Posts Tagged ‘Judge Goeke’

Tax Roundup, 8/21/14: IRS says saving the company still “passive;” Tax Court says otherwise And: the $105.82 c-note!

Thursday, August 21st, 2014 by Joe Kristan

Programming note: No Tax Roundup will appear tomorrow, August 22.   I will be up in Ames helping teach the ISU Center for Agricultural Law and Taxation class “Affordable Care Act (ACA): What Practitioners Need to Know in the morning.  Webinar registration is closed, but you can still  attend as a walk-in.

 

S imageS imageS-SidewalkYou saved the company.  Big deal.  Apparently pulling the company you started from the brink of failure wasn’t enough to convince the IRS that a taxpayer “materially participated” and could deduct losses on his tax return.

Charles Wade was a founder of Thermoplastic Services, Inc. and Paragon Plastic Sheeting, both S corporations.  After his son Ashley took over daily management of the business, he still owned a significant stake in the company.  He never really retired, though.  From the Tax Court (my emphasis, footnotes omitted in all Tax Court quotes):

With Ashley there to handle day-to-day management, Mr. Wade became more focused on product and customer development. He did not have to live near business operations to perform these duties, so petitioners moved to Navarre, Florida. After the move he continued to make periodic visits to the facilities in Louisiana and regularly spoke on the phone with plant personnel.

In 2008 TSI and Paragon began struggling financially as prices for their products plummeted and revenues declined significantly. Mr. Wade’s involvement in the businesses became crucial during this crisis. To boost employee morale, he made three trips to the companies’ industrial facility in DeQuincy, Louisiana, during which he assured the employees that operations would continue. He also redoubled his research and development efforts to help TSI and Paragon recover from the financial downturn. During this time Mr. Wade invented a new technique for fireproofing polyethylene partitions, and he developed a method for treating plastics that would allow them to destroy common viruses and bacteria on contact. In addition to his research efforts, Mr. Wade ensured the companies’ financial viability by securing a new line of credit. Without Mr. Wade’s involvement in the companies, TSI and Paragon likely would not have survived.

Slacker.  At least according to the IRS, who said that this participation failed to rise to the level of “material participation” and disallowed over $3 million in pass-through losses on Mr. Wade’s return.

The Tax Court took a different view.  Judge Goeke explains :

A taxpayer materially participates in an activity for a given year if, “[b]ased on all of the facts and circumstances * * * the individual participates in the activity on a regular, continuous, and substantial basis during such year.” A taxpayer who participates in the activity for 100 hours or less during the year cannot satisfy this test, and more stringent requirements apply to those who participate in a management or investment capacity.  The record reflects that Mr. Wade spent over 100 hours participating in TSI and Paragon during 2008, and his participation consisted primarily of nonmanagement and noninvestment activities. Ashley managed the day-to-day operations of the companies; Mr. Wade focused more on product development and customer retention.

Although Mr. Wade took a step back when Ashley became involved in the companies’ management, he still played a major role in their 2008 activities. He researched and developed new technology that allowed TSI and Paragon to improve their products. He also secured financing for the companies that allowed them to continue operations, and he visited the industrial facilities throughout the year to meet with employees about their futures. These efforts were continuous,  regular, and substantial during 2008, and we accordingly hold that Mr. Wade materially participated in TSI and Paragon. 

20120801-2It’s notable that the judge did not require Mr. Wade to produce a daily log.  Apparently there was enough testimony and evidence to show that his participation crossed the 100 hour threshold.

The 100 hours might not have been considered enough under some circumstances.  Usually the IRS holds taxpayers to the default 500-hour test for material participation.  This case is unusual in its use of the fall-back 100-hour “facts and circumstances” test. It’s good to see the Tax Court use it, as the IRS seems to think this test never applies.

It’s also interesting that the efforts at “customer retention” were counted.  This could be useful in planning for the 3.8% Obamacare Net Investment Income Tax.  The NIIT taxes “passive” income, defined the same way as the passive loss rules.  A semi-retired S corporation owner who still calls on some of old accounts after turning daily operations over to successors might be able to avoid the NIIT under the logic of this case.  If so, though, it would be wise to keep a calendar to prove it.

Cite: Wade, T.C. Memo. 2014-169

Related:

Russ Fox, A Passive Activity Case Goes to the Taxpayers.  “Hopefully the IRS can get more of these cases right at audit and appeals–they’ll be dealing with many more of these over the coming years.”

Paul Neiffer, More than 100 but Less than 500.  “It is nice to see that a subjective test went in the taxpayer’s favor.”

Material participation basics.

 

How far does $100 go in your city?  Last week the Tax Foundation issued a map showing how far $100 goes in different states.  Now they have issued a new map in The Real Value of $100 in Metropolitan Areas (Tax Policy Bl0g).  It is wonderful — just scroll your cursor over your town.

In Des Moines, $100 is good for $105.82.  In New York, it gets you $81.83.

 

TaxGrrrl, Anna Nicole Smith’s Estate Loses Yet Another Run At The Marshall Fortune

Tony Nitti, Could The IRS Disallow Ice Bucket Challenge Charitable Contributions?  Go ahead, IRS, just try it.  You’re just too popular.

William McBride, Earnings Stripping, Competitiveness, and the Drive to Further Complicate the Corporate Tax (Tax Policy Blog)

Roberton Williams, One Downside Of Inversions: Higher Tax Bills For Stockholders (TaxVox)

Kay Bell, How does the U.S. corporate tax rate compare to other countries?  Poorly.

TaxProf, The IRS Scandal, Day 469

 

David Brunori, Using Local Cigarette Taxes for Schools Is Silly (Tax Analysts Blog).  Smoke ‘em if you got ‘em.  For the children!

Cara Griffith, Was Oregon’s Tax Incentive Deal With Intel Unnecessary? (Tax Analysts Blog).  No, it was absolutely necessary to enable the Governor of Oregon to issue this press release and YouTube announcement.  That’s the point, after all.

 

Quotable:

The United States gets little tax from Americans overseas today. Most of them live in high-tax countries and have no U.S. income tax in any event because of FTCs and the section 911 foreign earned income exclusion. But as we all know, Congress couldn’t care less about this subject, and this is all a non-starter. Better to place your money on a genetically modified flying pig.

Robert L. Williams in Tax Analysts ($link)

 

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Creativity fails to protect custom homebuilder from capitalizing costs

Wednesday, October 2nd, 2013 by Joe Kristan
Flickr image courtesy Garreth Wilcock under Creative Commons license.

Flickr image courtesy Garreth Wilcock under Creative Commons license.

The inventory capitalization rules of Code Section 263A often come as an unhappy surprise to clients.  It’s especially true when a client has bought a bunch of new fixed assets and expects bonus depreciation to make their tax go away.  If that bonus depreciation is attributable to manufacturing or production assets, a lot of it might end up as part of year-end inventory for tax purposes, pushing off the deduction for a year — and causing unexpected tax this year.

All “producers,” and retailers with receipts over $10 million, are subject to the Sec. 263A “uniform capitalization,” or “UNICAP” rules.  Costs subject to 263A have to be capitalized as part of the cost of inventory or constructed property, and are only recovered when that property is sold.  Costs commonly added to inventory under Sec. 263A include tax depreciation in excess of financial statement depreciation, indirect labor, and overhead costs that the tax law considers attributable to production activities.

A Texas custom homebuilder, Frontier Custom Homes, took a creative approach to getting around these rules.  The Tax Court takes up the story:

     As a preliminary matter, we must decide whether Frontier, as a custom homebuilder, is subject to the UNICAP rules under section 263A. Frontier contends its business model is centered around sales and marketing, not production-related services. The thrust of its argument is that custom homebuilders differ from speculation homebuilders because their price premiums and profitability come not from cost control, but rather from the creativity of their salespeople, designers, decorators, and marketing employees.

Section 263A requires taxpayers that produce real property to capitalize certain costs. The term “produce” includes “construct, build, install, manufacture, develop, or improve.” Sec. 263A(g)(1).

Frontier contends it is outside the scope of section 263A because it does not employ the tradesmen — e.g., carpenters, welders, and plumbers — who actually build the homes. All of those activities are subcontracted out. It therefore claims its actual employees’ services, and the related costs incurred, are more reflective of a sales and marketing company that manages the creation of a custom product rather than a construction company producing streamlined goods. 

The Tax Court didn’t appreciate the creative approach (my emphasis, footnotes and citations omitted):

 Speculative homebuilding is the classic production activity to which section 263A applies. Frontier’s argument is that custom homebuilding is different from speculative homebuilding and that this difference keeps its activities out of the reach of section 263A. Before Frontier sells a home, it builds it; before Frontier builds a home, it designs it. After Frontier creates the design for each custom home, it subcontracts out the physical labor to the tradesmen who actually build the home. Frontier’s use of subcontractors for the physical home construction is not enough to exempt Frontier from section 263A.  The creative design of custom homes is ancillary to the actual physical work on the land and is as much a part of a development project as digging a foundation or completing a structure’s frame. The construction of a home cannot move forward if the design step is not taken. Therefore, we reject Frontier’s argument and find Frontier is a producer of real property subject to section 263A.

The court went on to uphold the IRS capitalization of specific costs attributable to production activities to the home inventory, including part of the owner’s salary, employee bonuses, design costs, salary for office employees, employee benefits, payroll taxes, insurance, and other office expenses.   Because the taxpayer had not assigned costs to inventories, the court accepted the IRS numbers.

The moral?   The IRS believes in Sec. 263A, and so does the Tax Court.  There is no exception for creativity.   Your Sec. 263A result is likely to be better if you make the computations and assign costs yourself to production activities.  If you have gone through the effort to make a reasonable computation, the IRS agent is unlikely to quibble over the small stuff, in my experience.  But if you don’t bother to capitalize costs under Sec. 263A at all, they’ll do it for you, and you won’t care for the results.

Cite: Frontier Custom Builders, Inc., T.C. Memo 2013-231

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Tax Roundup, 3/12/2013: What tax protester “victory” really means.

Tuesday, March 12th, 2013 by Joe Kristan

20130312-2It just doesn’t work.  The “Tax Honesty Movement” got excited a few years back when Louisiana attorney Tom Cryer was acquitted on criminal tax charges.  For example:

The Internal Revenue Service has lost a lawyer’s challenge in front of a jury to prove a constitutional foundation for the nation’s income tax, and the victorious attorney now is setting his sights higher.              

“I think now people are beginning to realize that this has got to be the largest fraud, backed up by intimidation and extortion and by the sheer force of taking peoples property and hard-earned money without any lawful authorization whatsoever,” lawyer Tom Cryer told WND just days after a jury in Louisiana acquitted him of two criminal tax counts.

There’s just one problem with the idea that this struck a death blow to the income tax:  he still owes the taxes.  Even though he’s dead.  Being aquitted in a criminal tax case doesn’t make it legal to not pay taxes any more than the O.J. Simpson acquittal legalized multiple homicides in Brentwood.

The Tax Court yesterday ruled that Mr. Cryer owes taxes, interest and civil fraud penalties for tax years for which he didn’t file income tax returns.  From the Tax Court:

In essence, Mr. Cryer claimed that the income he received during the tax years at issue from certain “sources” was taxable under Louisiana law, but not under Federal law. In United States v. Clayton, 506 F.3d 405, 412 (5th Cir. 2007), the Court to which an appeal would lie in this case, cited and followed its prior unpublished opinion holding that “the argument that income derived from sources within the United States” is not taxable under Federal law is “patently frivolous” and “absurd”.

The moral: No matter how convincing they are on the Internet, “Tax Honesty” arguments don’t work.  They will not keep the IRS from taxing you.  When “winning” means staying out of jail but paying 75% civil fraud penalties, you set the bar for victory too low.

Cite: Cryer, T.C. Memo. 2013-69

Related: Daniel B. Evans, The Tax Protester FAQ

Prior Coverage:  ‘NOT GUILTY’ DOESN’T MEAN ‘NOT TAXABLE’

 

Nick Kasprak, Weekly Map: State and Local Sales Tax Rates, 2013 (Tax Policy Blog)

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Peter Reilly,  Carried Interest Debate Heats Up Without Much Light .  A reasonable outline of the issues involved in the so-called “loophole” for private equity:

If “carried interest” were really just a loophole it would not need such an elaborate fix.  In fact, it is based on fundamental principles of partnership taxation.

I don’t think it’s a problem, so I don’t think it needs fixing.  Related:  New York Times Dealbook, Why Carried Interest Is a Capital Gain.

 

Tony Nitti, Contrarian Tax Planning: Increasing Income To Take Advantage Of The AMT

Missouri Tax Guy, Is that Gift Taxable?

Martin Sullivan, Showdown in Kansas: Realtors vs. Governor (Tax.com).  Will Kansas eliminate the home mortgage deduction on its state returns?

Jeffrey M. Kadet,  Tax And Territoriality: The Corporate 99% Versus The Law School 1%

William Perez,  IRS Plans Spending Cuts Due to Sequestration.  They can’t answer their phones, but they still want to regulate preparers.

Kay Bell,  NYC soda ban overturned. Would a soda tax have been better?  Maybe better, but still unwise.

TaxGrrrl, Former Detroit Mayor Found Guilty On Multiple Counts, Including Tax Charges.  Poor Detroit.

 

Tax News from the Animal Kingdom.

Beavers’ tax-evasion trial to begin (WGNTV.com)

Former Bear Chris Zorich charged in tax case  (WGNTV.com)

Fmr. Eagle Freddie Mitchell pleads guilty in tax scheme (6ABC.com)

 

Remember, Calendar 2012 1120 and 1120-S returns are due Friday!

 

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Ex-linebacker Romanowski calls an audible. Bad call.

Thursday, February 21st, 2013 by Joe Kristan
20130221-1

Wikipedia image

Bill Romanowski couldn’t have played 16 years in the NFL by defying his coaches.  When he retired from the NFL, he appears to have become more difficult to coach.  That led to a $13 million investment loss, plus loss of deductions, according to a Tax Court decision yesterday.  Yet the Tax Court didn’t tack on personal foul accuracy-related penalties.

NFL players are notoriously bad at managing their money.  One source says “By the time they have been retired for two years, 78% of former NFL players have gone bankrupt or are under financial stress because of joblessness or divorce.”  Mr. Romanowski took a wise step to avoid this trap.  From the Tax Court:

From the late 1990s until early 2004 petitioners employed a financial adviser, Kathy Lintz. According to Mrs. Romanowski, Ms. Lintz “Basically * * * took care of everything” regarding petitioners’ finances, including managing their portfolio and allocating them a monthly stipend. Ms. Lintz also collected relevant information from petitioners in order to have their tax returns prepared by a certified public accountant (C.P.A.) and reviewed the completed tax returns before sending them on to petitioners. Ms. Lintz is a certified financial planner, but she is not an accountant or an attorney.

As a result, the Romanowskis faced retirement with the ability to finance a $13 million investment.  Then they decided to defy their coach.

According to the Tax Court, Ms. Lintz referred the Romanowskis to an attorney, a Rodney Atherton with Greenberg Traurig, LP, to deal with tax issues arising from a real estate investment in Colorado.  That’s where things started to go wrong.

During October 2003 Mr. Romanowski met with Mr. Atherton at the Greenberg Traurig office in Denver. At the meeting they discussed petitioners’ real estate investment issues as well as certain other issues. Mr. Atherton told Mr. Romanowski about a horse-breeding business, ClassicStar, which had retained Greenberg Traurig in July 2003 in connection with certain transaction and tax issues, including review of a tax opinion ClassicStar had received from another law firm. ClassicStar was working with Mr. Atherton, among others at Greenberg Traurig, to review the tax opinion.

Unfortunately, according to the Tax Court, the attorney wasn’t just looking out for the Romanowskis:

Although he testified multiple times to the contrary, the evidence is clear that Mr. Atherton received improper payments from ClassicStar as a result of petitioners’ choosing to enter the program. Mr. Atherton claimed that multiple documents regarding payments he received from ClassicStar were sent to him (from ClassicStar) in error. Many of those documents were chain emails which contained conversations between Mr. Atherton and ClassicStar employees in which Mr. Atherton used terms such as “fee splits” and “percentage” when discussing the amount of money ClassicStar would pay to him or Greenberg Traurig for bringing people into the program.

The Romanowskis fell in love with the horse program, which appears to have been intended as a tax shelter from the outset, what with “NOL illustrations” for net operating loss refunds being provided in the process.

The financial planner saw it that way:

On February 4, 2004, Ms. Lintz resigned as petitioners’ financial adviser, partially because of petitioners’ investment in the program. Ms. Lintz’s resignation letter states that petitioners choose to “enter into an aggressive tax shelter”, presumably the [ClassicStar] program.

In other words, the Romanowskis stopped listening to Ms. Lintz’s coaching and called their own play, investing $13 million into ClassicStar (much of it borrowed).  The rest is just predictable details.  The program never had the thoroughbred horses that it claimed, using most of the funds to breed less-desirable quarterhorses — and the Romanowskis went along.  Over time the program went bust and the Romanowskis lost their investment.  And now, they have lost their tax deduction on hobby-loss grounds, with the Tax Court upholding a $4.4 million deficiency.

The judge cut the Romanowskis slack on the penalties, though, apparently based on his belief that their attorney had a conflict of interest in advising the Romanowskis about the horse investment:

While a taxpayer familiar with the field of tax would have done several things differently from petitioners, petitioners were not sophisticated or knowledgeable in the field of tax. Petitioners had good reasons for the trust they placed in Mr. Atherton.

Decision for IRS, except for penalties.  And a “notify the carrier” moment for Greenberg Traurig.

The Moral?  Professional football may not be the best training for investments.  And when the coach tells you to run the play as called, there’s probably a good reason.

Cite: Romanowski, T.C. Memo 2013-55

Tony Nitti has more, as do the TaxProf and Russ Fox.

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What happens when a real attorney tries tax protest arguments?

Wednesday, August 1st, 2012 by Joe Kristan

Arguments that you don’t have to really pay federal income taxes never go away despite a long and dismal record of failure.  They are typically advanced by self-educated folks, often claiming to have spent hundreds of hours researching the tax law to prove that it doesn’t exist.  Non-lawyers tend to do poorly in advancing legal arguments.  If a real lawyer tried these arguments, might it go better?

Nope. 

A Maryland Attorney stopped filing tax returns after 2004.  The IRS eventually noticed.  The result was assessment of additional tax and penalties for fraudulent failure to file.  The attorney took the matter to Tax Court, where Judge Goeke sets the scene:

Petitioner testified that during 2006 “without looking for it” he discovered information which led him to conclude that he was not required to file Federal tax returns or pay Federal income taxes. As a result, petitioner has not filed a personal Federal tax return for any year since 2004.6 However, petitioner did make a $2,000 estimated tax payment to the U.S. Treasury for the 2005 tax year and also made a payment to the U.S. Treasury of $45,000 in April 2006, in connection with the filing of a Form 4868, Application for Automatic Extension of Time To File U.S. Individual Income Tax Return, for 2005. The $45,000 payment was credited to petitioner’s 2005 income tax account.7 Petitioner did not make any payments with respect to his 2006 tax.

So he discovered the secret to not paying tax but extended his 2005 return anyway?  Old habits are hard to break, I suppose.  The IRS started poking around, subpoenaing his bank records.  He didn’t care for that:

After learning of the subpoenas duces tecum issued to his banks, petitioner filed a motion to dismiss seeking to have his case dismissed without prejudice. Petitioner mailed a letter to M&T Bank in which he stated: “Because I am dismissing this case, the Subpoena issued by the IRS to M&T Bank should no longer be valid, and M&T Bank should not be required to respond by producing copies of my account records.” Shortly after he mailed this letter to M&T Bank, we denied petitioner’s motion to dismiss.

I know attorneys are “officers of the court,” but I don’t think that lets them quash subpeonas.

So how did the arguments fare in Tax Court?  Badly:

Petitioner repeatedly claims his arguments are not frivolous, but we disagree. Regarding petitioner’s constitutional arguments, courts have previously stated that “The constitutionality of our income tax system — including the role played within that system by the Internal Revenue Service and the Tax Court — has long been established.” Crain v. Commissioner, 737 F.2d at 1417-1418; see also Powers v. Commissioner, T.C. Memo. 2009-229; DiCarlo v. Commissioner, T.C. Memo. 1992-280. We therefore hold these constitutional arguments are frivolous.

The judge suggested that there might be more behind the arguments than an accidental discovery of the secret to tax-free lawyering:

Petitioner argues that he stopped filing tax returns only upon discovering information in 2006 which led him to conclude that he was not required to file tax returns or pay taxes. We believe it more likely that petitioner stopped filing tax returns because of his larger tax burden resulting from the increasing profitability of his law practice.

Rather than making the arguments more effective, it seems that being a lawyer made things worse for the taxpayer:

Petitioner is a highly intelligent individual with graduate degrees in both engineering and law. He is an accomplished businessman and attorney, having formed his own successful law practice which he incorporated as an S corporation for tax reasons after an accountant suggested doing so. Although he does not practice in the area of tax, nor did he take any tax courses in law school, petitioner has the intelligence and ability to recognize the frivolous, incorrect, and completely discredited nature of the arguments he has made in support of his failure to pay Federal taxes or file a Federal tax return. We find these facts are further evidence of fraud.

The judge upheld the assessed tax and the fraudulent failure to file penalties. 

The Moral? Crackpot arguments don’t become legal scholarship in the hands of a trained lawyer.  Garbage in, garbage out.

Cite: Worsham, T.C. Memo 2012-219.

UPDATE: The TaxProf has more.

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Tax pro’s airplane deduction misses the runway.

Tuesday, May 29th, 2012 by Joe Kristan

A man who operated tax prep businesses in California and Nevada probably felt that he knew how to arrange things to stay out of tax trouble.  The Tax Court decided otherwise last week in the case of Joseph Anthony D’Errico v. Commissioner

TPM was a C corporation set up by the taxpayer to provide management services to S corporations that he owned in the tax prep business.  It’s possible that he used the C corporation for the “bracket racket,” diverting enough income from the S corporations to fully use the 15% corporate bracket, but the case doesn’t say so.  The taxpayer sold his S corporation businesses in 2005, which would leave the taxpayer with a management C corporation with nothing to manage. A few weeks before the January 1, 2005 sale of his businesses, the corporation got another asset:

 In December 2004 TPM purchased a Cessna airplane (airplane) for $137,500. Mr. D’Errico  had a pilot’s license and several years of flight training at the time TPM purchased the airplane. Mr. D’Errico testified that TPM purchased the airplane in order for him to travel quickly between TPM’s purported office at the Barton Drive home in Stateline, Nevada, and his two active tax preparation corporations

So what does a mangement company with nothing to manage do with its airplane?

On December 29, 2004, TPM entered into an “Aircraft Leaseback Agreement” (leaseback agreement) which allowed the flight training company Flying Start Aero to make the airplane “available to the public for rental” for no more than 75 hours per month. The leaseback agreement stated that TPM was entering into the agreement “with the intention of generating some revenue for the purpose of offsetting a portion of the aircraft operating costs”. Even though the airplane was leased to Flying Start Aero, TPM was still responsible for airplane expenses such as insurance and maintenance. The lease was canceled by Flying Start Aero in early 2006 upon TPM’s failure to pay such expenses.

The airplane was not used in TPM’s tax management related business during 2005 or 2006. Petitioner claimed in his testimony that he used the airplane on business related trips in both January and April 2007. However, Mr. D’Errico did not introduce a log of his airplane use during 2007 into evidence. The only 2007 airplane records summarized expenses one Matthew Laughlin incurred in a trip to Los Angeles. Mr. Laughlin had been Mr. D’Errico’s certified flight instructor since Mr. D’Errico began to fly in 2001. Mr. D’Errico testified that Mr. Laughlin “came out from Denver to talk to me about multiple uses for the airplane. He thought it would be a good idea for us to start our own flight school, in which he would have a flight school and I would rent the airplane to his flight school.”

Perhaps it was an excellent idea, though nothing apparently came out of it.  Deducting the airplane expenses in the corporation also seemed like a good idea:

On its TYE April 30, 2006, tax return TPM reported income from the airplane rental of $21,869, airplane expenses of $17,042, and airplane depreciation of $11,408. On its TYE April 30, 2007, tax return TPM reported no airplane rental income,7 airplane expenses of $19,351, and total depreciation of $7,324.

The corporation also deducted expenses for a Chevy Tahoe that the taxpayer testified was “exclusively for business use,” according to the opinion.  The corporation also deducted phone expenses, “supplies,” and meals.  The corporation paid “rent” to the taxpayer for an office in his home.  Also:

TPM deducted utility expenses for the Barton Drive home of $2,695 and $2,491 for its TYE April 30, 2006 and 2007, respectively. These expenses included cable television, Internet, gas, electric, and certain repairs.

Well, the corporation didn’t have a business to manage.  Maybe having cable and Internet gave it something to do. 

The Tax Court didn’t like the deductions.  It had this to say about the airplane:

TPM argues that the airplane was necessary for its tax management business because Mr. D’Errico had to travel between Nevada and southern California to fulfill TPM’s business obligations to [his tax preparation S corporations sold in 2005]. However, at the time TPM purchased the airplane, Mr. D’Errico knew that he was going to be selling… TPM has produced no evidence that the airplane was used in TPM’s tax management business after 2004.

The Tax Court didn’t just disallow the deductions (my emphasis):

As discussed above, TPM failed to establish that it conducted business-related activities at the Barton Drive home, with the result that the rent payments made to Anthony D’Errico are not deductible by TPM. Further, Mr. D’Errico failed to introduce evidence to support his claim that he used only a portion of the Barton Drive home as his personal living area. Neither the lease between TPM and Anthony D’Errico nor the sublease between Mr. D’Errico and TPM identifies certain areas of the Barton Drive home reserved for TPM’s business use. We find that Mr. D’Errico derived a personal benefit from his use of the entire Barton Drive home and received constructive dividend income as a result of the rent payments made by TPM.

Petitioners have also failed to prove TPM’s entitlement to deductions for the airplane expenses. Further, petitioners have failed to introduce evidence to show that Mr. D’Errico did not benefit from TPM’s purchase of the airplane or TPM’s paying for rental of another airplane for Mr. D’Errico to fly. Mr. D’Errico admitted that he “enjoy[ed] flying and everything” and that he used the rented airplane to continue his flight training. Mr. D’Errico also discussed using TPM’s airplane to start a flight training school with his certified flight instructor, Mr. Laughlin. Finally, petitioners failed to substantiate any amount of business travel or lack of Mr. D’Errico’s personal use of the airplane during the years at issue. We find that Mr. D’Errico derived a personal benefit from the airplane expenses paid by TPM and received constructive dividend income as a result.

When an expense of a C corporation is changed to a “constructive dividend” in an audit, the taxpayer loses twice: the corporation loses a deduction, but the taxpayer gets extra dividend income. 

The Moral? Sometimes when taxpayers sell their business, they think it might be a good idea to keep the business around “in case they need it.”  That’s fine, if pointless, but when you don’t have a business any more, you no longer have a reason to claim business expense deductions.  If the corporation pays arguably personal expenses, you run the risk of losing the corporation deduction while boosting your personal tax bill.   That’s true no matter how much you know about taxes.

Cite: D’Errico, T.C. Memo 2012-149.

 

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Million dollar mortgages: when division = subtraction

Friday, May 18th, 2012 by Joe Kristan

Filing separate returns can be an expensive move.  It was more expensive than usual for a Brooklynette in Tax Court yesterday.

The taxpayer bought a residence for $1.35 million in 2007.  She lived there with her husband and paid all of the $1 million  mortgage, including $49,739 in interest during 2007. For reasons not made clear in the Tax Court opinion, she filed her 2007 return “married filing separate,” rather than jointly with her husband.  

The tax law limits how much home mortgage interst you may deduct based on the amount of the loan.  For joint filers, you can only deduct interest on up to $1.1 million in home mortgage debt: $1 million “acquisition indebtedness” and $100,000 in “home equity indebtedness.”  As with many other deductions, the tax law cuts these amounts in half for married-filing-separate returns.  The Tax Court takes up the story (my emphasis):

There is no dispute that the property meets the definition of a qualified residence and that the mortgage interest petitioner paid is qualified residence interest because it was paid on acquisition indebtedness and home equity indebtedness secured by the property.

In his notice of deficiency respondent allowed petitioner to deduct home mortgage interest on a total of $550,000 of indebtedness ($500,000 in acquisition indebtedness under section 163(h)(3)(B)(ii) plus $50,000 of home equity indebtedness under section 163(h)(3)(C)(ii)). Petitioner claims that she should be allowed to deduct interest paid on the entire $1 million of indebtedness.

Petitioner correctly asserts that the parenthetical indebtedness limitations of section 163(h)(3)(B)(ii) and (C)(ii) are $550,000 for each spouse filing a separate return. However, petitioner further claims that these limitations were enacted so that, collectively, a married couple filing separately can claim $1.1 million of aggregate indebtedness across both of their returns and is not limited to claiming a maximum of $550,000 on any one return. We disagree.

In short, the Brooklynette said that if her husband wasn’t using all of his deduction on his separate return, she could use it for him.  Separate returns don’t work that way.  Strangely, if they had stayed unmarried but moved in together, she could have deducted the whole $1.1 million.

Citation: Bronstein, 138 T.C. No. 21

Related:

Sophy’s choice: unmarried couples get only one $1.1 million deductible home mortgage loanf

Mortgage deduction traps?

Rick Santorum makes Obama-esque tax planning move

 

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At-risk rules still bite

Wednesday, April 4th, 2012 by Joe Kristan

Passed in the 1970s to close a long-forgotten generation of tax shelters, the At-risk Rules of Section 465 still have some teeth.  A New York man learned this the hard way in Tax Cour yesterday.

Our taxpayer was an owner of a family window and door manufacturer.  An old friend turned him on to an opportunity to invest in an oil and gas lease partnership.  Our New Yorker bought in for $110,000 cash and a $200,000 “subscription note.”

 His 2001 return claimed a non-passive loss of $275,045 from the partnership.  He deducted another $15,003 in 2002, while picking up $16,000 in interest income from the partnership.  The partnership distributed $32,407 to him in 2003 in termination of his interest.  He never paid off any of the $200,000 “subscription note.”

So where we stand: for a net investment of $77,593 (the $110,000 contribution less the terminating distribution), he received tax losses of $274,048.  Sweet.

Form 1065 K-1 capital and debt allocations

Except for the At-risk rules.   These rules allow you to take deductions attributable to borrowings only if you are “at-risk” for the debt — if you are on the hook personally if they go bad.  They arose when equipment leasing deals and cattle partnerships would “invest” in wildly-overpriced equipment or cattle purchased with non-recourse debt that would never be paid, depreciating the entire inflated price.  The rules also provide that if you get off the hook from your “recourse” debt, you can have income to the extent you get off the hook for debt you used to claim deductions.  That’s what happened here.  From the Tax Court opinion:

We find that the subscription note and assumption agreement liabilities were genuine debts in 2002 but were not genuine debts in 2003. Our conclusion turns primarily on the lack of payments made and enforcement sought after the termination and liquidation of PW Partnership at the beginning of 2003.

We also note that additional facts support our conclusion that the debt became nongenuine in 2003. No demand for payment was made by any party upon the subscription note maturity date of December 31, 2009, and petitioner had made no arrangements to pay the balance due as of the time of trial, even though the amount due was allegedly accruing interest at 15%. To the extent petitioner claims the subscription note and related assumption agreement still represented genuine debts at the time of trial, we do not agree.

What did that mean for the taxpayer?

…section 465(e) provides that if zero exceeds the amount for which the taxpayer is at risk in any activity at the close of any taxable year the taxpayer shall include in his gross income for such taxable year an amount equal to the excess.

Petitioner was initially at risk for $310,000 in PW Partnership and reduced his risk to zero in 2003 as a result of receiving flowthrough losses and distributions totaling $310,000.6 After he had reduced his amount at risk to zero, his liability for $200,000 of his original amount at risk became nongenuine. This lowered his amount at risk to negative $200,000 in 2003. See sec. 465(b)(2). We therefore hold that petitioner must recognize a $200,000 gain for 2003 pursuant to section 465(e).

Your partnership K-1 has information to help you know whether you are “at-risk” for losses.  Section K lists the partner’s share of partnership liabilities.  If you have losses in excess of your investment and your losses over time also exceed the “recourse” debt on section K of your K-1, there’s a good chance you have an “at-risk” problem.

Cite:  Zeluck, T.C. Memo 2012-98

Related: Understanding K-1s: is my basis ‘at-risk’?

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It’s hard to be a real estate professional

Friday, January 13th, 2012 by Joe Kristan

It’s been a rough run in recent years for folks in the real estate game, for non-tax reasons. The tax law doesn’t make it easy to be a real estate professional either, as a Pennsylvania man learned yesterday from the Tax Court.
The tax law’s “passive loss” rules only allow you to deduct “passive” losses to the extent of passive income, except when you dispose of the activity in a taxable sale. For most taxpayers, rental real estate losses are automatically passive under the tax law. For non-real estate activities, the tax law determines whether you are passive based on the extent of your participation in the business.
“Real estate professionals” have a special deal. Their real estate losses aren’t automatically passive; they are instead tested under the usual “material participation” standards. That makes everyone want to be a real estate pro, at least on their tax returns. Unfortunately the tax law doesn’t make it easy to be a real estate pro. To qualify, you have to:
- Spend at least 750 hours per year participating in a real estate trade or business that you own, and
– You have to spend more time on real estate activities than other activities.

The second requirement makes it very difficult for anybody with a full-time non-real estate job to be a real estate pro under the tax law. It was too high a bar for Mr. Vandergrift from Pennsylvania (citations omitted; my emphasis):

Petitioners maintain Mr. Vandegrift qualifies as such an individual. He testified that over one-half of the total time he spent in business activity was devoted to the real estate business. We found Mr. Vandegrift to be generally honest and forthright, but his time estimate is suspect given his employment as a salesman for an employer in a business unrelated to the real estate activity. His subjective estimate also suffers from a lack of contemporaneous verification by records or other evidence.

We have held that the regulations do not allow a postevent “ballpark guesstimate” of time committed to participation in a rental activity. We are forced to find on the record before us that petitioners have failed to carry their burden of establishing that Mr. Vandegrift spent over one-half his work time in the real estate business.

The only case I’ve seen where a taxpayer with a full-time day job qualified as a real estate professional had two unusual facts: A cushy day job that didn’t require a lot of time, and a taxpayer who kept meticulous time records. Absent those facts, someone with a non-real estate day job is probably not going to qualify as a real estate pro under the passive loss rules.
Cite: Vandegrift, T.C. Memo. 2012-14

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Airplane deduction crashes

Thursday, September 1st, 2011 by Joe Kristan

Mr. Douglas owns a trucking company S corporation that specializes in “critical timing” deliveries. That business is only as good as your drivers.
He decided that an airplane would be handy to get drivers to where they need to be in emergencies. The S corporation bought a Cessna 172 in 2007 for and Mr. Douglas started taking flying lessons. By the end of 2007 he had not advanced beyond the flying lessons and held only a student pilot’s license.

Flickr image by dimworld under Creative Commons license.
The S corporation took a Section 179 deduction in 2007 for the Cessna’s $135,000 purchase price. Section 179 allows taxpayers to deduct in one year a limited some assets that would otherwise have to be capitalized and depreciated. One catch: an asset has to be “placed in service” by year-end to qualify for the deduction. The IRS said the flying lessons didn’t count, so it was off to Tax Court, where things went badly:

An aircraft cannot be considered ready and available for business use without a suitable pilot to fly it. During 2007 no employees or officers of Bantam held a pilot’s license that would have enabled them to use the aircraft to transport a replacement driver. Petitioners’ vague assertion that there were “stand-by pilots” in 2007 is not credible. There is no evidence in the record, aside from Mr. Douglas’ statement, that there were any “stand-by” pilots for the aircraft; and there is no evidence at all that would support a finding that Bantam had access to standby pilots on an expedited schedule, which was the alleged business reason for the aircraft. There is no evidence in the record of any agreement between a qualified pilot and Bantam that might suggest his or her availability for the purpose of flying drivers to disabled vehicles on short notice.

Decision for IRS. Consolation prize for taxpayer: he convinced the Tax Court that he relied on his preparer in taking the deduction, so no penalties were assessed.
The Moral: No pilot, no deduction.
Cite: Douglas, T.C. Memo 2011-214.
Related: Section 179: First, you have to have a business

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Ken Lay wins in Tax Court. But he’s still dead.

Tuesday, August 30th, 2011 by Joe Kristan

Ken Lay got $10 million from Enron in a deal structured as a sale by him of an annuity contract to Enron. As the contract cost him $10 million, he reported no gain on his 1040 on the transaction.
The IRS said that he still owned the contract after getting the $10 million, so it was all taxable income. Yesterday the Tax Court decided for Mr. Lay — well, technically, for his estate, as Mr. Lay died in 2006.
Former Enron advisor Paul Krugman has not commented on the decision.
More from The TaxProf and Kay Bell.
Cite: Lay, T.C. Memo. 2011-208

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Perhaps he should have phrased that another way

Friday, December 3rd, 2010 by Joe Kristan

If you build and sell one house, one time, any gains are probably capital gains. If you build a bunch and cross the line to being a “developer,” you start generating ordinary income. The distinction between “developer” and “investor” is murky and has generated lots of litigation. One thing is clear, though: if you are “in the business” of developing and selling houses, you have ordinary income.
Which is why one taxpayer may regret his choice of words in his Tax Court testimony. This taxpayer had treated gains on the sale of real estate as capital gains; the IRS said it was ordinary. How did the taxpayer phrase it to the judge?

“I’m in the business of buying material, fixing houses and reselling them.”

That made the judge’s job pretty easy:

Petitioners’ real estate transactions were conducted in the ordinary course of a trade or business and not for investment purposes. Accordingly, we find that respondent correctly treated petitioners’ real estate activities as giving rise to ordinary income derived from a trade or business.

The taxpayers represented themselves in Tax Court. I suspect an attorney might have warned them to watch their language more carefully.
Because the income was trade or business income, it also triggered self-employment tax on top of the ordinary income tax. On top of that, the returns were filed late — 1998, 1999 and 2000 returns were filed in 2002 — so another 25% of the underpayment was tacked on as a late filing penalty. I can’t help but think that the late filing of three years of returns helped attract IRS scrutiny — which is another reason timely-filing is wise.
The Moral? If you litigate an issue it Tax Court, you won’t do well if you agree with the IRS argument in your testimoney.
Cite: Garrison, T.C. Memo. 2010-261

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