No Time Limit on Excise Tax on Abusive Roth IRA

Originally Published on forbes.com on July 6th,2011

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I was never that excited about converting regular IRAs to Roth’s.  You paid a big bunch of money now, maybe spread over a couple of years, so you wouldn’t have to pay in the future.  Always seemed a little like hitting your head against the wall because it feels so good when you stop.  The plans which projected enormous fortunes for your great grandchildren had two important assumptions.  The first was that you could pay the tax on the rollover with non IRA funds, so that the whole smash could go into the Roth.  The other was that you were some sort of investment genius.

Grant Thornton came up with a method that made the whole thing much more attractive.  Robert K. Paschall liked the idea , although, despite being an MITgraduate, he never quite understo0d how it worked.  In its decision yesterday, the Tax Court explained to him that the plan did not work.

Besides signing a lot of papers, Mr. Paschall had to do two things as part of the plan.  He had to open a Roth IRA funding it with $2,000 and he had to pay Grant Thornton $120,000.  His regular IRA with $1,392,801.96 was then rolled over to a self directed account.  Then two Nevada corporations were formed Telesis and West Star.  Frankly, it gets a little fuzzy here.  The Roth IRA purchased Telesis for $2,000 and the regular IRA purchased West Star for $1,272,801.96 (notice the $120,000 difference).  There was some money shuffled between the corporations.  Then they were merged with Telesis being the survivor.  When the dust had settled all the money was in the Roth.  The court summed up nicely why this was an excess contribution:

The substance of what happened in the instant case is that approximately $1.3 million began the year in Mr. Paschall’s traditional IRA and was transferred to his Roth IRA by the end of the year with no taxes being paid. Mr. Paschall did not attempt to provide a nontax business, financial, or investment purpose for what he did, and this Court cannot ascertain one. Instead, Mr. Paschall, incited by and at the urging of Mr. Stover, used corporate formations, transfers, and mergers in an attempt to avoid taxes and disguise excess contributions to his Roth IRA.
The Audit

Mr. Paschall’s 2000 return, the year of the transaction, was prepared by Grant Thornton for no extra charge.  His subsequent returns were prepared by Kruse Mennillo, where the Grant Thornton partner who had presented him with the plan had moved.Sometime in 2003 or 2004 Mr. Paschall received some distressing news:
Grant Thornton was turning over the names of people who had engaged in Roth restructures to the IRS. Mr. Stover at this time advised Mr. Paschall that the Roth restructure was legal but that he “might want to disclose on [his] income tax returns the structure”. Mr. Paschall thereafter attached to Telesis’ and his personal tax returns Forms 8886, Reportable Transaction Disclosure Statement.  Sometime in 2004 Mr. Paschall received, via Mr. Coopit, a memo concluding that the Roth restructure “was legal and met with all tax laws”.

Finally in 2008 Mr. Paschall received deficiency notices for the years 2002 through 2006.  The notices were not for income taxes, but for the excise tax for excess contributions to a Roth.  The excise tax is 6% of the lesser of the orignial excess contribution or the balance in the account.  That is each year.  Plus penalties of course.  Now the earnings of the Roth are tax free as are distributions from it.  So how bad is a 6% excise really ?  Suppose you put $1,000,000 into a Roth and you would have been subject to a 30% tax rate.  All you have to do is earn 20% and you beat the excise tax.
Statute of Limitations

Mr. Paschall argued that deficiencies for the earlier years were barred by the statute of limitations.  The excise tax is computed on Form 5329.  Generally the 5329 is attached to Form 1040.  Mr. Paschall had timely filed Form 1040 for all the relevant years.  That did not, however, start the statute of limitations with respect to the excise tax:

Section 4973 imposes an excise tax on excess contributions to Roth IRAs which is to be reported and disclosed on Form 5329. Upon review of Mr. Paschall’s Forms 1040, respondent was not reasonably able to discern that Mr. Paschall was potentially liable for a section 4973 excise tax. While a line on each Form 1040, i.e., line 54 for 2000, line 55 for 2001, line 58 for 2002, line 57 for 2003, line 59 for 2004, and line 60 for 2005 and 2006, states “Tax on qualified plans, including IRAs, and other tax-favored accounts. Attach 5329 if required”, Mr. Paschall left these lines blank, giving respondent no indication of his excess contribution.

Penalties

Mr. Paschall thought that he should not be subject to penalties since he had relied on qualified professionals.  He never went outside the loop of professionals who were being compensated on a value billing basis in seeking advice though.  It is reminiscent of EMC founder Richard Egan’s   doomed tax shelter:
Mr. Paschall should have realized that the deal was too good to be true. See LaVerne v. Commissioner, supra at 652-653. Mr. Paschall is a highly educated and successful businessman. He explained to this Court that because he grew up in the Depression, he was conservative with his investments and worried “about having enough money” to last through retirement. Yet he paid $120,000 for a transaction that he “did not fully understand”.

Mr. Paschall had doubts, repeatedly asking whether the Roth restructure was legal. Despite these doubts, he never asked for an opinion letter or sought the advice of an independent adviser, including Mr. Jaeger, who was preparing his tax returns at the time he met Mr. Stover. This was even after he received a letter warning him that there might be problems with the Roth restructure and that his name was being turned over to the IRS.

Other Recent Case

In the case of Michael Oshman, the IRS failed in its attempt to assert Roth excise taxes.  Mr. Oshman was building up his Roth balance by having his closely held company pay commissions to a foreign sales corporation owned by his Roth.  Since the IRS did not attack the income tax character of those payments, the Court did not allow it to treat the payments as disguised Roth contributions.  In Mr. Paschall’s case, the income tax sins all took place in 2000 and were old and cold by the time the IRS caught up with the transaction.

Divorce Attornies Need to Watch Their Language

Originally published on Passive Activities and Other Oxymorons on June 17th, 2011.
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Betty L Klebanoff v. Commissioner, TC Summary Opinion 2011-46

I've been going back and forth whether to make much of this one or not.  Taxpayer entered into a business venture, whether as a partner or not is a little unclear.  They received a $51,000 "draw" against profits that never materialized.  When her return was due it wasn't clear what she was supposed to report so she didn't report anything.  Then they gave her a K-1 which said she had received a guaranteed payment.  The venture had by then fizzled.  Soon after the IRS audited her.  Her position was that the $51,000 was not reportable.  IRS said it was ordinary income subject to SE tax.

The Tax Court ended up with short term capital gain - distribution from a partnership in excess of basis.  Not only was there no SE tax, there was also no penalty, which I think was on the generous side :

Petitioner was aware that she received $51,000 in payments from Mirus during 2007. She did not understand the legal or technical ramifications of those payments. She made attempts to contact Mirus and Messrs. Buck and Colson, but she did not receive any response regarding the $51,000 in payments. Petitioner did not receive any notification from Mirus before her 2007 income tax return was due and was filed. At the time her 2007 income tax return was due and being filed in 2008, petitioner's lawyer was engaged in negotiations in an attempt to work out some settlement of her interest in Mirus. There was uncertainty about whether petitioner would receive additional amounts from Mirus and/or Messrs. Buck and Colson and as to the nature of the payments already received. Petitioner decided to wait and file an amended return for 2007 after she was able to better address the taxability of the $51,000 in payments.


The events that culminated in the filing of the first Mirus partnership return and petitioner's income tax return were followed in relatively short order by respondent's audit of petitioner's return and the issuance of a notice of deficiency. Petitioner consulted tax professionals who advised her and caused her to file an amended partnership return for Mirus reflecting that the $51,000 in payment was a draw and that Hospice and Rock were the partners of Mirus.

It was therefore reasonable for petitioner to take the position that the $51,000 was not taxable in her 2007 tax year. Under those circumstances, petitioner's actions were reasonable and she is not liable for an accuracy-related penalty.

I really don't see a defensible argument for not reporting the $51,000 somehow or other, but it was a confusing mess, so I'm glad she got a break on the penalty.

Tuwana J. Anthony v. Commissioner, TC Summary Opinion 2011-50

If you have a business that involves selling various items, inventory is likely to enter into your tax computations.  You can't just deduct what you spent on the stuff from what you got paid for stuff in each year.  You have to consider stuff that is bought in one year and sold in a different year.  If you are talking about big items you might specifically identify them, but if its a lot of small stuff you need to take a short cut.  The short cut is this.  To figure your cost of goods sold you take the amount that you spent on stuff during the year ("purchases") and add the cost of stuff you had on hand at the beginning of the year "opening inventory".  That is your cost of goods available for sale.  To get your "cost of goods sold" (which is the number that you get to reduce your income by) you need to subtract the cost of stuff you didn't sell, "ending inventory".  Getting that number can be a bit of production.  It's one thing if you have an auto dealership with paper work on each vehicle from the factory.  If you have a retail store with all sorts of little tchotchkes it can be more of a production.  One way to approach it is to list out all the items with their selling prices and then reduce the total by your mark-up.

Ms. Anthony apparently forgot that last step.  She was audited for 2004 and was able to convince the Tax Court that her ending inventory was overvalued because it was at retail selling price.

During settlement negotiations in docket No. 5791-07S, petitioner affirmatively raised, inter alia, the issue of whether the $41,097 reported ending inventory on petitioner's 2004 Federal income tax return should have been reported as $20,548. Specifically, petitioner took the position that she erroneously reported her 2004 ending inventory using her retail selling price—rather than her cost—for the inventory.

The 2004 case was settled in 2009.  There was a little problem though.  The incorrect 2004 closing inventory was used as the 2005 opening inventory.  This could have been a gotcha on the IRS, since the statute was closed on 2005, but that is not the way it worked out:

In Tuwana J. Anthony v. Commissioner, Docket No. 5791- "07S”, based on representations made by you, the Tax Court made a determination that your ending inventory for 2004 was $20,548, instead of $41,097 as reported by you. Under section 1311, the same adjustment is required to be made to your beginning inventory for 2005. *** This results in an increase to your [2005] income of [$20,549]. On the basis of the above inventory adjustment and other adjustments that petitioner and respondent agreed to, respondent determined a $5,516 deficiency in petitioner's 2005 Federal income tax. Although the section 6501 3-year period of limitations for 2005 had expired at the time respondent issued the notice of deficiency on January 7, 2010, respondent relied on the mitigation provisions of sections 1311 through 1314 to issue the notice of deficiency to petitioner.

On the basis of the foregoing, we find that all requirements of the applicable mitigation provisions have been met and that respondent properly relied thereon in issuing petitioner the notice of deficiency for 2005. Petitioner's opening inventory for 2005 is reduced from $41,097 to $20,548 consistent with the adjustment made to her 2004 ending inventory.

Jose B. Magno, et al. v. Commissioner, TC Summary Opinion 2011-43

This was another case about the real estate trade or business exception to the passive activity loss rules.  The taxpayer hadn't made the aggregation election and his testimony about time spent was not persuasive:

During the audit stage of this proceeding, Mr. Magno told respondent's revenue agent that he worked approximately 25 to 30 hours per week on his financial planning and services business. That conversation was documented in the revenue agent's notes, and the revenue agent testified credibly to its contents at trial. At trial, however, Mr. Magno testified that he worked principally as a financial consultant from January through August 2005. He also testified that he became a full-time manager of the first and second residences in 2006 and 2007 and that he reduced the number of hours which he devoted to his financial consulting services business to “about” 500 hours per year.


We credit the testimony of respondent's revenue agent and therefore conclude that Mr. Magno must have worked more than 1,250 hours during each subject year in real property trades or businesses to qualify as a real estate professional under section 469(c)(7)(B)(i). 6 Mr. Magno was not able to corroborate with written documentation his assertions that more than one-half of the personal services he performed in trades or businesses during the subject years were performed in real property trades or businesses. Accordingly, we find that Mr. Magno has not proven that he meets the requirements of section 469(c)(7)(B)(i).

I'm starting to find these cases a little tedious, but I'm going to continue to report on them.

Timothy O. Micek v. Commissioner, TC Summary Opinion 2011-45

In 1999 petitioner and Ms. Micek orally agreed that petitioner would help support Ms. Micek by paying her $1,250 every 2 weeks. To memorialize this agreement, on November 10, 1999, petitioner signed a spousal support affidavit, stating that he promised to pay Ms. Micek $1,250 biweekly via direct deposit. A notary public of the State of New Jersey notarized the spousal support affidavit. Throughout the years at issue, petitioner made payments to Ms. Micek pursuant to the spousal support affidavit.

While petitioner was making payments, he was diagnosed with multiple sclerosis and was forced to stop working. As a result, in 2003 petitioner stopped making the required payments. On April 21, 2003, petitioner's attorney received a letter from Ms. Micek's attorney inquiring why petitioner had terminated the “alimony/expense payments”.

The issue before us is whether the spousal support affidavit qualifies as a written separation instrument as defined by section 71(b)(2). The spousal support affidavit is a written instrument, signed by petitioner, promising to pay Ms. Micek $1,250 every 2 weeks. As discussed above, a separation instrument does not require a specific medium or form and does not have to be signed by both husband and wife. Further, even though Ms. Micek did not sign the spousal support affidavit, petitioner testified that he reached an oral agreement with Ms. Micek with respect to support payments during their separation. This meeting of the minds not only is memorialized by the spousal support affidavit, but also is supported by the letter from Ms. Micek's attorney received by petitioner's attorney on April 21, 2003, describing the payments she had been receiving from petitioner as alimony payments. Accordingly, the spousal support affidavit qualifies as a written separation instrument as defined by section 71(b)(2), and petitioner is entitled to his claimed alimony deductions for the years at issue.

It looks like the IRS may have been whipsawed by this decision.  If not I would not like to be in the shoes of Ms. Micek's attorney since his use of the word "alimony" was an important element in the decision.  He should have been aware of whether his client was reporting the payments as taxable income.

Six Year Statute on Basis Overstatement - Another Circuit Heard From

Originally published on Passive Activities and Other Oxymorons on June 1st, 2011.
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SALMAN RANCH, LTD. v. COMM., Cite as 107 AFTR 2d 2011-XXXX

Although it is a little lawyerly for me I've been following cases about the circumstances in which a six year statute of limitations can be triggered by basis overstatements.  I wrote about three cases which gave three different answers with a follow-up that indicated that the Tax Court is sticking with the three year statute.  Now the tenth circuit weighs in.

This decision follows the reasoning in the Grapevine case, by the Federal Circuit that the IRS regulations, which would require the six year statute, are entitled to deference even though they were issued after the affected tax years (2001 and 2002).  This case had an extra wrinkle in that the same partnership with the same facts had gotten a ruling from the Court of Claims that the three year statute applied.  The Court noted one big difference.  The regulations:

The Partnership contends that because the Federal Circuit has already held for the 1999 tax year “that the alleged overstatement of the basis [of the ranch] by the Partnership did not constitute an omission from gross income under § 6501(e)(1)(A),” Salman Ranch II, 573 F.3d at 1377, we are bound by collateral estoppel to decide the same. We disagree. While the Partnership is correct that Salman Ranch II involved the same parties, relevant facts, and issue as this case, it can no longer contend that the “applicable legal rules remain unchanged.”Sunnen , 333 U.S. at 600.
 As we have held, we must give Chevron deference to the new treasury regulation, and it is readily apparent that the regulation “so change[d] the legal atmosphere as to render the rule of collateral estoppel inapplicable” in this appeal. See Sunnen, 333 U.S. at 600. Any suggestion by the Partnership that the regulation cannot be the source of intervening authority is belied by the Court's decision in Sunnen, a tax case. There, the Court made clear that “an interposed alteration in the pertinent statutory provisions or Treasury regulations” is sufficient to render collateral estoppel unwarranted. Id. at 601. This is so, the Court said, because the principle of collateral estoppel “is designed to prevent repetitious lawsuits over matters which have once been decided and which have remained substantially static, factually and legally. It is not meant to create vested rights in decisions that have become obsolete or erroneous with time, thereby causing inequities among taxpayers.” Id. at 599 (emphasis added). Thus, “where the situation is vitally altered between the time of the first judgment and the second, the prior determination is not conclusive.” Id. at 600. We hold that the treasury regulation is a new intervening authority which requires us to depart from Salman Ranch II.

Decisions like this one and Grapevine might have more far reaching implications.  The next time someone finds Son of Boss style "loopholes", there may be the threat of them being closed by retroactive regulation.

If You Kill Your Parents It's Your Own Fault You are an Orphan

Originally published on Passive Activities and Other Oxymorons on May 13th, 2011.
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Here are a few items that I didn't quite get to in tax season.

CCA 201106015

The law firm provides one of its attorneys to perform legal services for a municipality. It's usually the same attorney every time. The firm sends an invoice to the municipality, and the municipality pays the firm. The municipality does not issue a Form 1099. The attorney is paid by the law firm. Small municipalities essentially contract out for these services when they can't afford their own full time city attorney.

The question is whether the IRS should assert that the attorney is an employee of the municipality, rather than an employee (or partner) of the law firm for purposes of the services provided to the municipality.

My answer is no. The attorney is not an employee of the municipality. ———————————

It is nice to know that sometimes national office will restrain the overzealous.  What they would be accomplishing other than creating aggravation for the small municipality is beyond me.

Roger S. Campbell, et ux. v. Commissioner, TC Memo 2011-42

There were a couple of issues in this case around substatntiation, but the main thing was a hobby loss question on Amway activities.  I remember going to some Amway presentations and it is really shocking to me that people can actually lose money on something that sounds like such a good deal.

Petitioners did not conduct the Amway activity in a businesslike manner. Although they maintained a separate bank account for the activity and maintained records for certain aspects of it, petitioners never used these records as an analytical tool for improving profitability. Mrs. Campbell testified that she did not know whether the Amway activity was profitable in any given year until she completed petitioners' tax return for that year which, for 2 of the taxable years in issue, did not occur until almost 2 years later. It is a fair inference that petitioners' recordkeeping was directed more towards substantiating deductions on a tax return than assessing the profitability of the Amway activity.

Considering all the facts and circumstances, including especially the confusing state of petitioners' Amway records, we conclude that a substantial portion of the costs of goods sold respondent disallowed for 1998 and 1999 represents Amway purchases that petitioners withdrew from inventory for personal use or use in their other businesses. This commingling of the Amway merchandise, resulting in substantial inaccuracies in reported costs of good sold, is further evidence that petitioners' Amway activity was not conducted in a businesslike fashion. It also resulted in petitioners' claiming business deductions for personal expenditures.


Although petitioners have prior entrepreneurial experience and both operated other businesses concurrently, they had no experience with operating a direct marketing distributorship before they were recruited as Amway distributors. Petitioners obtained advice only from their upline distributors and other interested Amway individuals, persons who had a direct financial interest in the maximization of petitioners' sales volume, without regard to petitioners' profitability.

In view of the foregoing, petitioners have failed to prove that they carried on their Amway activity with the requisite objective of making a profit. Consequently, their deductions arising from the Amway activity are limited by section 183.

In the presentations it was always about you recruiting people who recruit people and so on. It always seemed that somebody somewhere had to be selling an awful lot of soap for the thing to work.

U.S. v. THOMAS, Cite as 107 AFTR 2d 2011-1599

This was a protester who was complaining about having to file all his delinquent returns as a condition of his supervised release.  He figures the IRS already did substitute returns and that it was going to be hard to dig up records from that long ago.  The Court had no sympathy as they cited one of my favorite jokes.

We hold that the district court correctly calculated the applicable sentencing range and did not abuse its discretion in imposing an obligation to file all unfiled tax returns and pay all outstanding tax arrears as a condition of supervised release.

We note that any difficulties that may arise from the age of the necessary documents or the passage of time are entirely self-inflicted; had he complied with his duty to file the returns when they were initially due, there would be no such troubles. His contention on appeal that this state of affairs amounts to a “burden” imposed by the district court is absurd, like killing your parents and complaining of being an orphan.


Jeffrey S. Charlton, et ux., et al. v. Commissioner, TC Memo 2011-51

This was a statute of limitations case.  The underlying plan was clearly a loser:

During 1998, Jeffrey and Timothy formed Graphic Connections Group, LLC; Wealth Builders International, LLC; and Golf Links Display Group, LLC (collectively, the partnerships). Pursuant to the partnerships' operating agreements, Jeffrey and Timothy each had a 1-percent interest, and the domestic trusts had a 98- percent interest, in each of the partnerships. The domestic trusts paid the personal expenses of Jeffrey's and Timothy's families and distributed income to the Belize trusts. Jeffrey and Timothy used foreign bank accounts in Belize and Antigua to access the income. On August 1, 1999, Token Trust purchased Titan Trust's and Timothy's interests in the partnerships.

One of my rules is to not get involved in any plan that includes a place I can't easily point out on the map. (Belize is in Central America by the way.  You probably already knew that.)  As it turned out though the Tax Court believed that Mr. Charlton was gullible rather than fraudulent:

Jeffrey, who undoubtedly had a penchant for fast and easy money, foolhardily followed the Aegis system (i.e., structuring the transactions and resisting the IRS audit). See Niedringhaus v. Commissioner, 99 T.C. 202, 211 (1992); Gajewski v. Commissioner, supra. Nevertheless, Jeffrey maintained adequate records and made all pertinent information available to Mr. Moore, his longtime trusted, yet imprudent, CPA. See Niedringhaus v. Commissioner, supra at 211. To his detriment, Jeffrey relied on the professional judgment of Mr. Moore, who inexplicably believed in and acquiesced to an elaborate scheme designed by con artists. See Estate of Temple v. Commissioner, 67 T.C. 143, 162 (1976) (holding that reliance upon an accountant to prepare accurate returns may negate fraudulent intent if the accountant was supplied with all the information necessary to prepare the returns); Marinzulich v. Commissioner, 31 T.C. 487, 490 (1958) (holding that a taxpayer's reliance upon his accountant to prepare an accurate return may indicate an absence of fraudulent intent).

If you are using Mr. Charlton as a guide to your future plans, I would point out that if you go shopping for a CPA who is as gullible as you are, you might not be able to rely on who ever you end up with.  If you talk to two of them and neither one will drink the Kool-Aid with you, give it up.

Tax Court Sticking with Three Year Statute on Basis Overstatements

Originally published on Passive Activities and Other Oxymorons on April 27th, 2011.
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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.
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HOME CONCRETE AND SUPPLY, LLC v. U.S. 107 AFTR 2d 2011-767
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.

P.S.

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

Nasty Surprise Brewing for Winner of Employee Classification Suit

Originally published on Passive Activities and Other Oxymorons on December 27, 2010.
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CCA 201049027

If the 'skeeters don't get him. then the 'gators will.

I'm making this a bonus post.  One of the things that I worry about a lot is 1099 compliance (I have to take a break from global warming every once in a while).  It was the topic of one of my earliest posts.  An insidious observation in several IRS audit manuals, including the one for auto body repair shops, is that there might be more money in penalties for failing to file 1099's and backup withholding then in disallowing deductions.  You see if you were supposed to send somebody a 1099, then you were supposed to have  asked them for their ID number.  Since you didn't ask they didn't give it to you.  Therefore, you should have withheld from their payment and remitted it.  You can get out of the backup withholding by getting them to sign an IRS form that says they reported the income.  Good luck.

CCA 201049027 lays out an even more insidious tactic.  Suppose the IRS launches an effort to characterize service providers as employees.  These things can take a long time.  The Cheryl Mayfield decision which I wrote a post about was decide in October 2010.  It concerned proposed employment taxes for 2003 and 2004.  Well of course if they had really been employees, you wouldn't be subject to back-up withholding.  But let's say, for the sake of argument, that you win on that issue in Tax Court.  Now, after all that time does the Service have the ability to assess back-up withholding if your 1099 compliance has been less than perfect.  According to this CCA, they can.  On top of that, the Tax Court does not have jurisdiction on the issue of back up withholding.

Issue 1:

The Tax Court does not have jurisdiction under § 7436 to determine the application of backup withholding liability for any workers determined to be independent contractors.

Issue 2: If a Taxpayer filed Forms 945 and thus started the running of the period of limitations on assessment with regard to backup withholding, the issuance of the NDWC may nonetheless suspend the period of limitations with respect to the backup withholding.

I get the sense that they feel they may not be on firm ground with this interpretation :

We recognize the potential incongruity in noting that the Tax Court does not have jurisdiction over § 3406 taxes in a § 7436 proceeding while also asserting that the proper issuance of the NDWC suspends the period of limitations with respect to § 3406 taxes. However, due to the unique nature of employment taxes, there is no perfect analogy in the deficiency arena to apply to the operation of § 6503(a), a provision involving income tax deficiencies, in the employment tax arena. The principles we distill above from §§ 6213 and 6503 are especially apt in light of the uniqueness of the situation where assessing one type of employment tax (e.g., backup withholding on non-employees) is inconsistent with assessing another type of employment tax (e.g., social security and Medicare tax on employees). Furthermore, these principles only apply to situations where the period of limitations for assessment of § 3406 taxes is open at the time the NDWC is issued.

Also they were not anxious to release it.

CASE DEVELOPMENT, HAZARDS AND OTHER CONSIDERATIONS

This writing may contain privileged information. Any unauthorized disclosure of this writing may undermine our ability to protect the privileged information. If disclosure is determined to be necessary, please contact this office for our views.

Please call Ligeia Donis at (202) 622-0047 if you have any further questions.

I was thinking of giving Ms. Donis a call and make her the blog's first interview, but I'm passing on it.  If this serves as a timely warning thank RIA Checkpoint and the Freedom of Information Act.  You can thank me too.

What's New With The Chief Counsel?

Originally published on Passive Activities and Other Oxymorons on December 24, 2010.
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There have been quite a few items of interest from the chief counsel's office.  Here is what I think was worth noticing through mid December.  I've got next week ready to go and these will start getting stale, so I'll make this a Merry Christmas bonus post.

CCA 201049041

The IRS will not transfer or redesignate a payment that has been applied to a taxpayer's account to satisfy a different liability of the taxpayer if the payment was applied according to the taxpayer's instructions. If the IRS applies a payment contrary to a taxpayer's instructions, the IRS will, upon request by the taxpayer, transfer the payment to the intended tax liability.
A corporation that believes it will have overpaid its estimated tax for the tax year may apply for a quick refund on Form 4466, Corporation Application for Quick Refund of Overpayment of Estimated Tax, before the 16th day of the 3rd month after the end of the tax year at issue, but before it files its income tax return, if the overpayment is at least 10% of the expected tax liability and at least $500. A corporation should not file Form 4466 before the end of its tax year.

If you run into cash flow problems it would be nice if you could apply estimated income tax payments to payroll tax deposits, which have much more ferocious penalties.  No such luck though.  An estimated income tax payment is gone at least until after the end of the year in question.


CCA 201049040

As we discussed, we agree with your conclusion. Lines 3 and 8 of Form 6251 do not apply to taxes incurred in connection with a trade or business. See § 56(b)(1)(A), (b)(1)(D); Reg § 1.62-1T(d)

There is an AMT preference for taxes, but it would not apply, for example, to real estate taxes on Schedule E for a rental property.  I don't think the principle extends to state income taxes attributable to a Schedule C activity.

CCA 201049035

The email responds to your request for assistance. You asked for advice regarding whether there is any limitations period applicable to reducing tax liability based on a net operating loss (NOL) carryback.

Section 6511(a) provides that a “[c]laim for credit or refund of an overpayment . . . shall be filed by the taxpayer within 3 years from the time the return was filed or 2 years from the time the tax was paid, whichever of such periods expires the later.” Section 6511(d)(2) provides an additional special period of limitation with respect to a claim for a refund or credit relating to an overpayment attributable to a NOL carryback. The relevant portion of section 6511(d)(2) provides, in lieu of the 3 year period of limitation prescribed in section 6511(a), the period shall be the period ending 3 years after the due date of the return (plus extensions) for the taxable year of the NOL.

In this case, the Service disallowed the taxpayer's purported claim for credit because it determined that it was untimely. However, you provided that the NOL carryback, if allowed, would not result in an overpayment which would generate a credit or refund but would simply reduce the taxpayer's outstanding tax liability. Even though there are restrictions on the time within which the Service may allow a claim for credit or refund, no such statutory impediments exist to prevent the carryback of an NOL to reduce a taxpayer's outstanding tax liabilities.

This might be of interest to someone dealing with collections who has had things go from bad to worth.  Possibly a carryback from a subsequent disastrous year can alleviate an outstanding debt.

CCA 201049030

 Subject: Filing joint return after filing of substitute for return ————

You asked whether a taxpayer can elect joint status after the Service has filed a substitute for return under section 6020(b) and has issued a notice of deficiency to the taxpayer. The Tax Court held in Millsap v. Commissioner, 91 T.C. 926, 936-937 (1998), acq. in result, AOD-1992-03, that a taxpayer is not foreclosed from electing joint status after the Service has prepared a return under section 6020(b) because the return does not constitute a “separate return” filed by the individual for purposes of section 6013(b). Because the taxpayer has not previously filed a separate return in this case, section 6013(b) does not apply, therefore, the taxpayer may file a joint return provided that none of the exceptions in section 6013(a) apply.

Section 6013(a)(2) states that “in the case of death of one spouse the joint return may be made by the surviving spouse . . . if no return for the taxable year has been made by the decedent, no executor or administrator has been appointed, and no executor or administrator is appointed before the last day prescribed by law for filing the return of the surviving spouse.” The facts that you provided did not state whether an executor or administrator had been appointed. Thus, if an executor or administrator was not appointed, the taxpayer may file a joint return with respect to himself and his deceased spouse. See IRC section 6013(a)(2). 

If you are married and he Service does your return for you it will be married filing separately.  You may be able to reduce the tax if your spouse will consent to a joint return.  If your spouse happens to be dead, you might be able to consent for them.  Definitely has the makings of a Law and Order episode.