Let That Whistle Blow

Originally published on Passive Activities and Other Oxymorons on June 27th, 2011.
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CCA 201117033

The IRS is very careful about disclosing confidential information but if you insist that they correspond with you in prison, it's on you that the warden gets to see your tax troubles.  Chances are you are not a prime candidate for identity theft.

Subject: RE: ———————-You could continue to send mail to his home address, since it obviously is forwarded to his current “residence.” You could also ask him, in a letter, where he would prefer that you send mail to him. If he lists his current abode, then send it there. We can assume that he knows that some, if not all, of his mail is opened by the authorities. There would be no disclosure violation for using the address that he requests. ————————


COLEBROOK?EL v. IRS, Cite as 107 AFTR 2d 2011-XXXX

The Plaintiff, Noble Roderick Colebrook–El, alleges that Defendants, Internal Revenue Service's (“IRS”) and its agents, Debra Hurst and Beth Jones's, attempt to collect his federal tax debt violated his Constitutional rights, the Moroccan Treaty, and several other Acts of Congress. The factual allegations contained in the Complaint, titled “Affidavit and Petition and Injunction and Order of Protection,” are at times indiscernible and largely irrelevant to the issues in this case. Plaintiff appears to allege that the IRS, a federal “corporate” agency, lacks the requisite statutory authority to collect taxes from him due to his status as a United States citizen who is a Moor of Cherokee descent. Plaintiff owes $19,566.36 in unpaid taxes. Plaintiff seeks to enjoin the IRS from collecting the taxes owed, to have any and all levies lifted, and to be reimbursed for all court costs associated with this action.

It's always interesting to learn something new.  I thought that this protester was totally off the wall claiming tax exemption as a "Moor of Cherokee descent".  Silly me.  There is actually is such a group of people.  They are descendants of African Americans held as slaves by the Cherokees.  There is a fairly recent controversy about whether members of the group should be considered tribal members.  Here is something on that.  So this guy is no further off the wall than most protesters and sheds some light on a neglected area of American history.  He still has to pay taxes, though.

Murray S. Friedland v. Commissioner, TC Memo 2011-90 This is one of those cases that is interesting for the cautionary tale included in the story behind the story.  Mr. Friedland was appealing his denial of a Whistleblower award.

Petitioner, a CPA, submitted a Form 211, Application for Award for Original Information (whistleblower claim), to respondent's Whistleblower Office (Whistleblower Office) in September 2009 concerning alleged violations of the Internal Revenue Code. He alleged that Lawjoy Realty Corporation (Lawjoy) and 601 West 149th Street, Inc. (West 149th), both C corporations, failed to pay millions in Federal corporate income taxes by impermissibly treating real property sales as stock sales in a corporate liquidation. He asserts that the structure of the sales was a sham and solely motivated to evade income taxes. Petitioner appears to have been a shareholder of both Lawjoy and West 149th.

This adds a new wrinkle to tax planning.  Mr, Friedland was presumably a minority shareholder in these companies, since some of the tax burden would somehow come out of his share.  It happens that Mr. Friedland was unsuccessful, but the IRS did recently award 4.5 million to an accountant who turned in his employer. I find the whole concept extremely distasteful but I think that in planning transactions that are at all aggressive it would be wise to keep out of the loop anyone who is not ethically bound to non-disclosure.

Bruce A. Brown, et ux. v. Commissioner, TC Memo 2011-83

This is another sad life insurance story.  Although life insurance is often thought of in the context of estate taxes, it is really not different than any other asset when it comes to transfer taxes.  Good planning will structure it so that it is not owned by the decedent keeping the build up in value out of her estate.  Any appreciating asset owned outside an estate produces the same benefit.  The connection to estate taxes is that the policy provides liquidity at just the right moment.  Life insurance is a tax favored vehicle for income tax purposes though.  Any build-up in value is tax deferred and proceeds payable by reason of the death of the insured are not taxable income.  People figure out ways to use life insurance policies to create income tax problems for themselves though.  Usually it has to do with policy loans.  This was one of those cases.

In total Mr. Brown paid $44,205 in premiums: $11,999 by check, $28,532 by loans, and $3,674 by dividends.

Northwestern's Computation of Taxable Gain

Northwestern sent Mr. Brown a Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc. The Form 1099-R showed a gross distribution of $37,365.06 and a taxable amount of $29,093.30. The Form 1099-R described the $37,365.06 as “loans repaid at surrender” and described the $29,093.30 as “taxable amt. at surrender”.

According to Northwestern's calculations, the $29,093.30 taxable amount was equal to the policy's cash value of $37,365.06 minus what it called “net cost” of $8,271.76. Net cost was calculated as “total premiums” (the premiums paid by loans, $28,532; by checks, $11,999; and by dividends, $3,674) minus what Northwestern called “total dividends” (in which Northwestern included the $2,986.94 dividend payment to Mr. Brown in 2004, the $31,063.30 received by Mr. Brown on surrender of the paid-up additional insurance in 2004, and the $1,883 dividend payment to Mr. Brown in 2005).

Mr. Brown prepared the Browns' return, which did not report any income from terminating the life insurance contract. Before filing the return, he consulted Mrs. Brown about the Form 1099-R. They believed that Northwestern based its report that Mr. Brown had a $29,093.30 taxable gain on the theory that a debtor has a taxable gain when a creditor cancels a debt. They believed Northwestern was incorrect because Northwestern had not forgiven Mr. Brown's debt. Having concluded that Northwestern analyzed the termination of the policy incorrectly, the Browns made no further attempt to determine the proper tax treatment of the transaction.

Incidentally the Browns are both attorneys and Mrs. Brown has an LLM in taxation.

As I read the case the numbers get a little confusing.  It seems pretty clear that the Browns never actually received any money.  The problem was the interest:

The policy allowed Mr. Brown to borrow from Northwestern against the policy's cash value. The policy labeled these loans “premium loan[s]” if they were applied to policy premiums or “policy loan[s]” if they were used for anything else. Both types of loans accrued interest at an annual effective rate of 8 percent. If unpaid, the interest was capitalized, meaning Northwestern added accrued interest to principal. ........

 By 1997 the annual interest accrual exceeded the premium; by 2002, it was twice the premium.

The interest which was being paid with policy loans did not add to basis.  It was a non-deductible expense.  That is how you can use an insurance policy to manufacture phantom taxable income for your self.  As a counterfactual to this scenario it would be interesting to look at what it would have cost the Browns to have had a term life insurance policy of $100,000 for 23 years (Actually in the later years their net death benefit would have been less than $70,000).  My guess is that it would have been a bit less than the $12,000 of actual cash outlay they had on this policy.  Maybe half.  And there would have been no phantom income when they decided the policy wasn't needed anymore.

To add insult to injury, the Brown's got hit with an accuracy related penalty.

What is Nothing ?

Originally published on Passive Activities and Other Oxymorons on April 25h, 2011.
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 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.

A Sad Life Insurance Story

Originally published on Passive Activities and Other Oxymorons on January 31st, 2011.
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John M. Sanders v. Commissioner, TC Memo 2010-279

I've mentioned in a previous post that life insurance has some marvelous income tax benefits.  The build-up in value is tax deferred and becomes income tax free if it is paid by reason of the death of the insured.  Life insurance salesmen will sometimes claim it saves estate taxes.  This is a bit of a fallacy.  The estate tax savings come from having the insurance owned outside the decedent's estate.  Any appreciating asset would produce the same benefit.  Life insurance does have the merit of providing liquidity exactly when it is needed in some estate plans.  It all kind of makes me feel bad for Mr. Sanders who managed to figure out a way to manufacture taxable income for himself without the cash to pay the taxes.

Mr. Sanders had a $25,000 life insurance policy with New York Life.  He paid $31 per month on the policy from 1979 to 2006.  Between 1990 and 2004 he borrowed $7,136 on the policy.  Under the terms of the policy, interest on loans accrued at 8%. In 2006 he received a letter that the loan amount and accumulated interest was $17,203, which was $517 more than the policy's surrender value.  Unless he paid $517 the policy would be cancelled.  He didn't pay the $517 so his policy was cancelled.

He received a 1099-R from New York Life showing a distribution of $17,292.  The taxable amount was $7,175.  That is the gross distribution of $17,292 less premiums of $10,117.  Mr. Sanders found the whole thing a little confusing :

Petitioner testified that he disagrees with the taxable amount shown on the Form 1099-R because he “just did the math basically in my head” and he thinks New York Life's “mathematics are way off.”

The Tax Court didn't find much merit in his argument.

These vague contentions do not rise to the level of a “reasonable dispute” so as to impose any burden of production on respondent pursuant to section 6201(d). In any event, stipulated documentation of petitioner's premium and loan history with New York Life corroborates the information reported on the Form 1099-R.

I have a lot of sympathy for Mr. Sanders.  He paid $10,117 to an insurance company.  He drew out $7,136.  It appears coincidental that the amounts are so close, but he ended up being taxed on the entire withdrawal plus $39.  Of course he had the peace of mind that somebody would be getting $25,000 less the outstanding loan balance in the event of his death.  According to standard valuation tables that comfort would be worth less than $25 a year until Mr. Sanders was in his forties.  We can't tell from the case how old he was when he started the policy so I don't think I will go any further with that part of the analysis.

A key fact that does not receive much emphasis is:


Between 1990 and 2004 petitioner borrowed $7,136 against the policy. Insofar as he recalls, he used the proceeds for personal purposes.

So the interest that he wasn't paying was "personal interest" and not deductible.  When he constructively paid it with a deemed distribution of the cash surrender value of his policy, there was not an offsetting deduction.   He had taxable income because he didn't pay the interest he incurred for borrowing his own money.  Go figure. This was probably not the outcome that Mr. Sanders expected when he started dutifully paying his $31 per month while we were all worrying about the hostages and cursing the Ayatollah.  I hope somebody from New York Life expressed some sympathy.

Have Some Free Insurance - Not

This was originally published on PAOO on September 13th, 2010.

Previously I have waxed, eloquently (at least by my lights). on the tax advantages of life insurance.  The build up in value is tax deferred and if it is realized by the death of the insured, it is tax free.  I also indicated that any complicated plan involving life insurance usually merits scrutiny, since frequently the actual point of the plan is make a sale.

The case of Gerlie V. Richard et ux TCM 2010-159 provides a cautionary tale.  They received some life insurnace without having to go out of pocket in the first year.  Apparently the commission on the policies ranged between 110% and 145% of the first year premium. 

Eagle Financial Group, Inc, by some sort of wild coinidence a company owned by the agent who sold the policies, issued them a check in the amount of the first year's premium.  They issued a recourse note in the amount of the premium advance to Eagle.  There were, however, never any payments made on the note.  The policies were cancelled in 2003 and Mr. Smith, the agent, was sued by Ohio National Insurance Co for "rebating".

Here is the cautionary part of the tale.  The tax court ruled that the loan was not bona fide.  Therefore, the Rickards were taxable on the rebate and owe $75,966 in income tax for 2001.  Ouch.

Aggressive Life Insurance Plan Fails - Or Maybe Not

This was originally published on PAOO on August 13, 2010.

One of my favorite plays is Guys and Dolls.  My daughter and I occasionally attempt to sing Sit Down You're Rocking the Boat.  You should be glad this is a text blog and not You-tube.  Trust me.  At any rate, at an early point in the play, somebody proposes a bet to Sky Masterson.  He then tells a story about his father explaining to him that someday someone would come up to him with a fresh pack of cards, with an unbroken seal and offer to bet that the jack of spades would jump out of the pack and squirt cider in his ear.  Sky's father tells him to not take the bet, because he can be certain that if he does there will be cider in his ear. 

I can picture my son someday reflecting on the various pieces of wisdom he may have garnered from me.  If he were to craft a parable like the jack of spades story, it might well involve someone saving vast amounts of income tax by purchasing a life insurance policy.  Of course the poor kid has had to listen to his sister and I attempting Sit Down You're Rocking the Boat, so he may be more focused on old people not attempting to sing.

Life insurance actually is a very tax efficient vehicle.  The build-up in value, if there is any, is tax deferred and proceeds paid by reason of death are free of income tax.  The claim that it saves estate taxes is somewhat fallacious.  The key there is to have the policy owned by an entity that is not includable in the taxable estate.  Any appreciating asset that goes into an entity not included in the estate will achieve the same result.  What is particularly good about the life insurance is that it provides liquidity just when it is needed.  Or when your heirs need it to be a little more glum.

Despite all its merits, life insurance is a product that is sold more often than it is bought.  And when you are trying to sell something, particularly something financial, there is nothing like a tax gimmick to help the sale along.  So when presented with a complex plan involving life insurance, bear in mind the fate of Karl and Deborah Mathies who were featured in 134 TC 6 this February. 

The  plan that the Mathies's bought into was called PAT - for Pension Asset Transfer.  How did the Mathies learn about the plan ? Well it was like this :


 1998 petitioners employed an attorney of their long acquaintance, Philip Spalding, Sr., to help plan their estate. Philip Spalding, Sr., introduced petitioner to his son, Philip Spalding, Jr., who was an insurance agent. The Spaldings proposed, among other things, that petitioner use some of his IRA funds to buy life insurance through a profit-sharing plan pursuant to a so-called Pension Asset Transfer (PAT) plan marketed by GSL Advisory Service (GSL) and Hartford Life Insurance Co. (Hartford Life).
 
The plan called for a roll over of IRA funds into a profit-sharing plan of their S corporation.  Then the S corporation makes a very large premium payment on a life insurance policy.  Next the taxpayer buys the policy and transfers it to an irrevocable life insurance trust. The irrevocable life insurance trust then trades it for a fully paid up policy. So what's the trick ?  The trick is that the policy has a very large surrender charge. (I'm shifting to round numbers here.) The pension plan paid 2,500,000 for an  $80,000,000 "interest sensitive" second-to-die policy.  At the time of the transfer, the policy had a cash value of 1,300,000, but a surrender charge of $1,000,000.  The theory was that if the pension plan were to ask the insurance company for a check, the plan would get a check for 300,000, so why should it expect to get anything more from a plan beneficiary. 

When the irrevocable trust received the policy, it was able to convince the company to waive the surrender charge by exchanging the policy for a fully paid up second-to-die policy for almost 20,000,000.  The IRS contended that the policy was really worth 1,300,000 and tagged Mr. and Mrs. Mathies with 1,000,000 of additional income.  The tax court agreed with the IRS.  So the Mathies have too come up with an additional $300,000 in taxes plus about 9 years worth of interest.  They were residents of California at the time, so there is probably close to another $100,000 on the tab.

I am putting this forth as a cautionary tale, because this could be an incredible disaster for the Mathies if they don't have the odd half million or so to pay the tax bill that they hadn't planned on when they first went into the plan.  Presumably the asset in the irrevocable trust isn't available for that purpose.  We also don't know if there was any gift tax assessment or if that just slid by.  Assuming for the sake of argument, that there was no gift tax problem and then they had put some money aside for the income tax contingency, the plan doesn't seem to have done that badly.  They had 2.5 million in an IRA and the assumed side fund that I just made up.  They don't have either of those now, but when they die their heirs get almost 20 million free of income and estate taxes.  At least one of them has to live a really long time for that to not be a fairly decent deal.

It is worth noting that in 2008, the IRS got an injunction against promoters of the PAT plan (US v Lichtig 102 AFTR 2d 2008-7064).  The tax court did not sustain an accuracy related penalty against the Mathies, but such will likely not be the fate of people who in the future attempt variants of this particular scheme.