Monday, June 30, 2014

Threaten to Go Bankrupt - That Will Really Scare Them

Originally published on Passive Activities and Other Oxymorons on May 9th, 2011.
IN RE: MITCHELL, Cite as 107 AFTR 2d 2011-979

I sometimes think that many people believe that if you are couple of days late filing your tax return a SWAT team of armed IRS agents will surround your house.  The enforcement mechanisms are much more creaky than that.  It is possible to slide  deeply into non-compliance and continue to live a normal life.  After a while, you will just get used to it.  You might think about cleaning up your act but you will be in a hole that is way too deep.

That is what happened with Larry Mitchell:

Between 1986 and early 2006, Mitchell was self-employed and worked for Kennon Parker as an independent contractor. Due to Mitchell's status as an independent contractor, Kennon Parker did not withhold payroll taxes from his commission checks, and Mitchell was responsible for remitting his outstanding federal income and employment taxes to the Internal Revenue Service (“IRS”). Until 1998, Mitchell paid all federal taxes owed; however, on multiple occasions he fell behind in payments, which resulted in levy threats and repayment plans with the IRS.

Starting in 1998, Mitchell simply stopped filing tax returns and stopped paying his federal income taxes. Mitchell maintained this pattern of noncompliance for five years, until June 2003, when he filed late returns for 1998 through 2002. At the time Mitchell filed these late tax returns, he did not make any payments toward his past due taxes for 1998 through 2002. At trial, Mitchell testified that he did not pay his taxes from 1998 to 2002 because his living, business, and divorce expenses fully exhausted his income.

You are supposed to organize your life so that you are living on your after tax income.  Once you are past a certain income level, though, your taxes may well be your largest expense.  If you are going to cut back in that area, why not go all the way ?

Mitchell earned an annual adjusted gross income  of over $100,000 from 1998 to 2002, with the exception of 2000 when he earned approximately $88,000. When asked at trial why he had not paid anything towards his past due taxes even though in 2001 he earned over $170,000, 6 Mitchell responded: “[i]t doesn't take a rocket scientist to figure out that I'm going to owe somewhere around [$]300,000 plus interest and penalties. So at that point, I haven't filed anything. I don't have [$]300,000. I don't want to open this up yet.” . Additionally, from 2003 to 2006, despite consistently earning an annual adjusted gross income over $175,000, Mitchell did not pay any amount towards his past due taxes for 1998 to 2002, with the exception of payments made in July and August of 2006 under his installment agreement with the IRS.

I have observed in a couple of posts including this one that there are two distinct areas of tax practice.  The first is the determination of the correct tax. As an individual you start that ball rolling when you file form 1040.  That is the beginning and the end of that process for most people. The IRS assesses the tax that you computed and you are done. It is possible that you will be audited and not like the result of the audit.  You can then appeal within the IRS.  If you still don't like the result you can then go to tax court or federal district court or the court of claims.  If you don't like what they have to say there are appellate courts in the various "circuits" that the country is divided into.  If you don't like what the appellate court has to say there is the US Supreme Court, but they don't hear too many tax cases.  Once that determination process is complete what happens if you don't pay ?

Do they throw you in jail ?  Well, actually that is possible.  There is, in fact, a third area of tax practice, that I don't get involved in at all. Jack Townsend has a very nice blog on the subject with the self-explanatory title of Federal Tax Crimes.  Putting that aside, the second area of tax practice is collections.  For most people that process begins and ends by them making a timely payment of the assessed tax.  Instead you can do nothing and at some point the IRS will start the ball rolling or you can start it yourself by filing an Offer in Compromise.  If the IRS has started the ball by sending you a notice of intent to levy your property you can file Request for a Collection Due Process or Equivalent Hearing.  Although you can raise "doubt as to liability", generally there is no dispute about the correct tax at this point.  It is all about your ability to pay.

Mr. Mitchell and his attorney worked the collection system to the max with three offers in compromise and an installment agreement that was in effect for a while.  It is not my normal area of practice but I think they may have pushed it just a little beyond the envelope:

Mitchell's attorney sent a letter on November 12, 2004 to the IRS, which warned:

[I]n determining what is in the best interest of the IRS, the Service should look at reasonable collection potential ... due to the fact that the taxpayer could file bankruptcy against all of the non-payroll taxes except 2002 and 2003 (and could do so against 2002 in April, 2006, and against 2003 in April, 2007).

It reminds me of a story one of my college classmates told me. He and another Air Force attorney were at a base discussing a case with opposing counsel, who was encouraging them to settle because the expenses of the case, which the governent might have to bear depending on the outcome, could be quite high since depositions would have to be taken here there and everywhere.  At that moment a fighter jet took off.  My friend, who had been an electronics weapons officer before the Air Force sent him to law school, pointed to the quickly receding plane and said:

"You see that plane that just took off.  It's going to use $20,000 worth of fuel before it lands.  Are you really telling me that your firm is going to outspend the United States Air Force ?"

Threaten bankruptcy.  I'm sure that's going to have the IRS collection guys just shaking in their boots.  "Bankruptcy - Oh My God.  We never thought of that.  We could have had an armed escort at this meeting, but bankruptcy never entered our mind.  We better settle."

The letter from the attorney did serve a purpose - to the government.  It was not picked up by the trial court which discharged his tax indebtedness, but the appellate court took note of it:

Third, in November of 2004 while the third offer in compromise was pending, Mitchell's attorney sent a letter to the IRS warning that Mitchell “could file bankruptcy against all of the non-payroll taxes except 2002 and 2003 (and could so against 2002 in April, 2006, and against 2003 in April, 2007).” In other words, if the IRS refused to accept Mitchell's third offer in compromise of $35,000 for over $200,000 in tax debts, Mitchell would file bankruptcy and discharge his tax debts. Although the bankruptcy court had this letter in its possession, it apparently overlooked the paragraph in which Mitchell's attorney made this threat, and therefore it did not consider the letter as evidence of Mitchell's willfulness.

The appleate court did consider it evidence of willfulness.

So Mr. Mitchell still owes the taxes:

The bankruptcy court clearly erred in its finding that Mitchell did not act with the requisite mental state to satisfy the discharge exception of § 523(a)(1)(C). Accordingly, we REVERSE the decision of the district court and hold that Mitchell's tax debts for 1998 to 2002 fall within the scope of the § 523(a)(1)(C) exception, and therefore, such tax debts are not dischargeable in bankruptcy.

Enterpeneur Wants Comprehensive Tax Compliance Solution

Originally published on Passive Activities and Other Oxymorons on May 8th, 2011.
In inviting guest bloggers, I have not limited myself to other tax nerds.  I want to get the viewpoint of people who have to deal with tax problems, while spending their time on more socially productive activities.  I am very gratified that Bobbie Carlton has agreed to be featured here

I met Bobbie at Mass Innovation Nights, but she is not just somebody you can meet there she is the founder.  Now if the founder of Mass Innovation nights identifies the need for a new tax software product, how long before someone is coming out with it ?  Here is what she has to say:
Two weeks ago I got a big book in the mail – no, not a delivery from Amazon but a book-sized sheaf of paper called my taxes. As an entrepreneur, a small business owner, and a part-time employee of yet a third company, with a freelancing spouse, two kids and a house, our taxes are probably a mite more complicated than most people but nothing that far out of the ordinary. We work with a wonderful CPA. I keep careful records all year, carefully logging mileage in an Excel spreadsheet, inputting my receipts, and in general, spending a lot of time I don’t have keeping this one more ball in the air.

I am the co-founder of a monthly product launch party and networking event called Mass Innovation Nights. We’re readying a new website and want to provide it as a platform to help other communities do the same thing we’ve been doing for the last two years – helping innovators and entrepreneurs get more buzz for their products by using social media. In a single night one of our events can generate hundreds of blog posts, tweets, Facebook and LinkedIn posts, online video and pictures. It is great, “no” cost visibility for the companies and their innovative products (more than 250 of them in just two years.)

One thing most of these products have in common is a reason for being – they solve a problem. They make something easier, faster, prettier, tastier, cheaper, better. I see new products all the time – a lot of companies send me cool new products because I blog about innovation.

Here, try this out. Tell us what you think. And, I usually am able to quickly discern the problem they solve. And every time I see a problem, someone comes up with a product to solve that problem. Until now.

Where’s my small business tax solution? Yes, yes. I know about all the lovely tax software tools. (And, since I have a CPA, why do I need that anyway?) But what I am talking about is an integrated tax dashboard that collects my mileage from the car, that I scan receipts into, that helps me log hours (and maybe even invoice them back to clients) and captures all those home office deductions. I have mobile location-based tools like foursquare and SCVNGR that know when I am walking into a Starbucks and yet neither one can capture how many unreimbursed miles I drove to get there and log it to my account? COME ON. Get with the program. They are wonderful toys but give me a solution for my business and I will be forever grateful.

Bobbie Carlton is the co-founder of Innovation Nights LLC, the founder of Carlton PR and Marketing and the Director of Marketing for Accounting Management Solutions . Follow her on Twitter.

If there is one issue that is common to just about every single audit or tax case it is substantiation.  When dealing with auto use and meals and entertainment it is absolutely critical as the Cohan rule no longer works in those areas so the product that Bobbie is suggesting might have quite a market.

Check This List Before You Check Out

Originally published on Passive Activities and Other Oxymorons on May 7th, 2011.
Erskine Company the Post 2010 Tax Act Checklist April 15, 2011

This blog is entering a new stage.  I have been soliciting guest posts and some have come in..  I have some promises too.  You know who you are, I won't forget.  I am very gratified to have as my first guest blogger, Matthew F. Erskine

Matthew Erskine is the managing partner of this fourth generation law firm. He focuses his estate planning and trust services practice on serving business owners, professionals, individuals, families, collectors, and inheritors of significant assets. Helping his clients and their families achieve their goals by providing customized solutions. Matt carries on his family’s tradition of integrity, continuity, and service.

Who needs a review of their Estate Plan due to the New Tax Laws?

All clients should have their estate plan reviewed if:

1. Their net worth is $3.5 million ($7 million for a couple) or higher,

2. They own stock or other interest in a closely held company,

3. They own a significant amount of artwork, collectibles, commercial real estate, legacy real estate compounds or other unique assets,

4. They own an interest in a Family Limited Partnership or Family Limited Liability Company, or

5. They may inherit any of these assets.

The Questions to ask:

1. Is the estate plan drafted for maximum flexibility?

a. Look for either a large QTIP or Clayton QTIP election being allowed in the estate tax return,

b. Look for a disinterested independent trustee who has broad powers to distribute income, principal, powers of appointment and to terminate superfluous trusts as the tax laws change.

2. Is the possible use of disclaimers outlined?

Sunday, June 29, 2014

It's 10:00 PM Should You Know Where Your IRS Agent Spouse Is ?

Originally published on Passive Activities and Other Oxymorons on May 6th, 2011.
PMTA 2010-068

I've got a huge backlog, so I probably shouldn't be pushing this one to the head of the list but I can't help myself.  First of all it's been months since any PMTA's have been released.  I was afraid that they had been abandoned.  PMTA stands for Program Manager Technical Assistance. My first scoop was about a PMTA concerning lien releases for short sales.  This one is of little practical import, but I couldn't resist it since it mentions one of my favorite neighborhoods and points out a neat aspect of working for the IRS.  There's also something about carrying guns.  The PMTA is about the potential for improper disclosure of information.  There ae two questions.

The first is whether agents can send people with powers of attorney an email acknowledging receipt of something:

When a POA sends a CWA to the IRS, the POA often requests acknowledgement from the IRS that the IRS received the CWA. CWA examiners would like to send a return email to the POA which states “Rcvd.” The email would not contain any other identifying information.

Silly goose, of course not:

An IRS examiner may not send an email to a taxpayer's power of attorney to acknowledge the IRS's receipt of a Central Withholding Agreement because the acknowledgement of receipt would be return information and the transmission of the acknowledgement by unsecured email would violate the IRS's policy against the transmission of return information by unsecured email.

Can't be too careful.  That "Rcvd" might fall into the wrong hands.

That's not the fun part of the PMTA.  Here is the fun part:

Whether an examiner may notify his spouse or other relative of his whereabouts when he conducts compliance activities at a taxpayer's business at night

What do you think ? - Well, of course not.

An IRS examiner may not notify his spouse or other relative of his specific location when he conducts compliance activities at a taxpayer's business or place of engagement at night if the location of a taxpayer's business would identify the taxpayer. An examiner may tell his relative his general location while conducting compliance activities in the field at night or give a phone number where his family can reach him if necessary.

Robin and Terry have had a lot of work to do in the last year.  They are the couple of indeterminate gender and marital status who help me avoid awkward pronoun problems.  I introduced them in a post on registered domestic partners and they have been featured in several posts, like this one, on same sex couple tax issues.  For this post we can leave their gender entirely indeterminate (same, different, whatever).  Robin is an IRS agent and Terry is a police officer.  Although the PMTA says that an IRS examiner cannot notify "his spouse or other relative", I think from the context of the memo Section 3 of DOMA is not relevant.  In other words they mean that Robin cannot tell anybody outside the IRS the destination for the night's investigative activities.

The memo goes on to provide an example of the level of disclosure that might be permitted:

For example, an examiner may tell a relative that he is in the Chelsea neighborhood in Manhattan. Because of the vast number of taxpayers that reside, do business, or perform in the Chelsea neighborhood, this information would not identify the taxpayer. However, as discussed above, the examiner could not tell his relative what business or venue in the Chelsea neighborhood he had visited. Similarly, an examiner could tell his relative that he planned to conduct compliance activities at the Empire State Building so long as he did not state which office within the building he planned to visit. Examiners may also tell their relatives that they have arrived safely at their location, how long they intend to be at the location, when they expect to be home, and give their relative a phone number where their relative can reach them.

 Chelsea is a very small geographic area, but as noted it has a lot in it including my high school.  Presumably if Robin and Terry lived in Wyoming and Robin told Terry what county the business Robin was auditing was in, Terry would be able to narrow it down to three or four businesses.  The IRS is sensitive to the hostitlity that revenue agents, like Robin might be subject to, which is why Robin would like to be able to disclose whereabouts to Officer Terry. They address it in the memo:

Examiners are also encouraged to utilize the IRS's armed escort program if the taxpayer has been designated a potentially dangerous taxpayer.

That really caught my interest and I now have more useless information such as whether the escort will be from CI or TIGTA.  You can check that out here, if you would like.  One more reason for me to not work for the IRS.  I'm too old for the gun toting jobs so if I got assigned to something like checking on strip clubs, I might need an armed escort.  It could be, though, that my protector will be a young woman.  I mean how embarassing is that ?  On the other hand I would be absolutely prohibited from telling my SO what I was up to.  At least that would be a comfort.

Hard Rock Case Still Up in the Air Though Some Elements Well Grounded

Originally published on Passive Activities and Other Oxymorons on May 5th, 2011.
MORTON v. U.S., Cite as 107 AFTR 2d 2011-XXXX

I promised myself that if I got far enough ahead on my Monday, Wednesday, Friday commitment, I would start doing more posts.  The MWF posts have been done on a roughly FIFO (first in, first out) basis so some of them have aged a bit.  I'm going to grab from the top of the pile for any Tuesday Thursday bonus posts, so they might be a little fresher.

This is a bit of a celebrity case.  Peter Morton was one of the founders of Hard Rock Cafe.  His Los Angeles restaurant, Mortons, was the setting for the Julia Phillips novel "You'll Never Eat Lunch in this Town Again".  He sold the Hard Rock Hotel in Las Vegas in 1995, but he continues to own the brand.  The dollars involved are pretty respectable.  It is a refund claim for $9,755,483.  Absent all that, I would still find the case intresting.  There are three issues two of them somewhat sophisticated and one fairly mundane.  Ironically the taxpayer was able to get summary judgement on the sophisticated issues but the mundane one remains undecided.

The question is about the deductibity of private jets and whether a like-kind exchange of jets was blown.  One aspect of the like-kind exchange issue is very straightforward:

In 1999, Plaintiff sought to exchange the G-III for the G-IV aircraft. The main reasons for this exchange were concerns about the safety and the level of noise generated by the G-III. Plaintiff entered into an agreement with a qualified intermediary for the exchange and an escrow agreement with an escrow agent. The agreement was executed on September 30, 1999, but the escrow agent accidentally and in contravention of the escrow agreement wired funds from the escrow account to RWB. Mr. Ogaz returned the funds the following day.

Ooops. Don't you hate when that happens ?  The Court ruled, however, that with a properly drafted exchange facilitation agreement, an error by one of the parties will not void exchange treatment.

Defendant acknowledges that Plaintiff abided by these requirements and would have effected a valid like-kind exchange but for the accidental placement of funds into RWB's account instead of the escrow agent's account.  Defendant stresses that before the funds were placed in escrow, the money was deposited into RWB's checking account; thus Defendant contends that because RWB had possession and control over the funds, Plaintiff had “actual receipt” of them. 

We disagree that an accidental transfer followed by an immediate return of funds would constitute actual or constructive receipt. Significantly, Plaintiff was bound by contract not to “receive, pledge, borrow or otherwise obtain the benefits of the Exchange Value” for at least 45 days.. Legally, he could not do anything but return the funds to the proper account. If he had done anything other than return the funds, he would have been liable for conversion, or even theft. 
Additionally, Plaintiff should not be penalized for another's mistake when he took every step to validly effect a deferred like-kind exchange. Plaintiff complied with all the requirements of the qualified intermediary safe harbor over which he had control; he did not have control over the mistaken actions of a third party. Because he complied with the requirement in all other aspects, we conclude that he validly effected a deferred like-kind exchange.

In many cases good documents cannot salvage poor execution.  One of my earliest posts illustrates this principle in the case of family limited parnterships.  Of course in the like-kind exchange area, the right documents are crucial as Ralph Crandall discovered much to his chagrin.  I would say, however, that "poor execution" might be a little harsh for a mistake like depositing in the wrong account and fixing the mistake the next day.  Compare it to the Estate of Sylvia Riese where the property of a terminated QPRT was not retitled for months and no rent was ever paid by the grantor.  If the Tax Court can forgive that, having the money in the wrong account for a day should also be forgivealbe.  Let's call it less than perfect execution.

This was also a Section 183 case, sometimes referred to as "hobby loss". but the actual title is "Activities Not Engaged in For Profit":

In the case of an activity engaged in by an individual or an S corporation, if such activity is not engaged in for profit, no deduction attributable to such activity shall be allowed under this chapter except as provided in this section.

It is not surprising that Mr. Morton owned several entities for several different purposes- ownership of different property, management, etc.  He picked one of them RWB, an S corporation, to own the jet.  He provided the corporation with the funds to pay related expenses.  A different corporation 510 Development Corporation hired the flight team of pilot, co-pilot and flight attendant.  We don't need to get into the details of the purposes of the various entities to frame the issue.  RWB, all by itself, was not about to make a profit from owning the plane.  So the IRS wants to disallow any expenses over and above some charter income.  Mr. Morton maintains that the plane was being used for his overall enterprise - himself and all his various entities.  The Court approves of the latter approach:

Case law supports Plaintiff's “unified business enterprise” theory and would allow him to take deductions for aircraft use that furthers the business purpose of entities other than RWB. This deduction may be allowed despite the fact that the aircraft is titled in RWB's name, and RWB did not use the aircraft to further its particular profit motive. As long as Plaintiff used it to further a profit motive in his overall trade or business, the deduction is allowed.

I think that both the holdings in this case are pretty important.

Mr. Morton has not, however, entirely won - at least not yet and the reason is pretty mundane:

Given that Plaintiff may impute his business activities and the business activities of one entity to his other entities, the Court must still examine whether the evidence shows that the aircraft expenses were for legitimate business purposes. The facts are in dispute. Defendant contests the purpose of many of the trips, and specifically takes issue with Plaintiff's trips to the Hamptons because his children, girlfriends, and friends of his children traveled with Plaintiff on the aircraft and stayed with Plaintiff at his vacation homes. RWB kept flight logs that identified the date and time of the trip, the number of passengers, the departure and arrival airports, the time in flight, and the pilots. However, RWB did not keep systematic records of the identity of the passengers on its flights nor the reasons why any passengers were on its flights.  The lack of information about the people included on the trip makes it difficult to say at this point definitively that the flights were or were not for business purposes.

Though Plaintiff met with his accountant sometime after the trips to categorize them as “personal” or “business,” , the Court cannot definitively say that these meetings were sufficiently contemporaneous to regard these categorizations as conclusive. Plaintiff said little at oral argument to enlighten the Court about the process of determining the business or personal nature of the trips. Because the Court is unconvinced of Plaintiff's categorizations, it defers judgment on the nature of the individual trips. The Court also must defer a determination as to whether depreciation deductions are allowed because this determination is dependent on substantiating the business usage of the aircrafts.

If the Gulfstream is classified as personal use property, it would be disqualified from 1031 treatment.  I will hazard a guess that 1031 would not be that imporant in that case as the plane would not have been depreciable.

Note that this is a refund case so Mr. Morton must have spent over $20,000,000 or so of after tax dollars on his jets.  In case you are wondering what other perks go with being the founder of the Hard Rock Cafe, check out his super model on again off again girl friend Linda Evangelista

Creative College Funding Plan Fails

Originally published on Passive Activities and Other Oxymorons on May 4th, 2011.

Their are certain types of tax chiselling that I find particularly perniscious.  Anything involving exempt organizations that is at all shady always disturbs me.  Sometimes the humorous element mitigates the offense.  Like the regular church goer who always drops a couple of Benjamins in the plate or the fellow who started an exempt organization to distribute his own sperm.  (The Darwinian implications of his plan are rather frightening.  Imagine the world slowly being taken over by the descendents of a group of women disinclined to collect sperm in the traditional manner and that one guy.)

Dr. Setty Gundanna Viralam's scheme had no such redeeming quality, not even originality:

In 1998 P-H transferred stocks and cash to X, an organization described in I.R.C. sec. 501(c) that was not a private foundation. X sent P-H acknowledgment letters for the stock transfers which stated that no goods or services were provided for the “donation” of the stocks. X sold the stocks in 1998. X maintained a segregated account for P-H in its records, reflecting the stocks and cash received, the proceeds from the sales of the stocks and their reinvestment, the dividends and interest generated by the assets in the account, and the disbursements from the account in subsequent years.

Promotional materials provided to P-H by X represented that P-H would be able to direct the distribution of the funds in the account for purported charitable purposes, including student loans and as compensation for the performance of charitable services by P-H or members of his family. P-H anticipated at the time of the transfers of the stocks to X that account funds could be used for student loans to his children. Ps claimed a charitable contribution deduction on their 1998 Federal income tax return equal to the fair market value of the stocks and the cash transferred to X.

(P-H must stand for "Petitioner-Husband" i.e. Dr. Viralam.The spouse is Prabhavathi Katta Viralam.)  Here is the part of the case that I found the most amazing:

Petitioner Setty Gundanna Viralam (petitioner) owned a 50-percent interest in a medical practice, which he sold in 1998 for $2,262,500, generating a taxable gain of $2,261,750 in that year.

The only Florida physician that I could find by that name is a pediatrician.  A sale of a pediatric practice for over $4,000,000 is truly astounding.  I suspect that there is an interesting story behind that story.  Frequently, medical practices have little or no fair market value. Note that Dr. Viralam's basis was $750.00.

Dr. Viralam began getting some financial planning ideas from a company called xelan (There seems to be a difference of opinion about whether it is supposed to be capitalized.)  To those enamored of more traditional sounding names it was also referred to as Economic Association of Health Professionals, Inc.  I thought the more exotic name had to have some sort of of Greek origin (Xenophon, xenophobia), but it is actually an invented word:

`x', the individual's savings required to finance lifestyle costs through life expectancy, with 'elan' the French word meaning a lifestyle of personal freedom.” 

I wasn't able to confirm that definition of 'elan' instead getting:

elan - ardor: a feeling of strong eagerness (usually in favor of a person or cause); "they were imbued with a revolutionary ardor"; "he felt a kind of religious zeal"

elan - dash: distinctive and stylish elegance; "he wooed her with the confident dash of a cavalry officer"

elan - enthusiastic and assured vigor and liveliness; "a performance of great elan and sophistication"

I have a pretty good bs detector and the name alone is enough to elevate its reading.  I don't give myself bs detecting points when I have the benefit of hindsight, though.

At any rate the plan sounded pretty neat:

Donors and their family members may work for and be compensated by their family public charities for good works (teaching, research, or providing pro bono services) they perform on behalf of their family public charities. *** The Financial Education Program also explained with reference to Foundation accounts that Your family then is the advisor to that fund as to the way the money is invested. And the growth on the invested money accrues tax deferred. Anytime you want to you could take the money out of your family public charity and pay yourself compensation to do good works. The Foundation also offered Foundation account holders a student loan program whereby Foundation account funds could be disbursed as loans for college and graduate school tuition and related expenses. The program's terms further provided that the loans could be repaid (with interest) either through repayments generally commencing 5 years after graduation or by the recipient's providing charitable services for designated periods. A xelan financial counselor wrote petitioner in April 1998 recommending that he “Establish a Foundation account for charitable giving, income tax reduction planning, estate tax reduction, educational funding, and future retirement planning.”

I really wish that this worked.  There are physicians I know who would actually squirrel away a significant portion of their income in a plan this so that they would be able to pay themselves to work with Medecins Sans Frontieres.  Using the money to make student loans to your own kids is definitely over the top, though.

As part of the package Dr. Viralam received an attorney's opinion:

After establishing his Foundation account, petitioner received a letter from the law firm of Conner and Winters, legal counsel to the Foundation. The letter expressed an opinion that it was more likely than not that a contributor would be entitled to a deduction for a charitable contribution to the Foundation. The letter represented that the opinion expressed therein was based on an examination of the Foundation's certificate of incorporation, its bylaws, resolutions of its board of directors, and representations made to the Commissioner of Internal Revenue in connection with the Foundation's application for recognition of section 501(c)(3) tax-exempt status. However, the letter stated that Conner and Winters had not examined any documents pertaining to, and would not render an opinion as to the tax effect of, any of several programs of the Foundation, including “donor advised distributions”, “educational loans”, and “charitable service [performed by a donor] for the Foundation”. The letter expressly disclaimed any opinion on the tax effect of “any specific charitable or other activity of the Foundation or any donor with respect to the Foundation”.

Here is my version of the letter:

Dear Dr. Viralam

The IRS has not revoked the 501(c)(3) status of this organization - yet.  So if you give it money, its probably deductible.  We will certainly not stick our neck out on all the really neat parts of the plan that the snake oil salesmen told you about.  Caveat emptor.

As far as I can tell the whole xelan thing was shut down in 2005.  What is at stake in this case though are charitable contributions for 1998 and gain from the sale of the donated property. As it worked out the largest use of the account's funds was student loans to Dr. Viralan's son, Vinay. I doubt that perfect execution would have salvaged this plan, but execution was less than perfect :

On July 6, 2001, Vinay executed documents with respect to the $17,247 loan for his tuition and expenses at the University of Pennsylvania. The documents included a “Commitment Agreement” (commitment agreement) and an “Education Expense Repayment Agreement” (repayment agreement).

In the commitment agreement Vinay agreed to participate in the Foundation's “Educational Funding Program” and, in return for receiving educational loans from the Foundation, to provide 2,000 hours of charitable work for the Foundation for each year of educational expenses advanced. The commitment agreement stated that if Vinay did not undertake sufficient charitable work to repay the educational expenses advanced, he would repay the Foundation all educational expenses advanced that were not reduced by charitable services, together with interest according to the terms of the repayment agreement. Finally, the commitment agreement stated that “the student will provide regular reports, at least annually, of his or her progress in the course of study and intended work, as well as, his or her plan to meet the obligations of the Agreement.”
The Foundation's approval of petitioner's son as a student loan beneficiary was perfunctory. The Foundation sent petitioner a distribution request form on which the approval for a student loan for Vinay had already been signed by a Foundation official before petitioner executed the form. There is no evidence that the Foundation reviewed Vinay's qualifications or otherwise exercised any independent judgment in selecting him for a student loan. In the circumstances, it is obvious that the selection of Vinay as a beneficiary of the Foundation's student loan program arose from his relationship to petitioner and as a result of petitioner's direction.

Although the commitment agreement required Vinay to provide an annual report, there is no evidence that he did so.

On September 16, 2003, respondent issued petitioners a notice of deficiency for 1998 disallowing their claimed charitable contribution deduction for the transfers of stocks (and cash  ) to the Foundation and determining an accuracy-related penalty. Eleven days earlier, petitioner arranged for an entity he and Vinay controlled to pay the Foundation $70,300, the total of the distributions to the University of Pennsylvania on Vinay's behalf from petitioner's Foundation account.  This payment was credited to petitioner's Foundation account. The Foundation thereupon waived all interest that had accrued under the terms of the repayment agreement and returned the commitment agreement and repayment agreement to Vinay marked “paid in full”, along with a letter confirming that the $70,300 payment had fulfilled Vinay's obligation to the Foundation.

So on to the penalties.

We find that petitioners were negligent because petitioner failed to make a reasonable attempt to ascertain the correctness of a deduction which would seem to a reasonable or prudent person to be “too good to be true” under the circumstances. A reasonable or prudent person would have perceived as “too good to be true” a deduction for a supposed charitable contribution where the amounts deducted could be used to fund student loans for his own children. The same is true with respect to the avoidance of capital gains taxes on the sales of stocks where the proceeds remained under petitioner's control for use by his children. To the extent petitioner ascertained the validity of the charitable deduction or capital gains exclusion from xelan's employees or its printed materials, there was an obvious conflict of interest on the part of persons promoting xelan's programs.

What about that great legal letter ?

Thus, while the letter specifically identified the student loan program petitioner contemplated using, it expressly refrained from offering any opinion concerning the tax effects of participation in the program and confined itself merely to describing certain features of the program. If anything, the Conner and Winters letter should have put a professionally educated person such as petitioner on notice that further inquiry was warranted concerning the student loan program.

It will be interesting to see if there are more xelan cases coming.

Saturday, June 28, 2014

Is Print Material Worth the Paper it is Printed On Anymore ?

Originally published on Passive Activities and Other Oxymorons on May 2nd, 2011.
Revenue Ruling 2010-25

I've been kicking myself for posting a backlog of material that I think is getting stale.  It's from March and maybe even February.  Today I received my copy of the latest issue of the Journal of Accountancy.  As usual it includes something from the most current issue of The Tax Adviser, which I'll probably get tomorrow.  Here is what the ruling is about.  There is a limitation on home mortgage indebtedness based on the outstanding balance of the mortgage.  The limit is a mortgage balance of $1,000,000,  In order to qualify the loans proceeds must have been attributable to acquiring a residence and secured by such residence.

Then there is home equity indebtedness.  Interest on that is also deductible with the mortgage balance limit being $100,000.  Home equity indebtedness just has to be secured by a residence.  You can have spent the money on anything.  So what happens if somebody takes out a mortgage of say $1,500,000 to purchase a residence.  To make the math easy lets say its at 5% and was outstanding all year.  I and a lot of other practitioners thought you could deduct $55,000 of the $75,000 you had to pay.  $50,000 is acquisition indebtedness.  $5,000 is home equity indebtedness.  As it turns out there were two tax court decisions that said otherwise (Pau TCM 1997-43 and Catalano TCM 1997-43).  According to those decisions you can spend home equity indebtedness proceeds on anything except the acquisition of the residence securing it.

Revenue Ruling 2010-25 might seem a little shocking to those who think the IRS is voracious behemoth.  The ruling says the (I hate to say this) common-sense view, which is more favorable to the taxpayer, is correct.  So it's nice to have some good news there in the Journal of Accountancy and the Tax Adviser.  I think, however, the information would have been more useful in say February or maybe even March since you probably don't want to have to amend a return for a $5,000 deduction.  As a matter of fact, a lot of taxpayers with the business affairs that go with $1,000,000 plus houses might be afraid that an amended return would trigger an audit.  (It's a common belief.  After 30 years I still don't know whether there is anything to it.)

Well here is the observation that is the point of this post.  You could have read about the ruling in this blog on November 10.  Not to give myself too much credit.  These guys, whom I haven't been following, had it on October 26.  It was here on October 14.  Rubin on Tax, who always seems to beat me to the punch when we blog on the same thing also had it in October.  James Edward Maule of Mauled Again also had it a little ahead of me.

I'm not striving to give up to the minute information.  I try to put a little more into my posts than just the bare material, so if something is covered by a lot of bloggers I'm probably not going to be at the head of the pack.  There is big difference between one month and six, though.  More importantly there is a big difference between two months before the beginning of tax season and two weeks after the end.  The article in the Journal really doesn't add anything that could possibly justify a six month wait for the information.

Learning to Be a Bad Guy

Originally published on Passive Activities and Other Oxymorons on May 2nd, 2011.
IRSIG TAS-13.1-10-0311-001

I'm not going to explain the acronym above.  It's internal IRS stuff that only a real nerd would go combing through.  At any rate this document gave my evil inner self some more material to work with.  I occasionally reflect on how I could be a much more effective villain than many of those you see portrayed in movies.  Just a couple of items.  When I get the drop on the good guy, it's bang, bang and I'm out of there.  I won't spend half an hour gloating about the genius of my nefarious plot, while unbenknownst to me the forces of good are converging.  When the forces of good have finally converged they will find a dead good guy and will be none the wiser about my master plan.  Secondly and perhaps more importantly, my minions will be well trained in the use of their weapons.  If you want to be one of my minions, you better fire at least expert.  None of this stuff with the good guy running through a gauntlet of fire picking off my minions with a pistol while they can't hit him with rifles.  If the nefarious plot can't finance a few thousand rounds of small arms ammunition to maintain proficiency, it's real not worth doing.

Probably, though, I would start off my career as a villain by moving to the dark side of the tax preparation business.  You can learn about the opportunities from studying the cases of people who have been encouraged by the courts to take up another trade.  Here is a post I wrote about them a while ago.  Now some new ideas come from an unexpected source.  The Taxpayer Advocate Service is an independent agency within IRS that helps people sort out problems.  Some of those problems are the collateral damage caused by rouge preparers.  The IRSIG (whatever that stands for) is giving guidance on unscrambling those eggs :

There is a small segment of the tax return preparer community who defraud taxpayers and the IRS by inflating deductions and credits, and directing refunds to the preparers' bank accounts without the taxpayers' knowledge. There are also preparers who inflate taxpayers' tax liabilities and the amount of withholding in an effort to divert larger refunds into the preparers' bank accounts. There are many variations on the scenarios, and you will need to review the facts closely to determine the appropriate steps to take.

When I've gone out camping with the tax return preparer community, I've always wondered about those shady looking characters who don't seem to know the words to "Michael Row The Boat Ashore".  I always suspected that they were IRS CID agents just checking in on us.  Now I know better.  They are that "small segment".

At any rate taxpayers advocates are tasked with cleaning up the mess:

The following three examples demonstrate how to advocate for taxpayers who have been victims of refund thefts by tax preparers. The following examples are representative of only a portion of the cases in TAS's inventory.

The evil genius of the "small segment" comes through in the first example :

Sally provides a tax return preparer with her W-2 and relevant information. The preparer completes Form 1040, reflecting a zero tax liability, and indicating Sally is eligible for a $350.00 refund. After providing Sally with a copy of that return, the preparer electronically files a different return with the IRS. Sally is not aware that the preparer altered the return before he electronically filed it by inflating income and the credit for income tax withholding; the preparer reported a tax liability of $500.00 and withholding of $3850.00, thereby increasing the refund to $3,350.00. Unbeknownst to Sally, the return preparer designated two bank accounts into which the $3,350.00 refund is split: $350.00 is direct deposited into Sally's account and the balance of $3,000.00 is direct-deposited into the preparer's own account. Thus, Sally has received the refund to which she thought she was entitled, based on the copy of the return the preparer had provided to her.

Notice the subtle brilliance.  Sally is somebody not worth stealing from.  So he steals some money for her, which he then steals from her.  This can end up making life pretty miserable for Sally until the taxpayer advocate comes to the rescue.  They've got work to do:

1. Case Advocates build their case by securing a copy of the return given by the preparer to Sally, the administrative file, and Sally's bank statement reflecting that she only received a portion of the refund.

2. Secure a written statement from Sally signed under penalty of perjury, which reflects that a) the other bank account did not belong to Sally, and that Sally had no knowledge that the preparer was depositing a portion of the refund into that account, and b) Sally had no knowledge that the preparer had filed a different return with the IRS. The written statement should include the closing phrase, “This statement is true to the best of my knowledge and belief, under penalties of perjury” right above or below the signature.
3. Case Advocates will refer their cases on TAMIS to a Campus Technical Advisor (CTA) indicating “Preparer Refund Fraud.” 

4. The CTA will review the account and administrative file. When appropriate, the CTA will provide language for an Operations Assistance Request (OAR) recommending that a) the IRS reverse the $3,000.00 refund from Sally's account, and b) the IRS abate the $500.00 tax liability that was assessed when the IRS received the fraudulent return from the preparer. The CTA will return the case to the Case Advocate on TAMIS. 

5. The Case Advocate will issue the OAR to Examination. Should the IRS not comply with the OAR, the Case Advocate needs to evaluate the reason for the Exam's failure to grant relief. If the Case Advocate believes the reason is insufficient, the Case Advocate should elevate to his/her manager for consideration of a TAO.

The second example is a variation on the first, that is even messier for the taxpayer, named Robert:

A tax return preparer completes Robert's return, indicating a refund of $300.00. After providing Robert with a copy of that return, the preparer electronically files a different return with the IRS. Robert receives the $300.00 refund he was expecting. Several months later, Robert receives a notice of examination and contacts the IRS. Robert learns that a refund for $3,000.00 was issued from his account. The IRS advises Robert that his original return reported Schedule C income and one dependent. Robert is not self-employed and has no dependents. Thus, the preparer had altered the return before electronically filing to increase the amount of the refund and to split the refund into two accounts $ 300.00 direct-deposited into an account belonging to Robert, and $2,700.00 direct-deposited into an account belonging to the preparer. Robert is concerned that the IRS's examination of his return will result in him owing the IRS for the preparer's fraudulent refund. He immediately files an amended return with the IRS.

The final example involves Form 8888, which I must confess I was not familiar with:

A return preparer completes Judy's return, indicating a tax liability of $500.00, withholding of $1,500.00, and a refund of $1,000.00. The preparer provides Judy with a copy of that return and tells her he will electronically file the return for her. Before the preparer electronically files the return, however, he changes the tax to $100.00, but does not change the withholding, so that the amount of the refund is now $1 ,400.00. The preparer splits the refund on Form 8888, so that Judy gets the $1,000.00 that she was expecting, but the preparer has $400.00 direct deposited into his own bank account.

The taxpayer advocate has another convoluted five step process to straighten that one out.  I gave up on thinking about working for the IRS when I found out I was too old for any of the pistol packing jobs.  I think I might enjoy being a taxpayer advocate though.  Kind of like a tax nerd social worker.  It may be that I have gotten paid from time to time for doing what they will do for free, but I don't mind the competition.

Some Stubborn People

Originally published on Passive Activities and Other Oxymorons on April 29th, 2011.
Patrick M. Mooney v. Commissioner, TC Memo 2011-35
John A. Raeber v. Commissioner, TC Memo 2011-39
U.S. v. Mostler, 107 AFTR 2d 2011-847

In a fiduciary capacity I once found myself between a tax protester and the IRS. The result was me and the rest of his family being tortured in probate court for over a decade.  Thanks to that experience and a tendency to accumulate generally useless information that I find entertaining, I tend to follow protester type cases.  I have an admiration for stubborn independent thinkers.  There is a limit, though and these folks go well beyond it.

Patrick M. Mooney v. Commissioner, TC Memo 2011-35

 Mr. Mooney did some independent study on the Income Tax Code. He came up with something extraordinary which he shared with the world:

Petitioner operates his own Web site, on which he has published, among other things, an editorial entitled “Unlearning Pays! Hendrickson, Mooney and Others Bring IRS to (Code) in effect for the year in issue, and all Rule references are to the Tax Court Rules of Practice and Procedure, unless otherwise indicated. Heel.” In that editorial, he wrote: "[A] private sector worker's earnings are not legally subject to the federal tax on income. They never have been, and as long as we still have a Constitution, they never will be.” In that editorial, he also described his plans to request refunds for taxes withheld from his earnings in previous years and to assert that he is not subject to withholding in the current year. He wrote that his strategy is a “get out of income taxes free' Monopoly card” for life.

The website is still there although I didn't find the tax advice or any commentary on how it worked out for him. It was one of those really brilliant plans:

In accordance with the plan described on his Web site, petitioner submitted a Form 1040, U.S. Individual Income Tax Return, for his 2005 tax year with zeros in all boxes for reporting income. He claimed a refund of $2,647.48, which was the amount of Social Security and Medicare taxes that had been withheld from his paychecks. He attached to the Form 1040 two Forms 4852, Substitute for Form W-2, Wage and Tax Statement. In his testimony at trial, petitioner stated that his contention that he had zero income in 2005 is based on his belief that he did not participate in any taxable activity since he lives in the Commonwealth of Virginia and works for private corporations. During 2005, petitioner received $32,207 for services performed for Interstate Industries, Inc. (Interstate Industries), and $2,400 for services performed for the Centre, Inc. (the Centre). Petitioner submitted to both entities Forms W-4 on which he claimed to be exempt from income tax withholding because he expected to have no Federal tax liability. In consequence, the payors withheld no income tax from his compensation.

Despite its fearsome reputation in some circles, the IRS actually has a lot of patience with this type of nonsense:

Respondent also referred petitioner to documents on the Internal Revenue Service Web site titled “Why do I Have to Pay Taxes?” and “The Truth about Frivolous Tax Arguments”, which provided petitioner with specific legal citations explaining why frivolous tax-protester arguments similar to his own have been rejected. Petitioner read both documents.

My mother used to say "Patience is a virtue". I agree and also note that it doesn't always work:

Petitioner dismissed those warnings and respondent's letter, writing that respondent's position has “no merit in the law”, and he protested respondent's disallowance of his refund claim in a letter dated June 15, 2006.

The court found that his behaviour was fraudulent.

Despite petitioner's being fully informed by respondent about the frivolous nature of his arguments, petitioner's correspondence with respondent has been filled with tax-protester arguments and has not addressed the factual accuracy of respondent's determination. Petitioner has also previously attempted to use similar arguments to dispute his tax liability before this Court, and he is aware that we consider such arguments frivolous and groundless. Petitioner was unsuccessful in his prior litigation before this Court. Yet petitioner has persisted in claiming that he is not subject to Federal income tax or income tax withholding.

I always think of fraud as requiring a little more cleverness than this mishegas.  On the other hand I think the Tax Court cut him a break on the penalty for wasting the Tax Court's time:

We have already imposed a $1,000 penalty pursuant to section 6673(a)(1) on petitioner in petitioner's prior case, during which he raised substantially the same arguments that he has now raised in the instant case. Apparently, the $1,000 penalty did not deter petitioner from making frivolous and groundless arguments before this Court. Accordingly, we shall impose a $2,000 penalty on petitioner pursuant to section 6673. If petitioner persists in raising frivolous arguments before this Court, wasting time and resources that should be devoted to taxpayers with genuine controversies, and continues to refuse to shoulder his fair share of the tax burden, we will not hesitate in the future to impose a significantly higher penalty. Petitioner should think carefully before he files another frivolous or groundless petition with this Court.

The maximum penalty is $25,000.

John A. Raeber v. Commissioner, TC Memo 2011-39

Mr. Raeber was not quite as wacky as Mr. Mooney.  He is probably not a "tax protester" in the classic sense.

In 2006 and 2007 petitioner worked as a self-employed consultant to various architects throughout the world. He operated his consulting business as a sole proprietorship and reported his income and expenses from the business on a Schedule C. Petitioner timely filed Forms 1040, U.S. Individual Income Tax Return, for 2006 and 2007, and attached Schedules C on which he reported gross income of $336,475 and $334,860, respectively, and business expenses of $252,013 and $253,490,  respectively.

Respondent audited petitioner's 2006 and 2007 returns and requested that petitioner substantiate all of his Schedule C business expenses. Petitioner refused to substantiate any of his claimed business expenses, arguing that the substantiation requirement violates his Fifth Amendment rights under the U.S. Constitution. Respondent then issued petitioner a notice of deficiency disallowing petitioner's deductions for business expenses claimed on his Schedules C.

I have some level of sympathy with his argument:

Petitioner argues that reporting his expenses on his 2006 and 2007 Schedules C and signing his returns under penalty of perjury constitute sufficient substantiation.

The Court does not:

We have long held that signing a return under penalty of perjury is not sufficient to substantiate its accuracy.

I think I get the Court's point much as I would like to live in a world where a man's word is his bond.

This is where I start losing sympathy for Mr. Raeber:

At trial the Court warned petitioner that his Fifth Amendment claim would not excuse him from his burden to substantiate his claimed business expenses and offered petitioner an additional opportunity to introduce evidence to satisfy his burden. However, petitioner continued to assert his Fifth Amendment privilege and offered no further evidence to substantiate his claimed business expenses. Accordingly, we sustain respondent's disallowance of petitioner's deductions for business expenses claimed on his Schedules C for 2006 and 2007.

So there you are in a court and the judge is explaining to you that the privilege against self-incrimination, one of the two things that you can learn are in the Constitution by watching television regularly, doesn't apply to tax returns.  (The other thing you learn is "separation of church and state", which actually isn't there).  Do you really think that you are the first person since 1913 to make this argument and that the system is going to see the error of its ways ?

U.S. v. Mostler, Cite as 107 AFTR 2d 2011-847

From a young age, Mostler claims to have held the belief that the payment of federal income taxes was voluntary. Despite this belief, Mostler paid his income taxes from 1982 through 2000. Following some additional research, largely conducted on the Internet, Mostler decided not to pay his taxes from the years 2000 through 2005. Although he was contacted by IRS agents, their refusal to respond to his letters with an affidavit of authority to collect taxes led him to conclude that he still did not have to pay. When an IRS agent arrived at his home, however, it caused some familial strife, and Mostler agreed to pay his back taxes and to continue to pay his taxes going forward. Despite this agreement, he still maintains his belief that the payment of federal income taxes is entirely voluntary.

In a recent post about abusive tax shelters, I observed that if you start talking about whether a six year statute of limitations applies, it is a sign that you have a really bad plan on your hands.  What could be worse ?   What is worse is when you start arguing about jury instructions.

Mostler first argues that the District Court's jury instruction on the issue of willfulness was confusing as a whole, although he concedes that no single statement by the District Court was incorrect. The District Court stated as follows: 

The third element the Government must prove beyond a reasonable doubt is that the defendant acted willfully. Willfully means a voluntary and intentional violation of a known legal duty.... Defendant's conduct was not willful if he acted through negligence or a mistake or accident or due to a good faith misunderstanding of the requirements of the law. A good faith belief is one that is honestly and genuinely held. A good faith misunderstanding of the law or a good faith belief that one is not violating the law negates willfulness, whether or not the claimed belief or misunderstanding is objectively reasonable. A defendant's views about the validity of the tax statutes are irrelevant to the issue of willfulness and need not be considered by the jury. However, mere disagreement with the law or belief that the tax laws are unconstitutional or otherwise invalid does not constitute a good faith misunderstanding of the requirements of law. All persons have a duty to obey the law whether or not they agree with it. Any claim that the tax laws are invalid, unconstitutional, or inapplicable is incorrect as a matter of law.

 Mostler asserts that this instruction left the jury confused because although the issue of whether the tax laws actually did apply to him is irrelevant for the jury, the issue of whether he believed that the tax laws applied to him is at the heart of his defense. He argues that a reasonable juror easily could have concluded from this instruction that she was required to convict even if Mostler had a good faith misunderstanding of the mandatory nature of the tax laws.

Sadly the majority of us deluded people who believe that taxes are mandatory will be paying for Mr. Mostler to be closely supervised for 18 months.

As long as we continue to have a self-assessment system and a free country, there are going to be
cases like this.  Weak enforcement and the multiplication of procedural safeguards sometimes make me think that taxes are effectively voluntary for a lot of people.

Friday, June 27, 2014

Tax Court Sticking with Three Year Statute on Basis Overstatements

Originally published on Passive Activities and Other Oxymorons on April 27th, 2011.
Carpenter Family Investments, LLC, et al. v. Commissioner, 136 T.C. No. 17

The fight over whether a six year statute applies to basis overstatements, which I posted on , earlier today continues.  The Tax Court has ruled that the three year statute applies.  This particular cases is appealable to the Ninth Circuit.

When enacting section 6501(e)(1)(A) in 1954, Congress could not possibly have foreseen the development of the tax shelter industry and the use of complex devices, such as Son-of-BOSS transactions, which seek to artificially inflate bases of partnership assets to achieve tax alchemy. Much as we may be tempted, we cannot speculate on how the Congress that enacted section 6501(e)(1)(A) would have meant it to apply in the present-day context. To paraphrase Justice Holmes, we do not inquire what the legislature would have meant. Cf. Holmes, “The Theory of Legal Interpretation”, 12 Harv. L. Rev. 417, 419 (1899), reprinted in Collected Legal Papers 207 (1920) (”We do not inquire what the legislature meant; we ask only what the statute means.”). In this case, we do not even ask what the statute means; we merely ask what the Court of Appeals for the Ninth Circuit and the Supreme Court have told us the statute means.

The Court of Appeals for the Ninth Circuit tells us that Colony controls the meaning of the phrase “omits from gross income” as it now appears in section 6501(e)(1)(A). Bakersfield Energy Partners, LP v. Commissioner, 568 F.3d at 778. And the Supreme Court has told us, in Colony, that this phrase does not include an overstatement of basis. We thus hold that only a 3- year limitations period under section 6501(a) applies here. Consequently, we hold the FPAA issued after the expiration of this 3-year period to be untimely. We further hold petitioner's and the partners' consents executed after the FPAA was issued to be invalid. We will therefore grant petitioner's motion for summary judgment. The Court has considered all of respondent's contentions, arguments, requests, and statements. To the extent not discussed herein, we conclude that they are meritless, moot, or irrelevant.

Presumably, we haven't heard the last on this issue.

Should IRS Gets Extra Time to Nuke Abusive Shelters ?

Originally published on Passive Activities and Other Oxymorons on April 27th, 2011.
BEARD v. COMM. 107 AFTR 2d 2011-552
GRAPEVINE IMPORTS, LTD v. U.S., Cite as 107 AFTR 2d 2011-1288

Back in October I wrote about Fidelity International Currency, the epic story of EMC founder Richard Egan's doomed tax shelters.  One of the things that I highlighted in the case was attorney Stephanie Denby's meticulous documentation of the thought process that went into the transactions:

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.

One of her comments concerned basis:

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.

It reminded me of an apocryphal story about an accountant who advised his clients "Put in puchases.  They never look there.", whenever he encountered a disbursement of dubious deductibility.

One of the commnents on that post was:

Jeff said...
ignoring the effectiveness of the reg, this case certainly shows the need for reg §301.6501(e)-1T(a)(1)(iii).

What's that about besides proving that Jeff is even more of a tax geek than I am ? Here's the deal.  The statute of limitations is three years on tax returns.  That means that if you filed timely you can relax about 2007.  Of course there are exceptions.  There are always exceptions, except when there aren't any, which would be an exception.  The relevant one here is that if you omitted more than 25% of your gross income, the statute of limitations is 6 years.  What the regualtion did for all returns that were still open in September of 2009 was "clarify" that an overstatement of basis was an ommission from gross income.

Home Concrete was a fairly typical "get some basis with a one sided entry" type of deal:

On May 13, 1999, each of the taxpayers initiated short sales 1 of United States Treasury Bonds. In the aggregate, the taxpayers received $7,472,405 in short sale proceeds. Four days later, the taxpayers transferred the short sale proceeds and margin cash to Home Concrete as capital contributions. By transferring the short sale proceeds to Home Concrete as capital contributions, the taxpayers created “outside basis” equal to the amount of the proceeds contributed. 2 The next day, May 18, 1999, Home Concrete closed the short sales by purchasing and returning essentially identical Treasury Bonds on the open market at an aggregate purchase price of $7,359,043.

They weren't at all ashamed of what they did:

Home Concrete's 1999 tax return reported the basic components of the transactions. Its § 754 election form gave, for each partnership asset, an itemized accounting of the partnership's inside basis, the amount of the basis adjustment, and the post-election basis. The sum of the post-election bases is indicated at the end of the form. On its face, Home Concrete's return also showed a “Sale of U.S. Treasury Bonds” acquired on May 18, 1999 at a cost of $7,359,043, and a sale of those Bonds on May 19, 1999 for $7,472,405. The return also reported the resulting gain of $113,362. Similarly, the taxpayers' individual returns showed that “during the year the proceeds of a short sale not closed by the taxpayer in this tax year were received.”

Eventually the IRS caught on:

Notwithstanding these disclosures, the Internal Revenue Service (“IRS”) did not investigate the taxpayers' transactions until June 2003. The IRS issued a summons to Jenkins & Gilchrist, P.C., the law firm that assisted the taxpayers with the transactions, on June 19, 2003. The parties agree that substantial compliance with the IRS summons did not occur until at least May 17, 2004.

As a result of the investigation, on September 7, 2006 the IRS issued a Final Partnership Administrative Adjustment (“FPAA”), decreasing to zero the taxpayers' reported outside bases in Home Concrete and thereby substantially increasing the taxpayers' taxable income.

Absent the six year statute, they were too late.  They tried to argue that since the case hadn't been decided by September of 2009, the new regulation should apply, but the Court wasn't buying it:

In Colony, Inc. v. Commissioner of Internal Revenue, the United States Supreme Court held that an overstatement of basis in assets resulting in an understatement of reported gross income does not constitute an “omission” from gross income for purposes of extending the general three-year statute of limitations for tax assessments. 357 U.S. 28 [1 AFTR 2d 1894] (1958). Because Colony squarely applies to this case, and because we will not defer to Treasury Regulation § 301.6501(e)-1(e), which was promulgated during this litigation and, by its own terms, does not apply to the tax year at issue, we reverse and hold that the tax assessments at issue here were untimely.

The Beard decision was a similar deal.  The Court gave a nice summary of the concept:

Short selling is often a way to hedge against the market, but a Son-of-BOSS transaction relies on the delayed tax recognition of a short sale for a gamble of a different kind. In Son-of-BOSS, the taxpayer contributes the proceeds of the short and the corresponding obligation to close out the short to another legal entity in which he has ownership rights (usually a partnership). The taxpayer (or, perhaps more accurately, the tax-avoider) then sells his rights in the partnership, claiming an inflated outside basis in the partnership corresponding to the amount of the transferred proceeds without an offsetting basis reduction for the transferred liability. This is advantageous for the taxpayer because the capital gains tax on such a transaction is calculated by subtracting the outside basis from the amount recognized in the sale of the ownership rights, so a higher outside basis means lower capital gains tax and more money in the pocket of the taxpayer. Therefore, the gamble in the Son-of-BOSS transactions was that the participant could legally increase his outside basis in a partnership by not reporting the offsetting transferred contingent liability of the short position on his tax return.

The timing in Beard was similar.  It was a 1999 return that the IRS did not catch up with until 2006.  The Court in Beard (Seventh Circuit as opposed to Fourth Circuit in Home Concrete) concluded that in a non-business transaction the six year statute applies:

Using these definitions and applying standard rules of statutory construction to give equal weight to each term and avoid rendering parts of the language superfluous, we find that a plain reading of Section 6501(e)(1)(A) would include an inflation of basis as an omission of gross income in non-trade or business situations. See Regions Hospital v. Shalala, 522 U.S. 448, 467 (1997); Hawkins v. United States, 469 F.3d 993, 1000 (Fed. Cir. 2006). It seems to us that an improper inflation of basis is definitively a “leav[ing] out” from “any income from whatever source derived” of a quantitative “amount” properly includible. There is an amount—the difference between the inflated and actual basis—which has been left unmentioned on the face of the tax return as a candidate for inclusion in gross income.

They get there without even considering the IRS regulation.  Had they needed it, though, they would have used it:
Much ink has been spilled in the briefs over whether temporary Treasury Regulation Section 301.6501(e)-1T(a)(1)(iii) would be entitled to Chevron deference if Colony were found to be controlling. This temporary regulation, which was issued without notice and comment at the same time as an identical proposed regulation, purports to offer taxpayers guidance by resolving an open question and stating definitively that in the case of a disposition of property, an overstatement of basis can lead to an omission from gross income. This temporary regulation has since been replaced by a nearly identical final regulation, issued after a notice and comment period. T.D. 9511 (eff. Dec. 14, 2010), 75 Fed. Reg. 78,897. Because we find that Colony is not controlling, we need not reach this issue. However, we would have been inclined to grant the temporary regulation Chevron deference, just as we would be inclined to grant such deference to T.D. 9511.

Grapevine Imports was close to an identical fact pattern to Home Concrete even to the extent of partiotically using contracts on US Treasuries to create phony basis.  In Grapevine, the Federal Circuit reviewing a Court of Claims decisions says that the new regulations make all the difference:

The new Treasury regulations cannot, of course, change the Tax Code. But they may reflect the Treasury Department's exercise of authority granted by Congress to interpret an ambiguity in that code. Where an executive department, entrusted with interpretive authority, promulgates statutory interpretations that are reasonable within the circumstances established by Congress, then the courts must defer to that interpretation. Chevron, U.S.A., Inc. v. Natural Res. Def. Council, Inc., 467 U.S. 837, 843–44 (1984).

When the Court of Federal Claims entered judgment for Grapevine, the Treasury Department had not yet exercised its interpretive authority over the limitations periods at issue in this case. It now has, and we, like the Court of Federal Claims, are obliged to defer to that interpretation. We therefore reverse the entry of judgment for Grapevine and remand for further proceedings.

Frankly this stuff is all a little too lawerly for me being a simple minded CPA, who loves debits to equal credits. I would like to extract a practical lesson from it.  There are probably some people who did Son of Boss deals or similar offenses against the fundamentals of double entry in 2005 or maybe even 2004 who thought they were home free and now have to start sweating again, while they vigorously root for the Fouth Circuit.  The lesson is this.  If you are thinking about a transaction or return filing positions and find yourself getting into a discussion of whether a three year statute or a six year statute would apply, just don't do it.


I did a follow-up on this as the Tax Court just issued another ruling on this issue.

What is Nothing ?

Originally published on Passive Activities and Other Oxymorons on April 25h, 2011.
 What did you get, kid ?
                             I didn't get nothing. 
                            I had to pay $50 and pick up the garbage

Estate Of Axel O. Adler v. Commissioner, TC Memo 2011-28

I thought I'd be able to make more out of this, but there is really a very simple point.  If you want valuation discounts, don't rely on fractional interest in real estate.  Form a family limited partnership.

Private Letter Ruling 201104066

I find that the hardest things to go through are private letter rulings.  They come in fairly tedious batches of late S elections and IRA rollover mishaps.  It's rare that there is anything really interesting except denials of exempt status.  Nothing yet has risen to the level of comic masterpiece equivalent to the tax court decision in Free Fertility, but some of them are pretty good.  This one was about horses.  I think the IRS has something against horses:

The general purpose of this corporation shall be to identify, conserve, safeguard, and propagate the genetic integrity of the horse originally found in the possession of the Tr. in Country, and those bred in other countries by breeders whose foundation stock was drawn entirely from those tribes of the T

Your Articles further provide, "the purpose shall be accomplished through research of historical and genetic (scientific) data to add to the X or disqualify horses from the 'X', according to the standards as set down in said 'X'. The purpose shall be additionally accomplished through education of the international horse community, the general public, and youth (by publication), regarding historic, genetic and athletic value of these endangered genetic lines, and collection and sharing of historic artifacts, letters and documents."

I don't know.  Sounds pretty good to me.  IRS didn't like it:

You have not demonstrated that you do not inure to the benefit of private individuals. You, M, maintain a website, g, that contains links to private sellers of Q horses. Those breeders earn a profit, and private benefit, by being able to sell horses and/or stud services to interested persons. As a result, under section 1.501(c)(3)-d(1)(ii) of the regulations, you do not meet the requirements of section 501(c)(3) of the Code.

The Service did suggest that they might qualify under 501(c)(5):

You are similar to the organization described in Rev. Rul. 55-230. You are organized to guard the purity of the breed of Q horses; to promote interest therein; and to help fund research on the genetics of this breed of horses. You state that you are unlike this organization because you are not a horse registry. We disagree because you do maintain a partial horse registry, as you maintain listings of horses and their genetic parents in your newsletters. You are also similar to the organization described in Rev. Rul. 55-230 because you promote and fund research on the genetics of this particular breed of horse.

Michael P. Schwab, et ux. v. Commissioner, 136 T.C. No. 6

This is probably worth a full length post, but I'm not going to get to it.  In case you've been holding your breath, it's what ties in to the quotation from Alice's Restaurant.  The Schwabs had participated in something called an 'Advantage 419' plan, which then invested in variable life insurance policies.  When I was interviewed by The Wandering Tax Pro one of his questions was what is the best tax advice I could give to anyone.  Frankly, I lied.  I save my best advice for paying clients, but the best advice, which I can give for free is pretty good- Sometimes you should just pay the taxes. It's pretty clear that paying the taxes and stuffing the after tax income in a mattress would have been a better deal than this plan worked out to be.

 Because of IRS activity in the area, the Schwabs decided that their 419 plan wasn't such an advantage anymore.  The variable life insurance policies were distributed.  The taxpayers and the IRS were arguing about whether surrender charges should be considered in valuing the policies.  There was no net surrender value after considering surrender charges, so the taxpayers argued that like Arlo they didn't get nothing. The Court after grousing about the poor record it had to work with took a different approach.  It attempted to compute the fair market value of the policies, which as it turned out was something but not much.  Because of a no lapse provision the policies provided coverage for a short time before they expired.  The Court used standard valuation tables to come up with a value of about $2,000, which was more than 0, but a lot less than the $80,000 or so the IRS was arguing for.

Songie S. Milhouse, et vir., v. Commissioner, TC Summary Opinion 2009-012

This decision was dated 2/9/2011 so I suspect the number is wrong. That's what they have in RIA anyway and who am I to argue?  It is an innocent spouse case in which the spouse is found innocent.  Mrs. Milhouse had separated her finances from her husband because of a pattern of irresponsibility on his part.  She put money into a joint account that she had access to, but he ran.  The IRS thought that since she could have looked at the account, she should have known about his unreported income.

Respondent did not offer any corroborating evidence at trial to support a finding that petitioner had actual knowledge of the items giving rise to the deficiency, nor did respondent substantively cross-examine petitioner or Mr. Todd on the scope of petitioner's knowledge. Petitioner, on the other hand, credibly disavowed any actual knowledge of the items giving rise to the deficiency and provided a vigorous cross-examination after Mr. Todd's direct testimony. Accordingly, we hold that petitioner did not have actual knowledge of the items giving rise to the deficiency that would preclude the granting of relief under section 6015(c)

It was good that Mrs. Milhouse won the case, but I think the lesson here is that if you think your spouse is not financially responsible, think very carefully before filing a joint return.  Just because the vast right wing conspiracy thinks civilization will end if gay people are allowed to file them doesn't mean they are always a good deal.

Thursday, June 26, 2014

Is IRS Ready to Attack Advance Bonus Arrangements ?

Originally published on Passive Activities and Other Oxymorons on April 22nd, 2011.
CCA 201104039

This is a short one so I will reproduce it in full :

Hi ———-, I haven't encountered the issue before. I don't know whether the arrangement is common in the industry but I suspect it is. I think the issue is whether the advances in anticipation of future bonuses were bona fide loans. The rev ruls attached are the relevant authority (not the material cited in the TAM and the write p which seem -u inapposite). It would be relevant what happens if an employee terminates before the “loan” is repaid, and how the arrangement is documented and what actually occurs in practice. We could discuss factual development with you and the agent.

Attachments: Rev Rul 68 239, Rev Rul 68-337 -

It would be nice if we knew what "the industry" is.  Unless they are cleared up in the same tax year, an arrangement where someone is getting a "loan" against a future bonus is probably fraught with peril for both the employer and the employee.  If it is a common practice in you industry, this might be a heads up.  It's interesting that the Chief Counsel is dusting off some pre-Woodstock revenue rulings.  They are also pretty short so I can give you the bulk of them:

Rev. Rul. 68-239, 1968-1 CB 414

Advance payments made to salesmen against unearned salary, commissions, or other remuneration for which they are to perform services, but which they are not legally obligated to repay are wages at the time of payment for Federal employment tax purposes.

The M company makes advance payments (actually or constructively) to its sales employees against unearned salary, commissions, or other remuneration for services to be performed. The advances are charged to each employee's account, and any advance in excess of the later earned salary, commissions, or other remuneration is carried as an account due from the employee. If an employee's services are terminated, the excess is charged to profit and loss.

Advance payments actually or constructively made by M to an employee for services to be performed are “wages” for Federal employment tax purposes at the time of payment where the salesman's obligation in return is to perform services. Under the circumstances, amounts advanced by the M company to its salesmen are subject to the taxes imposed by the Federal Insurance Contributions Act and the Federal Unemployment Tax Act, and to the Collection of Income Tax at Source on Wages.

Rev. Rul. 68-337, 1968-1 CB 417

Advance payments made to employees that they are legally obligated to repay are not wages for Federal employment tax purposes.
The question is whether advance payments made to employees of the M company are wages subject to the taxes imposed by the Federal Insurance Contributions Act, the Federal Unemployment Tax Act, and the Collection of Income Tax at Source on Wages (chapters 21, 23, and 24, respectively, subtitle C, Internal Revenue Code of 1954).

The M company engages in a general investment banking business and maintains trading departments in its principal offices in several cities. These departments are operated by employees who have profit-sharing agreements with the company. At the end of each calendar month a statement of account is made for the employees showing the net profits credited to their accounts. The net profits represent the gross earnings of such employees, less expenses incurred in the operation of the trading departments. The employees may make withdrawals at any time of amounts standing to their credit. They are also allowed, with limitations, cash advances where there is no credit balance in their accounts. At the time such cash advances are made, they are set up by the company on its books as amounts due from employees and are acknowledged by the employees either by note or letter.

In the instant case, there is an acknowledgment of the indebtedness by note or letter, the M company carries the balances as accounts due from employees, and there is a legal obligation on the part of the employees to repay the advances. This obligation must be satisfied although the employment is terminated prior to payment. The advance payments in the present case are, therefore, distinguishable from those in Revenue Ruling 68-239.

Under these circumstances, the advance payments to the employees of the M company are loans and are not wages for purposes of the taxes imposed by the Federal Insurance Contributions Act, the Federal Unemployment Tax Act, or the Collection of Income Tax at Source on Wages.

So the revenue rulings are pretty clear.  If you want to have a deferral, there has to be a legal obligation to repay.  Since when these revenue rulings were written George Orwell's famous dystopian novel still had a future date, they did not address interest.  (Code Section 7872 was added in 1984.  Thanks to a novel called The Pale King, literary tax geekiness is going to become trendy.  I just got the novel for my Kindle.  It remains to be seen whether I'll write about it here or in my bizzaro blog.)  With the short term AFR at 0.55% charging or imputing on advances will not be that big a deal.  Nonetheless, I think this sort of thing is a very bad idea.

The reason it is a bad idea is that in order for it to work the employer must be able to legally enforce repayment from employess who don't earn the expected bonuses.  I can only think of two possible reasons that you would be advancing them their bonuses.  One is because they think they are  investment geniuses.  The other, probably more common, is that they need the money to maintain their desired lifestyle.  In the first instance, there is significant risk that they won't be able to repay.  In the latter, there is a virtual cetainity.  Not only that, they are in effect either investing or living on their gross income rather than their after tax income.  Even if they continue as employees there will be a strong inclination to put off the day of reckoning.