Posts Tagged ‘Judge Gustafson’

Tax Court makes IRA ownership of your business even more dangerous

Friday, May 10th, 2013 by Joe Kristan

20120511-2Owning a closely-held business through your Individual Retirement Account has always been a high-wire act of tax compliance.  The Tax Court snipped one end of the wire for many IRA-owned corporations yesterday.

The biggest danger of owning your business in an IRA has been the risk of having a “prohibited transaction.”  The tax law has hair-trigger rules for pension funds and other exempt organizations to prevent abuse of the funds by related parties or trustees.

Prohibited transactions are foot-faults.   If you have one, the 15% tax applies to the “amount involved” for each year of the transaction, even if you didn’t mean to do any harm — even if you in fact did no harm.  There is no “good-faith” out.   Worse, prohibited transactions terminate your IRA, triggering any untaxed income within the account.

In yesterday’s case, a taxpayer acquired a C corporation through an IRA.  The taxpayer then guaranteed loans to the corporation.  The Tax Court said this constituted an “indirect extension of credit” to the IRA (my emphasis):

 As the Commissioner points out, if the statute prohibited only a loan or  loan guaranty between a disqualified person and the IRA itself, then the prohibition could be easily and abusively avoided simply by having the IRA create a shell subsidiary to whom the disqualified person could then make a loan. That, however, is an obvious evasion that Congress intended to prevent by using the word “indirect”. The language of section 4975(c)(1)(B), when given its obvious and intended meaning, prohibited Mr. Fleck and Mr. Peek from making loans or loan guaranties either directly to their IRAs or indirectly to their IRAs by way of the entity owned by the IRAs.

That triggered both a prohibited transaction and the termination of the IRA.  The corporation was sold in 2006.  The termination of the IRA status meant the gain was taxable on the IRA-owner 1040s, rather than sheltered in an IRA.  Worse, the court upheld “accuracy-related” penalties.

Have you ever tried to get a loan for a closely-held corporation without personal guarantees?  It can be difficult, especially when you have a new business.  Unfortunately, owners of startups are often sorely-tempted to use their IRAs as owners, as it may be their best source of equity capital.  This case shows how dangerous IRA ownership of your business can be.

I suspect there are a lot of similar taxpayers out there, with much riding on any appeal of this case.  The consequences to these folks will be catastrophic, in the same league as the ruin caused by Incentive Stock Options (ISOs) exercised just prior to the dot-com collapse.   The ISO disaster was bad enough to get Congress to enact legislative relief.  This could also get Congressional attention.

Cite: Peek, 140 T.C. No. 12.

 

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F. Lee Bailey, tax litigator

Tuesday, April 3rd, 2012 by Joe Kristan

F. Lee Bailey once had fame as an attorney like a rock star.  His name is no longer a popular synonym for “awesome lawyer,” so maybe that’s why he decided to see whether he should try his hand at tax litigation. 

He certainly chose a difficult case — his own.  The IRS was after him on several issues, the biggest of which was an attempt to tax him on client funds that he was holding (long story involving a foreign fugitive).  The IRS wanted to tax him on about $5.9 millions of funds on the grounds that it was available for his personal use.  The Tax Court assessed him on about $450,000 of the funds that he “wrongly appropriated” and later repaid.

Mr. Bailey did less well on the hobby loss portion of his case.  He failed to convince the judge that his custom-built yacht was a “for-profit” activity.  One of the elements of the “hobby loss” tests is whether the taxpayer derives personal pleasure from the activity.  Mr. Bailey said the yacht was just no fun.  From the Tax Court opinion:

The Commissioner contends that Mr. Bailey took a great deal of personal pleasure from sailing on the Spellbound with his family and friends, but Mr. Bailey claims that “[i]t’s no fun to drive a boat”. Mr. Bailey testified that the steering wheel and navigational instruments of the Spellbound are isolated from the rest of the deck, and the pilot is therefore isolated from the party-goers on the deck.

While it may be true that Mr. Bailey did not enjoy piloting the yacht, the record belies the claim that he derived no personal pleasure from it. First, the Spellbound was built to Mr. Bailey’s specifications, and he testified that it was beautiful. Second, the record does not show that Mr. Bailey always took on the job of piloting the Spellbound. PBR hired a captain and crew to sail and maintain the Spellbound, and Mr. Bailey could have used their services to pilot the yacht any number of times. Even assuming arguendo that Mr. Bailey piloted the Spellbound on every personal trip–and that he disliked the task–we find that he derived pleasure from sharing the yacht with his family and friends and that he anticipated doing so when he purchased the yacht in 1989.

This factor–elements of personal pleasure–is in the Commissioner’s favor.

The 143-page opinion covers over a dozen different tax disputes the famous litigator had with the IRS, with the IRS prevailing on most of them, to the point that the court upheld an accuracy-related penalty

Peter J. Reilly has much more. 

Update: The TaxProf also has more.

Cite: Bailey, T.C. Memo 2012-96

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You’re tax-exempt? That doesn’t always mean you’re tax-exempt

Thursday, September 29th, 2011 by Joe Kristan

While the tax law provides many entities the opportunity to be tax-exempt, there are limits. The government doesn’t want tax exempt entities to use their exemption to compete with taxable businesses. It wouldn’t be fair to the taxable entities, and it would cut into the government’s action.
That’s why we have the “Unrelated Business Income Tax.” This tax can be understood as the corporation income tax applied to business activity of otherwise tax-exempt entities. It’s something exempt entities, including IRAs and pension funds, should be careful of any time they have income from things other than interest, dividends and capital gains. And it can crop up in surprising ways, as the National Education Association learned yesterday in Tax Court.
The NEA publishes two magazines for its members, and it generates unrelated business income from selling ads. The NEA deducted its circulation costs against this income. The IRS said that because the magazines are available to all NEA members, it was required to allocate a portion of its dues income to its income from the magazines. The Tax Court sided with the IRS, saying the tax law

…requires an allocation of membership dues to circulation income if the exempt organization’s members have a legal right to receive the publications. For the years at issue, NEA members had such a legal right to receive the periodicals. The fact that NEA also made most of the content of the periodicals available on the Internet does not change this conclusion. Consequently, the IRS was correct in requiring NEA to allocate a portion of its membership dues to circulation income.

The decision, unless reversed on appeal, will cost NEA $1.1 million. It reminds us that tax exempt status has its limits, and that exempt organizations need to be careful with investments that aren’t plain-vanilla.
Cite: National Education Association of the United States, 137 T.C. No. 8
Related: Got UBIT? Why IRAs need to be careful where they invest

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Tax Court: No casualty loss deduction for casualties you inflict

Thursday, March 10th, 2011 by Joe Kristan

The tax law allows an itemized deduction for “casualty losses” not covered by insurance, to the extent they exceed 10% of your adjusted gross income. A taxpayer yesterday learned that it doesn’t apply to casualties that you inflict.
A taxpayer ran over a pedestrian while driving, and the victim later died of the injuries. The taxpayer had to pay a $250,000 wrongful death settlement that apparently wasn’t covered by insurance. They deducted the payment as a casualty loss. The taxpayer, whose last name is Pang, said the payment was the result of a casualty, after all — the casualty suffered by the poor pedestrian. The Tax Court said that the tax law doesn’t mean that kind of casualty:

The Pangs maintain, however, that their $250,000 settlement payment is deductible under section 165(c)(3) as a casualty loss because Webster’s Dictionary defines “casualty” as “[l]osses caused by death, wounds” and the accident victim’s death in December 2002 was certainly a casualty.
This issue is resolved not by Webster’s definition of “casualty” but by the Code’s provisions for “casualty loss” quoted above. Moreover, the Pangs’ position conflates two distinct things — the victim’s casualty (which occurred when he died in 2002) and the Pangs’ financial loss (which occurred when they made their payment in 2004)4 — and does not explain how the “casualty” of the victim results in a deductible “casualty loss” for the Pangs under section 165.
This Court has held that “physical damage or destruction of property is an inherent prerequisite in showing a casualty loss.” Citizens Bank of Weston v. Commissioner, 28 T.C. 717, 720 (1957), affd. 252 F.2d 425 (4th Cir. 1958). The Court of Appeals for the Ninth Circuit, to which an appeal in the present case would lie, likewise requires physical damage to the taxpayer’s property as a prerequisite to a casualty loss deduction… As a result, although the death of the pedestrian was certainly a “casualty” in the general sense of the word, and although one could say that the Pangs suffered a subsequent economic “loss” when they paid the wrongful death settlement, we cannot hold that Congress intended such a payment to be a “casualty loss” within the meaning of section 165(c)(3).

Decision for IRS.
The Moral? Make sure your auto or umbrella policy covers this sort of thing; The tax law won’t help you with the cost of racking up a body count.
Cite: Pang, T.C. Memo. 2011-55
UPDATE, 3/11/2011: The TaxProf has more.

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