News From The Boston Tax Institute

Lu Gauthier of the Boston Tax Institute  has given me permission to reproduce his email blasts.  BTI is a great value for live tax continuing professional education.  If you decided to contact BTI because you read about it here, be sure to mention it to Lu. It won't get you a discount or me a commission, but it will show him that this blogging thing is a thing.

I've gotten a little behind.  So this one represents a few installments.

Our thanks to Moore McLaughlin, CPA, Esq and Cory Bilodeau, Esq. for another update.  

In an opinion issued on May 19, 2015, the Tax Court in Redisch, TC Memo 2015-95, held that a couple did not convert their Florida vacation home to property held for the production of income. The rental effort was not serious and the property was never rented. As a result, they could not deduct Schedule E deductions related to the home or claim a loss under Code Sec. 165 when the property was sold for less than what they paid for it.  In general, no deduction is allowed for the expenses incurred in maintaining a personal residence.  Similarly, a loss incurred on the sale of a personal residence generally is considered personal in nature and can not be deducted.  However, taxpayers may deduct all the ordinary and necessary expenses paid or incurred during the tax year for the management, conservation, or maintenance of property held for the production of income.  Whether an individual has converted his personal property to one held for the production of income is a question of fact.  In the case of a converted residence, the Tax Court often looks to five factors to determine the taxpayer's intent: (1) the length of time the house was occupied by the individual as his residence before placing it on the market for sale; (2) whether the individual permanently abandoned all further personal use of the house; (3) the character of the property (recreational or otherwise); (4) offers to rent; and (5) offers to sell. No one factor is determinative, and all of the facts and circumstances are considered.  Similarly, in order for a taxpayer to deduct a loss, it must be incurred in a trade or business, be incurred in any transaction entered into for profit, though not connected with a trade or business, or arise from some sort of casualty or theft.  A taxpayer can claim a loss on property purchased or constructed  as a primary residence if, before its sale, it is rented or otherwise appropriated to income-producing purposes and is used for such purposes up to the time of its sale.

I noticed this case also and may be covering it on forbes.com [PJR]

Our thanks to Moore McLaughlin, CPA, Esq. and Cory Bilodeau, Esq. for the following update.

In an opinion published on May 26, 2015, the Tax Court held in Fargo, T.C. Memo 2015-96, that the taxpayer's sale of real estate in an unsolicited one-time bulk sale produced ordinary income and not capital gain, notwithstanding the absence of physical improvements over a ten year period. The Court found that the taxpayer's original development intent continued throughout the entire holding period.  The court analyzed 8 factors and found that 4 favored the Taxpayer and 4 favored the IRS.  However, the Court noted that the taxpayer's actions indicated a continued desire to develop the property until the time of the sale.

If the Taxpayer engaged in proper tax planning, it may have been possible to structure the transaction in a manner that locked in capital gains.  This type of tax planning will be discussed at the update on Federal Income Taxation of Real Estate on June 3 in Waltham by tax attorneys Moore McLaughlin, CPA, Esq. and Cory Bilodeau, Esq., both from the tax law firm McLaughlin & Quinn, LLC.

I was pretty excited about this case, but ulitmately decided to pass on it.  One thing that threw me was that the partnership had owned the property in 1997 giving the impression that it had been held in the partnership a really long time.  On rereading I noted that the case has kicked around a long time with the sale being around 2001. It is pretty messy and complicated.

Our thanks to Paul Ferreira for the following email!

The IC-DISC:  Are you still missing the boat on adding value to many of your clients?

The Interest Charge-Domestic International Sales Corporation (IC-DISC) is the last surviving export incentive available for privately-held companies whose products are delivered outside of the United States.  Originally enacted by Congress in 1971, the IC-DISC is a tremendous federal income tax savings vehicle as well as a lucrative addition to the services for you and your firm to deliver to current and target clients.  Many clients in a variety of industries qualify for the IC-DISC.  Clients that manufacture products within the US as well as those that distribute US made products outside of the US will qualify for the IC-DISC.  Likewise, seafood caught within the US and scrap metal processed within the US will qualify.  Our 1/2 day seminar on IC-DISC will be presented from 9:00am-12:30pm on 6/8 in Waltham  followed by a 1/2 day seminar entitled Federal & State R & D Credits from 1:30pm-5:00pm.  Please remember that two 1/2 day seminars on the same day are only $225 instead of $150 each!  

Now that seems like something worth looking into.

The nexus and apportionment provisions have been changing requiring both taxpayers and tax practitioners to reexamine whether or not their activities or client activities have subjected them to income taxation in states where no such requirement existed previously.  No longer is a physical presence required within a state before its taxing jurisdiction is permitted.  Taxpayers and their advisors need to re-evaluate their compliance positions in many states.  Coupled with the change in nexus requirement in some 40 states, a growing number of states have adopted market-based sourcing requirements for purposes of sourcing receipts with 3 of the 6 New England States adopting the change.  The new sourcing requirements can create either multiple inclusion or non-inclusion of particular sales receipts for purposes of income tax apportionment.  These changes, coupled with the unique provisions of New Hampshire's combined reporting, provide some potential tax benefits for businesses conducting activity in the State.

  

We will discuss the nexus changes and the market-based sourcing requirements that are developing across the country and where the New England States currently position themselves during the morning session.  During the afternoon session, we will discuss the New Hampshire reporting requirements for combined groups.  Join us at our June 5th seminar entitled Economic Nexus & Combined Reporting in Peabody, MA and determine whether your clients now have (1) filing responsibilities in one or more states where there was no such requirement in the past (2) the receipts apportionment methods changed requiring different documentation and possible double inclusion of income and (3) can benefit from filing combined returns in New Hampshire. Evaluate your clients' exposure and risk before the Departments of Revenue knock on their door.

Those "Live Free Or Die" license plates and income tax exemption for wages give New Hampshire an undeserved reputation as a tax haven of sorts. If you ever contemplate doing business there, you might be surprised.

Our thanks to Kenneth J. Vacovec, Esq. for the following email!

Reminder to all:

The FBAR filings now must all be done electronically only, on Form 114. Third party filers are  authorized to file on behalf of clients on Form 114 a,  which must be signed by the client and provided to the third party filer for their records prior to the electronic filing. All the paperwork must be prepared and received in time to file by June 30, 2015 for the 2014 filings. There are no filing date extensions at all allowed. We fear that with all the FBAR publicity and focus by the IRS on these filings, that the IRS will begin a program of imposing penalties for filings after the June 30 date. Also, there are very specific requirements for the information needed in the filing which requires strict attention to the form instructions. Certain entries such as: AKA, DBA, SAME and UNKNOWN cannot be used. You must  push your clients for complete information in time for the June 30 filing date!!!

I lose a lot of sleep over foreign reporting issues.

In a rather lengthy decision (Coastal Heart Medical Group, Inc., et al., v. Comm., TCM 2015-84 (5/4/15)), the Tax Court concluded that a medical doctor who failed to group his various business activities and failed to aggregate his various rental real estate activities failed to prove that he was a real estate professional and also failed to prove that he materially participated in each of his separate business activities so that losses from these passive activities were disallowed and the 20% taxpayer accuracy-related penalty applied.  If you have a client with multiple business and/or rental real estate activities which have net losses, it may behoove you to take a fresh look at these activities to see if they have been grouped or aggregated in the most advantageous manner.  If you would like to come up to speed on passive activity losses, grouping, real estate professionals and aggregation, material participation, the 3.8% tax on net investment income, and the treatment of rental real estate for purposes of the 3.8% tax, we are offering a number of seminars in various locations to help you.  Please consult our 2015 Spring Brochure at the icon shown above for seminars, dates, and locations beginning with Passive Activity Losses on 5/27 in Waltham and The Treatment of Rental Real Estate for Purposes of the 3.8% Tax on 5/28 in W. Springfield.   

Coastal Heart is one that I covered on forbes.com.  There is a really wild back story  to it which includes a doctor being framed with planted drugs and a gun

Our thanks to Robert E. Clark for the following email!   

Can I collect Social Security as a spouse and wait until I am older to collect a higher amount on my own work record?  Many married couples ask this question as they plan for their retirement.

For the answer to be yes, one member of a couple must have filed for benefits to open their record.  Workers open their record by starting to collect their own Social Security.  Or, if they have reached Social Security's full retirement age, by filing and suspending benefits.  A worker under full retirement age cannot file and suspend benefits.

Once your significant other's record is open, you must be full retirement age to file only for benefits as a spouse and delay filing for your own retirement benefit.  If you are under full retirement age, you must file for your own retirement benefit first before filing as a spouse.

I keep telling my covivant that marriage is not something that old people should do, but this social security thing has me thinking.  The idea is that you collect on your spouse's record until your 72 or something like that so your benefit is maxed.

Our thanks to Phillip R. Dardeno, CPA, MST for the following email!

Commissioner Mark Nunnelly, Massachusetts Department of Revenue

Mark Nunnelly has been appointed as the new Commissioner of the Department of Revenue.   He is responsible for overseeing nearly 2,000 DOR employees in offices across the state who work in tax administration, child support enforcement and local services for cities and towns. He was appointed on March 30, 2015.

Commissioner Nunnelly formerly worked for Bain Capital.  Commissioner Nunnelly joined Bain Capital, one of the world's foremost private investment firms, in1989 as a Managing Director. He held a number of leadership roles as part of the firm's growth and global expansion and worked extensively in the business services and technology industries.  Prior to joining Bain Capital, the Commissioner was a Partner at the consulting firm Bain & Company, working in the US, Asian and European strategy practices.  Previously, he worked at Procter & Gamble in product management.  Additionally, Commissioner Nunnelly founded, and had operating responsibility for, several entrepreneurial ventures. He has been deeply involved in a number of Massachusetts and national philanthropic efforts, with a particular focus on children and national service. 

Commissioner Nunnelly received an MBA with Distinction from Harvard Business School and an AB from Centre College.

A new Commissioner has always brought about change in the organization. New ideas, different priorities, and new focuses will certainly be seen over the next few months.

Putting somebody from Bain Capital in charge of the Revenue Department seems kind of odd.  Can't help but wonder whether it will be the fox watching the hen house or it takes a - well you know how that one goes.

In Jose A. Lamas v. Comm., TCM 2015-59 (03/25/15) the Tax Court concluded that  two real estate development businesses (Shoma and Greens) could be GROUPED together because they met all five nonexclusive factors in Reg. 1.469-4(c) and were an appropriate economic unit in which T materially participated. The investor exception did not apply, and the work not customarily done by owners exception did not apply. Assuming arguendo that T worked < 500 hours in Shoma and Greens, T met the signification participation activity test #4 because he significantly participated in Bella Vista and in Shoma and Greens and materially participated for > 500 hours in all of his significant participant activities.  Grouping as well as several other topics will be discussed in our full day seminar entitled Passive Activity Losses on 5/27 in Waltham.  Grouping as well as all of the decided cases and administrative pronouncements on Grouping also will be discussed in detail in our new 1/2 day seminar entitled Grouping for Purposes of Sections 469 and 1411 on 6/12 in Waltham.  Grouping can be used to deduct losses that otherwise would be passive and not deductible and also can be used to avoid reporting income as passive income subject to the 3.8% tax on net investment income.  If you want to learn about Passive Activity Losses, Section 1411, and Grouping, come to a BTI seminar!!!  Don't waste your time and money elsewhere.

Lamas is another case I covered on forbes.com. There was another fascinating back story involving deforestation and political intrigue that the rest of the tax blogosphere let pass.

On 4/13/15, the Tax Court (in Richard Leyh v. Comm., TC Summary Opinion 2015-27 dated 04/13/15) concluded that taxpayers who elected to aggregate their rental real estate activities and who kept a detailed contemporaneous log of the time spent operating their 12 rental properties were real estate professionals (REPs)who could deduct $69,531 of losses against their non-passive income such as wages.  The court allowed the taxpayer wife to include the travel time in driving from their principal residence to the rental properties to perform services.  Although a Tax Court Summary Opinion cannot be cited as precedent, it is comforting to see pro sese taxpayers (taxpayers who represent themselves) beat the IRS with a detailed contemporaneous log and travel time.  The election to aggregate the properties also was critical to the taxpayers' victory.  If you represent taxpayers who purport to be real estate professionals, you may want to advise them to make an election to aggregate (if they have not already done so), keep a detailed contemporaneous log of the time spent servicing the rental properties, and remember to include travel time in their original log.  If you want to learn more about REPs, please join us at our full day seminar entitled Passive Activity Losses on 5/27 or at a special 1/2 day seminar entitled Real Estate Professionals on 6/12 in Waltham.  Section 469 continues to be one of the most important, misunderstood, and heavily litigated areas of tax practice today!       

I don't know why I let this one pass.  Probably too worried about Kent Hovind.

Our thanks to Todd Weaver of Strategies for College for the following email!  


Think that your role as business advisor, family confidant, and tax savings guru is all that you need to be concerned with?  Think about this:  You can offer a client a choice of $18,000 in tax savings OR a $38,450 college grant.  That's a $20,450 difference.  Attend our seminar and find out what actually happened.  If you're not paying attention to clients with college bound kids, you could be saving tax dollars and losing college funding dollars.  The ramifications of not being well informed could be very costly. 

Come to our seminar entitled Strategies For College on June 24th at the Hyatt house in Waltham in order to learn how to deal with opportunities like this.

I always worry that when tax planning concepts appropriate for the very well heeled get pushed down a level or two that things like college financial aid get lost in the shuffle.

I'll try not to get so far behind on Lu's updates again, but I can't make that a firm promise.

From The Boston Tax Institute

Lucien Gauthier has given me permission to reprint his e-mails to his customers.  Here is the latest.

In Larry Williams v. Comm., TCM 2015-76 (04/16/15), the Tax Court applied Reg. 1.469-2(f)(6) to recharacterize the net rental income from rental real estate, which was rented by an S corporation which was wholly-owned by the taxpayer to a wholly-owned C corporation in which the taxpayer materially participated, as NONPASSIVE income.  If the taxpayer had owned the rental real estate individually or perhaps though a single member LLC, there would have been no question that -2(f)(6) applied, and the Tax Court concluded that owning the rental real estate through a wholly-owned S corporation should not change this result.  Sections 469 and 1411 may be the two hottest areas of tax practice today.  If you would like to learn more about section 469 from a Tax Attorney/CPA with two masters degrees in taxation and 28 years of experience with section 469, please attend our full day seminar on May 27 entitled Passive Activity Losses at the Hyatt house in Waltham!!!           

 2015 SPRING 8 PAGE BROCHURE  

I'm behind on my reading thanks to tax season.  There is a good chance that I will find the Williams case to be forbes worthy. 

IRS Disses Doggie Diplomas and Other Developments

Originally published on Passive Activities and Other Oxymorons on June 22nd, 2011.
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FISHER v. U.S., Cite as 107 AFTR 2d 2011-XXXX, 04/19/2011

There has already been a partial decision in this case which I mentioned in a previous post.  The government got summary judgement on whether a restrictions on transferability discount would apply to a single asset family limited partnership.  Apparently that was not the end of the story. After all there are still discounts for lack of marketability (even if they let you sell the damn thing nobody would want to buy it anyway) and minority interest.  This particular decision, which is also not the end of the story is about evidence.  The taxpayers want to bring into evidence what the IRS was originally willing to allow.  The IRS doesn't think that relevant.

The present Motion in Limine seeks to preclude Plaintiff from introducing evidence of the minority interest and lack of marketability discounts used by the IRS in arriving at the February 13, 2006 assessments. See generally dkt. no. 101. The United States contends that because this case involves a de novo review of the fair market value of the property at issue, the calculations of the IRS at the administrative stage are irrelevant. Id. at 4. Plaintiff contends that evidence should be allowed in rebuttal if Mark Mitchell, CPA (“Mitchell”), the United States' expert, testifies that the minority discount should be seven percent rather than the nineteen percent purportedly used by the IRS in the February 13, 2006 assessment. Dkt. No. 105 at 3.


In this case, introduction of evidence of the minority interest discount used by the IRS in the February 13, 2006 assessment is irrelevant. The issue is what the correct minority interest discount is, not what it was previously determined to be. Accord. Janis, 428 U.S. at 440; see also R.E. Dietz Corp. v. United States, 939 F.2d 1, 4 [68 AFTR 2d 91-5238] (2d Cir. 1991) (“The factual and legal analysis employed by the Commissioner is of no consequence to the district court.”). The previously used minority interest discount has no baring on factfinder's de novo determination of the property's fair market value. Because evidence of the previously used minority interest discount is irrelevant, it must be excluded.

This reminds me a little of the Levy case.  They were starting with a 30% discount and took it to a jury which allowed them 0%. (It was also a refund case so being stuck with the 30% was actually as bad as it could get.) In that case the taxpayers were trying to keep out the amount the family actually ultimately received.

Private Letter Ruling 201117036

This was an organization formed to provide credit counselling services that was denied exempt status.

Based on the information you provided in your application and supporting documentation, you are not operated for exempt purposes under section 501(c)(3) of the Code. An organization cannot be recognized as exempt under section 501(c)(3) unless it shows that it is both organized and operated exclusively for charitable, educational, or other exempt purpose. You failed to meet the operational test of section 1.501(c)(3)-1(a)(1) and section 1.501(c)(3)-1(c)(1) of the Regulations because you are organized for substantial private and commercial purposes, and operate in the same manner as a private commercial entity.


To qualify under IRC section 501(c)(3), an organization cannot have a non-exempt purpose that is more than insubstantial. Your primary activity is the provision of pre-bankruptcy certification and post-bankruptcy counseling for fees. You devote most of your time and activities to selling bankruptcy certifications to the general public under the guise of financial counseling. You have not shown that you are operated exclusively to educate individuals for the purpose of improving or developing their capabilities. Rather, the fact that no educational materials will be provided unless the client registers for a counseling session is an indication of operation for a primarily business purpose. Your primary focus is to expand your client base and to issue bankruptcy certificates as quickly as possible in order to generate revenue. Analogous to the organization described in Better Business Bureau of Washington D.C., Inc. v. United States supra, your activities appear to have an underlying commercial motive that distinguishes your educational activities from that carried out by a university or educational institution.

If you want to be recognized as a charity maybe you could kind of like do something charitable.

Private Letter Ruling 201117035

Here the IRS shows its narrow speciesism.  Among the possible purposes that qualify for exemption is "education".  It turns out, though, that it has to be human beings who are being educated.  Doggy University (the name I made up for the anonymous ORG in this ruling) does not qualify.

ORG holds dog obedience training classes, and awards the dogs a degree after completion of the course and also award, them prizes at the shows events. While the owners received some instruction as to the training of the dogs, it is the dog that is primary object of the training.




The nature of obedience training requires that the owner of the dog appear at the classes so that the dog is trained to respond to his owner's commands. While the owner receives some instruction in how to give commands to his dog, it is the dog that is the primary object of the training. The dog is also the primary object of the subsequent training in sporting and show events. Therefore, the organization's training program for dogs is not within the meaning of educational as defined in the regulations.


Dog training in the manner you describe is not exempt purposes as described in IRC section 501(c)(3), because the organization's training program for dogs as well as its dog shows is not within the meaning of educational as defined in the regulations . In fact, you primarily serve the private interests of the dog owners and thus not operated exclusively for 501(c)(3) purposes.


Private Letter Ruling 201117011

Taxpayer was granted 120-day extension from date this letter was issued, to make election under Code Sec. 469(c)(7)(A); to treat all of his interests in rental real estate as single rental real estate activity effective stated year.


Rental activities are "per se" passive.  There is an exception for people in real estate trades or businesses if they meet certain requirements.  They still have to materially participate in the properties.  Absent the election to aggregate the material participation standard can be challenging when there are multiple properties.  Taxpayers who have failed to make the election can sometimes get relief with a late election as the taxpayer in this ruling did.

To Keep Your Story Straight You Need to Know What it Needs to Be

Originally published on Passive Activities and Other Oxymorons on May 27th, 2011.
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Yusufu Y. Anyika, et ux. v. Commissioner, TC Memo 2011-69

After the introduction of the at-risk rules, real estate was the last real tax shelter.  Then came the passive activity loss rules.  The passive activity loss rules (Code Section 469) require us to put our trade our business activities (including interest in flow through entities) into buckets.  Losses in the passive bucket can only be used to the extent of gains in the passive bucket (It is not an "offset".  Passive capital gains release passive ordinary losses.  So sometimes a gain can reduce your liability.)  Losses that are not used are carried forward and are attached to the activity that generated them.  They are released when the activity is fully disposed of even if there is no passive income in that year.

Activities are classed as passive based on how much you participate in them.  Their are a number of ways to meet the "material participation" standard.  The simplest is 500 hours per year.  "Rental activities" are special.  They are deemed to be passive regardless of how much time you spend on them.  There is an exception to that rule.  Rental losses are not "per se" passive to people engaged in real estate trade or businesses.  The magic number here is 750 hours:

such taxpayer performs more than 750 hours of services during the taxable year in real property trades or businesses in which the taxpayer materially participates.

Sometimes people miss that "materially participates" part of the requirement.  In order for the exception to work for many people, they need to make an election to aggregate all their real estate activities for purposes of measuring material participation. Otherwise somebody with five properties might not be considered to be materially participating in any of them.

Now the 750 hours is not the whole story as Mr. Anyika discovered a bit late in the game.  Here is his situation:

Petitioners, Yusufu Yerodin Anyika (Mr. Anyika) and Cecelia Francis-Anyika (Mrs. Francis-Anyika), are married and filed joint returns for tax years 2005 and 2006. Mr. Anyika is employed as an engineer, and he works 37.5 hours per week, 48 weeks per year. Mrs. Francis-Anyika is employed as a nurse, and she works 24 hours per week.

Mr. Anyika has been purchasing, renovating, managing, and selling rental properties since the 1990s. He views his rental real estate activity as a second job and as an investment. During 2005 and 2006, Mr. Anyika owned two rental properties.

Mr. Anyika spent a good bit of time on the properties and thought he should qualify for the real estate trade or business exception.  He explained this in his petition and at trial:

 In their petition and at trial, petitioners contended that Mr. Anyika qualified as a real estate professional because he had spent at least 750 hours actively managing the rental properties. On Form 4564, Information Document Request, submitted by petitioners during their audit, petitioners declared, under penalty of perjury, that Mr. Anyika devoted 800 hours per year to working on the rental properties during 2005 and 2006.

With that nice fifty hour cushion he thought he was all set. Unfortunately 750 hours is not the only requirement.  Here is the other requirement:

more than one-half of the personal services performed in trades or businesses by the taxpayer during such taxable year are performed in real property trades or businesses in which the taxpayer materially participates

Mr. Anyika also worked full time as an engineer which took up substantially more than 800 hours per year.  He tried to salvage the situation:

It was only after the Court had explained the law that Mr. Anyika understood, for the first time, that he would have to have spent at least 1,800 hours engaged in the real estate business in order to qualify as a real estate professional under section 469(c)(7)(B). After understanding that, to qualify, he had to spend more hours engaged in managing the rental properties than he did working as an engineer, Mr. Anyika began to contend that he had spent the equivalent of 8 hours per day, 5 days per week, 48 weeks per year (1,920 hours per year) working on the rental properties. After being confronted during trial by the evidence of his prior signed statement that he worked 800 hours per year on the rental properties, Mr. Anyika stated that he was “speaking from memory with the exact numbers”, and that to be sure, he would need to look over the numbers more closely.

The Court did not find him credible:

We do not find Mr. Anyika's testimony that he worked approximately 1,920 hours per year on the rental properties credible. Not only does it contradict his earlier signed statement, but it also changed during trial once Mr. Anyika realized that he would need to have devoted more hours to his real estate properties than to his job as an engineer (i.e., he would need to have spent more than 1,800 hours working on the rental properties), instead of the 750 hours he had originally believed would be sufficient for him to qualify as a real estate professional under section 469(c)(7).

When it came to the penalties taxpayers tried the classic "Turbo Tax made me do it" defense.  The Court, using more measured if less colorful language, gave the old data processing answer to the Turbo Tax defense - Garbage in, Garbage Out.  Their has been much talk, of late, of what the qualifications of people who prepare tax returns should be.  Their will be special exams with members of some professions such as CPA's exempt from taking then.  Based mainly on reading tax court decisions, I think members of some professions should be required to take a special exam before they are allowed to prepare their own returns specifically engineers and attorneys.  Nobody ever listens to me, though.

Through The Hoops

Update

The Tax Cuts and Jobs Act has added a new hoop.  It conveniently comes at the end.  Code Section 461(l) disallows excess business losses, Here is an example form RIA

 In 2018, T, a single taxpayer, has deductions of $500,000 from a business. T's gross income from the business is $200,000. T's excess business loss is $50,000 ($500,000 – ($200,000 + $250,000)). The $50,000 excess business loss is treated as part of the taxpayer's net operating loss (NOL) carryfoward in later years.

Originally published on Passive Activities and Other Oxymorons on February 23rd, 2011.
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A lot of our time was spent training in January as we geared up for another tax season.  I'm going to share with you one of the little talks I always give.  I know you all love to see lots of Code references and the like, but I'm going to gloss over them.

A lot of people think that the complexity in the in the tax law comes from special tax breaks and deductions and we can enter into an era of simplicity by having some sort of flat tax with a low rate and minimal deductions.  What that viewpoint fails to recognize is that the taxation of income, as opposed to gross receipts, is inherently complex.  It may be that if you looked at the Code you would be able to pare it down substantially by eliminating provisions that encourage affordable housing or historic renovation or the like.  All that would not touch the inherent complexity.

You could view the history of tax reform since the mid seventies as largely a war against tax shelters.  If you look at your Form 1040 you will see that "Taxable Income" is on Line 43.  The really interesting number, though, is on Line 22 "Total Income". The numbers that go into making up Line 22 (Line 7 through Line 21) have an interesting feature.  Some of them can be negative numbers.  If you are in a very lucrative profession you might have a very big positive number on Line 7 (Wages, salaries, tips, etc.).  If that number drops unharmed down to Line 22  the various deductions that will start whittling it down are for the most part subject to a host of limitation and pretty much require a direct dollar for dollar cash outlay for each dollar of deduction.  Speaking in very broad generalities to seriously carve away at the Line 7 number as it hurtles towards line 43, you need a big negative number before you hit Line 22 (total income).  The most likely place for that big negative number is Line 17 (Rental real estate, royalties, partnerships, S corporations, trusts, etc.)   Other possibilities are Line 12 (Business income or (loss)) and Line 18 (Farm income or (loss)).  Much of the complication in tax rules can be viewed as trying to prevent you from legitimately putting in those negative numbers.

Of course all the rules that have been put in place to stop those negative numbers are generally applicable and have to be dealt with by people who really aren't trying to get away with anything.  Also, the rules have been put into place over a period of time.  When a set of rules was put into place to stop abuse and abuse continued, it was not replaced by a new set of rules.  It was supplemented by additional rules.  To make sense of this both for the purpose of planning and also to do returns correctly I have used the metaphor of a series of hoops to jump through.  In order to get that negative number onto your return the hoops must be jumped through in order.  If you don't get through the second hoop, it doesn't matter what a good job you do on the third.  The only flaw in the analogy is that the hoops are not necessarily pass fail.  A step might limit your loss, without eliminating it.  When that happens there is that much less to jump through the next hoop with.

You could write a book about each of the hoops (As a matter of fact multiple books have been written about them).  I will only discuss each of them very briefly.  The point of my lesson on this is that despite some relationships among them, they operate independently and as I noted above in order.  So, here are the five hoops:

                                               1. For Profit
                                               2. Allocation
                                               3. Basis
                                               4. At-risk
                                               5. Passive Activity Loss Rules
                                               6. Excess business losses (TCJA)

1. For Profit - The activity generating a deductible loss has to be an activity that you enter into with the expectation or at least the hope of making a profit.  This is a pass/fail hoop.  The IRS seems to think that anybody who loses money in any business having anything to do with horses is just doing it for fun.  The Tax Court is sometimes persuaded otherwise.  Complex foreign currency swapping transactions that have a remote chance of producing a stupendous return are an example of something the IRS seems to be able to win on.

2.Allocation - Assuming that there is a loss being generated in an entity of some sort in a business that is trying to make a profit, does a share of that loss really go to you ? If we are talking about Schedule C or Schedule F, the question would be whether the business is really your business.  S corporations allocate loss on a per share per day method unless the shareholders agree to an interim closing of the books.  That's pretty straight forward.  Then we come to partnerships, which we will see as we progress, is where the real action is.  Partnership allocations have to have or be deemed to have "substantial economic effect".  This is governed by the infamous 704(b) regulations.  Just to give you a feel for them, I was going to reproduce the table of contents.  I thought better of it.  Trust me. The regulations get incorporated either directly or by reference into most partnership agreements.  There is a huge understanding gap between the drafters - attorneys who never look at tax returns and return preparers - CPA's who don't always read the agreements.

3.Basis - If all you ever do is put money into a business, have losses, have income and take money out basis is simply the net of all those (Money in and profits are plus, money out and losses are minus).  It you contribute property or obtain an interest by gift or inheritance it gets more complicated.  This is the area where partnerships shine.  The thing that many people do not understand is that basis can never go below zero.  Never.  If there is a loss in excess of your basis that loss is suspended.  If you withdraw funds in excess of your basis you recognize gain.  The thing about partnerships though is that your share of the partnership's liabilities is included in your basis.  So you can have losses greater than the amount of money that you put in.  When this is referred to as "negative basis" what is really meant is that your share of the liabilities is greater than your basis.  The correct term is "minimum gain".  Minimum gain is the amount of gain that you would have to recognize if you abandoned your partnership interest, because, in that event, your share of the liabilities would be a deemed distribution to you. The one good thing about the nasty allocation rules is that generally a partnership will not allocate a loss to somebody who doesn't have basis to absorb it.  That happens all the time with S corporations.

4.At-risk - This is frequently confused with basis but it is a different concept.  Probably the best way to think of it is basis lite.  If you incur a liability that gives you basis but you are somehow insulated from loss, as is the case of a non-recourse liability, you are not at-risk for that amount.  If you are dealing with real estate, however, most conventional financing that is non recourse will be considered "qualified non-recourse" and exempt from the at-risk rules.

5. Passive Activity Loss Rules - Hoops 2 through 4 are somewhat interrelated. The final hoop is another whole system. The Passive Activity Loss rules (Code Section 469) were part of the Tax Reform Act of 1986 (Note that that act was epic in its scope such that we now have The Internal Revenue Code of 1986.  Previously it was 1954. )  The PAL rules require us to put our trade our business activities into buckets.  (There are some wonderful regs about how big the buckets can be and what can go into each of them).  Then the buckets are classified as to whether we materially participate in them.  Rental activities are per se passive.  There is a lot to these rules and by my lights they really did kill tax shelters, at least as I knew them in my youth.  Sometimes people will say that you can offset passive income with passive losses.  This is a dangerous thought trap.  Gains and loss retain their character so that the sale of a passive activity at a capital gain will release previously suspended ordinary losses.

6. Excess business losses - See above.

I have only very lightly touched on each of these areas.  The point of the post, though, is that you must remember that they are separate sets of rules that must be independently evaluated.

Time To Purge The Draft Posts

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

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

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

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

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

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

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


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

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

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


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

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

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

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

They Also Serve

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

This was originally published on October 8th, 2010.

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

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

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

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

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

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

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

Real estate election relief

This was originally published on PAOO on September 6th, 2010.

When I titled this blog Passive Activities and Other Oxymorons, it was by no means, because I intended to write only on the passive activity loss rules.  If I was going to totally devote myself to one tax topic it would be the capital account maintenance rules of 704(b) (That blog would be titled "Minimum Gain - Maximum Pain").  Fortunately, I once saw the slides of a presentation of someone else who is passionate about those rules.  I think they also had a thing for 704(c).  One of the slides practically screamed "There is no such thing as negative basis".  I feel a certain bond with that person, but I'm really not anxious to meet with them.

At any rate the passive activity loss rules do seem to be cropping up quite a bit.  In a recent case which I'm thinking doesn't merit its own post (Gregory J. Bahas, et ux. v. Commissioner, TC Summary Opinion 2010-115) Linda Bahas tried to use the real estate professional exception.  She hadn't made the aggregation election and the services she provided were as an employee not as a business owner.  Other than that Mrs. Lincoln how did your enjoy the play ?  At least she didn't have to put up with the court telling her she was ballpark guestimating her time.

There is some good news, though.  A quick review of the context might be in order first.  The passive activity loss rules were created more or less out of whole cloth by the Tax Reform Act of 1986.  They require us to sort trade or business activities into those in which we materially participate and those in which we don't.  One of the concepts in the rules is that rental activities are per se passive.  This may have been an example of someone getting their notions about reality from watching TV infomercials about making a fortune in real estate with no capital and very little work.  Regardless, my philosophy about tax rules is that they are what they are.  In the early 1990's relief from the per se passive rule was granted to real estate professionals.

In order for this relief to be effective, though, it is frequently necessary for them to elect to aggregate all their real estate activities.  Without the election they would have to establish material participation in each property. Donald Trask (TCM 2010-78) was able to establish that he spent enough time to be considered a real estate professional, but he had not made the election and his time was spread over 33 properties. 

PLR 201033015 was addressed to taxpayers who were qualified, but had failed to make the election.  Since they had relied on a tax preparer who had failed to advise them of the necessity of making the election, the service granted them an extension of time to make it.

If you have been posting negative numbers from real estate investments to your return on the theory that you or your spouse is a real estate professional, you should make sure that you have made the election.  If not you may want to consider requesting relief.  Furthermore, I generally believe in keeping tax returns indeefinitely, but if you must dispose of some of them, be sure to keep the return for the year that you made the election.  It is relevant for all future returns in which you are claiming its effect and I know from experience that you cannot rely on the IRS to preserve it for you.

LLC Member Not Presumed to be Passive

This was originally published on PAOO on August 30th, 2010.

In Action On Decision 2010-002 the IRS acquiesced in a Court of Claims decision (Thompson v. US 104 AFTR 2d 2009-5381) holding that a membership interest in a LLC was not presumptively passive.  Since the LLC is really the entity of choice, if you want a flow through this can be of significance. The passive activity loss rules were probably the most novel element of the Tax Reform Act of 1986.  They created a new taxonomy of business undertakings based on each individual taxpayers participation in the business.

The income or loss created by passive activities are aggregated and, in general, the losses are only allowed to the extent of the income.  It is erroneous to think of the process as an offset, because the various types of income and losses retain their character.  So if you have a capital gain from one passive activity and an ordinary loss from another activity, the ordinary loss will be allowed, while the capital gain will retain its character as a capital gain.  Losses without accompanying gains languish suspended from year to year until they are released by the total disposition of the activity giving rise to them.  It all gets tracked by Form 8582.  If you have been involved in passive activities it could be a worthwhile exercise to review your 8582's from year to year.  You will have two sets, one for the regular tax and another for the alternative minimum tax.  If you have switched tax preparers, there is a decent chance something got lost in transition.  It can happen even from preparers switching software.

The cleanest way out of the morass of passive activity concerns is "material participation".  The regulations give an individual seven ways to establish material participation :

(1) The individual participates in the activity for more than 500 hours during such year.


(2) The individual's participation in the activity for the taxable year constitutes substantially all of the participation in such activity of all individuals (including individuals who are not owners of interests in the activity) for such year;


(3) The individual participates in the activity for more than 100 hours during the taxable year, and such individual's participation in the activity for the taxable year is not less than the participation in the activity of any other individual (including individuals who are not owners of interests in the activity) for such year;


(4) The activity is a significant participation activity (within the meaning of paragraph (c) of this section) for the taxable year, and the individual's aggregate participation in all significant participation activities during such year exceeds 500 hours;


(5) The individual materially participated in the activity (determined without regard to this paragraph (a)(5)) for any five taxable years (whether or not consecutive) during the ten taxable years that immediately precede the taxable year;


(6) The activity is a personal service activity (within the meaning of paragraph (d) of this section), and the individual materially participated in the activity for any three taxable years (whether or not consecutive) preceding the taxable year; or


(7) Based on all of the facts and circumstances (taking into account the rules in paragraph (b) of this section), the individual participates in the activity on a regular, continuous, and substantial basis during such year.

The regulations go on to state that if the taxpayers interest in the activity is as a limited partner qualification for material participation can only come from items 1, 5, and 6 above. Thus a limited partner who does more than any other individual in the activity will not be considered to be materially participating if that amounts to less than 500 hours.  In the Thompson case the service had argued that an LLC membership interest was the same as a limited partnership interest for purposes of this regulation.  The Court of Claims did not agree and the service has thrown in the towel on this issue.

This decision should further bolster the LLC as the entity of choice where a flow though is desired.  Taxpayers should bear in mind though that if they are posting negative numbers from an activity, the IRS will likely attack any reconstruction of their time as a ballpark guesstimate (This has become a term of art apparently).

Guess me Out of the Ballpark

This was originally published on PAOO on August 6th, 2010.

The case of Marcel Ajah (TC Summary Opinion 2010-90) is about the ultimate oxymoron - "passive activities". The concept of passive activities embodied in Section 469 is a creature of the Tax Reform Act of 1986's attempt to drive a stake through the heart of the tax shelter vampires after the silver bullet of the at-risk rules under 465 had failed to eliminate them. Oddly enough while the at-risk rules specifically excluded real estate, the passive activity rules specifically target it, by indicating that rental activities are per se passive. This was a source of real aggravation to people who actively manage their own real estate. In the 1990's there was a relaxation for people who spent most of their time in trades or businesses related to real estate.

In order to take advantage of the relief many taxpayers needed to make a special election to treat all their rental real estate activities as one activity. Otherwise, the exception to the "per se" passive rule would do them no good unless they were "materially participating" in each of their properties. Since the basic standard of material participation is 500 hours per year (there is a separate 750 hour requirement to be recognized as being in a real estate trade or business), even very hard working people can't materially participate in more than a couple. There are wonderful regulations that explain to you how to go about grouping your activities to keep track of whether you are meeting the material participation standard.

Marcel Ajah illustrates the Achilles heel of the whole system, though. Most people don't keep very good track of how they spend their time. The regulations do not specify a particular method, but the cases beginning with William Goshorn in 1993 (TCM 1993-578) seem to characterize any method that taxpayers use to reconstruct their time as being a "post-event ballpark guesstimate". "Ballpark guesstimate" which seems to me to be a fairly robust concept is apparently limited to estimates of time spent to satisfy material participation requirements.

Marcel Ajah and his wife owned two rental properties, the commercial building out of which he operated his medical practice in Jamaica, NY and a single family residence in Baltimore MD. They claimed that Mrs. Ajah qualified as a real estate professional. They lost the case on two grounds.

Mrs. Ajah argues that she qualifies as a real estate professional for the year in issue. She relies upon certificates from the Long Island Board of Realtors, Inc., the Multiple Listing Service of Long Island, Inc., and the State of New York Department of State Division of Licensing Services. These certificates reflect, respectively, that for 2005 she pledged to adhere to the realtor code of ethics, had completed required courses on broker rules and regulations, and was licensed as a real estate broker. Mrs. Ajah testified that she worked at least 20 hours a week for the 52 weeks of 2005 on the two rental properties. Mrs. Ajah did not offer any evidence as to the number of hours she worked as an attorney in 2005. No contemporaneous record, calendar, appointment book, or any other method of recording time spent between rental real estate activities and activities as an attorney was provided. Thus, the Court is unable to conclude that more than one-half of Mrs. Ajah's personal services were devoted to the rental properties.


We conclude that Mrs. Ajah's method of calculating her time spent participating in the rental activities constitutes an impermissible “ballpark guesstimate”.

The other problem was that the Ajahs had not filed the election to aggregate meaning that she would have to meet the 750 hour requirement on each of the properties which wasn't even in her ballpark.

Earlier in the year Donald Trask (TCM 2010-78) who owned 33 rental properties managed to convince the tax court that he spent more than 750 hours working on them, but he was hung by the failure to make the election to aggregate. The fact that he had aggregated the properties in reporting his income and loss was not sufficient.

It is not always advantageous for the real estate professionals to make the election, but it is definitely something that should be looked at. There is no question that if you are posting negative numbers from real estate or side businesses on your returns you should be doing something to keep a current record of your time. My own experience working with appeals on this issue is that the Service will characterize almost any reconstruction of time spent as being a "ballpark guesstimate". And they aren't handing out any peanuts or cracker jacks,