Posts Tagged ‘Judge Kroupa’

Tax Roundup, 1/28/14: Another Iowa ESOP debacle. And: soft skills!

Tuesday, January 28th, 2014 by Joe Kristan


20120920-3
Iowa gets all of the good bad ESOP cases.  
Thanks largely to the energetic work of a single ESOP evangelist in the 1980s and 1990s, Iowa has been treasure trove of cases involving faulty employee stock ownership plans.  The pinnacle of these cases may have been the Martin v. Feilen case, finding violations sufficient for the Eighth Circuit to rule that a district court “abused its discretion” by not banning the Iowa ESOP evangelist from doing any further ERISA work.

Iowa’s bad ESOP history got another chapter yesterday in Tax Court.  The ESOP involved a Rockwell, Iowa S corporation, which had an ESOP owner.  The non-ESOP shares were owned by the corporation’s sole employee and his wife.

So many things can go wrong with this sort of arrangement, and they all did — starting with Sec. 409(p).  Judge Kroupa explains (some citations omitted, emphasis added):

  Responding to perceived abuses, Congress in 2001 enacted section 409(p), which generally limits the tax benefits available through an ESOP that owns stock of an S corporation unless the ESOP provides meaningful benefits to rank-and-file employees.

There are significant tax consequences when an ESOP violates the section 409(p) requirements. For one, an excise tax equal to 50% of the total prohibited allocation is imposed. Sec. 4979A. Furthermore, the ESOP will not satisfy the requirements of section 4975(e)(7) and will cease to qualify as an ESOP. 

Those are pretty severe penalties.  So how do you violate Sec. 409(p)? Roth and Company alum Nancy Dittmer explains:

Section 409(p) is satisfied if “disqualified persons” do not own 50% or more of the S corporation’s “stock.” This stock includes allocated and yet-to-be allocated ESOP shares, synthetic equity of the S corporation, and any shares held directly in the S corporation. The ESOP shares and any synthetic equity are considered to be “deemed-owned” shares for purposes of Section 409(p).

In general, a disqualified person is any ESOP participant who owns 10% or more of the ESOP’s stock. 

20140128-1As our Rockwell taxpayer was the only employee of the S corporation and, by attribution, the only owner of the ESOP, he owned 100% of the shares.  Those of you who are good at math will realize that 100% exceeds 50%, and 409(p)’s excise tax and plan disqualification applies.

So things looked dark for the Rockwell ESOP.  Yet there was a glimmer of hope — not only was the ESOP screwed up, so was the S corporation.  The corporation had 2 classes of stock, which normally disqualifies an S corporation election.  If the corporation isn’t an S corporation, it can’t violate 409(p)!  Alas, Judge Kroupa decided here that two (OK, more than two) wrongs didn’t make a right:

     Petitioner represented to respondent that it qualified as an S corporation for 2002 when it filed its election to be treated as such. Respondent relied on this representation for 2002 because petitioner reported on its 2002 Form 1120S that it owed no income tax because of its electing to be treated as a passthrough entity under subchapter S. The statute of limitations on assessment now bars respondent from adjusting petitioner’s income tax liability for 2002. See sec. 6501(a).

Petitioner was silent regarding its desire to be treated as something other than an S corporation for 2002. Petitioner cannot avoid the duty of consistency, however, by simply remaining silent. Allowing silence to trump the duty of consistency would only encourage gamesmanship and absurd results. Therefore, we will treat petitioner as an S corporation for 2002 under the duty of consistency. 

This bundle of bad facts resulted in $161,200 in taxes and another $76,000 or so in penalties.

The moral?  In spite of media reports, it can be dangerous to game the ESOP rules to avoid tax on S corporation income.  There are many hazards and much legal complication.  If you want to have an ESOP, be sure to bring in a specialist.

Cite: Ries Enterprises, Inc., T.C. Memo 2014-14.

 

Me: IRS gives mulligan to elect portability for $5 million estate exclusion

Paul Neiffer, Not Too Late to Make Portability Election!  I have more here.

Kay Bell, Decoding your W-2

TaxGrrrl, Do You Need To File A Tax Return In 2014?   

 

TaxProf, The IRS Scandal, Day 264

Kyle Pomerleau, The U.S. Has the Highest Corporate Income Tax Rate in the OECD (Tax Policy Blog):

OECD corporate rates

And as Iowa has the highest corporate rate in the U.S., at 12%, we’re number 1!  In a bad way.

 

Robert D. Flach is right on time with your Tuesday Buzz!

 

Career Corner: Soft Skills Are For Pansies (Going Concern)

 

 

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Tax Roundup, 12/12/12: Iowa income tax reform on hold? And Warren calls for more taxes on non-Warrens.

Wednesday, December 12th, 2012 by Joe Kristan

What’s missing here?  Governor Branstad had an interview with the Associated Press about his plans for the coming legislative year.  Topics covered include

- Property tax reform

- Education reform

- “Accepting” higher spending.

Anything missing?  Not a word here about income tax reform.  The governor had been talking about income tax reform in the runup to the elections, but hasn’t said much about it since.  I’m getting the feeling that Iowa’s chilly business tax climate isn’t warming up anytime soon.

What the current model of the Iowa tax law would look like if it were a car.

They could have thought about that before they voted for it.  From Byron York:

Sixteen Democratic senators who voted for the Affordable Care Act are asking that one of its fundraising mechanisms, a 2.3 percent tax on medical devices scheduled to take effect January 1, be delayed.  Echoing arguments made by Republicans against Obamacare, the Democratic senators say the levy will cost jobs — in a statement Monday, Sen. Al Franken called it a “job-killing tax” — and also impair American competitiveness in the medical device field.

You mean taxes matter?  Who knew?  (via Instapundit)

 

Warren Buffett calls for another tax increase on people who aren’t Warren Buffett.  From CNBC:

Warren Buffett isn’t limiting his call for higher taxes to a minimum rate for very rich Americans who get a large chunk of their income from investments.

He’s also one of several dozen wealthy people who have signed a statement calling for a “strong tax on the largest estates.”  It’s been released by a group called “United For a Fair Economy.”

Like the income tax hikes he supports, this increase wouldn’t affect him, because he plans to leave his pile to the Bill and Melinda Gates Foundation, where it will escape estate tax.  I’ll take him seriously if he calls for reducing or eliminating the estate tax charitable deduction.  Going Concern has more.

Peter Reilly, Warren Buffett And George Soros Want Higher Estate Tax Than Obama Proposes

 

In Iowa he’d have to collect sales tax too.  The Tax Court yesterday told a Houston patrolman learned that he was in independent contractor when performing security services off-duty.  From the decision (citations omitted):

An employment relationship is indicated when the service recipient has the right to control the details and means by which the worker performs the services.  In contrast, independent contractor status is indicated where the opposite is true.  This factor is generally critical in determining the nature of a working relationship.  Petitioners did not demonstrate that the third parties maintained the requisite right to control Mr. Specks in the performance of the security services.

Also, his employers clients didn’t withhold taxes from his payments.  If there’s no withholding, that’s a strong clue that you are not an employee.  Off-duty officers in Iowa are also expected to collect sales tax for their services.  (Specks, T.C. Memo 2012-343)

 

Jack Townsend links to a study of plea agreements in federal criminal cases.  While much of his post is of interest only to attorneys, this quote from the study should be read by anybody tempted to file a return (or not file) based on the idea that the income tax is unconstitutional (my emphasis):

These constitutional challenges do not work out well for defendants. Almost twenty years ago, the United States Supreme Court held that a considered, fundamental disagreement with the constitutionality of the tax laws does not represent a valid defense to a charge of tax evasion. Yet even with this guidance, many tax resisters remain unwilling to concede the point, and demand to take their cases to trial. One exasperated federal judge catalogued some of the “tired arguments” advanced by these defendants: 

That defendants continue to press these arguments in court despite their nonexistent odds of success underscores how many parties simply do not behave as extrapolation from likely trial outcomes might predict.

There’s no point trying to convince tax protesters that they are wrong in theory.  All you can point out is that their arguments never work when it matters.

 

Patrick Temple-West,  Boehner tries to keep GOP ranks behind him, and more (Tax Break)

TaxGrrrl,  Boehner, Obama Talks Heat Up But Still No Deal On Taxes, Spending

 

Jason Dinesen,  What Couples in Same-Gender Marriages Should Be Doing, Tax-Wise, Before Supreme Court Ruling.  I think it’s likely the court will require the IRS to recognize same-sex marriages, and Jason’s post is a must read for affected taxpayers. 

Paul Neiffer,  File Your Gift Tax Return.  It gets the statute of limitations started.

David Brunori,  Time To Get Rid of the Deduction for State And Local Taxes.  (Tax.com)  When the taxes arise from business income, like from S corporations and partnerships, I disagree.  It any case, it should only come with rate reductions.

Brian Strahle,  State Budgets and Taxes:  What Will Happen in 2013?

Jim Maule,  Ohio as Role Model for Tax Policy

Buzz time!  It’s Wednesday somewhere, so Robert D. Flach has a new roundup of good tax stuff.

The Critical Question:  Is your response to taxes genetic? (Kay Bell)

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Tax Court: no homebuyer credits for S corprorations, LLCs.

Tuesday, May 22nd, 2012 by Joe Kristan

Flickr Image by Joe Shlabotnik under Creative Commons License

The futile and wasteful homebuyer credits are history, except for cleaning up the messes in court.  The Tax Court yesterday ruled that two sets of homebuyers foot-faulted their way out of their credits — one by by having their corporation buy their house, and one by using an LLC.

The S corporation case involved a Nevada home through their Wyoming S corporation, “Santsu,” which also owned rental properties that the couple operated.  The tax court takes up the story:

Sanstu was the legal owner of the property. The property was petitioners’ principal residence. Petitioners had not owned another principal residence during the prior three years.

Petitioners claimed the $8,000 tax credit on their Form 1040, U.S. Individual Income Tax Return, for 2009. Sanstu did not claim the tax credit on its Form 1120S, U.S. Income Tax Return for an S Corporation, for 2009. Respondent issued a deficiency notice to petitioners, disallowing the tax credit.

The court said that didn’t work because the tax law allowed the credit only to “individuals” (Citations omitted, emphasis added):

We hold that S corporations are not individuals for purposes of section 36.  A corporation, at its core, is a business entity organized under State or Federal law, whether an association, a company or another recognized form. A corporation that satisfies certain criteria may elect small business status for Federal income tax purposes.  An S election does not alter the corporation’s corporate status; it merely alters the corporation’s Federal tax implications.  Items of income, deduction, loss and credit generally pass through to the shareholders.  S corporations remain freestanding entities “independently recognizable” from their shareholders.  Individual taxpayers, on the other hand, are subject to tax under section 1, which sets rates for married and unmarried individuals, heads of households, and estates and trusts.  A corporation’s income is not subject to tax under section 1. Rather, tax is imposed on corporate income under section 11. Accordingly, corporations are not individuals within the meaning of section 1.

As an extra kick in the teeth for the taxpayers, apparently an IRS representative had told them it was OK to use the S corporation.  Tough, says the court:

It is unfortunate when a taxpayer receives inaccurate information. We have recognized, however, that incorrect legal advice from an IRS employee does not have the force of law and cannot bind the Commissioner or this Court.

If there’s real money at stake, don’t take the word of some IRS person on the phone.  Get it in writing or get professional help.

The LLC Case involved the purchase of a New Jersey residence by “Jacco,”  a family LLC owned by the taxpayers and their four children.  Using similar reasoning as in the S corporation case, the court said that the taxpayers were out of luck because the LLC is not an individual.  The taxpayer tried another way around, saying that the LLC should be disregarded as the “alter ego” of the taxpayers.  No go, said the court:

Petitioners contend that Jacco was actually their alter ego and, therefore, should be disregarded for purposes of deciding whether petitioners are entitled to claim the first-time homebuyer credit personally. By contending that Jacco was their alter ego, petitioners seek to have the Court pierce the corporate veil. Respondent contends that, pursuant to New Jersey law, an individual member has no interest in specific LLC property.  Respondent further contends that New Jersey caselaw does not support petitioners’ veil-piercing theory.

In the absence of fraud or injustice, New Jersey courts generally will not pierce the corporate veil.  As the New Jersey Supreme Court has explained, the “purpose of the doctrine of piercing the corporate veil is to prevent an independent corporation from being used to defeat the ends of justice, to perpetrate fraud, to accomplish a crime, or otherwise to evade the law”.  Even where the corporation7 has no separate existence and the corporate form has not been respected, New Jersey courts will pierce the veil only where the corporation has been used to perpetuate a fraud or other injustice… Neither party contends that Jacco’s corporate form has been used to perpetuate some fraud or injustice, and the record does not disclose any fraud or injustice that would cause us to disregard the existence of Jacco. Accordingly, petitioners are not entitled to claim the first-time homebuyer credit on the basis of their alter ego theory.

The result should be different if the reseidence were purchased by a single-member LLC, which is normally “disregarded” from its owner under the tax law.  The multiple owners of the entity presumably prevented that here, but the court didn’t say so specifically.

Cites:

S corporation case: Trugman, 138 T.C. No. 22

LLC Case: Rospond, T.C. SUmm. Op. 2012-47

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Buy.com founder learns the truth about the Tax Fairy

Thursday, January 19th, 2012 by Joe Kristan

There is no tax fairy, despite of the best efforts of big law and accounting firms a decade ago. The founder of Buy.com learned the sad truth the hard way this week when the Tax Court ruled against his “OPIS” tax shelter, marketed by KPMG. The court ruled that the shelter failed to protect Scott Blum from $25.7 million in federal taxes for 1998, 1999 and 2002. It also upheld a $10.2 million penalty assessment. The TaxProf has more.
Cite: Blum, T.C. Memo. 2012-16

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Did the Tax Court just abandon the ’750 hours for every rental activity’ test?

Monday, September 12th, 2011 by Joe Kristan

Last year a Tax Court decision implied an additional hurdle for taxpayers wanting to claim that they “materially participate” in an activity. A decision last week appears to have quietly removed this hurdle.
Net rental losses are normally “passive” unless you qualify as a “real estate professional.” Passive losses are deductible only to the extent of passive income. If you qualify as a real estate pro, then you can deduct rental losses if you “materially participate” in your real estate activities under the same participation tests that apply to other activities.
To be a real estate pro, you have to pass two tests:
- You have to participate more than 750 hours in a real estate trade or business, and
- Your real estate activities have to take more time than anything else you do.
A 2010 Tax Court decision said there was an additional test:

Because petitioners did not elect to aggregate their real estate rental activities, pursuant to section 469(c)(7)(A) petitioners must treat each of these interests in the rental real estate as if it were a separate activity. See sec. 469(c)(7)(A)(ii). Thus, Mrs. Bahas is required to establish that she worked for more than 750 hours each year with respect to each of the three rental properties.

At the time I argued that the last sentence was wrong — that the 750 hour test does not apply separately to each rental activity absent the “aggregation election.” A decision last week may indicate that the court has seen the light on this issue.
Last week’s case (discussed here) involved a taxpayer who had a day job that wasn’t in real estate, but that left him enough free time to do a lot of real estate work on his own properties. The Tax Court found that he was a qualifying real estate pro:

On the basis of the record and testimony provided at trial, we find that Mr. Miller has established that he spent more than 750 hours performing significant construction work as a contractor and on his rental real estate activities. We find that Mr. Miller spent more time on his construction work and rental properties than he did piloting vessels in the years at issue.

Mr. Miller completed a number of significant construction projects, both as a contractor and as a landlord, in the years at issue. He also performed a number of additional real estate tasks including researching properties, bidding on properties, finding tenants, collecting rent and performing maintenance work at rental properties. Mr. Miller presented contemporaneous work logs for his construction and rental activities and provided compelling testimony and witnesses. Thus, we find that Mr. Miller is a qualified real estate professional within the meaning of section 469(c)(7)(B)

.
The judge noted that Mr. Miller had not elected to “aggregate” his properties. Nowhere in the analysis of whether the taxpayer qualified does the judge consider whether he had to work 750 hours in each property to be able to count the rental hours towards the 750-hour minimum; in fact, he found that none of the properties reached the 750 hour requirements on their own.
I think that means the Tax Court has come around to my view. Sure, it would be nice if they would cite the Tax Update Blog in their decision (ahem!), but as long as they get the law right, that’s what matters.
Cite: Miller, T.C. Memo. 2011-219

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Real estate tax tip: have a cushy day job

Friday, September 9th, 2011 by Joe Kristan

If you have a day job that’s not in the real estate business, it’s hard to qualify for the “real estate professional” loophole in the “passive loss” rules. The tax law treats losses from rental real estate activity as automatically “passive” if you don’t qualify, and those losses are only deductible if you have “passive” income. If you are a real estate pro, you can deduct real estate losses if you meet the passive loss “material participation” rules that apply to all taxpayers for non-real estate losses.
To qualify as a real estate pro, you have to pass two tests:
- You have to spend at least 750 hours on your real estate activity, and
- You have to spend more time in your real estate business than you do on any other job you have.
The second test is usually impossible to pass if you have a non-real estate day job. But it can happen, as the Tax Court showed yesterday. The taxpayer husband, Mr. Miller, had a day job as a harbor pilot in San Francisco. He also had rental real estate property that Mrs. Miller helped him operate. Fortunately, piloting, while a skilled profession, seems to not be all that time-consuming:

At the age of 29, Mr. Miller became a partner in the San Francisco Bar Pilots Association (SFBPA) and began piloting commercial seagoing vessels for SFBPA.4 During the years at issue, Mr. Miller piloted client vessels for the SFBPA, including large container ships, passenger cruise ships and large military ships. He piloted these client vessels from 13 miles at sea, outside the San Francisco Bay Channel, throughout the San Francisco, San Pablo and Suisun Bays, including the Sacramento and San Joaquin Rivers.
Mr. Miller’s schedule as an SFBPA pilot requires that he work seven days and then have seven days off. Mr. Miller generally is not required to actually work for all of his seven days “on.” His schedule is also somewhat flexible and predictable. SFBPA pilots know roughly when they will have to work during their “on” time and can trade turns in the pilot rotation, subject to limitations.

That enabled him to throw himself into his real estate projects, and throw himself he did:

In addition to Mr. Bogart, other witnesses described Mr. Miller’s work ethic as extraordinary. A friend, pilot and partner of Mr. Miller’s at SFBPA testified to his “one in a million” work ethic, saying that he did not know anyone who worked harder. Mrs. Miller testified that she had to go to Mr. Miller’s construction sites to see her husband.

Wisely, Mr. Miller maintained records of his time, and he convinced the Tax Court that he met both the 750-hour and more-than-other-job requirements:

Mr. Miller completed a number of significant construction projects, both as a contractor and as a landlord, in the years at issue. He also performed a number of additional real estate tasks including researching properties, bidding on properties, finding tenants, collecting rent and performing maintenance work at rental properties. Mr. Miller presented contemporaneous work logs for his construction and rental activities and provided compelling testimony and witnesses. Thus, we find that Mr. Miller is a qualified real estate professional within the meaning of section 469(c)(7)(B).

But being a real estate pro is only the first step. Mr. Miller had to prove he “materially participated” in the loss activities. Mr. Miller passed that test for two of the activities, but not for four others:

Bennett Valley property for over 100 hours per year for the relevant years.10 We are also satisfied that their participation was not less than the participation of any other individual for those years. It follows, and we hold, that petitioners materially participated in the rental real estate activities at the Pepper Road property and the Bennett Valley property in the relevant years and the deductions attributable to those activities are not subject to limitation under section 469.
Petitioners have not shown, however, that they participated in the rental real estate activities at the Morning Glory property, the Lind property, the Price property or the Emerald property for over 100 hours per year for the relevant years.

The Moral: If you’re day job isn’t in real estate brokerage or development, you need a day job that isn’t very time consuming to qualify as a real estate professional. Then you have to work your butt off on your real estate work, and keep good records of your time.
Cite: Miller, T.C. Memo. 2011-219
Related: Being a ‘real estate professional’ only opens the door; it doesn’t carry you inside

(more…)

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Tax Court: pledge of stock of one S corporation doesn’t create “at-risk” basis for related S corporation

Wednesday, September 7th, 2011 by Joe Kristan

If you want to deduct losses from your S corporation, you need to clear three hurdles:
- You have to have basis in your S corporation stock or debt from a personal loan to the S corporation;
- The basis has to be “at-risk”; and
- You have to not run afoul of the “passive loss” rules.
A Michigan couple tripped over the first two tests in Tax Court last week, leaving them with a $16 million deficiency. We talked about the basis problems yesterday, so let’s hit the “at-risk” problem.
The taxpayers borrowed money to fund “Alpine,” a money-losing S corporation. They pledged the stock of another S corporation, “RFB,” as security on the loan.
Congress enacted the “at-risk” rules in the Ford administration to shut down that era’s tax shelters. Taxpayers would enter equipment leasing partnerships financed with debt secured by the equipment. If the loan went unpaid, the lender could repossess the equipment, but the partners weren’t personally on the hook. The at-risk rules fought this by saying a pledge of other property “used in the business” does not by itself create at-risk basis. A pledge of personal property not used in the business, in contrast, does make you “at-risk.” While Congress wasn’t willing to let equipment lessors cross-collateralize their lease property to get at-risk basis, it was willing to let taxpayers deduct losses if they put their personal assets on the line.
The Tax Court held that in this case the RFB stock was “property used in the business” because it had business ties to Alpine (citations omitted):

Pledged property must be “unrelated to the business” if it is to be included in the taxpayer’s at-risk amount. The Alpine entities were formed by petitioner to expand RFB’s existing cellular networks. RFB also used some of Alpine’s digital licenses to provide digital service to RFB’s analog network areas. RFB then allocated income from the licenses back to Alpine. The RFB stock is related to the Alpine entities.

The Tax Court held that even if the RFB stock were unrelated, the taxpayers were not really on the hook for the loans in any case.
The at-risk rules are obscure and often overlooked. That can be dangerous. You don’t have to have a business set up as a tax shelter to run into these rules. Any time you have financing where you are not personally on the hook for a loan, except in third-party real estate financing, these rules can bite. Even if you personally liable for a loan, the at-risk rules can still apply if the loan is from a related party, especially a party connected with the business.
Cite: Broz, 137 T.C. No. 5
Related:
Brother-sister S corporations can be bad basis news
S CORPORATION SHAREHOLDER LOSES BASIS APPEAL

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Brother-sister S corporations can be bad basis news

Tuesday, September 6th, 2011 by Joe Kristan

When you lose money in your business and can’t deduct it, that’s a bad thing. When your losses come from an S corporation, you can only deduct your losses to the extent you have basis in S corporation stock, or in loans you have made to the S corporation.
When taxpayers have two or more S corporations, they can find themselves running out of basis in one of the corporations while having plenty of basis in the other one doing them no good. For a Michigan couple, this turned out to be a $16 million problem.
The couple was in the cell phone licensing business. They had two S corporations, RFB and Alpine. Things went badly, and the owners and the corporations all went into bankruptcy in 2003 — but only after the couple got a $16 million tax benefit from Alpine losses. The IRS disallowed the losses, both because of basis limits and for other issues.
The couple said they had enough basis in Alpine to deduct their losses because they borrowed money from RFB and loaned it to Alpine. The tax law doesn’t like “back-to-back” loans from an S corporation to its owners to another S corporation. In the Oren case, the owner of the Dart Trucking business lost millions of tax deductions funded that way. While such loans theoretically can work, they have to meet a stiff test, as the Tax Court explains (citations omitted):

When the taxpayer claims debt basis through payments made by an entity related to the taxpayer and then from the taxpayer to the S corporation (back-to-back loans), the taxpayer must prove that the related entity was acting on behalf of the taxpayer and that the taxpayer was the actual lender to the S corporation. If the taxpayer is a mere conduit and if the transfer of funds was in substance a loan from the related entity to the S corporation, the Court will apply the step transaction doctrine and ignore the taxpayer’s participation.

The Tax Court said the taxpayers failed here. They said the paperwork didn’t show that the funds were first lent by RFB to the owners, and then back to Alpine; instead the loan ran from RFB to Alpine, bypassing the owners and therefore giving them no basis:

Petitioner never substituted himself as “lender” in the place of RFB. There is no evidence that the Alpine entities were indebted to petitioner rather than to RFB. Interest on the unsecured notes accrued and was added to the outstanding loan balances…
Moreover, the payments petitioners made to Alpine from the CoBank loan proceeds were characterized as advances, rather than loan distributions, at the time the payments were made. The payments were recharacterized as loans only through yearend reclassifying journal entries and other documents. The loan ran from RFB to the Alpine entities, and petitioners served as a mere conduit for the funds. Accordingly, we find that the Alpine entities were not directly indebted to petitioners.

This was bad news for the taxpayers. Most of these problems might have been avoided if the taxpayers had used an S corporation holding company structure, with an S corporation parent holding two electing “Qualified S corporation Subsidiaries,” or “Q-Subs.” These combine all of your basis in one place, eliminating the problem of shifting basis between corporations.
The taxpayers still had one argument left, though, which we’ll address tomorrow.
Cite: Broz, 137 T.C. No. 5.

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Using a security as security doesn’t give you investment interest

Friday, August 12th, 2011 by Joe Kristan

Like any exotic subculture, the tax world has its own legends and superstitions. The Tax Court popped one superstition yesterday: the belief that you can turn non-deductible personal interest into deductible investment interest by securing the loan with stocks or bonds.
An Albuquerque couple bought themselves a nice house, financing it with a loan for $1,578,000. Longtime readers will spot a problem right away: that’s more home loan than you can deduct interest on. The tax law only allows deductions of interest on loans up to $1.1 million: $1 million for acquisition debt plus $100,000 in home-equity debt. That left $478,000 of loan with no obvious deduction potential.
The couple tried to solve the problem by securing the loan not only with the house, but also with $650,000 worth of Intel stock. They then treated the extra interest as “investment interest,” which is deductible to the extent of investment income (interest, dividends, and optionally, capital gain). Investment interest exceeding investment income carry over to later years.
It didn’t work. The Tax Court explains (my emphasis, citations omitted):

The allocation of debt and related interest is not affected by the use of property to secure repayment. The temporary regulations under section 163 provide an example of a taxpayer who finances a car purchase for personal use with a loan and pledges corporate stock held for investment as security. The example treats the interest expense as personal interest and not investment interest, even though the loan is secured by investment property. Id.
Here, petitioners used investment property to secure repayment of a loan for a personal residence rather than a car. This distinction is without a difference. The use of investment property to secure repayment of indebtedness has no effect on the allocation of debt and interest. Rather, it is the “use” of the debt proceeds that determines the allocation.

They used the loan to buy the house, not the Intel stock. That means the only available deduction is for the house. If a home loan exceeds the $1.1 million limit, it is nondeductible “personal” interest.
The Moral? When you buy a really big house, it may be bigger than your mortgage interest deduction.
Cite: Ellington, T.C. Memo. 2011-193

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Snipes strategy fails in Bakersfield

Friday, August 5th, 2011 by Joe Kristan

The team of tax geniuses that got Floridian Wesley Snipes where he is today was also active out west. A Bakersfield man got bad news this week from two different courts after working with tax advisors linked to the jailed actor.
Mark DeVries was a plumbing contractor. He stopped filing tax returns, and in time IRS agent RA Chynoweth was assigned to find out why. The Tax Court outlines the unconventional approach Mr. DeVries and his advisors took with the IRS examination:

Petitioners’ representative and attorney, Milton H. Baxley II (Mr. Baxley), sent letters to the institutions to which RA Chynoweth issued summonses. Petitioners authorized both Mr. Baxley and Mr. Bryan Malatesta, on Forms 2848 attached to each of the letters, to represent them for the years 1985 through 2004. The letters stated that the relevant IRS summons was unauthorized by statute, the Code has not been enacted as positive law, the IRS is not an agency of the United States government and the institution will be held liable if the requested documents are released without court order. Mr. DeVries and the IRS were each sent a courtesy copy of each of the letters.
Later that year, Mr. Devries’ son Jason Henry DeVries sent an invoice for $1 million to RA Chynoweth, billing the revenue agent for the use of purportedly copyrighted property.

Mr. Baxley was involved in the Snipes IRS examination too. He was enjoined in 2003 from a number of tax activities.
The rather aggressive response to the IRS exam continued. Again from the Tax Court:

During the examination, Mr. DeVries also made a Freedom of Information Act (FOIA) request for RA Chynoweth’s personnel file.
Mr. DeVries filed a lawsuit in the California Superior Court, Kern County, against IRS Revenue Officer Douglas McDonald and RA Chynoweth in 2002.8 Mr. DeVries alleged interference with contractual relations, libel, slander, nuisance, intentional and negligent infliction of emotional distress, trespass, conspiracy and imposition of a constructive trust. Mr. DeVries sought over $50 million in damages plus significant punitive damages and injunctions. He caused RA Chynoweth to be served with the lawsuit by a process server at his personal residence. Mr. DeVries’ lawsuit was eventually dismissed.
Ultimately, petitioners’ efforts to derail RA Chynoweth’s investigation failed.

Failed? Imagine that.
The aggressive approach failed yesterday in Tax Court, which upheld 75% penalties for fraudulent failure to file tax returns. It failed also in the criminal case that resulted from the exam; on Monday a federal judge sentenced Mr. DeVries to 27 months in prison — short of Mr. Snipes’ 36 months, but no fun in any case.
The Moral? Suing your IRS agent for “libel, slander, nuisance, intentional and negligent infliction of emotional distress, trespass, conspiracy and imposition of a constructive trust” hasn’t worked yet. Perhaps a less confrontational approach to IRS exams would have been wise.
Cite: DeVries, T.C. Memo. 2011-185

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District Director? We don’t need no stinking District Director!

Thursday, May 12th, 2011 by Joe Kristan

Usually tax protesters use the same old ridiculous arguments — the 16th amendment was never properly ratified, wages aren’t taxable, Section 861 makes wages non-taxable in the U.S., the gold fringe on the courtroom flag makes the court an admiralty court, and so on. That’s why it’s news, sort of, when the Tax Court bothers to address a new tax protester argument in a full published decision, like they did yesterday.
A taxpayer advanced the novel argument that when the IRS eliminated its District Directors, it eliminated its ability to collect taxes. Judge Kroupa takes up the story:

Petitioner’s only argument in his 2-sentence petition is that he does not owe the frivolous return penalties because proper assessment cannot be made in the absence of a district director.
Respondent filed a motion for summary judgment, and petitioner filed a response. This is the first time this Court has addressed in a published Opinion the question of whether the absence of a district director causes an assessment to be invalid.

He then explained why the taxpayer’s argument fails:

The district director position and responsibilities were assigned to others after the Internal Revenue Service Restructuring and Reform Act of 1998 (RRA), Pub. L. 105-206, 112 Stat. 685, required the Commissioner to eliminate or substantially modify the IRS’ national, regional and district structure. Id. sec. 1001, 112 Stat. 689. To ensure continuity of operations, the RRA specifically included a savings provision. Id. sec. 1001(b). The savings provision applies to keep in effect regulations that refer to officers whose positions no longer exist. Id. It also provides that nothing in the reorganization plan would be considered to impair any right or remedy to recover any penalty claimed to have been collected without authority.

So they anticipated the argument. The court upheld frivolous return penalties, but declined to also apply penalties for taking a frivolous position in Tax Court.
The elimination of District Directors still causes some confustion for practitioners and taxpayers. Old regulations still in force require taxpayers to make some filings with a District Director, and there no longer is such a thing. Notice 2003-19 provides updated addresses for such filings.
Cite: Grunsted, 136 T.C. No. 21.

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(Economic) substance abuse in Carroll, Iowa

Wednesday, November 17th, 2010 by Joe Kristan

If you think the 20% and 40% “economic substance” penalties in the Obamacare legislation are just a threat for elaborate tax shelters from fancy-pants big city law and accounting firms, a Tax Court case yesterday out of Carroll, Iowa will make you think again.
20101117-1.jpgA Carroll couple had operated a trucking business out of their home since 1967. They lawyered up in 2000 and set up three new entities — two C corporations and an LLC. One C corporation had the trucking operations, while the other was a “consulting” business that provided “management services” to the trucking business. Real estate was put into the LLC, which filed as a partnership.
The 87-page Tax Court opinion outlines a confusing series of payments between the controlled entities that resulted in no taxable income in the C corporations and reduced taxable income on the 1040. The taxpayers testified in their own defense, to no avail:

Before turning to the issues presented, we shall comment on the respective testimonies of [the couple], who were the only witnesses at the trial in these cases. We found those testimonies to be in certain material respects questionable, implausible, vague, inconsistent, unpersuasive and/or self-serving. We shall not rely on the respective testimonies…

The court said the arrangements amounted to a tax-avoidance scheme:

Based upon our examination of the entire record before us, we find that the only intended objective of the respective transactions between (1) (a) Transfer and Consulting and (b) Leasing and Consulting, under which Consulting purported to provide to each of those companies certain services, and (2) the [taxpayers] and Consulting, under which Consulting purported to agree to buy the [taxpayers'] residence, was the… tax-avoidance objective of having Consulting pay the [taxpayers'] personal living expenses with funds which Transfer and Leasing paid to Consulting and for which Transfer and Leasing claimed tax deductions for their respective taxable years at issue.

Here’s where the Obamacare penalty changes come in:

On that record, we find that the respective transactions at issue were not entered into for nontax business reasons, were entered into only for tax-avoidance reasons, and did not have economic substance.

New Section 6662(b)(6) provides a non-waivable penalty for tax understatements attributable to transactions that lack “economic substance.” The penalty is 40% (20% if there was “adequate disclosure”) of the understatement. The taxpayers in Carroll were hit with a 20% “accuracy related” penalties in the neighborhood of $20,000. If the new rules applied to the years at issue (they don’t), they might have faced a penalty twice as large, with no opportunity for a “reasonable cause” reduction (though the judge in this case rejected “reasonable cause” arguments for penalty reduction, despite the use of an attorney to set up the structure and prepare tax returns).
The Moral? The Tax Court doesn’t like it if they think you are trying to deduct personal expenses, and the new economic substance penalties will raise the stakes.
Cite: Sundrup, Et. Al, T.C. Memo 2010-249

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Crop failure: Farmer’s Section 179 deduction comes up weeds

Tuesday, November 2nd, 2010 by Joe Kristan

With the Section 179 deduction raised to a maximum of $500,000 this year and next, it’s going to be a big part of many tax lives. But an Eastern Iowa farm couple yesterday was tripped up by an obscure limit on the deduction.
The Section 179 deduction allows taxpayers to fully deduct property in the year it is placed in service; otherwise it would be capitalized and depreciated over several tax years. Only a few years ago, the Section 179 deduction was limited to $15,000 per year, per taxpayer. “Stimulus” bills have raised it drastically in recent years.
The farmers put property in service in 2004, 2005 and 2006. They purchased the property in their own names. But the farm operations were actually run in a corporation called “Circle T.” The farmers leased the property to their farm corporation and to “C & A, Inc.,” an unrelated corporation. Here’s where things got messy.
The tax law restricts Section 179 deductions of non-corporate taxpayers when their property will be rented out. Such leased property is normally ineligible for the Section 179 deduction, unless two requirements are met. The Tax Court explains (my emphasis):

Non-corporate lessors may expense the cost basis of section 179 property by meeting a two-prong test. First, the term of the lease, taking into account options to renew, must be less than 50 percent of the class life of the leased property. Sec. 179(d)(5)(B). Second, petitioners’ section 162 business expenses for the leased property claimed during the initial 12-month period following the transfer of the property to the lessee must exceed 15 percent of the rental income produced by such property.

The first test allows very short-term leased property to get Section 179 treatment; the second test requires that there be significant non-rental expenses in the business. Unfortunately, the Tax Court found that the taxpayers failed to adequately document their lease agreements:
Petitioners assert that they satisfied the first prong because they annually renewed the terms of the leases of their farm-related property with Circle T and C & A. Petitioners therefore contend that the lease term is a year long so as to be less than 50 percent of the class life of the farm-related property. Respondent argues the lease terms are indefinite and therefore petitioners cannot satisfy the first prong. We agree.
All lease agreements between petitioners and Circle T and C & A were oral, and none of the farm-related property lease agreements was memorialized in writing. Moreover, petitioners have not presented any evidence regarding the terms for the leased farm-related property. The failure of a party to introduce evidence, which, if true, would be favorable to that party gives rise to the presumption that the evidence would be unfavorable if produced.

The Tax Court found that the lease terms weren’t one-year renewable leases, but were instead “indefinite”; as a result, the court said that it could not conclude that the leases were for less than 50% of the useful life of the property. That made the property fail the non-corporate lessor rules, so its cost has to be recovered over a period of years through depreciation. Adding insult to injury, the court imposed the 20% “accuracy-related penalty” for the tax understatement, saying that the taxpayers failed to show any evidence of their tax preparer’s qualifications.
The moral: Beware the non-corporate lessor rules, and document your related-party transactions carefully.
Cite: Thomann, TC Memo 2010-241
UPDATE, 11/3: Paul Neiffer has more.
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Tax Court: fruit and tree, corn and stalk.

Wednesday, October 13th, 2010 by Joe Kristan

20101013-1.JPGThe tax law says that the fruit has to be taxed to the tree where it grew. The Tax Court yesterday told a Northwest Iowa farmer that the same thing goes for corn.
Washta, Iowa farmer Jerry Slota formed a corporation in 2005, according to the Tax Court (my emphasis):

In September 2005 petitioners organized the corporation and filed articles of incorporation with the Iowa secretary of state. Petitioners were the sole shareholders and served as the only directors of the corporation. Petitioners and the corporation did not sign or execute a deed, sales contract or other written agreement conveying, transferring or leasing the land or the crops from petitioners to the corporation. The only asset petitioners conveyed to the corporation upon its organization was $10,000 from petitioners’ individual account to a bank account established for the corporation (corporate account).
In October 2005 Mr. Slota deposited all USDA payments received in 2005 into petitioners’ individual account, except for one USDA payment of $6,142 that petitioners deposited into the corporate account. Mr. Slota then transferred into the corporate account the USDA payments he had deposited into petitioners’ individual account after October 5. In addition, Mr. Slota deposited into the corporate account all crop sales proceeds received after October 5.

According to the Tax Court, then, the land and the growing crops remained in the farmer’s personal ownership, but he reported the crop sale income on the corporate return:

Petitioners hired a tax adviser to prepare and file their Federal income tax return for 2005. Petitioners reported $195,938 from crop sales and $61,416 in USDA payments on Schedule F, Profit or Loss From Farming. Petitioners claimed an expense deduction for $44,165 of USDA payments and $20,532 of crop sales proceeds that petitioners deposited into or transferred to the corporate account. Petitioners reported only $481 of self-employment tax liability.

The returns as filed reached an attractive result:

The corporation also filed a corporate Federal income tax return for the fiscal year ending September 30, 2006. The corporation reported $370,647 of income that was offset by an equal amount of expenses resulting in zero taxable income.

Too attractive, according to the Tax Court:

The only property that petitioners assigned or transferred to the corporation was the proceeds from the crop sales and the USDA payments. The assignment of income doctrine provides that a taxpayer cannot escape tax liability for income the taxpayer earned by transferring the income to another. Lucas v. Earl, supra. It is equally fundamental that taxpayers may not avoid paying tax on income by transferring crop sales proceeds to a newly organized corporation in a section 351 transaction. Weinberg v. Commissioner, 44 T.C. 233 (1965), affd. in part, revd. in part and remanded sub nom. Commissioner v. Sugar Daddy, Inc., 386 F.2d 836 (9th Cir. 1967). Mr. Slota owned the farmland and the crops and earned the income when he sold the crops. Further, as the owner of the land and the crops, Mr. Slota, not the corporation, received the payments from the USDA. Accordingly, petitioners received the crop sales proceeds and USDA payments on their own behalf.

Bottom line: the income was taxed to the farmer, not the corporation. Worse, the court hit them with a $12,000+ “accuracy-related” penalty:

Petitioners failed to submit any evidence showing the return preparer’s experience or qualifications and failed to show that they provided all the necessary and accurate information to a tax adviser. We cannot simply accept petitioners’ bald assertion that they relied upon a tax adviser as a defense against the accuracy-related penalty.

The Moral? Getting appreciated farmland out of C corporations is a staple of rural Iowa tax practice. It would sure be handy if you could split your income with a corporation without having to face that ugly two-level tax on C corporation property sales and distributions. Unfortunately, if you want farm income taxed to a corporation, you have to put the farm and the crops into the corporation — not just the crop proceeds.
Cite: Slota, T.C. Summ. Op. 2010-152.
UPDATE: More from Roger McEowen at the Iowa State University Center for Agricultural Law and Taxation.
Image showing approximate location of Washta, Iowa courtesy Google Maps.

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Coverage rules bring down doctor’s ESOP

Thursday, August 5th, 2010 by Joe Kristan

A Houston Plastic surgeon, Dr. Scott Yarish, got an offer to sell one of his five medical practice businesses. His lawyer, a Mr. Riddle, got to work, recommending an S corporation owned by an ESOP to shelter sale proceeds and other business income, as the Tax Court explains:

He advised Dr. Yarish to form an S corporation to manage his four medical practice entities as well as the medical practice Dr. Pisarki sought to purchase. The medical practice entities would pay a “consulting fee” to the S corporation and then deduct the fees as management services.
Mr. Riddle further recommended that the S corporation sponsor an ESOP to defer income earned by the S corporation. It was intended that the income of the S corporation would pass through to the ESOP, and, because the ESOP would be tax exempt, it would pay no tax on the income until it was distributed to the ESOP participant. Dr. Yarish would be the sole ESOP participant. In effect, Dr. Yarish’s medical practice entities would divert money to an entity owned by a tax-exempt trust, creating a substantial cash and property benefit solely for Dr. Yarish.

A cunning plan. Unfortunately for the doctor, ESOPs are “qualified plans.” To keep employers from funding lavish plans for owners or executives while leaving out other employees, the qualified plan rules have “coverage requirements.” These often complex rules require that non-highly compensated employees be covered as well as the big shots, and the testing for these rules is done across related-employer groups. Still, all worked out well, until…
Respondent audited the ESOP after the ESOP terminated. Respondent’s examination concerned whether all eligible employees of Dr. Yarish and his medical entities participated in the ESOP. Respondent sought documents from petitioner regarding the ESOP. Petitioner provided respondent with, among other things, a list of related entities and a census of employees in the controlled group or affiliated group. These documents contradicted petitioner’s statement in its application that it was not a member of an affiliated service group or a controlled group of corporations under common control.

Now things went badly. The IRS retroactively revoked the “determination letter” stating that the ESOP failed to disclose its affiliated group status when it applied for the letter. That has all sorts of horrendeous potential consequences, including the loss of deductions and civil penalties. The Tax Court upheld the IRS.
The moral? Don’t set up a tax-advantaged qualified plan, like an ESOP or profit-sharing plan, with the expectation that you can leave employees out, even by putting the employees in a separate company. When you do set up a qualified plan, work with somebody who does qualified plan work for a living, and make sure they know about all of the business interests of the owners.
Yarish Consulting Inc., T.C. Memo. 2010-174
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