Spouses Owning Businesses, Divorce And Taxes

A fundamental concept in taxation is that an “accession to wealth” represents taxable income, unless the Code says otherwise.

There are limits on this, of course, otherwise you would be immediately taxed when your mutual fund or house went up in value. The Code will (usually) want to see a triggering event, such as a sale, exchange or disposition by other means. You don’t pay tax on your stock gain, for example, until you sell the stock.

But the concept also creates problems. For example, consider the recent development of crowdfunding. You have an idea for the next great breakfast sandwich, and you reach out on the internet for money to get the idea going. You have accession to wealth, but is the money taxable to you? The tax consequence can get very murky very quickly. For example:

·        If you provide investors with breakfast sandwiches, there is an argument that you sold sandwiches.

·        If investors instead receive ownership (say shares of stock), we would sidestep that sale-of-sandwiches thing, but you might have an issue with securities laws.

·        If investors receive nothing, one could argue that the monies were a gift. The closer you get to detached generosity without expectation of economic gain, the better the argument.

Let's next consider accession to wealth in a divorce context. Here is Code Section 1041:

(a) General rule. No gain or loss shall be recognized on a transfer of property from an individual to (or in trust for the benefit of)—

(1) a spouse, or

(2) a former spouse, but only if the transfer is incident to the divorce.

(c) Incident to divorce. For purposes of subsection (a)(2), a transfer of property is incident to the divorce if such transfer— 

(1) occurs within 1 year after the date on which the marriage ceases, or

(2) is related to the cessation of the marriage.

Believe it or not, the general definition of income could trigger when marital assets are divided upon divorce. That makes little sense, of course, so Section 1041 provides an escape clause.

Question: how much time do you have to separate the marital assets?

The first answer provided in (c)(1) is one year. It is immediately followed by (c)(2) which (appears to) expand the answer to any period as long as the asset transfer is related to the cessation of marriage. That is a bit open-ended, so the tax Regulations interpret (c)(2) as up to six years.

The Belots started a dance school in New Jersey in 1989. The wife was the dancer and creative force, while the husband attended to the business side. Eventually they had several dance studios, a corporation to manage them and a partnership to own the real estate. They did well. While owned 100% by the spouses, the husband and wife were not necessarily 50:50 owners in each entity.

They started divorce action in 2006,and adjusted their ownership in each entity to 50:50. The divorce was finalized in January, 2007.

There is a reason they got divorced. Tired of her ex-husband's participation, Ms. Belot bought-out his share in 2008 for $1,580,000.

Mr. Belot took the position that this was not taxable under Section 1041. The IRS took the opposite position and billed him almost $240,000 in tax and penalties.

Off to Tax Court they went.

The IRS argued that each and every transaction had to come under the umbrella of Section 1041. There was no question that the first transaction qualified, but the second transaction – cashing-out Mr. Belot entirely – did not because it represented an event arising after the divorce. The second settlement represented a business contingency and was not related to the divorce decree.

The IRS was following a hyper-technical interpretation of its Regulations.

The problem is that the Code does not say "pursuant to the divorce decree." It instead says "related to the cessation of marriage." The divorce decree is arguably the most vivid expression of such cessation, but it is not the only one. The Belots were clearly still dividing marital assets owned at the time of divorce.

The Court decided in favor of the Belots.

Why did the IRS even pursue this?

The IRS was enforcing the everything-is-taxable position, unless excluded by the Code somewhere. 

Credit Card Debt And Yankee Doodle Dandy

There is a tax doctrine known as the Cohan rule. It is named after the American composer and playwright George M. Cohan, the subject of the movie Yankee Doodle Dandy. While a renown musician, composer and playwright, he was not much of a recordkeeper, and he found himself in front of the Court defending his business expenses against challenge by the IRS. The Court took an extremely friendly stance and allowed him to estimate his deductions.

While the Cohan rule still exists (in some capacity) today, it should be noted that the tax Code has been changed to disallow the next George Cohan any tax deduction for estimated meals, travel and entertainment. Those particular deductions have to be substantiated or no deduction will be allowed, with or without a friendly judge.

I just read a case where (I believe) a variation on the Cohan rule came up.

The case has to do with cancellation of indebtedness income.

Did you know you could be taxed if a credit card company forgives your balance?

The reason is that the tax Code considers an "accession to wealth" to be "income" (with exceptions, of course). Take the conventional definition of wealth as 

... assets owned less debts owed ...

and you can see that the definition has two moving parts. The asset part is easy - your paycheck increases your bank account, if only fleetingly. The liability part in turn is the reason you can borrow money and not have it considered income (assets and liabilities increase by the same amount, so the difference is zero). Have the bank forgive the debt, however, and the difference is no longer zero.

Newman did something odd. He wrote a check on his Wells Fargo account and opened a new account at Bank of America. He withdrew money from the new account. Meanwhile the check on Wells Fargo bounced.

Bank of America wanted its money back. Newman did not have it anymore.

Impasse.

You may know that a bank will issue a Form 1099 (Form 1099-C, specifically) when it cancels a debt. That 1099 informs the IRS about the forgiveness, and it is a heads-up to them to check for that income on your tax return.

            Question: when does the the bank issue the 1099?

In general it will be after 36 months of inactivity. Newman bounced the check in 2008 and received the 1099 in 2011.

Newman left the 1099 off his tax return. The IRS put it back on.

The Court decided Newman had - potentially - income in 2011.

Newman fired back: he did not have income because he was insolvent in 2011, and the tax Code allows one to avoid debt income to the extent one is insolvent.

You and I use another word for "insolvent" in our day-to-day conversation:  bankrupt.

Bankrupt means that you owe more than you are worth. The tax Code has an exception to debt income for bankruptcy, but it only applies if one is in Bankruptcy Court. But what if you are trying to work something out without going to Bankruptcy Court? The Code recognizes this scenario and refers to it as "insolvency."

So Newman had to persuade the Court that he was insolvent.

One would expect him to bring in a banker's box of bank statements, credit card bills, car loan balances and so forth to substantiate his argument.

The Court looked and said:

At trial petitioner provided credible testimony that his assets and liabilities were what he claimed they were."

"Testimony?"

What about that banker's box?

Newman ran a Hail Mary play with time expiring on the game clock. While a low-probability play, he connected for a touchdown and the win.

To a tax advisor, however, Newman was decided differently from Shepherd, another Tax Court case from 2012 where the taxpayer needed much more than his testimony to substantiate his insolvency.

Why the difference between the two Court decisions?

With that question you have an insight into the headaches of professional tax practice.

What Does It Mean To Rely On A Tax Pro?

You may know that permanent life insurance can create a tax trap.

This happens when the insurance policy builds up cash value. Nice thing about cash value is that you can borrow against it. If the cash value grows exponentially, you can borrow against it to fund your lifestyle, all the while not paying any income tax.

There is always a "but."

The "but" is when the policy terminates. If you die, then there is no tax problem. Many tax practitioners however consider death to be extreme tax planning, so let's consider what happens should the policy terminate while you are still alive. 

All the money you borrowed in excess of the premiums you paid will be income to you. It makes sense if you think of the policy as a savings account. To the extent the balance exceeds whatever you deposited, you have interest income. Doing the same thing inside of a life insurance policy does not change the general rule. What it does do is change the timing: instead of paying taxes annually you will pay only when a triggering event occurs.

Letting the policy lapse is a triggering event.

So you would never let the policy lapse, right?

There is our problem: the policy will require annual premiums to stay in effect. You can write a check for the annual premiums, or you can let the insurance company take it from the cash value. The latter works until you have borrowed all the cash value. With no cash value left, the insurance company will look for you to write a check.

Couple this with the likelihood that this likely will occur many years after you acquired the policy - meaning that you are older and your premiums are more expensive - and you can see the trap in its natural environment.  

The Mallorys purchased a single premium variable life insurance policy in 1987 for $87,500. The policy insured Mr. Mallory, with his wife as the beneficiary. He was allowed to borrow. If he did, he would have to pay interest. The policy allowed him two ways to do this: (1) he could write a check or (2) have the interest added to the loan balance instead.

Mallory borrowed $133,800 over the next 14 years - not including the interest that got charged to the loan.

Not bad.

The "but" came in 2011. The policy burned out, and the insurance company wanted him to write a check for approximately $26,000.

Not a chance said Mallory.

The insurance company explained to him that there would be a tax consequence.

Says you said Mallory.

The policy terminated and the insurance company sent him a 1099 for approximately $150,000.

It was now tax time 2012. The Mallorys went to their tax preparer, who gave them the bad news: a big tax check was due.

Tax preparer became ex-tax preparer.

The Mallorys did not file their 2011 tax return until 2013. They omitted the offending $150,000, but they attached the Form 1099 to their tax return with the following explanation:

Paid hundreds of $. No one knows how to compute this using the 1099R from Monarch -- IRS could not help when called -- Pls send me a corrected 1040 explanation + how much is owed. Thank you."

The IRS in turn replied that they wanted $40,000 in tax, a penalty of approximately $10,000 for filing the return late and another penalty of over $8,000 for omitting the 1099 in the first place.

The Mallorys countered that they had no debt with the insurance company. Whatever they received were just distributions, and they were under no obligation to pay them back.

In addition, since they received no cash from the insurance company in 2011, there could not possibly be any income in 2011.

It was an outside-the-box argument, I grant you. The problem is that their argument conflicted with a small mountain of paperwork accumulated over the years referring to the monies as loans, not to mention the interest on said loan.

They also argued for mitigation of the $8,000 penalty because no one could tell them the taxable portion of the insurance policy.

The Mallorys had contacted the IRS, who gave them the general answer.  It is not routine IRS policy to specifically analyze insurance company 1099s to determine the taxable amount.

They had also called random tax professionals asking for free tax advice.

COMMENT: Think about this for a moment. Let's say you receive a call asking for your thoughts on a tax question. The caller is not a client. Your first thought is likely: why get involved? Let's say that you take the call. You are then asked for advice. How specific can you be? They are not your client, and the risk is high that you do not know all the facts. The most you can tell them - prudently, at least - is the general answer.

This is, by the way, why many practitioners simply do not accept calls like this.                            

The Court did not buy the Mallory's argument. It was not true that the Mallorys were not advised: they were advised by their initial tax preparer - the one they unceremoniously fired. After that point it was a stretch to say that they received advice - as they never hired anyone. A phone call for free tax advice did not strike the Court as a professional relationship providing "reasonable cause" to mitigate the $8,000 penalty. 

The Mallorys lost across the board.

Stop Shoveling, Mr. Edwards

I am looking at a case where the IRS assessed over $1 million in tax and over $790,000 in penalties against a taxpayer.

Apparently this amount was too low, so the IRS added another $202,000 in tax and $152,000 in penalties.

Good grief. Just because you have a shovel doesn’t mean you should keep digging.

If you wondered how $202,000 in tax triggers $152,000 in penalties, it is because the IRS asserted fraud. The fraud penalty is 75%.

This immediately removes this taxpayer (?) from my range of practice. It is one thing to take an aggressive tax position. It is quite another to cross the street, jump the fence and walk into marching-band halftime fraud show.

Fraud requires the IRS to show intent by the taxpayer. This is a difficult standard and made more so by a tax Code that can be heatedly argued by opposing parties.

That said, I was speaking with another CPA this week representing a business tax audit which has stretched over several years. We have bounced ideas on this audit before, and he was telling me that the IRS intends to assert fraud penalties. That surprised me a bit, as there was (to the extent of my knowledge) no indication that revenues were underreported. Deductions, however, were a different story. This was one of those clients that deducted everything in sight – whether or not it was his and twice if you weren’t keeping count. Bam!! Fraud penalty.

And I tell you what I told my friend: I do not believe the penalty will stick if his client pursues the matter. Mind you, the case may have to go to Court, as there is a price to pay for being reckless. His client may not pay the fraud penalty, but the client will pay a tax professional.

Back to our tax case: Edwards.

This case has been in the system for a long time, as the IRS is assessing the 2000 tax year.

Edwards owned a corporation (Magna Corp) in North Carolina. Magna was involved with health insurance and workers’ compensation.  It received commissions from selling insurance, including:

                Sunshine Co                                     $128,239

                Fidelity Group                                   $276,528

Sunshine Co made the checks payable to Edwards individually. This happens, and generally the business owner endorses the check over and deposits it in the business account. That did not happen here.

Fidelity made its checks payable to Capital Marketing, a company owned by a Magna employee.

COMMENT: OK, that is odd. It goes without saying that the money did not make it back to Magna via normal channels.

There must be more to the story, as Capital Marketing also sent over $1.1 million to a Bear Stearns brokerage account owned by Edwards. The account was not in his name, though. It was in the name of “Carolina Green.” 

COMMENT: Folks, here is a tip from a 30-year tax CPA. You probably want to hold up going all Shakespeare-like naming personal bank and brokerage accounts.  Couple that with opaque, almost untraceable and frequent cash transfers and you are likely to have a revenue agent parked in your life for a while.

Edwards was also building a house, and Capital Marketing transferred over $1.4 million to his builder.

                COMMENT:  Enter opaque and untraceable.

Edwards and his wife filed their 2000 tax return and reported a little over $36,000 in income.

Edwards was indicted for mail fraud, wire fraud, money laundering and a rash of other things. He entered a voluntary guilty plea to many of the charges. The IRS held up until the criminal trial was done. That is the reason that we are reading about a 2000 tax case in 2016.

It has to be an upstream row to defend yourself in Tax Court when you have already been criminally convicted. Suffice to say, it did not go well for Edwards.

He could have tried a little harder not to insult the Court’s intelligence, however. He argued, for example, that the $1.4 million that went to the builder was actually a loan to him.

Sure.

Banks make $1.4 million loans to people making $36,000 all the time.

Paying Tax Twice On The Same Income

Let me set up a scenario for you, and you tell me whether you spot the tax issue.

There is a fellow who is involved with health delivery services. He is paid by an insurance company, and he in turn pays out claims against that reimbursement. Whatever is left over is his profit.

In the first year, he received reimbursements from Cigna. There were issues, and in a second year he had to repay those monies. There was of course litigation. It turned out he was right, and Cigna – in yet a third year – paid him approximately $258,000.

Is the $258,000 taxable to him?

There is a doctrine in the tax Code that every tax year stands on its own. One has to resolve all the numbers that go into income for that year, even if some debate about an "exact" number exists. More commonly this is an issue for an accrual-basis taxpayer, meaning that one pays tax on amounts receivable even before receiving cash. Fortunately one is also able to deduct amounts payable (with exceptions) before writing the check. This is generally accepted accounting and is the way that almost all larger businesses report their income.

There is an alternative way. One can report income when cash is received and deduct expenses when bills are paid. This is the cash basis of accounting, and it too is generally accepted accounting.

For the most part, cash basis is the domain of smaller businesses. Depending upon the type of business, however, it may not matter if one is large or small. For example, an inventory-intensive business is required to use accrual accounting.

Our taxpayer is Udeobong, and he uses the cash basis of accounting.

When Cigna paid him the first time, he would have reported income in year one - the year he received the check.

When he repaid Cigna in year two, he had two options:

(1) He could deduct the payment in that second year, as he was repaying amounts previously taxed to him; or

(2) He could file his taxes for the second year using Section 1341, known in tax-speak as the “claim of right.”

The Code recognizes that just deducting the repayment in a second year could be unfair.  Let me give you an example. Let’s say that you received a very large bonus in 2014, large enough for you to retire. You invest the money and live comfortably, but 2014 was your bellwether year and is never to be repeated. Something happens – say that there is clawback - and you have to return some of the bonus in 2016. Sure, you could deduct the repayment, but that repayment could overwhelm your income in 2016. It is possible that you would lose any tax advantage once your income goes negative. If one looks at the two years together (2014 and 2016), you would have paid tax on income you did not get to keep.

That is where Section 1341 comes in. The Code allows you to do a special calculation:

·        You start off with the tax you actually paid in 2014

·        You then do a pro forma calculation, subtracting the repaid amount from your income in 2014. This gives you a revised tax amount.

·        You subtract the revised tax amount from the actual tax you paid in 2014.

·        The IRS allows you to claim that difference as tax paid in 2016.

The Code is trying to be fair, and for the most part it works.

There is one more piece you need to know. Udeobong did not either deduct the repayment or use the claim-of-right in year two. He did ... nothing.

Is the $258,000 in year three taxable to him?

Unfortunately, it is.

But why?

Because the Code gives him two options: deduct the payment in year two or use the claim of right alternative.

COMMENT: You may be wondering if he could amend his year-one return. This is the technical problem with every tax year standing on its own. Unless there were exceptional circumstances, the Code takes the position   that he received and had control over the income in year one, even if something occurs later requiring him to repay some or all of that income. Since he had control in year one, he had income in year one. Should he repay in a later year, then the repayment is reported in the later year.

The Code does not give him a third option of excluding the $258,000 in year three.

So he has to pay tax again.

It is a harsh result. One can understand the reasoning without the conclusion feeling fair or just ... or right.  I am also frustrated with Udeobong. There is no mention that he used a tax advisor. He had no idea of what he walked into.

He tried to save professional fees, perhaps because he saw his tax return as a simple matter of cash in and cash out. I understand, and I do not – in general – disagree. Still, one has to be cognizant when something unusual happens, like swapping real estate, exercising stock options or repaying Cigna a lot of money. The combination of "unusual" and "a lot" probably means it is a good time to see a tax expert.  

Pouring Concrete In Phoenix

I read the tax literature differently than I did early in my career. There is certainly more of “been there, read that,” but there is also more consideration of why the IRS decided to pursue an issue.

I am convinced that sometimes the IRS just walks in face-first, as there is no upside for them. Our recent blog about the college student and her education credit was an example. Other times I can see them backfilling an area of tax law, perhaps signaling future scrutiny. I believe that is what the IRS is doing with IRAs-owning-businesses (ROBS).

A third category is when the IRS goes after an issue even though the field has been tilled for many years. They are signaling that they are still paying attention.

I am looking at a reasonable compensation case.  I believe it is type (3), although it sure looks a lot like type (1).

To set up the issue, a company deducts someone’s compensation – a sizeable bonus, for example. In almost all cases, that someone is going to be an owner of the company or a relation thereto. 

There are two primary reasons the IRS goes after reasonable compensation:

(1)  If the taxpayer is a C corporation (meaning it pays its own tax), the deduction means that the compensation is being taxed only once (deducted by the corporation; taxed once to the recipient). The IRS wants to tax it twice. In a C environment, the IRS will argue that you are paying too much compensation. It wants to move that bonus to dividends paid, as there is no tax deduction for paying dividends.

(2) If the taxpayer is an S corporation (and its one level of tax), the IRS will argue that you are paying too little compensation. There is no income tax here for the IRS to chase. What it is chasing instead is social security tax. And penalties. Some of the worst penalties in the tax Code revolve around payroll.

There is a world of literature on how to determine “reasonable.” The common judicial tests have you run a gauntlet of five factors:

(1) The employee’s role in the company

(2) Comparison to compensation paid others for similar services

(3) Character and condition of the company

(4) Potential conflict of interest

(5) Internal consistency of compensation

Let’s look at the Johnson case as an example.

Mom and dad started a concrete company way back when. They had two sons, each of which came into the business. They specialized in Arizona residential development. As time went on, the brothers wound up owning 49% of the stock; mom owned the remainder. The family was there at the right time to ride the Phoenix housing boom, and the company prospered.

A downside to the boom was periodic concrete shortages. The company did not produce its own concrete, and the brothers came to believe it to be a business necessity. They presented an investment opportunity in a concrete supplier to mom. Mom wanted nothing to do with it; she argued that the company was a contractor, not a supplier. This was how companies overextend and eventually fail, she reasoned.

The brothers went ahead and did it on their own. They invested personally, and mom stayed out. They even guaranteed some of the supplier’s bank debt.

Who would have thought that concrete had so many problems? For example, did you know that concrete becomes unusable after 

(1) 90 minutes or

(2) If it reaches 90 degrees.

I am not sure what to do with that second issue when you are in Phoenix. 

The brothers figured out how to do it. They developed a reputation for specialized work. They worked 10 or 12 hours a day, managed divisions of 100 employees each, were hands-on in the field and often ran job equipment themselves. Sometimes they even designed equipment for a given job, having their fabrication foreman put it together.

Not surprisingly, the developers and contractors loved them.

That concrete supplier decision paid off. They always had concrete when others would not. They could even charge themselves a “friendly” price now and then.

We get to tax years June 30, 2003 and 2004 and they paid themselves a nice bonus. The brothers pulled over $4 million in 2003 and over $7 million in 2004.

COMMENT: I really missed the boat back in college.

The brothers were well-advised. They maintained a cumulative bonus pool utilizing a long-time profit-sharing formula, and they had the company pay annual dividends.

The IRS disallowed a lot of the bonus. You know why: they were a C corporation and the government was smelling money.

The Court went through the five tests:

(1) The brothers ran the show and were instrumental in the business success. Give this one to the taxpayer.

(2) The IRS argued that compensation was above the average for the industry. Taxpayer responded that they were more profitable than the industry average. Each side had a point. Having nothing more to go on, however, the Court considered this one a push.

(3) Company sales and profitability were on a multi-year uptrend. This one went to the taxpayer.

(4) The IRS appears to have wagered all on this test. It brought in an expert who testified that an “independent investor” would not have paid so much compensation and bonus, because the result was to drop the company’s profitability below average.

Oh, oh. This was a good argument.

The idea is that someone – say Warren Buffett – wants to buy the company but not work there. That investor’s return would be limited to dividends and any increase in the stock price. Enough profitability has to be left in the company to make Warren happy.

This usually becomes a statistical fight between opposing experts.

It did here.

And the Court thought that the brothers’ expert did a better job than the government’s expert.

COMMENT: One can tell that the Court liked the brothers. It was not overly concerned that one or two years’ profitability was mildly compromised, especially when the company had been successful for a long time. The Court decided there was enough profitability over enough years that an independent investor would seriously consider the company. 

Give this one to the taxpayer.

(5) The company had a cumulative bonus program going back years and years. The formula did not change.

This one went to the taxpayers.

By my count the IRS won zero of the tests.

Why then did the IRS even pursue this?

They pursued it because for years they have been emphasizing test (4) – conflict of interest and its “independent investor.” They have had significant wins with it, too, although some wins came from taxpayers reaching too far. I have seen taxpayers draining all profit from the company, for example, or changing the bonus formula whimsically. There was one case where the taxpayer took so much money out of the company that he could not even cash the bonus check. That is silly stuff and low-hanging fruit for the IRS.

This time the IRS ran into someone who was on top of their game.