbook preferred to make distributions to himself or herself. There is a special method that it is used to determine distributions in situations like that. It is the WIFL method (Whatever I Feel Like). I'm actually speculating here. The ruling just said that distributions were disproportionate.

The Company also had accumulated earnings and profits and excess passive income for three years running. Other than that Mrs. Lincoln, how did you enjoy the play?

Much to my surprise, the IRS has ruled this to be an inadvertent termination. I suppose if you drove blind folded that any crashes you had would be inadvertent too, but I don't recommend it. The shareholders have to amend their individual returns to pick up a deemed dividend for the amount of the earnings and profits. Also they have agreed that on receipt of the ruling they will make payments to bring distributions to shareholders into proportion with ownership. Why the stiffed shareholders are waiting till then is beyond me, but that's the deal.

So if you made your S election without purging and are having lots of passive income, its no big deal. You can clean it up. It is still the wiser course to purge first. Their will be interest on those amended returns and it costs money to get these rulings.

Courts and Value Billing

Canal Corporation and Subsidiaries v. Commissioner, 135 T.C. No. 9
KELLER, ET AL. v. U.S., Cite as 106 AFTR 2d 2010-6343, 09/15/2010

This was originally published on PAOO on November 3rd, 2010.

My father was fond of saying you need three things in life – a good doctor, a forgiving priest, and a clever accountant


I have these little stories I use to keep perspective. They are a combination of fact and speculation. The proportions vary. I sometimes hear that being a CPA is very stressful. I can get into that, but then I have my perspective story. Sometime, during the early part of the second Gulf War, my daughter's eighth grade class wrote encouraging letters to our service people abroad. I wasn't surprised that she got a reply, but the person replying was a bit of a surprise. He was a major, the executive officer of a helicopter battalion. I tried to imagine what his job must be like. It involves seeing that machines that don't look like they should fly keep flying. And that's just the tip of the iceberg. My speculation was that he received a stack of letters and that faced with the challenge of making sure that his collection of extremely stressed young people appropriately answered the schoolchildren in a way that reflected credit on the Army, he answered them all himself. Regardless it was a nice letter and I hope that he is now full colonel at a nice post in pleasant circumstance or perhaps even better collecting a well earned lieutenant colonel's pension. And when ever I think I have stress I think about him.

I believe that the biggest hazard CPA's face is not stress, but envy. It is in the nature of things that most CPA's who do well have client's who do even better, much better. In a free capitalist society, the most highly compensated people will be the successful entrepreneurs. That does not mean that entrepreneurial activity is over rewarded. Unsuccessful entrepreneurship garners fairly heavy penalties. In the process of failure, they may generate some complicated accounting work, but not the revenue to pay for it. A practice where those clients predominate, unless it is that of some sort of workout specialist, will not last. So a prosperous CPA sitting down to eat with a collection of his most prosperous clients will often be the least prosperous person at the table. Ironically, the more prosperous the CPA is, the more likely that he or she will be the least prosperous person at that particular table.

The concept of value billing has some very sound reasoning behind it, but I also think that the envy factor is the source of some of its attraction. I couldn't help but notice it in the banter between professionals that was such a rich part of Fidelity International Currency, the epic tale of EMC founder Richard Egan's doomed tax shelters

On May 26, 2000, Denby sent Reiss an e-mail regarding the previous day's meeting and her discussions with Helios after the meeting concerning fees:


... after the meeting I discussed with Helios the fees. The fees are based on a 3% rate. If KPMG were not involved Helios would just pocket a larger percentage. Since our connection came from KPMG, Helios would pay them a referral fee anyway. I think at the same rate. So [their] involvement does not cost more but just results in reallocation of the base fee. I know from other situations this reallocation occurs simply from [our] getting the name [from] KPMG. We are in the wrong business!

The writer was an attorney and the recipient a CPA, who was CFO of a family office. She was expressing the same frustration that led the CPA's at KPMG into a new and interesting way to do business. She or her firm was apparently getting paid by the hour to find a brilliant maneuver to save Mr. Egan's tax dollars. KPMG had already invested some hours in designing a brilliant scheme. They would not get paid for the additional hours they spent applying these principles to Mr. Egan's situation. They would get paid a percentage of the tax savings while incurring a relatively small marginal cost.

The outcome of the whole enterprise was not pretty for KPMG or many of their clients. KPMG found itself fortunate to be in any business. They were even pressured by the federal government to stop paying defense costs for some of their partners, a tactic which back fired on the government on constitutional grounds, but you should go to the federal tax crimes blog if you want to read about that type of thing. More to the point of this post, none of the opinions that the Egans paid for protected them from the imposition of penalties. They were viewed as part of the package and tainted by a lack of independence.

The disdain for professional imprimaturs unsupported by work has moved beyond the Son of Boss unbalanced entries to a deal that tax professionals felt deserved a bit more respect. Canal Corporation and Subsidiaries was a deferral deal. Instead of selling a subsidiary the taxpayer contributed it to a partnership and took a large distribution. The debt that funded the distribution was allocated to the contributing partner, which avoids the disguised sale rules. Of course, they didn't really want a liability, so the guarantee that supported the allocation was pretty tenuous.

Not to worry, they got a "should" opinion, the highest assurance possible from none other than PWC. If you can't rely on the people who count the votes for the academy awards, who can you rely on ? Turns out the client should have been a little more diligent than just cutting a check and asking for the envelope, please :

Chesapeake paid PWC an $800,000 flat fee for the opinion, not based on time devoted to preparing the opinion. Mr. Miller testified that he and his team spent hours on the opinion. We find this testimony inconsistent with the opinion that was admitted into evidence. The Court questions how much time could have been devoted to the draft opinion because it is littered with typographical errors, disorganized and incomplete. Moreover, Mr. Miller failed to recognize several parts of the opinion. The Court doubts that any firm would have had such a cavalier approach if the firm was being compensated solely for time devoted to rendering the opinion.
We are also nonplused by Mr. Miller's failure to give an understandable response when asked at trial how PWC could issue a “should” opinion if no authority on point existed. He demurred that it was what Chesapeake requested. The only explanation that makes sense to the Court is that no lesser level of comfort would have commanded the $800,000 fixed fee that Chesapeake paid for the opinion


Chesapeake did not act with reasonable cause or in good faith as it relied on Mr. Miller's advice. Chesapeake argues that it had every reason to trust PWC's judgment because of its long-term relationship with the firm. PWC crossed over the line from trusted adviser for prior accounting purposes to advocate for a position with no authority that was based on an opinion with a high price tag—$800,000.

The Keller opinion sheds a different light on the subject. It is a follow up to the Keller case which I mentioned briefly at the dawn of this blog noting that the role of the accountant bordered on the heroic. There was a family limited partnership all set to go with assets identified, etc., etc. Then the matriarch dies before she can sign anything. Don't you hate when that happens ? So her estate tax of 147,000,000 or so was computed with no valuation discount. Then one of the family's accountants got the notion that maybe they had gone far enough. So they sued for refund and in August of 2009, they won. The case came up again to determine deductible fees. Although the court was very deferential to the executor/accountant, they decided that a $2,400,000 "bonus" for future worker was not ordinary and necessary. They also disallowed a $9,470,606 contingency fee to attorneys (presumably the ones who handled the litigation on the valuation discounts).

Pricing on Purpose is a really good book and it offers some valuable perspectives on approaches for billing for professional services. I think, though, that these decisions raise some issues on the value of tax services that are detached from the amount of work that is involved. It is almost as if when you try to bill based on the value, the value disappears.

My final reflection is advice for the financial professionals who have those twinges of envy when they see the big checks is to try three techniques. The first is to go to the kitchen and get a glass of water from the tap and drink it. While you do that reflect on how few people in world historical terms have had such easy access to reasonably potable water. The second is that the next time somebody in the street asks your for money, engage with them. Ask them when they have last eaten and then sit down and have lunch with them. (If they are professional pan handlers, they will find this rather frustrating). If all else fails do a google search on "KPMG Tax Shelter Prison". It may well be that Attorney Denby was in the wrong business, but that didn't mean KPMG was in the right business.

I'm not giving up on the quote identifying contest. The one at the top is from a film and at the risk of making it too easy I will say the real hero of the film was an accountant (although he is not the "hero" of the film). Also Xavier graduates and old people probably don't have an edge on this one.

Time to Face the Music

Ramesh J. Bosamia, et ux. v. Commissioner, TC Memo 2010-218

This was originally published on PAOO on November 1st, 2010.

The tax law tolerates some significant asymmetrical results. For example if you make a charitable contribution of appreciated property, you get to deduct the fair market value of the property without recognizing income from the appreciation (If your basis is greater than the fair market value it would be smarter to sell the property and give the cash.) Deductions for depletion computed on the percentage method can exceed the basis of the depletable property. That's why having a gold mine is like having a gold mine.

Nonetheless, there are many situations where you ignore the big balance sheet in the sky at your peril. What Ramesh and Pragati Bosamia did was actually on the egregious side. They owned two S corporations - India Music (IM) and Houston-Rakhee Imports (HRI). IM sold sheet music to the public. It purchased the sheet music from HRI. IM was on the accrual basis of accounting. From 1998 to 2003 it recorded over $800,000 in cost of sales for sheet music that it purchased from HRI.

HRI did not do a very good job of collecting its receivables. During the six year period it collected exactly nothing from IM. It should come as no surprise that HRI was on the cash basis of accounting. The IRS finally caught up with this when they audited 2004. They disallowed any cost of sales for 2004 under Section 267 which limits accruals to related parties who are not themselves on the accrual basis.

The statute of limitations was closed on years prior to 2004. So the service took the position that the accruals had constituted an impermissible accounting method. This required a cumulative adjustment for all the accruals hitting the couple with just shy of $300,000 in tax and $60,000 in penalties for the 2004 year.

The Tax Court upheld the IRS determination.

.