Sunday, January 14, 2018

Mental Illness And The Statute Of Limitations

Many people and most tax practitioners (hopefully) know the statute of limitations on refunds from the IRS:
§ 6511 Limitations on credit or refund.
(a)  Period of limitation on filing claim.
Claim for credit or refund of an overpayment of any tax imposed by this title in respect of which tax the taxpayer is required to file a return shall be filed by the taxpayer within 3 years from the time the return was filed or 2 years from the time the tax was paid, whichever of such periods expires the later, or if no return was filed by the taxpayer, within 2 years from the time the tax was paid. Claim for credit or refund of an overpayment of any tax imposed by this title which is required to be paid by means of a stamp shall be filed by the taxpayer within 3 years from the time the tax was paid.

We can shorthand this as the “3 and 2” rule.

Then there was the Brockamp case in 1997, which many felt was unfair and which led Congress to write this beauty:

§ 6511 Limitations on credit or refund.
(h)  Running of periods of limitation suspended while taxpayer is unable to manage financial affairs due to disability.
(1)  In general.
In the case of an individual, the running of the periods specified in subsections (a) , (b) , and (c) shall be suspended during any period of such individual's life that such individual is financially disabled.
(2)  Financially disabled.
(A)  In general. For purposes of paragraph (1) , an individual is financially disabled if such individual is unable to manage his financial affairs by reason of a medically determinable physical or mental impairment of the individual which can be expected to result in death or which has lasted or can be expected to last for a continuous period of not less than 12 months. An individual shall not be considered to have such an impairment unless proof of the existence thereof is furnished in such form and manner as the Secretary may require.

Like so much of the tax Code, the heavy lifting is in the details. Brockamp had been senile. Congress addressed the issue by introducing the phrase “medically determinable,” and then handed the baton to the IRS to define what that verbal salad meant.

COMMENT: And there you have a capsule summary of how the Code has gotten away from us over the years. Congress writes words and then leaves it to the IRS and courts to determine what they mean. Congress did the pooch again with the Tax Cuts and Jobs Act.  Google “qualified business income” and tell me that isn’t an elmore waiting to happen.
The IRS issued its interpretation of “medically determinable” in Rev Proc 99-21:

SECTION 4. PROCEDURE Unless otherwise provided in IRS forms and instructions, the following statements are to be submitted with a claim for credit or refund of tax to claim financial disability for purposes of § 6511(h).
(1)   a written statement by a physician (as defined in § 1861(r)(1) of the Social Security Act, 42 U.S.C. § 1395x(r)), qualified to make the determination, that …

The IRS is pointing to the Social Security rules to define what a physician is. Methinks this is poor work. Why not reference Beat Bobby Flay to define meal expenses or Car Talk to define transportation expenses?

Let’s look at the Green case.

Richard Green and his wife (Hae Han) went to Tax Court in 2009. There were taxes due and tax refunds and quite the debate about offsetting one against the other.  The case eventually got to Sec 6511(h), and here is what the Court had to say about it:

An individual will not, however, be considered financially disabled unless proof of a medically determinable physical or mental impairment is provided in such form and manner as the Commissioner may require. More specifically, the Commissioner requires a written statement from a physician. Ms. Han, however, did not establish that she was financially disabled. In addition, she was treated by a clinical psychologist, not a physician, and thus could not and did not provide the requisite documentation.

Ms. Han’s letter was written by a psychologist. 
COMMENT: I am thinking: why is a psychologist not considered a “physician?” An optometrist is considered one for this purpose, although an optometrist has an O.D. and not an M.D.

There was no relief for Green and Han.

A number of practitioners considered this decision to be nonsense. The IRS had grafted a Medicare definition concerning payment for services onto Sec 6511(h), which was supposed to be a relief provision in the tax Code.

Enter the Estate of Stauffer, which is presently in Court.

Carlton Stauffer died in 2012 at the age of 90. His son is administering the estate. He discovered that his dad had not filed tax returns for 2006 through 2012. He filed those returns on behalf of his dad. One year alone – 2006 – had a refund of approximately $137,000.

The IRS denied the refund as outside the 3-year window.

The son appealed and pointed at Sec 6511(h).

His father had been seeing a psychologist, who treated him from 2001 until his death in 2012. The psychologist wrote a persuasive letter explaining how Carlton had suffered from psychological problems in addition to ailments including congestive heart failure, chronic obstructive pulmonary disease, leukemia, and chronic pneumonia. He explained how all these factors negatively impacted Carlton’s mental capacity, cognitive functioning, decision making and prevented him from successfully managing his affairs.

The IRS said: show us the “M.D.”

Why wouldn’t they? They had won with that play before.

The estate sued in District Court.

The IRS motioned to dismiss, order boneless chicken wings and watch the NBA over a pitcher of beer.

The District Court denied the IRS motion.

The Court pointed out that – for all the IRS’ power – that it could still review Rev Proc 99-21 under the “arbitrary and capricious” standard that government agencies are held to. The IRS had to articulate a rational connection for its standard, as well as explain why it rejected any reasonably obvious alternatives to the challenged rule.

The Court pointed out that Social Security does not restrict the types of professionals who may opine on whether someone has a disability qualifying for disability benefits. In fact, the opinion of a psychologist is given great weight in such a determination.

The Court did not see how the IRS dismissal of a psychologist’s letter passed the “arbitrary and capricious” standard.

Mind you, the Estate of Stauffer won a motion only; this does not mean that it will win the overall case.  

I for one hope it does.

Tuesday, January 9, 2018

Remember The Port

One thing about this blog is that it likely reflects what’s happening here at Intergalactic Command.

Here goes: it is unlikely that you will need an extensive and expensive estate tax plan, unless you (a) have unique family issues, such as a special needs child, or (b) have a tractor-trailer load of money.

Pass away in 2018 and you will not have a federal estate tax until you get to $11.2 million.
OBSERVATION: This amount increased under the new tax bill.
Folks, that excludes almost everybody.

I suppose you could live in a state with a state estate tax, like Illinois. If you do, here is some tax advice: move.

So how do you get into the federal estate tax?

It is easy enough in concept.  

Here goes:

                          Net FMV of assets you die with
                    Reportable gifts made over your lifetime

BTW, notice that assets you die with and assets you gifted away are added together. The IRS is going to tax you whether you kept stuff or gave it away. The nerd term for this is “unified” tax.

There are tricks and traps to “assets you die with,” but, for the most part, it means what it says. The “net” means you get to deduct your liabilities from your assets. The “FMV” means fair market value. Take a car for example. You might get its FMV from Kelly Blue Book.

What does “reportable gifts” mean?

Let walk around the block on this. Let’s say you made a gift to a family member in 2017. Do you have to report it?

Depends on the amount. For 2017 the annual gift tax exclusion was $14,000. This means that you could gift anyone on the planet $14,000 and the government did not need to know. If you were married, then your spouse and you could double-up, meaning that together you could gift $28,000 without the government needing to know.

Let’s say that you are single. You gifted someone $50,000 in 2017. What have you got?

Easy enough: $50,000 – 14,000 = $36,000 is reportable. Yep, you went over the limit. You have to file a gift tax return.

Mind you, it is very unlikely that you will have any gift tax due on that return.

Why not?

Let’s circle back to the formula:
                          Net FMV of assets you die with
                    Reportable gifts made over your lifetime

You haven’t died yet, so the first line is zero.

But you still have the second line.

Remember that you can die in 2018 with $11.2 million and not be taxed.

Folks, if someone has gifted over $11.2 million (mind you, this is over a lifetime), please call or e-mail me. I want to get into that person’s will – I mean, I want to develop a lifelong friendship with a kindred soul.  

What if you fudge the numbers? You know, play down the gifts a bit? Who will know once you are gone, right?

If you are married, there could be a hitch with this.

Let’s take a look at the Estate of Sower case.

Frank Sower passed away in 2012, leaving Minnie as his surviving spouse. He filed an estate tax return, and it showed an unused estate tax exclusion of $1,250,000.         
COMMENT: Beginning in 2010, any unused estate tax exclusion of the first-to-die spouse could carryover to the surviving spouse. For example, the exclusion for 2011 was $5 million. Let’s say that the first-to-die had a taxable estate of $3.6 million. The balance - $1.4 million – could transfer to the surviving spouse.
This was a big improvement in tax practice. Previously tax professionals used trusts – “family” trusts and “marital” trusts, for example - to make sure that estate tax exclusions did not go squandered. One can still use trusts if one wants, but it is not as mandatory as it used to be. The transfer of the unused exclusion to the surviving spouse is called “portability” (“port” to the nerds) and it required (and still requires) the first-to-die to file a federal estate tax return, whether otherwise required, if only to alert the IRS that some of the exclusion is being ported.

There was however a problem with Frank’s estate return: the preparer left out $940,000 of reportable gifts. That in turn meant that the unused exclusion was overstated, as those unreported gifts would have soaked up a chunk of it.

Minnie died in 2013. Her estate showed the unused exemption ported from Frank. It was wrong, but it was there. The same tax preparer must have done her estate return, as once again her reportable gifts were left off.

The IRS audited her estate return and caught the mistake. They wondered whether Frank’s return had the same issue. It did, of course, so the IRS adjusted Frank’s ported exemption.

When the dust settled, Minnie’s estate owed another $788,165.

Ouch. Folks, the estate tax has one of the highest rates in the Code. A lot of effort goes into minimizing this thing. At least Congress has gotten away from having  taxable estates begin at $600,000, as it did in the nineties. Average folk did not consider $600,000 to be “wealthy,” no matter what Congress and the grievance mongers said.

The estate litigated. They argued that the Frank’s estate had a closing letter (think magical letter, but the estate’s letter was non-magical); that the adjustment to the port was an impermissible second review of Frank’s return; that the IRS position improperly overrode the statute of limitations, and so on. The estate lost on all counts.

What do we learn from Sower?
(1) It is OK to port.
(2) But the IRS can adjust the port if you get it wrong.

What did we learn from this post?

Remember the port.

Saturday, December 30, 2017

The Backdoor Roth

It has come up often enough that I decided to talk about it.

The backdoor Roth.

What sets up this tax tidbit?

Being able to contribute to a Roth in the first place. More accurately, NOT being able to contribute.

Let’s say that you are single and work somewhere without a retirement plan. No 401(k), SIMPLE, SEP, nothing. You make $135,000.

Can you fund an Roth IRA?



Because you do not have a plan at work.

How much can you fund?

$5,500. That becomes $6,500 if you are age 50 or over.

Let’s say you have a plan at work.

How much can you fund?



Because you have a plan at work and you make too much money.

What is too much?

For a single person, $133,000. I question what fantasyland these tax writers live in where $133 grand is too-much-money, but let’s move on.

A Roth is a flavor of IRA. It is like going to Baskin Robbins and deciding whether you want your chocolate ice cream in a sugar cone or waffle cone. Either way you are getting chocolate ice cream.

Let’s say that someone wants to fund a Roth. Say that someone is a well-maintained, moderately successful, middle-aged tax CPA with diminishing dreams of ever playing in the NFL. He is married. His wife works. His back hurts during busy season. His daughter never calls ….

Uhh, back to our discussion.

He has a no plan at work. His wife does.

So we know the income limits will apply, as (at least) one of them is covered by a plan.

For 2017 that limit is $196,000.

Let’s say our tax CPA makes $18,000. His wife makes $180,000.

I see $198,000 combined. He is over the income limit.

Our CPA cannot contribute into a Roth, because a Roth is a flavor of IRA and he has exceeded the income limits for an IRA.

I suppose our CPA can ask his wife to dial it back a notch. Or get divorced.

Or consider a back door.

There are two things to understanding the backdoor:

(1)         We have discussed two types of IRAs: the traditional (that is, deductible) and the Roth. There is a third, although he has moved out of the house and rarely attends family events (at least willingly) anymore.

The third is the nondeductible. He is the wafer cone.

You get no deduction for putting money in. You will pay something when you take money out.

When you pull money out, you calculate a ratio:

 * Nondeductible money you put in/total value of account *

That ratio is not taxable; the balance is.

There is even a tax form for this - Form 8606. You are supposed to use this form every year you make a nondeductible contribution. I understand that there is a penalty for not doing so, but I have never seen that penalty in practice.

And no one would do this if a Roth is available. When you pull money out of a Roth, all of the distribution is nontaxable (if you followed the rules). That result will always beat a nondeductible.

The Roth effectively killed the nondeductible, which perhaps explains why the nondeductible is the unfriendly and distant family member.

But the nondeductible has one trick to its game: there is no income test to a nondeductible. Our tax CPA cannot fund a Roth (went over the limit by a lousy $2 grand), but he can fund that nondeductible. There is no deduction, but there will be no penalty for overfunding an IRA, either.   

(2)         But how to get this nondeductible into a Roth?

Call the broker and have him/her move the money from an account titled “Nondeductible IRA FBO Cincinnati Tax Guy” to one titled “Roth IRA FBO Cincinnati Tax Guy.”

This event is called a “conversion.”

You have to pay tax on a conversion.


Because you are moving money that has never been taxed to an account that will never be taxed. The government wants its vig, and the conversion is as good a time to tax as any.

How much tax?

Here is the beauty: since our tax CPA did not deduct the thing, tax law considers him to have dollar-for-dollar “basis” in the thing. If he put in $5,500, then his basis is $5,500.

Say he converts it when it is worth $5,501.

Then his income is $5,501 – 5,500 = $1.

Yep, he has to pay tax on $1 to convert the nondeductible to a Roth.

But there is ONE MORE RULE. Too often, tax commentators fail to point this one out, and it is a biggie.

He is probably hosed if he has ANY traditional (that is, deductible) IRAs out there. This triggers the “aggregation” or “pro rata” rule, and the rule is not his friend.

Let’s calculate a ratio.

The numerator is the amount he is converting: $5,500 in our example.

The denominator is ALL the money in ALL his traditional/deductible IRA accounts.

Say our tax CPA had $994,500 in his regular/traditional/free-range IRA before the $5,500 backdoor.

He now has $1 million after the backdoor.

His ratio would be 5,500/1,000,000 = 0.0055.

What does this mean?

It means that the inverse: 100% – 0.55% = 99.445% of every dollar will be taxable.

Counting with fingers and toes, I say that $5,470 is taxable.

The nondeductible saved him tax on all of $30, which appears to meet the definition of “near useless.”

So much for that $1 of conversion income he was hoping for. He got hung on the aggregation rule.

This is an extreme example, but any significant ratio is going to trigger significant taxable income on the conversion.

Is this deliberate by the IRS?

Does Tiger chase little white balls?

Our heroic and stoic tax CPA has other IRAs. The backdoor Roth has become unreachable for him.

Or has it?

Here is a thought: what if our tax CPA rolls ALL of his IRAs into the company 401(k)?
COMMENT: I know I previously said he did not have a plan at work. Work with me here, folks.
He would have to call the 401(k) people and see if they permit that. Federal tax law says he can, but that does not mean that his particular plan has to allow it.

Let’s say he can.

He now has zero/zip/zilch in traditional/deductible/sustainable IRAs.

Seems to me that he is back to converting for $1 in income, per our first example.

And there is your backdoor.

Friday, December 22, 2017

Individual Changes In The New Tax Bill

We have a new tax bill, and it is considered the most significant single change to the tax Code over the last 30 years. Here are some changes that may affect you:
·     Your tax rate is likely going down. A single person making $150,000, for example, will see his/her rate dropping from 28% to 24%. A married couple making $250,000 will see their rate drop from 33% to 24%. Whether married or not, the top rate has gone from 39.6% to 37%.
·     You will lose your personal exemptions next year. For 2017 the exemption amount is $4,050 for you, your spouse and every tax dependent. 
·      To make up for the loss of the personal exemptions, your standard deduction is going up in 2018. A single taxpayer will increase from $6,350 to $12,000. A married taxpayer will go from $12,700 to 24,000.
·      Many of your itemized deductions will be limited or go away altogether next year:
o   For 2017 you can deduct interest on up to $1 million on a mortgage used to buy your home.  In 2018 that limit will drop to $750,000.
o   For 2017 you can deduct interest on (up to) $100,000 of home equity loans. In 2018 you will be unable to deduct any interest on home equity loans.
o   For 2017 you can deduct your state and local income and real estate taxes, without limit. In 2018 the maximum amount you can deduct is $10,000.
o   For 2017 you can deduct a personal casualty loss (such as a car flooding), subject to a $100-deductible-per-incident and-10%-of-income threshold. You will not be able to deduct such losses in 2018, unless you are in a Presidentially-declared disaster zone.
o   For 2017 you can deduct contributions up to 50% of your income. In 2018 that increases to 60%.
o   If your contribution provides the right to purchase seat tickets to an athletic event – say to Tennessee or Ole Miss – you can presently deduct a percentage of that contribution.  In 2018 you will not be able to deduct any portion.
o   In 2017 you can deduct employee business expenses, certain similar or investment expenses, subject to a 2% disallowance. Starting in 2018 no 2% miscellaneous deductions will be allowed.
·     Medical expenses – for some reason – go the other way. Congress reduced the threshold from 10% to 7.5%, and it made the change retroactive to January 1, 2017. It is one of the few retroactive changes in the bill, and it will exist for only two years – 2017 and 018.
·     Get divorced and you might pay alimony. For 2017 you can deduct alimony you pay, and your ex-spouse has to report the same amount as income. Get divorced in 2019 or later, however, and your alimony will not be deductible, and it will not be taxable to your ex-spouse.
·      Move in 2017 and you may be able to deduct your moving expenses. There is no deduction if you move in 2018 or later.
·      You still have the alternative minimum tax to worry about in 2018, but the exemption amounts have been increased.
·      If you own a business, chances are the new tax law will affect you. For example,
o   If you own a C corporation, you will now pay tax at one rate – 21%. It does not matter how big you are. You and Wells Fargo will pay the same tax rate.
o   If you are self-employed, a partner or a shareholder in an S corporation, you might be able to subtract 20% of that business income from your taxable income. There are hoops, however. The new law will limit your deduction if you do not have payroll or have no depreciable assets, although you can avoid that limit if your income is below a certain threshold.
·     Your kid will provide a larger child tax credit. The credit is $1,000 for 2017 but will go to $2,000 in 2018.
What can you do now to still affect your taxes?
·      Rates are going down. Delay your income if you can.
·      For the same reason, accelerate your expenses, especially if you are cash-basis.
·      Prepay your real estate taxes. Yes, that means pay your 2018 taxes by December 31.
·      Pay your 4th quarter state (and city) estimated tax by December 31. You may even want to sweeten it a bit, although the tax bill does not permit one to prepay all of 2018’s state tax by December 31.
·      Remember that you are losing your 2% miscellaneous deductions next year. If you use your car for work and are not reimbursed, you will lose out. It is the same for an office-in-home. 

·   Congress is limiting or taking away many popular itemized deductions and replacing them with a larger standard deduction. This means your remaining deductions – mortgage interest, taxes (what’s left) and contributions are under pressure to exceed that standard deduction. If you do not think you will be able to itemize next year, you may want to accelerate your contributions to 2017. Remember that the check has to be in the mail by December 31 to claim the deduction in 2017.
There are some surprises to be had, folks. I was looking at an estimated 2018 workup for a routine-enough-CPA-firm client. The result? An over 16% tax increase. What caused it? The loss of the personal exemptions. It was simply too much weight for the increased standard deduction and slightly lower tax rates to pull back up. 

I hope that is not the norm. This is a hard-enough job without having that conversation. 

Merry Christmas

Friday, December 15, 2017

How Often Can The IRS Audit You For The Same Thing?

How often can the IRS audit you for the same thing?

I would have to ask two more questions before answering:

(1) Is the IRS auditing the same year?
(2) Is the IRS auditing the same issue?

Here is the relevant Code section:

            IRC Section 7605(b):

No taxpayer shall be subjected to unnecessary examination or investigations, and only one inspection of a taxpayer's books of account shall be made for each taxable year unless the taxpayer requests otherwise or unless the Secretary, after investigation, notifies the taxpayer in writing that an additional inspection is necessary.

Focus in on the lawyered wording:

            “unnecessary examination or investigations”
            “an additional inspection is necessary”

If I were the IRS, I would argue that all examinations and inspections are “necessary” and be done with the matter.

Fortunately, it does not work that way.

Let say that you are self-employed and deducted a bad debt – a sizeable one – in 2014. The IRS takes a look at it and raises some questions, as bad debts are a notorious area of contention with the IRS. After some back and forth the IRS agrees to the deduction.
Question: Can the IRS audit your 2014 tax return again?
Answer: Of course it can, at least until the statute of limitations expires. What it cannot do is audit your 2014 bad debt again. It already looked at that issue and did not propose an audit adjustment. There is only one bite at the apple.
This does not mean that you are untouchable, however.

Let’s say that you incur a huge net operating loss in 2016. You decide, after meeting with your tax advisor, to carryback the loss to 2014 and get a tax refund. You could really use the cash, with that loss and all.
Question: Can the IRS audit your 2014 bad debt again?
The answer may surprise you: Yes.

Here is the Court:
This is not a case where the IRS is subjecting the Taxpayer to onerous and unnecessarily frequent examinations and investigations. The reexamination of Year 1 is not a unilateral action on the part of the IRS, but in response to the Taxpayer’s election to carry back net operating losses and claim a refund.”
In other words, you started it.

Let me give you a second scenario: 

You have a large donation in 2014 and another large donation in 2015. You were audited for 2014. The IRS made no change to your return.
Question: Can the IRS audit your 2015 for the donation? 
Here is Internal Revenue Manual
(1) Repetitive audit procedures apply to individual tax returns without a Schedule C or Schedule F, when the following criteria are met:
·        a. An examination of one or both of the two preceding tax years resulted in a no change or a small tax change (deficiency or overassessment), and
·        b. The issues examined in either of the two preceding tax years are the same as the issues selected for examination in the current year.  
Answer: You should be able to stop this audit. The IRS looked at the same issue in the preceding year and found nothing.

BTW, note the references to Schedule “C” and “F” in para 1 above. Schedule C means that someone is self-employed, and Schedule F means that someone is a farmer. Those are two situations where a tax advisor would love to have this IRM protection. The IRS knows that too, which is why the IRS left out self-employeds and farmers.  
Question: What if the IRS audits you in 2014 for mileage and in 2015 for office-in-home expenses?  
Answer: You being are audited for two different things. What we are talking about is the IRS looking at the same thing, either more than once for the same year or more than once over a three-year period.

Let’s clarify a crucial point: what halts the second audit is NOT that you were previously audited on the same issue. What halts it is that you were audited and there was no change or an insignificant change. If you owed big bucks on the audit then you are fair game. 

A word of advice: you will have to let the examiner know. My experience is that he/she will be unaware until you bring it up. Address this issue early – for example, when the examiner is trying to schedule the visit – and you can stop the audit altogether.