IRS Tax Liens

What Is a Tax Lien?

A lien is the IRS’ first major step in order to collect back taxes. The lien is filed county-by-county and will attach to all property you own in that county.

Why is a Tax Lien Filed?

The lien is filed to secure the IRS’ position as your creditor. A lien by itself does not mean that the IRS will be taking your money or assets, but it can ruin your credit and make it near impossible to buy a home.

The IRS has a policy of automatically issuing a lien if your debt exceeds $10,000. Mind you, the IRS still has the discretion to issue a lien below that limit.

When is a Tax Lien Filed?

The IRS first sends a letter with an assessment of your tax liability. If ignored, there will be four more letters.

You will then receive the Notice of Federal Tax Lien (NFTL). This means that a lien has already been attached to your property. Remember that liens are public record. Expect your credit card rates to go up.

Effects of a Tax Lien

In addition to ruining your credit, a lien can lead to a levy. A levy is bad. This is when the IRS seizes your assets. You probably have heard of bank levies, where the IRS takes the money in your bank account. There are also wage levies (also called garnishments), where the IRS will give you an allowance to live on and take the rest of your paycheck.

What to Do About a Tax Lien?

The first thing is: don’t stick your head in the sand! This will not go away on its own, unless you are willing to earn no money and accumulate no assets for years and years.

Second: do something! Doing nothing was not your best plan. Take the time to research and learn about IRS collections - or hire someone who practices in this area. If it is a CPA, please be aware that not all CPAs practice tax representation. Preparing a tax return is not the same as representing before the IRS. 

The IRS Is Selling a Super Bowl Ring

I am a huge NFL fan. It is, without a doubt, my favorite sport.

Did you hear about Fuzzy Thurston’s tax problems?

Who is Fuzzy? His actual name is Fred Thurston. He played with the Green Packers from 1959 to 1967. He played guard in the first two Super Bowls under Vince Lombardi.

He was considered a tough football player and part of the famed “Power Sweep.” When asked how he prepared for the bitter cold of the Ice Bowl on December 31, 1966 at Lambeau Field against the Dallas Cowboys, he replied “About 10 vodkas.”

After football he became a restaurateur. He and partners, including Max McGee, opened a restaurant named Left Guard in Menasha, Wisconsin and eventually had six locations throughout Wisconsin. Fuzzy played left guard – hence the name of the restaurant.

The trouble arose with employment taxes. Somewhere between 1978 and 1980 the Janesville restaurant failed to remit payroll taxes withheld from employees. We have spoken of withholding before. These penalties are some of the toughest in the IRS arsenal. It makes sense, if you remember that these are withheld taxes. The money belongs to the employees, and the employer is merely a conduit for remittance to the Treasury. When the employer fails to remit, it not only deprives the Treasury but it has also robbed from its employees.

So Fuzzy had a withholding problem. The tax action goes against the company and the responsible persons at the company. As a partner, Fuzzy must have had enough authority to be considered a responsible person. So were his partners. His partners paid-off their actions, but Fuzzy fought his. The initial judgment against him in 1984 was approximately $190,000.

Fuzzy continued to fight. His liability, with interest and penalties for more than 25 years, is a little more than $1.7 million. The IRS is selling off his football paraphernalia, including his 1960 Packers helmet, two 1960 footballs signed by Packers players and Vince Lombardi, his NFL championship rings from 1958, 1961, 1962 and 1965,  and Fuzzy’s Super Bowl II ring. The IRS is searching for his Super Bowl I ring also, but it hasn’t turned up.

It’s an unfortunate story, but I have to point out that Fuzzy either dug in his heels unreasonably or otherwise received horrendous tax advice. Perhaps he felt that his partners stole from him and that he wasn’t responsible. Fine, but a quick education from his accountant might have included the concept of surrogate liability, and that as a partner in the restaurant he had triggered that liability. At that point it was not a matter of right or wrong, but rather a matter of emergency room decision-making. Stop the bleed, clot the wound, stabilize the patient, live to fight another day. I have to believe he could have come up with $190,000 in 1984. He could then have sued his partners, if it made him feel better. But he was not going to win the responsible person action against him with the IRS.

Your Accountant Makes the Mistake. Do You Owe Penalties?

If your accountant omits some of your income on your personal income tax return, is it fair that you should be penalized by the IRS?

Generally speaking, reliance on a tax preparer is “reasonable cause” to request penalty mitigation from the IRS. Generally, but not always.

Enter Stephen Woodsum (SW). SW has a bachelors degree from Yale and a masters from Northwestern. He was a founding director of Summit Partners, a private equity firm.

Note: Mr. Woodsum is financially savvy.

In 1998 SW entered a transaction described as a “ten year total return limited partnership linked swap.” This transaction involved Bankers Trust Company and Deutsche Bank and included a reference to paying interest at the “LIBOR rate” upon the “notional amount” of the “reference fund.”

        Note: Financially unsavvy people do not use these words.

So, the swap was to expire in 2008 – ten years. SW was unhappy with the performance of the swap and ended it in 2006. He received at that time a Form 1099 reporting the $3.4 million Deutsche Bank paid him and another 1099 for $60,291 of interest income.

SW gave all of his tax documents to his accountant. There were over 160 such documents. SW must have had a good year, as the $3.4 million was not the largest number on his tax return. It would however had been the third largest capital gain had the $3.4 million in proceeds been reported.

The accountant prepared the return, including the interest but excluding the $3.4 million.  Some accountant. SW and his wife met with the accountant on October 15, the day the return was due. They had to go over the federal return and 27 state income tax returns. The federal return alone was 115 pages.

Mr. and Mrs. Woodsum did not notice that the accountant had left out the $3.4 million.

The IRS did notice, of course, and wanted the tax and interest, as well as penalties.

Mr. Woodsum felt he did not have to pay penalties because… well, he relied on his accountant. I agree with SW.

The court made an interesting comment. It observed that courts have previously mitigated the penalties, but it continued …

It may be (and petitioners seem to expect the Court to assume) that the omission was the result of the C.P.A.'s oversight of one Form 1099 amid 160 such forms, but no actual evidence supports that characterization. The omission is unexplained, and since petitioners have the burden to prove reasonable cause and good faith, this evidentiary gap works against their defense.”

No actual evidence supports that characterization? I would have gotten a statement from the accountant clarifying that the accountant was provided but failed to include the 1099 on my return.

The court seemed unwilling to give SW as much latitude because of his financial sophistication. The court goes on…

Mr. Woodsum, however, makes no showing of a review reasonable under the circumstances. He personally ordered the termination that gave rise to the income; he received a Form 1099-MISC reporting that income; that amount should have shown up on Schedule D as a distinct item; but it was omitted. The parties stipulated that petitioners' “review” of the defective return was of an unknown duration and that it consisted of the preparer turning the pages of the return and discussing various items. Petitioners understated their income by $3.4 million—an amount that was substantial not only in absolute terms but also in relative terms (i.e., it equaled about 10 percent of petitioners' adjusted gross income). A review undertaken to “make sure all income items are included” (in the words of Magill)—or even a review undertaken only to make sure that the major income items had been included—should, absent a reasonable explanation to the contrary, have revealed an omission so straightforward and substantial.”

I have had clients who did the same as Mr. Woodsum. It did not occur to me that they were conducting an unreasonable review. They provided all documents, answered all questions, met with me and complained about the amount I told them they owed. These are wealthy people. This is not you or I, where the absence of our salary would be immediately noticeable on our return. Mr. Woodsum reported approximately $33 million of income on his return. Note that the sale was not even the largest number on a schedule to Mr. Woodsum’s return.

The court upheld the penalties.

Perhaps this is what happens when a private equity manager gets into a complex financial transaction with names like “ten year total return limited partnership linked swap.” This court was not willing to bend much on the reporting of a “Wall Street” transaction that requires a tax seminar to understand.
The penalties were over $100 thousand.

I wonder whether Mr. Woodsum is suing his accountant for malpractice.

There Are New Deductible Mileage Rates

The IRS has revised the deductible mileage rates for the second half of 2011.

The new and old rates are as follows:

                                                          NEW                                               OLD
Business mileage                          55.5 cents/mi                                   51 cents/mi
Medical or moving                         23 cents/mi                                      19 cents/mi
Charitable mileage                        14 cents/mi                                      14 cents/mi

The charitable mileage rate did not change because that rate is set by statute and not regulation. It requires Congress to change the charitable mileage rate.

The IRS Sues Over Conservation Easements

It has been several years since I visited Washington D.C. I saw a bit of tax news recently that got me thinking about it. Several years ago I was involved in the planning of a conservation easement in D.C. As Washington has 26 historic districts, this was not that unusual. Our client was renovating residential property, and the easement was for the building façade. We normally associate an easement with access to real property, but it can also be a legally enforceable right to preserve real property. In my case, what was being preserved was the outside of the building, which was of historical interest in a neighborhood of historical consequence. You could say that they were donating the right for future generations to look at the building.

The tax advantage? Quite simple: if you follow the rules you can obtain a charitable contribution for the easement. The deduction is (theoretically) the decrease in property value attributable to the grant of the easement. Memory tells me that a reasonable range for a facade is 10 to 14 percent of the building’s value, which is not insignificant.

This area is fraught with danger. An appraisal – or appraisals – is mandatory. The easement will be transferred to a government or charitable organization, so an attorney is required. You may have to obtain the mortgage lender’s agreement to subordinate their right to that of the government or charity receiving the easement.

The IRS challenged some of these donations early on. In some cases, the IRS argued that the donation was zero, although the IRS took considerable punishment in the courts for this position (Akers and Symington, for example).

I was reading Janet Novak’s article in Forbes where she stated that the Justice Department filed a lawsuit to enjoin the Trust for Architectural Easements from certain practices the IRS considers improper. The lawsuit demands that the Trust turn over the names of approximately 800 property owners in Baltimore, New York City and Boston who have claimed this type of deduction. The IRS has already identified more than 300 taxpayers for audit.

The IRS has been concerned with these easements because of their potential for abuse. In some cases, taxpayers have claimed deductions approaching 50% of the property’s value. In others the charity buys the property, places the easement and then sells it to the taxpayer – at a reduced price. The taxpayer makes two checks out – one to purchase the property and the other as a “donation.” He/she of course deducts the second check on his/her return.

The IRS has taken fire from practitioners who argue that it is over-zealous and not regarding Congress’ intent to encourage these easements. I admit that I felt that way at first. It was easy to see a heavy-handed IRS. Consider the following quote from the court in Symington, for example:

  "We are hard pressed to imagine a prospective purchaser of a 60-plus acre parcel of land who would not   have considered the restrictions of such an open-space easement in determining his offering price. The fact that a purchaser of Friendship Farm would have been precluded from even giving away part of his land if he ever so desired, for example, to his children, or, along the same lines, precluded from ever building an additional home on his property, would certainly have affected the purchase price he would have been willing to pay."

However, I am at a loss why I would structure a transaction requiring the charity to buy the real property and for my client to subsequently write two checks. I wouldn’t. I don’t see it how it reflects normal commercial terms. It feels oily, at least to me. The IRS may have valid grounds for this action.

Possible Change in the FUTA Payroll Tax

Beginning July 1, there may be a change in your FUTA payroll tax rate.

The FUTA tax is 6.2%, although the IRS allows a credit of 5.4% if you pay your state unemployment taxes on time. This makes for a net tax rate of 0.8%. FUTA applies to the first $7,000 of wages per employee. There has been a “temporary” surcharge of 0.2% since the 1970s, and that 0.2% is set to expire June 30, 2011. If the surcharge expires, the 5.4% state credit will nonetheless remain the same, making the net cost to the employer 0.6%.

Please be aware that a proposal in the President’s 2012 budget would make the 0.2% surcharge permanent. There is an alternate budget proposal that would increase the FUTA wage base from $7,000 to $15,000 per employee.

Should the FUTA surcharge expire, it will add to an already confusing year for payroll taxes. Remember that for 2011 employers are paying Social Security taxes of 6.2% while employees are paying 4.2%.

We at Kruse and Crawford are monitoring this issue and will available to answer any questions as June 30, 2011 approaches.

June 30th and the FBAR

If you have a foreign bank account, either personally or through work, please remember that you may have to report the account(s) to Treasury by the end of this month. This report is called the Report of Foreign Bank and Financial Accounts, Form TD F 90-22.1, and is usually referred to as the FBAR. If the value of the account(s) exceeds $10,000 at any time, then anticipate that you have to file.

Where the FBAR may get tricky is when one has a signature authority over a foreign account at work. Say for example that your company regularly travels to or has a location in Poland. It is very possible that there will be a Polish account, if for no other reason than for administrative ease. Say that you have authority to sign on that account, although you have no ownership over the account. The company owns the account, not you. Is an FBAR still required?

In the past many an accountant would have said no, but the rules are changing. Believe it or not, the situation described may require an FBAR, although it may also qualify for transitional relief. You do not want to mess with FBAR penalties, as they are quite severe and – in some cases – out of proportion to the money in the account. Treasury is convinced that considerable money is hidden offshore and is having much less patience with such matters.

Hiring Your Child

If you own a business, would it make sense to hire your child? There are different facets to this question, and the one we will discuss today are the tax consequences.

Income Taxes

You can pay your child up to $5,800 without either of you incurring an income tax liability. As long as the wages are reasonable for the work performed, the wages are deductible to your business and taxable to your child. The child’s standard deduction of $5,800 can reduce the child’s taxable income to zero, effectively sheltering the wages.

Is the “kiddie tax” a consideration? The answer is no, as the kiddie tax applies to the transfer of passive income, such as interest and dividends. The income we are discussing is earned income, and the kiddie tax does not penalize earned income.

How much can you save? Well, that depends on your tax rate. If you are in the 35% tax bracket, then you are saving $2,030 in federal income taxes alone ($5,800 times 35%). This amount may be less if there is social security or you as employer have to pay federal unemployment tax. What are the rules for those taxes?

Social Security Tax

The social security consequence will vary depending on the age of the child and whether you are self-employed.

The first requirement is that the child must be under the age of 18.

If you are self employed (which is to say, you are unincorporated and file a Schedule C), you do not have to withhold or pay FICA taxes on a child under the age of 18. If you are under the FICA limit for 2011, this may be an immediate tax savings of 14.13% (15.3% times .9235). If you are over, then the FICA savings reduce to 2.68% (2.9% times .9235).

If you are incorporated, then there are no social security savings, as a different rule applies.

What if you are a partner in a partnership (or a member in an LLC)? If the only partners (or members) are the parents, then you do not have to withhold or pay FICA. Otherwise the corporate rule applies.

Federal Unemployment Tax

The same rule as for FICA applies here, with one exception. If the child works for your unincorporated business, or in a partnership (or LLC) where you and your spouse are the only partners (or members), then the wages will not be subject to FUTA. Otherwise, FUTA will apply.

The exception is the age cutoff. For FUTA, the child must be under age 21.

Income Tax Withholding

Usually, an employee who had no income tax liability for the prior year and expects none for the current year can claim exempt status and have no federal income tax withholding. There is a different rule for children who can be claimed as dependents on their parents’ return. That child cannot claim exempt status if his/her income will exceed $950 AND include more than $300 of interest, dividends and passive income of that nature.

Mind you, it is possible that you will get back the withholding when your child files his/her individual income tax return.

275,000 Charities Have Lost Tax Exempt Status

You may remember that charities, even small ones which previously had been exempt from IRS reporting, were required last year to file with the IRS. There was a “postcard’ filing (990N) for the smallest, but nonetheless everyone had to report.

What prompted this was a change in the tax law in 2006. The Pension Protection Act made it mandatory for most tax-exempts to file, irrespective of their gross receipts. This was a seismic change from prior law. If an organization failed to file for three consecutive years, then the PPA required it to lose its exempt status.

Counting off three years, many of these organizations had to file for the first time last year (2010). The IRS yesterday announced that approximately 275,000 organizations did not comply and have therefore automatically lost their exempt status. In addition, procedures have been announced for these organizations to regain their exempt status, in some cases by paying as little as a $100 fee.

Note that the revocation of status does not affect charitable deductions for amounts donated to these charities before 2011. However, deductions going forward will be disallowed because the organization names have been published - unless the charity reinstates its exempt status.

United States v. Michael F. Schiavo

Let’s look at the matter of Michael Schiavo (United States v. Michael F. Schiavo). He was a bank director in Boston and had invested in a medical device partnership. This partnership had monies overseas. Schiavo decided to tuck the money (approximately $100,000) away and not tell anyone. He did not report the income and certainly did not file the Foreign Bank and Financial Accounts report (FBAR) with the Treasury on or before June 30 every year.

The partnership gave him about $100,000 in Bermuda to play with. He failed to file the FBARs for 2003 through 2008, so he was playing for a while.

He notices what the government was doing with UBS, meets with his advisor and decides to do a “quiet disclosure.” This means that he either amends his income tax return, files the FBAR, or both, without otherwise bringing attention to it. That is, it’s “quiet.”

The IRS had offered an amnesty program for foreign-account taxpayers back in 2009. The advantage was that the government would not prosecute. The downside was that there would be income taxes, penalties and a special 20% penalty for not having reported the monies originally. This program expired in October, 2009. Schiavo decided this was not for him.

The IRS has introduced another amnesty program in 2011, again allowing foreign-account taxpayers to come clean. This time the program covers two more years, and the penalties have been increased to 25% (with some exceptions). The IRS wants to increase the burden to the taxpayer so as not to reward the earlier act of noncompliance.

So Schiavo prepares and files FBARs for 2003 through 2008 but does not participate in the amnesty. That is, he is “quiet.” An IRS special agent then contacts him, whereupon Schiavo amends his income tax return to include the unreported income he just reported to the IRS via the FBAR.

You read this right. He made a quiet disclosure to the IRS but did not amend his income tax return to include the income he had just alerted them to.

The IRS estimates that the taxes at play were about $40,000.

Schiavo was convicted. He now faces a fine and possible jail time.

You are going to take this kind of risk for $40,000 in tax? Are you kidding me? You cannot retire on $40,000. Heck, one can barely send a kid to two years of college for $40,000. What was this guy thinking?

Appeal of Destino Properties, LLC

Here is a June addition to our ongoing discussion of questionable state tax laws.

This one takes us to California.

Destino Properties LLC (“LLC”) was organized in Nevada. It had one asset: a single family home in Nevada. The LLC had four members, three of which lived in California. One of the California members received the rental checks and deposited them to a California bank account. The LLC argued that the majority of its management activities, to the extent there were any, took place outside California.

Let’s add one more fact. California charges an $800 annual fee for LLCs and disregarded entities doing business or registered in the state. The LLC was not registered in California.

Question: does Destino have to pay the $800 fee to California?

The Franchise Tax Board (FTB) contended that Destino was doing business in California because actions by members are attributable to the LLC. Therefore, if the member performed activities in California, those activities could be imputed as LLC activities.

Think about this for a second. The one activity of the LLC was to rent property. It did this in Nevada. The title was in Nevada. The insurance was in Nevada. The real estate taxes were in Nevada. Last time anyone looked, Nevada was not a county of California. Did the managerial activities of the LLC (three-fourths of which were in California) outweigh THE SOLE operational activity of the LLC (which was ALL in Nevada)? What if the LLC was a plastic fabricator with a workforce of 200 employees? Would it still be pulled in by California? At which point would the operational activities of the LLC outweigh the managerial activities of its members?

California reasoned that receiving rental checks, authorizing repairs and hiring a California tax preparer all constituted “doing business” in California. Here is tax planning: hire K&C as your CPAs. We are in Ohio, which is not California. We might recommend that the rental checks also come here, and we could deposit them on your behalf. You could choose an Ohio or a Kentucky bank, as Kentucky is just across the river. That would be two less activities for California to claim.

What is going on, of course, is that California was going find nexus, no matter what.

The IRS is Pursuing 501(c)(4)s

The 2011 Workplan of the IRS Exempt Organizations Division states:

"[i]n recent years, our examination program has concentrated on section 501(c)(3) organizations. Beginning in FY 2011, we are increasing our focus on section 501(c)(4), (5) and (6) organizations."

The (c)(3) is the classic charity – Muscular Dystrophy or March of Dimes, for example. The purpose of a (c)(4) is to pursue a near-endless range of public policy goals through action and advocacy. Many of these entities are barred from (c)(3) status because they express their advocacy through political activity. It is quite common to couple a (c)(3) with a (c)(4). You already know some of the big (c)(4) players, organizations such as AARP and the National Rifle Association.

Now let’s carve-out the meaning of “political activities”:

* Promoting legislation germane to the (c)(4)s purpose is considered a permissible social welfare purpose. Therefore an organization can qualify as tax-exempt under( c)(4) even if the organization’s only activity is lobbying, as long as the lobbying is related to its exempt purpose.
* A social welfare purpose does not include participating in an election in order to advance or defeat a given candidate. Candidate-related activity cannot be the (c)(4)s primary activity. The IRS does not tell us what “primary” means, and advisors differ. Some advisors s feel comfortable with electioneering approaching (but always remaining below) 50% of the organization’s total activities. It is unclear how to even measure activities. What is the measure: dollars spent, time spent by staff and volunteers, a percentage of fixed expenses (such as rent)?

So lobbying is acceptable but electioneering is not.

Donations to (c)(4)s are not afforded the same protection as a (c)(3), and the IRS has held its powder for almost 30 years on whether it would consider (c)(4) donations to be subject to the gift tax.

That has changed.

How would the IRS know who donated to a (c)(4)? A (c)(4) has to disclose to the IRS on its 990 filing contributors who donated $5,000 or more. This list however does not have to be publicly disclosed. Therefore, you and I might not know, but the IRS would. It would not be a difficult task for the IRS to identify donors for audit.

And they have. The IRS has recently sent letters that read as follows:

"Your 2008 gift tax return (Form 709) has been assigned to me for examination. The Internal Revenue Service has received information that you donated cash to [REDACTED], an IRC Section 501(c)(4) organization. Donations to 501(c)(4) organizations are taxable gifts and your contribution in 2008 should have been reported on your 2008 Federal Gift Tax Return (Form 709)."

The federal gift tax applies to a gratuitous transfer of property by an individual. The gift tax is separate from the individual income tax. Not all gratuitous transfers are subject to the gift tax. Transfers between spouses are not considered gifts, for example. An individual can give away $13,000 per year to anyone for any reason without involving the gift tax. Donations to (c)(3)s are not considered gifts, irrespective of the amount. Donations to a 527 organization (that is, a PAC) are not considered gifts. Donations to a (c)(4) are considered gifts.

At least they are considered gifts by the IRS. The IRS pulled out almost 30 years ago, and the limited guidance and cases in this area leaves doubt that the IRS is correct. If one focuses in on the political nature of the contribution, then one has to consider Stern and Carson, for example. In Stern (CA-5, 1971), the IRS lost its argument that campaign contributions were taxable gifts. In Carson (CA-10, 1981) the Tax Court held that Congress did not intend for gift tax to apply to campaign contributions, and the Tenth Circuit affirmed on this point.

We almost undoubtedly will see this matter litigated.

The Mobile Workforce State Income Tax Simplification Act of 2011

Kudos to US Representative Hank Johnson (GA) for cosponsoring the Mobile Workforce State Income Tax Simplification Act of 2011. This bill was proposed in a previous session of Congress. At the end of each session, all bills and resolutions that haven’t passed are cleared. Rep Johnson has reintroduced the bill with Rep Coble (NC).

The concept is simple: if an employer sends employees temporarily across state lines, the employer will not have to register with and withhold taxes for the other state. Temporary is defined as 30 days or less.

Rep Johnson comments:

The tax system is already too burdensome and complicated as it is. This simplifies the code and would prevent Americans who work in multiple jurisdictions from being taxed by state and local governments other than the places in which they live or perform duties over an extended period.”

The hearing was May 25, 2011 before the Subcommittee on Courts, Commercial and Administrative Law.

As someone who has had to worry about this very same issue, I am pleased that someone up in Washington “gets it.”

Perhaps they should include sales taxes and also call in bureaucrats from Texas to explain their position on trade shows. Consider this gem. The Texas Comptroller determined that an out-of-state seller of dental equipment was required to collect sales taxes because it attended an annual trade show in Texas. Mind you, the orders were filled, shipped and billed from outside Texas, but the company did send a person to attend that trade show. Yipes!

Taxes on IRS-Prepared Returns Are Not Discharged in Bankruptcy

A recent bankruptcy case gave me pause. The case is Cannon v U.S.

The Cannons did not file tax returns for 1999 through 2001. The IRS audited and made income tax assessments based on the audit. This is known as a substitute return.

The Cannons later filed for bankruptcy. The IRS said that their taxes for 1999 through 2001 were nondischargeable.

What is the issue here? To be dischargeable in bankruptcy, a debtor’s taxes must meet several tests:

* The returns are due more than three years before bankruptcy
* The tax must be assessed more than 240 days before bankruptcy
* A return must have been filed more than 2 years prior to bankruptcy
* The return must not be fraudulent
* The taxpayer must not have attempted to evade tax

The issue is the definition of “return.” In 2005 the Bankruptcy Code was amended to include the following gem of wordsmithing:

...the term ‘return’ means a return that satisfies the requirements of applicable nonbankruptcy law (includ­ing applicable filing requirements.) Such term includes a return prepared pursuant to § 6020(a) of the Internal Revenue Code of 1986, or similar State or local law, or a written stipulation to a judgment or a final order entered by a nonbankruptcy tribunal, but does not include a re­turn made pursuant to § 6020(b) of the Internal Revenue Code of 1986, or a similar State or local law.”

So a return under IRC Section 6020(a) will qualify. What does Sec 6020(a) say?

6020(a) Preparation of Return by Secretary.—

If any person shall fail to make a return required by this title or by regulations prescribed thereunder, but shall consent to disclose all information necessary for the preparation thereof, then, and in that case, the Secretary may prepare such return, which, being signed by such person, may be received by the Secretary as the return of such person.

The Bankruptcy Code will accept the above but will not accept the following under Sec 6020(b):

6020(b)(1)Authority of secretary to execute return.—

If any person fails to make any return required by any internal revenue law or regulation made thereunder at the time prescribed therefor, or makes, willfully or otherwise, a false or fraudulent return, the Secretary shall make such return from his own knowledge and from such information as he can obtain through testimony or otherwise.

The problem is that a substitute return is a Sec 6020(b) return. If you owe tax with this IRS-prepared substitute return, you are facing the possibility that this tax is nondischargeable, even if the 2-year period has expired.

The question I have is whether amending an IRS-prepared Sec 6020(b) return will constitute filing a tax return and thereby begin the 2-year period. I am looking at Judge Easterbrook’s language in Payne, and Payne’s descendants, such as Creekmore and Links. I must admit, it as clear as mud.

The tax planning for this is pretty straightforward however: file your returns before the IRS catches you.

Senators Question IRS Gift Tax Enforcement

You may have read that the IRS has decided to pursue Section 501(c)(4) organizations. This beggars the question: what is a 501((c)(4) organization?

The (c)(4) is a tax-exempt. That is not saying much, as there are over two dozen types of tax-exempts in the Internal Revenue Code. So what is different about this flavor of tax exempt?

The( c)(4) must not be organized for profit and must be operated exclusively for the promotion of social welfare. Examples of (c)(4)s are AARP and the National Association for the Advancement of Colored People. You may also remember MoveOn.org and America Coming Together.

A (c)(4) may further its social welfare purposes through lobbying without jeopardizing its exempt status as long as it is consistent with the organization’s purpose. It cannot however be the organization’s primary activity. If it is, then one should consider a Section 527 organization.

Are donations to a (c)(4) deductible? That depends. Donations to 501(c)(4)s that are public entities (such as a volunteer fire station) are deductible. Donations to other (c)(4)s are not deductible.

So what has happened to draw the IRS’ attention? Tax advisors such as me have known for a long time that donations to a (c)(4) are not deductible, and we make adjustments when a client includes these amounts in a list of contributions. The IRS has now decided to pursue the (c)(4)s with the argument that contributions are taxable gifts by the donors.

A taxable gift? This is a new issue to me, and I have been at this for a while.

It has caught the Senate’s attention. Six senators from the Finance Committee recently wrote a letter to IRS Commissioner Shulman. The Finance Committee writes tax law in conjunction with the House Ways and Means Committee. The Senators wrote (in part):

The applicability of gift taxes to 501(c)(4) contributions is ambiguous. Historically, the IRS has deliberately opted against vigorous enforcement of the gift tax on 501(c)(4) contributions. There are good reasons for this. First, it is unclear if contributions to these organizations are eligible for the gift tax given their gratuitous nature, and the fact that the donations are made with the expectation that the organization will work to advance the donor’s policy views. Moreover, these contributions are clearly not designed for tax planning purposes or to avoid the estate tax. Most importantly, however, enforcement of gift taxes on contributions to 501(c)(4) organizations engaged in public policy debate runs an unacceptable risk of chilling political speech, which receives the highest level of constitutional protection under the First Amendment

This pattern of nonenforcement over a period of nearly three decades, coupled with the troubling issues regarding the adverse impact that enforcement might have on the exercise of constitutionally protected rights, raises important questions regarding the timing of the decision to enforce the gift tax on these contributions. Retroactive enforcement of the gift tax in this highly politicized environment raises legitimate concerns and demands further explanation."

The statement by IRS spokeswoman Michelle Eldridge did not assuage these concerns and left us with only more questions. According to Eldridge, “[a]ll of the decisions involving these cases were made by career civil servants without any influence from anyone outside the IRS.” We would expect that decisions regarding particular enforcement actions would be made by career civil servants. The more pressing question, not answered to date, is whether political appointees inside or outside the IRS were involved in any way in the decision to prioritize this category of cases."

I understand that (c)(4)s are not supposed to be piggybanks, but are there really enough tax dollars here for the IRS to prioritize this issue?

I was too young, but I have understood that President Nixon used the IRS as a political weapon against his opponents. In a country where half the population does not trust the current President to do the right thing, it is unfortunate to have the IRS call its neutrality into question. You can accept or hate the IRS, but it is imperative that the IRS act and be perceived as a neutral entity.

One can argue that perhaps there is no good time for this type of action, but the observation remains that this is not a good time.

I will come back in a separate post with more detail on the tax issues raised by (c)(4)s.

Tax Break for Exporters

We are taking a look at an Interest Charge – Domestic International Sales Corporation (IC-DISC).

As you can guess, this has to do with a company which exports. I remember the DISC as providing a tax deferral, but it has another tax feature that we like as much or more.

Here is quick breakdown of how the IC-DISC would work:

(1) There is an exporting company (ExCo)

(2) ExCo (or its owners) set up a second company (DISC) and elect to be treated as an IC-DISC.

(3) ExCo pays DISC a commission

(4) DISC pays no tax on the commission (up to a point) as long as 95% of its activities and assets are export-related.

NOTE: Do you see what is happening? DISC pays no tax on the commission. ExCo deducts the commission and reduces its tax.

(5) DISC may pay dividends to its shareholders.

(6) If DISC does not pay dividends, there will a charge to the shareholders. The charge will vary depending on whether the shareholders are individuals or a corporation. Individuals will pay interest (hence “Interest Charge – DISC”). There is a different tax treatment for corporations.

The DISC can be a “paper” company. That is, it does not have to perform any substantial economic functions. It does not have to have employees or office space, for example. Pretty much the only thing it has to do is keep its own books and records, which an accounting department can do. You incorporate, print some new stationary and continue doing what you were doing before. How much easier can this be?

There are of course limits on how to calculate the commission; otherwise you would have a product selling for $50 with a thousand dollar commission tacked onto it. The commission is 4% of the qualified export receipts or 50% of ExCo’s taxable income, whichever is greater.

The DISC can defer $10 million in commissions EVERY year. There is even a way to increase this limit.

The tax deferral is sweet, but Rick and I like the dividend treatment as much or more. We expect the DISC to be an S corporation, and its shareholders to be the same as those for ExCo. We can also see a wealth transfer opportunity here by having the younger generation as the owners of the DISC, while mom and dad (or grandmom and granddad) still own ExCo. We are thinking of having the DISC distribute every year. Under this scenario there is no deferral. We want to move money out of the main company (ExCo), which would otherwise be taxed at the maximum rate, and push it to DISC, whose dividends are taxable at 15 percent. This would be an immediate 20% tax savings.

The Collection Due Process Hearing

A client recently faxed me a Notice of Intent to Levy. His tax case is relatively simple, as we are not debating the amount of tax. Rather, he is in a position where he cannot pay-off his tax due. This requires a payment plan, which can blow up if the taxpayer misses a payment. He is self-employed with erratic income, so he is at ongoing risk of blowing up his payment plan. He unfortunately believes – or has believed – that we can reactivate a payment plan whenever he feels like missing a payment, but I believe we impressed upon him that this is not the case. The IRS becomes weary, and frankly so do we.

I thought this a good time to talk about the Collection Due Process hearing.

Once you receive a Notice of Federal Tax Lien (NFTL) or Intent to Levy, you have 30 days to request a CDP hearing. If so, the levy action will be suspended for the duration of the hearing. IRS Appeals conducts the hearing. The taxpayer can appeal a CDP hearing, if so inclined.

What happens if you miss the 30 days? Not all is lost. You can request an Equivalent Hearing as long as you file within one year of the NFTL or levy notice. The difference is that you cannot appeal an Equivalent Hearing.

You have to file a form (Form 12153) and state a reason for the hearing. In our case, we will request a collection alternative, such as an installment agreement. Our client does not qualify for an offer in compromise, which is another valid reason. Other reasons include requests to release or subordinate a lien, request for innocent spouse and a dispute over the amount of unpaid taxes. An important reason in today’s economy is financial hardship, which can include heavy medical bills, unemployment, and taxpayer’s reliance on social security or unemployment benefits.

An unfortunate note is that – even if the IRS accepts the collection alternative – interest and penalties will continue to accrue.

Losing Bankruptcy Protection On Your IRA

You probably know that monies in your IRA are protected from bankruptcy. No one intends to go there, but it’s nice to know that you have that safeguard.

What do you have to do to void that protection?

Enter Ernest Willis and his IRAs (Willis v Menotte).

Willis opened a self-directed IRA with Merrill Lynch in March, 1993. On December 20, 1993 he withdrew $700,000to help him with a real estate transaction. On February 22, 1994 he put the $700,000 back in the IRA.

NOTE: Let’s count the days… 12 + 31 +22 = 65 days. You may remember that you can withdraw money from your IRA and not have it count as a distribution IF you replace it within 60 days. Looks like Willis missed his count.

In January, 1997 Willis had problems with the stock market. He had to put money into his brokerage account (I presume he was on margin), so he wrote checks back and forth between his IRA and the brokerage account. The settlement takes a few days, so he could keep the brokerage account afloat by swapping checks. Since he was replacing the IRA monies within 60 days, he did not have a distribution.

Somewhere in here Willis partially rolled-over his Merrill Lynch account to AmTrust and Fidelity.

In February, 2007 Willis filed for bankruptcy. The creditor wanted his IRA. Willis said NO NO and NO. The IRA is protected by Bankruptcy Code Section 522(b) (4) (A). “Go away” says Willis.

The bankruptcy court takes a look at the IRA transactions. An IRA is not allowed to participate in certain transactions (called “prohibited transactions”) with its fiduciary. Guess what? If you direct a self-directed IRA, you are a “fiduciary.” Willis tapped into his IRA and did not replace the money within 60 days. The 60 days is not a suggestion; it is the statute. He didn’t make it. He put the money back in there, but this was not horseshoes. This was a prohibited transaction.

The court was also not too amused with the check swapping scheme and his brokerage account. The court observed that this had the effect of a loan between Willis and his IRA. An IRA cannot loan money, and it especially cannot loan money to its fiduciary. This was a prohibited transaction.

The bankruptcy court held against Willis. He appealed to the district court. That court sustained. Willis next appealed to the Eleventh Circuit, and the circuit court has just sustained the district court. Willis has lost.

How much money was in these IRAs? The Merrill Lynch account alone was over $1.2 million.

I have known clients to “borrow” from their IRA, and I especially remember one doing this while Rick and I worked together at another firm a few years ago. I remember counting down and sweating the 60 days. This was a sensitive client, and – if it blew up – I was going to take massive damage. Willis unfortunately did not keep it to 60 days. He must have been strapped, because he wound up borrowing from friends and family. He put the money back into the IRA, but he had missed the window. The later episode with the check swapping was just icing on the cake.

The court pointed out that once the IRA was tainted, the taint followed the partial rolls to the other two IRAs. His three IRAs were unprotected and could be actioned by his bankruptcy creditors.

Willis thought he was clever. He got schooled, and the tuition was expensive.

Another Warning on Deducting Auto Expenses

There is a very recent case concerning tax deductions for business use of a vehicle that I am considering as mandatory reading for many of our clients.

The pattern is repetitive. Either the business provides the car or the employee uses his/her car for business and is not reimbursed. Tax time we ask the following questions: what is your mileage? What do you have as documentation to support that mileage? We review the danger associated with this tax deduction (the IRS will disallow it if you cannot back it up), to which it seems most of the clients roll their eyes and go “yea, yea.”

Well, Jessica Solomon just got schooled. It’s a shame, too, as it sounds like Jessica was trying to do the right thing, but she just didn’t know what that meant. Let’s look at Jessica Solomon v Commissioner.

Jessica Solomon moved from Illinois to Missouri in 2006. First, let me say that I went to the University of Missouri, so I approve of her move. Second, she started work as a commission-only salesperson for seven months – June through December. She was peddling office supplies. Every day she started the morning at the company office in St Louis, and at the end of the day she finished with an evening meeting there. She only made $3,307 in commissions. Considering that she was reimbursed for NOTHING, it sounds to me like this was a waste of her time.

She kept a log in her car. At the start of the day she wrote down her mileage, and at the end she noted her mileage. Unfortunately, there was no other information, such as the towns, prospects or customers she was visiting. It was bare-boned, but it was something.

At the end of the year she went to H&R Block. They deducted her business expenses, including 18,741 business miles.

In January, 2009 the IRS issued a statutory notice disallowing all her mileage and employee expenses for 2006. Jessica, bless her heart, went to Tax Court representing herself (this is called “pro se”). It did not go well for Jessica.

Unfortunately, the court was right. Let’ go through this…

* It is an axiom in tax practice that deductions are a matter of legislative grace. This is fancy way of saying that there is no deduction just because you really, really want there to be one.
* If a taxpayer presents credible evidence on a factual issue concerning tax liability, Code Section 7491(a) shifts the burden of proof to the IRS.
* If Section 7491(a) kicks in, the IRS (or Court) may even estimate the amount of expenses, if the supporting documentation is poor or even nonexistent.
* There are some expenses where the burden of proof does not shift under Section 7491(a).
* A car is one of those expenses. Car expenses are addressed under Section 274(n).
* Section 274(n) says that no deductions are allowed with respect to listed property (think a car) unless very specific documentation requirements are met:

** The amount
** The time and place
** The business purpose
** The taxpayer’s relationship with the persons involved

The Court looked at her log. The court had several problems;

(1) The log noted only the beginning and ending mileage for each day

(2) The log included a 27 mile commute

(3) The log may have included personal trips

So far, I could have worked with this. I would ask Jessica for a Day Runner or some other record of who she visited, where and etc. In fact, had she submitted contact reports to the company, I would ask the company to provide copies for her tax audit. I need corroborating evidence. The evidence does not have to be on the same sheet of paper. In truth, it need not even had been created at the time, although that would of course carry more weight.

Unfortunately Jessica could not do this. Here is the Court:

Petitioner did not present any evidence at trial, such as appointment books, calendars, or maps of her sales territories, to corroborate the bare information contained in the mileage log…”

But the court KNEW that she had to use her car – right? Surely the Court would spot her something.

Although we do not doubt that petitioner used her Chevrolet Cavalier for business between June and December, 2006, we have no choice but to deny in full petitioner’s deduction for mileage expenses. For reasons discussed …, petitioner’s mileage log does not satisfy the adequate records requirement of Section 274(d).”

No mileage deduction for Jessica.

As I said, perhaps this case should be mandatory reading for many of our clients.

Signing Up for Social Security?

Those applying for social security beginning Monday, May 2, will have to select an electronic payment option – either direct deposit or a debit card. The debit card can be reloaded every month. One has to be careful, though, as fees will apply. For example, there is a $1.50 charge for transferring from the card to a checking or savings account.

If you are already receiving social security, then you have two more years – until March, 2013 - to make this decision.

Will Bankruptcy Protect Against An IRS Lien on Your IRA

It happened this busy season. As you may know, we do our share – and then some – of tax representation work. I would say that, despite our size, we do as much representation work as many firms in Cincinnati.

So what happened? A client wanted to know whether the IRS could lien her IRA.

Do you know the answer?

I’ll give it to you momentarily

I was looking at a tax case called Miles v Commissioner. Corrie Miles ran up past due taxes. The IRS filed liens for 1997 and 1998 which attached to her IRA.

Note: Under Section 6321 if a taxpayer fails to pay a liability after notice and demand, the IRS can file a lien on taxpayer’s property and rights to property.

If it goes to the next step, the IRS is allowed under Section 6331 to seize and sell the property (unless it is exempt) subject to a federal tax lien.

Corrie Miles filed for bankruptcy in 2003. Her 1996, 1997 and 1998 taxes were discharged.

Remember: Taxes more than three years old can be discharged.

Can the IRS go against her IRA?

What is your answer? Did Corrie keep her IRA?

This case went through Appeals and the Supreme Court has just refused to give it cert. But it did go that high up the chain. The IRS won. Why? Although Corrie went through bankruptcy, the IRS had a priority position going in to bankruptcy. The bankruptcy will not wipe out the lien. The IRS could proceed against Corrie’s IRA to the tune of $142,000 – the balance in the IRA before she went into bankruptcy.

Congress Speaks Up on Innocent Spouse Tax Relief

I am glad to see that Congress is addressing the IRS’s position concerning innocent spouse and litigated in Cathy Marie Lantz v. Commissioner.

Here is a summary of the issue:

There are three “types” of innocent spouse claims. Let’s refer to them by the Code subsections they are presented under: (b), (c) and (f). Type (b) is the classic innocent spouse: the erroneous items belong to one spouse; the other spouse did not know or have reason to know. Type (c) is for divorced spouses and allows each spouse to determine his/her liability as if the spouse had filed a separate return.

Type (f) is more of an expansive innocent spouse rule. It was passed years after the original provisions (it was passed in 1998), and it seeks to provide an opportunity for spouses who cannot meet the (sometimes technical) requirements of (b) and (c).

What (b) and (c) have in common is that the spouse has to file the innocent spouse claim within two years of contact by the IRS. What happens, though, if the one spouse is not told by the other spouse of the contact? Could happen. Some would say it will happen. Say further that two years go by. The spouse then learns of the problem and tries to pursue innocent spouse relief under (f). Does the two year rule apply to an (f) filing?

Interestingly, Congress did not include a two year rule in (f), a point which many practitioners, including myself, interpret to mean that Congress did not mean to include a two year rule in (f). Seems straightforward. The law was in place; Congress was aware of the law and chose not to include the two year requirement.

The IRS does not agree. The IRS argues that Congress delegated authority to it to write administrative Regulations for (f), and that, after consulting with Carnac the Magnificent, it believes that Congress intended for there to be a two-year requirement under (f). Congress just forgot to write it in to the law.

There was a case last year,Cathy Marie Lantz v. Commissioner, which unfortunately agreed with the IRS. To be fair, there is a technical argument, and the argument can be persuasive. Unfortunately, it does not pass the “common sense” test.

Congress has now chimed in and 49 Representatives — including all the Democrats who sit on the tax-writing House Ways and Means Committee — have told the IRS Commissioner that the IRS had “violated the spirit of the original law” in limiting relief to two years. Three Democratic senators — Max Baucus of Montana, the chairman of the Finance Committee; Tom Harkin of Iowa; and Sherrod Brown of Ohio — have sounded the same theme.

The national IRS taxpayer advocate - Nina Olson – has also asked for the two year limit to be extended or revoked.

Let’s hope something comes of this.

Mortgage Debt Forgiveness

We saw a home foreclosure reported this tax season.

You may remember that the Mortgage Relief Act allows taxpayers to exclude up to $2 million of mortgage debt forgiveness on their principal residence. This is an exception that the general rule that includes cancelled debt in income. The term of art is “qualified principal residence debt.” The key part here is “principal residence.” You can have several homes, but only one home can be your principal residence. A principal residence can be a house, a condominium, a cooperative, a mobile home or houseboat. I remember a fellow who docks his yacht off the coast of Jacksonville. I suppose he could consider his yacht his principal residence, if he and his wife lived there enough. It wouldn't be a bad life, as the yacht was around 100 feet long and had a professional crew. He was, needless to say, quite well-off.

Here is what doesn’t qualify: a vacation home, a second home, a business property or a rental property.

The debt itself must have been incurred to buy, construct or substantially improve that principal residence. Herein lays a possible trap. Say that you refinanced your house for $250,000 when its original mortgage was $180,000. You used the additional monies to … well, who knows what you did, but you did not fix-up the house. Maybe you sent a kid to college. If the house gets foreclosed and that debt cancelled, you may have a problem. Let’s say the debt is $250,000, to keep the discussion easy. Only $180,000 of that debt will qualify, as only $180,000 represents the purchase, construction or improvement (or refinancing of the same) of the principal residence. The remaining $70,000 ($250,000 – 180,000) represents income from cancelled debt. It may be that the $70,000 may be excludable under another provision (say insolvency), but it will not be excluded under the Mortgage Relief Act.

What I see as an unfortunate fact pattern is a saver who paid off, or paid down, his/her house and then runs up a second mortgage for unexpected debt, such as medical bills or unemployment. You can see that this mortgage would not have been incurred for the purchase, construction or improvement (or refinancing of the same) of a principal residence. There would be no relief for this person, at least under the Mortgage Relief Act.

Now It's Social Security Notices Concerning W-2s

The Social Security Administration is resuming their DECOR notice program. DECOR stands for “Decentralized Correspondence” and means that the SSA could not process a Form W-2. There is any number of reasons why this could happen, including:

1. Typographical errors
2. Name changes, including marriage
3. Misuse of a social security number

The SSA places these earnings in a suspense file called Earnings Suspense File (ESF) rather than posting to a worker’s account.

An employer is requested to check their records. If the worker is still employed, the employer may be requested to verify the employee’s social security card and number. If the employer and employee are unable to resolve the matter, the employee will be requested to contact a local SSA office. If the worker is no longer employed, the employer is required to document its efforts to verify the information.

You may remember that SSA has not sent out DECOR notices for several years because of litigation over Department of Homeland Security regulations.

Reporting Health Coverage on Forms W-2

Good news on reporting health coverage on employees’ W-2s.

You may recall that Obamacare requires the reporting of health coverage on an employee’s W-2. This rule was to be first effective for 2011 W-2s to be filed in 2012.

That was changed from 2012 to 2013 – in effect, a one year delay.

Now the rule has been changed again. Small firms, defined as having fewer than 250 employees – do not have to report health coverage on their 2012 W-2s to be filed in 2013.

Larger employers – defined as 250 employees or more – will still have to include this information on their 2012 W-2s.

Social Security Annual Statements

Did you see that the Social Security Administration will stop mailing annual statements to workers in order to save money?

The SSA plans to eventually resume mailing these statements to workers age 60 and over. It intends that those 60 and younger be able to download their statements.

The SSA starting mailing annual statements to individuals age 60 and over back in 1995. In 2000 it included workers age 25 and over. Last year it mailed out more than 150 million four-page statements, which list your earnings history and give an estimate of your expected retirement benefit.

SSA Commissioner Michael Astrue pointed out that the annual statements cost approximately $70 million each year to print and mail.

IRS Announces Changes to Its Tax Debt Activities

In February the IRS announced new rules easing, at least somewhat, the burden of its collection activities.

The change affecting the largest number of people concerns liens. The limit for automatic filing has increased from $5,000 to $10,000. Therefore, if your liability to the IRS is less than $10,000, you will not face the threat of a lien.

Why and how is this important? The three credit rating agencies pick-up and report these liens. As credit ratings become increasingly important in the hiring or rental process, a poor rating may cost you a job or a place to live. These liens can remain on a credit report for seven years.

The IRS will also change its procedures for removing liens. The IRS will now withdraw its lien once the debt is paid in full and the taxpayer requests it (although I question why the IRS was not doing this previously). The IRS will also remove a lien when a taxpayers enters into a direct debit installment agreement for $25,000 or less.

The small business version of an installment agreement will also be increased from $10,000 to $25,000. This program allows the business to pay tax over 24 months, if the tax liability is $25,000 or less.

For taxpayers with little hope of paying their tax debt, the offer-in-compromise program will now be expanded to taxpayers with incomes up to $100,000 and tax liabilities of $50,000 or less. This is twice the former limit.

Do not however interpret this to mean that offers will necessarily be easier to obtain. The number of accepted offers decreased from nearly 39,000 in fiscal 2001 to less than 11,000 in fiscal 2009, according to the Taxpayer Advocate. Let’s compare this to the number of liens, which have ballooned from 168,000 in 1999 to 1.1 million last year. Few, and very few, taxpayers get to settle their tax debt for “pennies on the dollar,” irrespective of the TV commercials.

Tucker v. Commissioner of Internal Revenue

I came across an interesting tax case: Tucker v Commissioner of Internal Revenue. This thing is virtually a case study in IRS procedure. It also involved a taxpayer that (a) owed monies to the IRS and (b) decided to day trade before remitting monies to the IRS. You can probably anticipate that things did not go as planned for Mr. Tucker.

Let’s go through some of the detail.

Tucker had filed returns for 2000, 2001 and 2002 but did not pay the tax. In 2003 he decided to pave his way to gold by day-trading. He owed the IRS approximately $15,000. He lost almost $23,000.

In May, 2004 the IRS sent him a Notice of Intent to Levy. He did not request a hearing.

In July, 2004 the IRS sent a Notice of Federal Tax Lien Filing (NTLF).

However, before he received the NTLF he submitted in July, 2004 a request for an Offer in Compromise. His total tax was approximately $24,000; with penalties and interest it was approximately $35,000. He proposed an OIC of $100 monthly for 60 months.

The OIC was rejected.

However, after he received the NTLF notice but before learning that the IRS rejected his OIC, Tucker filed in August, 2004 a Request for Collection Due Process (CDP) Hearing.

Note: The IRS generally notifies a taxpayer of a right to a hearing when it sends a levy. If the taxpayer requests the CDP hearing, the IRS may not file a levy until after the hearing. At that hearing the taxpayer may ask for an installment agreement, an offer in compromise or another collection alternative. The taxpayer may also dispute the amount of the tax liability.

With the request for a CDP, Tucker also requested an OIC.

Note: So Tucker requested an OIC in July and then again in August. This caused some confusion at the IRS. Tucker’s attorney withdrew the July OIC and offered instead an installment agreement.

Note: an OIC is not an alternative to the filing of an NFTL. It is an alternative to the filing of a levy. This tells me that Tucker missed the deadline for the May notice and was trying to catch up.

So now we are in May, 2005 and the CDP hearing was held over the telephone. Tucker’s attorney stated that Tucker no longer wanted the July, 2004 OIC with payments totaling $6,000. So, the following month (June, 2005) Tucker submitted new financials. The attorney proposed an installment payment arrangement of $326 a month.

The IRS reviewed the numbers, revised it to $316 and requested Tucker to sign and review a partial payment installment agreement (PPIA).

Hey, now we are getting somewhere.

Wait! The attorney now wanted to switch from a PPIA to an OIC.

Note: Why would he do this, you ask? There is a technical reason, as an OIC would (assuming Tucker adhered to all of the conditions) fix the liability to the IRS. A PPIA would be reexamined every two years for possible increases.

Tucker tried to sweeten the pot by proposing payments of $317 monthly. I guess he figured that that extra $1 per month would help his cause.

In November, 2005 the IRS rejected Tucker’s OIC.

Question: Why would the IRS do this? There can be several reasons, but one reason is that a lot of time was left on Tucker’s statute of limitations (SoL) period for collections. You may remember that there is a SoL of three years for the IRS to audit your return. There is a second, and less known, SoL on how long the IRS has to collect, assuming that it has audited or otherwise assessed your return. That second SoL is ten years. Tucker had more than five years left on this SoL, and the IRS was reluctant to give it up. Remember, under an OIC the IRS cannot revisit the numbers unless the taxpayer fails to comply.

In January, 2006 Tucker filed with the Tax Court. The Tax Court sent the case back to IRS Appeals to reconsider Tucker’s July, 2005 OIC. This second (supplemental) hearing was held September, 2006.

Here is the magic language by IRS Appeals:

Upon review, * * * [this settlement officer] believes that the stock sales are dissipated assets and believes the amounts dissipated should be included in a minimum offer calculation. As such, the minimum offer is actually full payment. These stock transactions in 2003 occurred * * * [after] the due dates of the 1999, 2000, and 2001 1040 returns. If you simply sold a little less than you bought, which was your option, you could have already paid the taxes in full.

So… the IRS is arguing that Tucker “dissipated” his assets and therefore refused his OIC.

In November, 2006 Tucker filed again with the Tax Court. He of course disagreed that he “dissipated” anything. The IRS responded in November, 2007. Tucker filed a motion in February, 2008.

Are we FINALLY getting to court?

Here is what the Tax Court had to say:

Mr. Tucker also argues that the Office of Appeals erred in determining that his day trading in 2003 constituted a dissipation of assets. We disagree in part.

Mr. Tucker was aware of his unpaid tax obligations for 1999 through 2001 when he transferred the $44,700 into his E*TRADE account. Despite having known tax obligations, Mr. Tucker still transferred the money and for nearly four months engaged in the highly speculative and volatile activity of day trading.

Mr. Tucker maintains that he did so in an effort to make enough money to pay off his delinquent taxes and other creditors, as well as pay his tax liability for 2002 that would be coming due.

The losses that Mr. Tucker sustained were not due to an unforeseeable event but rather were commonplace (especially for a neophyte) in such a highly volatile activity. Mr. Tucker knew he owed outstanding taxes; and he had the cash in hand that would have paid in full the taxes and accruals he owed as of early 2003 (i.e., for tax years 1999, 2000 and 2001); and yet he chose instead to devote that money to a risky investment. Mr. Tucker’s foray into day trading was purely speculative, and his already slim chances of success were undermined by his inexperience. In short, Mr. Tucker’s circumstances were of his own making.

Well, this is not going well for Tucker.

In the supplemental notice of determination, the settlement officer concluded that Mr. Tucker had dissipated $44,700 in assets, measured by his deposits into the E-Trade account. For purposes of summary judgment, we find that that conclusion was excessive. The mere act of depositing the money into the E-Trade account did not rise to the level of dissipation, but the day trading and the losing of the money in the account did. Because at the time in April 2003 that Mr. Tucker lost a total of $22,645 from his day trading activities, he had outstanding Federal tax liabilities of at least $14,975, we hold for purposes of summary judgment that Mr. Tucker dissipated assets of $14,975.

The parties agree that Mr. Tucker’s disposable income (i.e., monthly income over allowable monthly expenses) was $316 per month, and that there were 116 months remaining before his collection period expiration date.

As a result, Mr. Tucker’s future income subject to collection would be $316 x 116 months, or $36,656--an amount slightly less than the total of the payments he proposed in his OIC. However, as we determined above, the value of assets that Mr. Tucker dissipated through his day trading activities was $14,945. Under IRS guidelines, Mr. Tucker’s reasonable collection potential would therefore be $51,601--i.e., the sum of his future income stream ($36,656) plus the value of any dissipated assets (at least $14,945). Given that Mr. Tucker’s reasonable collection potential thus exceeded his outstanding tax liabilities, the settlement officer did not err in determining Mr. Tucker could fully pay his Federal income tax liabilities.

The part of this case that has attracted professional interest is the stern disapproval of the Tax Court (or, at least, of Judge Gustafson) of day trading while owing the IRS monies. Dissipated assets will not reduce the amount the IRS will accept in an installment agreement or offer. The risk therefore is one-sided: if you make money, you can pay the IRS sooner; if not, then you will owe the same as before, but with fewer assets at your disposal.

As For Tucker, he now owes the better part of $45,000 to the IRS. As too often happens, the taxpayer should have settled for the best available deal and carried on with his/her life.

High-Income Filers and the COBRA Subsidy

Do you remember the COBRA assistance payments available to workers laid-off between September, 2008 and May, 2010? The IRS is sending letters to remind them that some of the subsidy could be taxable.

The recapture is income-based. If the taxpayer is single, then recapture begins at $125,000 and phases-out at $145,000. For marrieds the range is $250,000 to $290,000. Income is defined as “Modified AGI,” which for most people will be AGI plus tax-exempt interest.

Were You 70 1/2 in 2010?

An important date is coming up if you turned age 70 ½ last year and decided to defer your first IRA withdrawal.

Example: A taxpayer born February 9, 1940 attained 70 ½ in 2010. A taxpayer born August 1, 1940 will attain age 70 ½ in 2011.

By April 1, 2011 a taxpayer who reached age 70 ½ last year must begin minimum required distributions from his/her IRA.

The taxpayer does not have to begin MRD is he/she is still employed and has a 401(k) at work. The initial date is delayed until such taxpayer retires. This exception does not apply to a 5%-or-more owner, however. He/she must begin MRDs at age 70 ½ whether or not he/she continues working.

To calculate the MRD from an IRA or several IRAs, the taxpayer would combine the balances in all IRA(s) to make the calculation. The MRD can be made from one or a combination of IRAs, however. Each IRA does not have to have an MRD, as long as the total from all IRAs equal the MRD.

The rule is different for qualified plans, such as 401(k)s. Each qualified plan must have its own MRD, which is the opposite of the IRA rule.

There is a steep 50% penalty for failure to take out MRDs. The penalty fortunately can be waived for reasonable cause and reasonable steps are being taken to remedy the failure. Still, one would prefer not to go there.

Fuel Tax Credit

We are in corporate tax season. I was thinking about a somewhat offbeat tax credit that we claim for one of our business clients. They work primarily with roadways and infrastructure. They have to power their equipment on-site, which means that many times they have to bring their own generators. They claim the fuel tax credit.

For a fuel-intensive business, this can add up. The credit for gasoline is 18.3 cents per gallon, and for diesel it is 24.3 cents. You are to keep certain records to support the credit, as can be expected. The records should include the name and address of the seller, the dates and quantity of purchase. Also, if there are different fuels - such as both gasoline and diesel – the records should differentiate between the two.

The credit is claimed on Form 4136. If the claim exceeds $750, the taxpayer can expedite the refund by filing Form 8849.

By the way, recreational use of a boat does not count for purposes of this credit.

You may want to check your state also. There may be an additional refund opportunity there.

Bonus Depreciation on Real Estate Construction

The question came up of whether any part of real estate construction would qualify for the bonus depreciation.

An asset qualifies for the bonus depreciation if:

(1) It has a MACRS recovery period of 20 years or less, is computer software or qualified leasehold improvement.

a. This generally excludes real estate as real estate has a MACRS period longer than 20 years.

(2) It is acquired after 9/8/2010 and before 1/1/2012

(3) Original use starts with the taxpayer

The bonus is not insignificant. The bonus for 1/1/2010 to 9/8/2010, for example, was 50%. This means that one could depreciate ½ the cost right off the top. Effective 9/9/10, that percentage was increased to 100%. That means that you can buy it and expense it – all of it – in the same year. One can elect out of the bonus if one does not need that much depreciation. It can happen. I saw an opt-out election today for a client.

The tax code therefore tries to exclude real property from bonus depreciation under Sec 168(k). That leaves us with personal property, and more specifically tangible personal property, as potentially qualifying. The tricky thing is that the tax code does not directly define the term “personal property” for purposes of depreciation. Instead the Code says that we should look at Regulation 1.48-1(c) for its definition of “tangible personal property.”

NOTE: Section 48 involves the now defunct investment tax credit (ITC).

We here have a loophole. We need to find something that looks like real property BUT is considered tangible personal property under Regulation 1.48-1(c). This could happen, as Section 48 was not concerned with depreciation; instead it was concerned with a tax credit. There has been ITC guidance from the IRS through field directives in diverse industries such as restaurants, dealerships and casinos.

Here are some common improvements that will qualify for the bonus depreciation:

(1) Landscaping, including a related irrigation system.

(2) Parking lots

(3) Perimeter fencing and sidewalks

(4) Clearing, grading and excavating directly related with the construction of sidewalks and parking lots

(5) Light poles

(6) Surveillance systems

(7) Signs

(8) Awnings

(9) Wall coverings

(10) Window treatments

(11) Decorative interior lighting

(12) Floor coverings, including carpets

(13) Certain exterior lighting

Heads up, therefore, if you are constructing a building. Make sure that your GC traps these costs for you, and you are well on your way to some significant tax write-offs.

Do Passthroughs Cost the Treasury Money?

Treasury Secretary Timothy Geithner started a bit of firestorm on February 15 in testimony before the Senate Finance Committee. By way of context, the White House is seeking to overhaul the corporate tax code. There is much discussion about doing away with certain deductions (the domestic production activities deduction, LIFO) in order to reduce corporate rates. As I have commented before, the U.S. has the second-highest corporate tax rate in the world.

Well, an ancillary issue is the tax treatment of “small business.” You know, the businesses that make up the client list of almost all U.S. CPA firms except those that begin with the names “Deloitte,” “Ernst,” “KPMG,” and “PwC.”

Here is the Secretary:

“Congress has to revisit this basic question about whether it makes sense for us as a country to allow certain businesses to choose whether they’re treated as corporations for tax purposes or not.”

Let’s have a quick and rough review of selected statistics. Business tax collections in 2007 were approximately $2.2 trillion, of which $1.4 was from “traditional” corporations, the balance being from S corporations, partnerships, LLC’s and proprietorships. Let’s look at the number of returns: of approximately 13 million business returns, slightly less than half were from “traditional” corporations.

Here is the Secretary again:

“What’s a little unique about our system relative to other countries is we do give a lot of businesses the choice of how their income should be taxed.”

We have a certain amount of choice on how we are taxed. Isn’t that quaint?

Today I was reading an article in Tax Notes by Martin A. Sullivan titled “Passthroughs Shrink the Corporate Tax by $140 Billion.” He points out that…

“Nowhere is the inefficiency of the tax more apparent than in the porous border between one group of business that must pay the tax and the group that can escape it.”

I have a plea for Mr. Sullivan: please tell me how my clients can “escape it.” Apparently I have been giving out erroneous tax advice for two decades. My advice is to reduce and minimize, but that’s about all I can do. Unless minimizing constitutes “escaping it,” in which case I have wasted a career in public practice. I should have finished my PhD and lectured on what I had never done in a profit-making capacity. I could then go on to a government office, maybe even the Cabinet.

The issue here is the how a C corporation is taxed. If a C has profits and pays dividends, the dividends are taxed a second time to the shareholder. If a C liquidates, it has to pay tax on any profit inherent in its assets; the distribution is then taxed again to the shareholder. C corporations may have a higher tax rate. Passthroughs try to avoid much of this by having one level of tax. If I own an S corporation, for example, the profit will be taxed once – to me and on my personal return. There are exceptions, but let’s set them aside for the moment.

Mr. Sullivan goes on:

“But the rise of S corporations and LLCs has also taken a big bite out of the taxable corporate sector.

“If the corporate sector’s share of business stayed at the same level as it was in 1999, it (the corporate tax) would be about 10% larger.”

Well, yes. The way that - if I stayed the same as I was in 1999 - my knees would not hurt me occasionally and my energy level would be 20% higher. Things change. Business owners – and advisors like me – would have responded with change, and it is hard to say what the results would have been, much less that they would have been to the government’s liking.

One last quote:

"Many would like to keep tax reform confined to the corporate sector. But politics aside, isn’t it reasonable to suggest that passthrough businesses that are relatively lightly taxed pay more to reduce taxes on C corporations?”

Rick and I could poll ALL OF OUR CLIENTS and see if they consider themselves “lightly taxed.”Keep you informed on that.

What Is the Tax Basis of an Asset Inherited in 2010?

The answer is: it depends.

We have two co-existing estate tax systems in place for 2010. One system imposes no federal estate tax, but at the cost of putting limits on the step-up of any inherited assets. The other imposes an estate tax, but with no limit on the step-up. The estate gets to decide.

We are used to thinking that the tax basis of an inherited tax asset is the value on the date of death. The idea is that the estate already paid tax, so to have the beneficiary pay tax again on any sale soon after the death would be unfair. The estate therefore gets to step-up the basis of the asset, preventing any appreciation in the asset (through the date of death) from being taxed again.

The dividing line is $5 million. When Congress changed the law late in 2010, it resurrected the estate tax but with a $5 million exemption. Therefore, an estate under $5 million would opt-in to the new tax law, increase the basis of any assets and pay no federal tax. Best result!

An estate over $5 million has to decide. If it opts-in, then there will be federal estate tax to pay. If it opts-out, there will be no federal estate tax but the step-up may be limited. The limits are as follows:

(1) All estates get a step-up up to $1.3 million

If the appreciation is $1.3 million or less, then the estate would opt-in. The end result is the same as opting out, as there is only so much step-up in the assets anyway.

If the appreciation is more than $1.3 million, then step-up is limited. And the estate has a decision to make.

(2) If there is a surviving spouse and the spouse receives estate assets…

Then there is an additional $3 million step-up for assets passing to the surviving spouse.

How would a beneficiary know what the estate did? Well, there is a new form – Form 8939. The executor of the (larger) estate will fill-out this form and send a copy to the beneficiaries. The problem is that the form has not yet been finalized by the IRS. If one sold an asset in 2010 – and that asset was inherited from someone who passed way in 2010 – it is likely that he/she will have to file for an income tax extension and wait on receiving this form from the executor.

The 2011 & 2012 Gift Tax Exemption

The lifetime gift tax exemption has been increased from $1,000,000 to $5,000,000 but only for 2011 and 2012. Is it worth taking advantage of the new exemption amounts? Definitely.

Let me preface by admitting the obvious: those amounts are way beyond the level most of us can gift. Nonetheless, there are people who can, and it is those people who hire tax CPAs - such as yours truly.

Why the rush? Well, who knows what Congress will do? We do know that these exemptions are available for the better part of two more years. When coupled with other tax techniques that can leverage the exemption amount, such as family limited partnerships or retained interest trusts, the opportunity for substantial family wealth transfers with no or minimal transfer tax consequence exists.

There is an issue here that has bothered the tax community. The estate tax is calculated by summarizing the taxable estate and adding-back any lifetime taxable gift transfers. If the gift exemption returns to $1,000,000 in the future, how will one calculate the “lifetime taxable gift transfers?” Will it be the excess over $5,000,000, as it is now, or will it be the exemption level in the year of death (say that level returns to $1,000,000)? I have read no serious tax commentator who expects that whipsaw to occur.

It is however a sad indictment of the instability of our tax system that such a question is even raised.

North Carolina Drops Lawsuit Against Amazon

You probably are aware that online vendors – such as Amazon – do not charge sales tax to customers outside their home state. You also know that this has created much the controversy with the states, ever eager to tax to anything that moves within their borders. To be fair, if a person went a sticks-and-bricks store to purchase an item, the transaction would be sales taxable. It is the intermediation of the internet that presents the problem. And it is a problem. For example, I recently purchased an item from Britain. Would it be reasonable for that vendor to charge me Kentucky sales tax, as I live in Kentucky and the transaction would otherwise go untaxed?

Take a start-up company, say Hamilton Educational (HE). HE makes and sells educational accounting videos of captivating content and quality. HE sets up a little website; its fame spreads; soon its videos are in intense demand and sold to every corner of the country. Is it fair, or even practicable, for HE to monitor its sales tax obligation to every state in the nation? What is the cost of this compliance? Does this cost outweigh any benefit to (name) the state? Has HE died before its birth, unable to comply with the administrative burden of its successful business model?

Enter North Carolina (NC). NC went after Amazon, requesting records of Amazon’s transactions with North Carolina residents. Think about this for a moment. The state is forcing a company to release its records about you. You are not involved in the litigation; heck, you are not even aware of the litigation. The privacy concern here is staggering.

The American Civil Liberties Union joined in a lawsuit against NC, and very recently NC settled the case. The state agreed to pay almost $100,000 in legal fees and ceased its action, but it reserved the right to go against Amazon and/or its customers in the future.

North Carolina had previously gone after Amazon for sales tax on the argument of economic nexus. This means that a company has “nexus” with a state if it derives a financial benefit from commercial transactions within that state. This is an interesting argument, in that a variation of that argument would subject me to New Zealand taxes for ordering the Lord of the Rings video trilogy. In Amazon’s case, NC argued that the economic nexus was provided by the affiliates, which are blogs or other online sites that provide links to products and/or offer coupons. I listen to online radio, for example. If a particular song captures my ear, I can click on the site, find out the artist and likely have a link to purchase the artist’s CD. That is an example of an affiliate.

Amazon cut its ties to its North Carolina affiliates in response.

North Carolina continued to chase Amazon for taxes before those affiliate ties were severed, resulting in the settlement mentioned above.

Do you see any winner in this story?

An ESOP Fable

Several years back there was a nifty tax-planning technique calling for the use of an ESOP as a shareholder or partner in an S corporation or partnership/LLC. You will remember that an ESOP is a qualified retirement plan and pays no taxes. To the extent that the ESOP is top-heavy - meaning that the key employees of the sponsoring employer own the majority of ESOP – this is quite the nifty tax technique. Leverage the ESOP and make the bank payments deductible as retirement contributions. These payments reduce the sponsor’s taxable income. Combine this with an ESOP on the receiving end – an entity which does not pay tax – and you have fields of tax gold.

Of course, someone has to push this to the limit and get slapped down.

Enter the law firm Renkemeyer, Campell & Weaver, LLP. These guys are based in Kansas and have a tax year ending April 30. For year 4/30/04 the firm had three attorney/shareholders and an S corporation as the fourth shareholder. The S corporation was owned by an ESOP.

The profit percentages were 30-30-30-10, with the S having the 10%.

The revenues were approximately 33-33-33-1, with the S having the 1%.

Oh, you can see this coming, you say?

Well, the law firm allocated approximately 88% of its income to the S corporation for year 4/30/04. You have probably already guessed that the only – or least predominant – participants in the ESOP were the three attorneys.

The IRS examined the year and said “you have to be kidding.” A tax CPA would phrase that to say that the transaction does “not reflect economic reality.” Accordingly, the IRS reallocated the law firm's net business income to its partners on the basis of their respective profit and loss interests.

The attorneys disagreed, and the case went to the Tax Court. The court held that the law firm failed to show that its special allocation (of income to the S corporation) was proper. The firm could (theoretically) have won the argument with the IRS, but it had to present some cogent economic argument for shifting almost 90% of its income to an entity which did virtually nothing. It did not. The court moved income from a tax-exempt entity (the S/ESOP) to the three individual partners. This resulted in individual income taxes. In addition, the income represented self-employment earnings to the three partners, which meant that they also owed self-employment taxes.

They pushed too far.

College Financial Aid and Taxes

College financial aid applications have appeared in the office. This is somewhat an annual exercise for us, but let’s take the opportunity to review the tax implications of financial aid.

First, don’t let the terms mislead you. For example, a student may receive a “grant”, a “scholarship” or a “fellowship.” With only this information, I cannot tell you what the tax consequence is going to be. There are two key issues here. First, does the recipient (or someone) have to pay the money back? If the answer is yes, you have a loan and there is no taxable income. Loans are generally not considered income, as there has been no addition to wealth.

Say you don’t have to pay it back. Second question: does the recipient have to work in order to receive it? If the answer is yes, then it doesn’t matter what it is called – grant, scholarship, fellowship or tuition reduction – the recipient has income. He or she can expect a W-2 at year-end. Now, this doesn’t mean that there will be federal tax due. It may be that the W-2 does not exceed the recipient’s standard deduction and personal exemption, for example. Or it may be that the recipient claims an education tax credit which more than offsets any federal tax.

By the way, the tax consequence does not drive-off the source of the money. The IRS is not concerned whether the financial aid comes from a government agency, a nonprofit or a corporation.

If the recipient does not have to repay or work, then the aid is nontaxable as long as:

(1) The recipient is a degree candidate

(2) The aid is restricted for tuition and related expenses OR the aid is NOT restricted for something OTHER THAN tuition and related expenses.

(3) The recipient has to actually incur tuition and related expenses, and those expenses have to exceed the financial aid.

There is a combination where the recipient does not have to repay or work and yet has taxable income. How? It’s not intuitive, I grant you.

Notice the language in (2) above: “tuition and related expenses.” What expense is not related? Room and board is the biggie here. To the extent that the recipient receives non-loan, non-W-2 financial aid AND the aid exceeds the cost of tuition, fees, books and supplies, the recipient has income. The translation is that aid for room and board is taxable.

Let’s use an example. Say that Meadow Soprano receives a scholarship to attend Big Name U. She receives $45,000 aid for the academic year, and she is not obligated to repay or work. Her tuition, fees books and supplies are $36,500. Meadow has $8,500 ($45,000 – 36,500) of taxable income.