Tuesday, March 31, 2015
Some tax cases are just fun to read.
Our story takes place in south Florida.
Dad started a business many years ago. It did well, and Dad in turn started three businesses for his children. He structured each business so that one sibling owned 60% and the remaining two siblings owned the balance. He gave each child (two daughters and a son) a controlling interest in their own business, with the remaining siblings owning a (non-controlling) interest.
All these businesses were somehow tied-in to real estate, whether by selling lumber, providing mortgages, payroll services or other activities.
Our protagonist (Jose Antonio Lamas) owned a company called Adrimar.
However the company we are interested is called Shoma, and it is (majority) owned by Jose’s sister and her husband (Masoud Shojaee).
Shoma formed an LLC (Greens at Doral) pursuant to a condominium development. The two companies were closely intertwined. Greens had the same ownership as Shoma, operated out of the same office, used the same employees and so on. Shoma intended to liquidate Greens once the project was done, which is the standard structure for these projects.
Shoma got itself into financial straits. Jose was called in to help turn Shoma around.
The soap opera is in the details of how Shoma got itself into difficulties. Turns out that Mr. Shojaee was using Shoma to guarantee loans for a non-family company he owned. He made a pledge to the University of Miami for $1.5 million, in return for which they were going to name a building after him. That is swell, except that he had no intention of using his own money. Instead he used Shoma money to fund the donation. He developed Shoma land – and we have a feel for his ethics at this point – but decided to run the development (and profits) through his own company.
Somewhere in here Jose and his sister had enough and in 2008 sued Mr. Shojaee.
Knock me over with a feather.
Shoma must have been losing crazy-level money, as Jose filed for a tax refund of over $5 million.
Here is an easy quiz: what happens when you file a tax refund of over $5 million with the IRS?
The IRS audits you, that’s what.
What is there to audit, you ask? The “real” audit would be on the business books, not Jose’s personal return, right?
Not so fast.
You see, if Jose did not “materially participate” in the business, then the business would be “passive” to him. He would not be able to offset his other income with that big “passive” loss. The loss would have to wait for passive income to someday soak it up.
Jose needed to provide time records to show that he worked over 500 hours, which is the gold-plated standard of showing “material participation” to the IRS.
Problem: he was not accustomed to working someplace where he kept time records. He didn’t have any. He had to go to plan B, which means evidencing his times through other means, such as by showing regular appointments and obtaining the testimony of other people.
He talked to Tania Martin, who was CFO for Shoma. She testified that she did not see Jose at the office, except maybe one time. There was a problem with her testimony, though. You see she worked remotely from North Carolina.
Francisco Silva was in-house counsel for Shoma. He testified that that Mr. Lamas would walk past his office in the morning and say “hi.” Other than that, he didn’t know “what, if anything, he was doing. I just don’t know.”
Then there was a stream of other people who worked regularly and extensively with Jose, including obtaining financing, soliciting investors, visiting jobsites and so on.
Alex Penelas, for example, was a former Miami-Date County mayor who testified that it was “more effective” to talk with Jose than Mr. Shojaee.
Jose had provided a letter to the IRS from his employer – Shoma - and signed by Mr. Shojaee, stating that he was a full-time employee. It appears that after brother and sister decided to sue, Mr. Shojaee sent a corrected letter to the IRS wherein he stated:
"Recently Shoma Development learned that the IRS requires active participation and 500 hours of work to qualify” and that “Jose Antonio Lamas had no direct nor indirect involvement with Shoma.”
Mr. Shojaee did request the IRS to keep this letter quiet, of course, lest it cause him family trouble. He is clearly all about the family.
The case finally gets to Court, which decides that Jose did work over 500 hours and that Mr. Shojaee was a creep.
But… there is one more thing.
You see, Jose worked for Shoma (an S corporation), not Greens (an LLC), and Greens was a substantial part of the loss.
Which brings us to the tax issue herein: can Shoma and Greens be combined, so that by showing material participation in Shoma, Jose also showed material participation in Greens?
The concept at play is whether the activities comprise an “appropriate economic unit,” a concept introduced to the tax Code as part of the passive loss rules in 1986. An example would be four related companies, each of which owns theaters: one east, one south, one north and one west. The common activity is owning theaters, and if there are enough other similarities then one could determine that the four companies comprise one economic activity. How is this important? If one shows a big loss while the other three show profits, for example. If they are one economic unit, the income and loss would automatically offset without having to employ a lot of tax planning.
So the Tax Court reviewed the rules in Regulation 1.469-4(c) for evaluating an appropriate economic unit:
(1) similarities and differences in types of business
(2) the extent of common control
(3) the extent of common ownership
(4) geographical location, and
(5) other interdependencies
It found that there was sufficient overlap between Shoma and Greens that Jose was materially participating in both, and that he was entitled to his tax refund.
And I suspect that Mr. Shojaee is no longer invited to family functions.
Sunday, March 22, 2015
It happened again this week. I was speaking with another accountant when he raised a tax question concerning an “estate” return. My stock question to him was whether it was an “estate fiduciary” or an “estate estate.” Both have the word “estate” in it, so one needs further clarification.
What is the difference?
If one dies with too many assets, then the government requires one to pay taxes on the transfer of assets to the next person. This is sometimes referred to as the “death” tax, and I sometimes refer to it as the “estate estate” tax.
It has gotten a little more difficult to trigger the federal estate tax, as the taxable threshold has been raised to over $5 million. That pretty much clears out most folk.
Then you can have the issue of the estate earning income. How can this happen? An easy way is to own stock, or a business – or perhaps a part of a business through a partnership or S corporation. That income will belong to the estate until the business is transferred to the beneficiary. That may require a trip to probate court, getting on the docket, waiting on the judge…. In the interim the estate has income.
And what do you have when an estate has income? You have an income tax return, of course. There is no way the government is not going to grab its share. I sometimes refer to that tax return as the “estate fiduciary.” A trust is a fiduciary, for example. The estate is behaving as a fiduciary because it is handling money that belongs to other people – the same as a trust.
Say that an estate receives a disbursement from someone’s 401(k). That represents income. This is usually a significant amount, and Hamilton’s Third Theorem states that a percentage of a significant number is likely to also be a significant number. This seems to always come as a surprise when the attorney fires over an estate’s paperwork – usually very near the filing due date – with the expectation that I “take care of it.”
Then we are looking for deductions.
A fiduciary has a deduction called an “income distribution,” which I rely upon heavily in situations like this. We will not dwell on it, other than to say that the fiduciary may be allowed a deduction when he/she writes a check to a beneficiary.
No, the deduction I want to talk about today is about a contribution to charity. Does our “estate fiduciary” get a deduction for a charity? You bet.
Let’s take this a step further. What if the estate intends to write a check to charity but it cannot just yet? Can it still get a deduction?
This is a different rule than for you and me, folks. The estate has a more lenient rule because it may have to wait on a court hearing and receive a judge’s approval before writing that check. The IRS – acknowledging that this could wreak havoc on claiming deductions – grants a little leeway.
But only a little. This rule is known as the “set aside,” and one must meet three requirements:
(1) The contribution is coming from estate income (that is, not from estate corpus)
(2) The contribution must be allowed by estate organizing documents (like a will), and
(3) The money must be permanently set aside, meaning that the likelihood that it would not be used as intended is negligible.
So, if we can clear the above three requirements – and the estate intends to make a contribution – then the estate has a possible deduction against that 401(k) distribution that I learned about only two or three days before the return is due.
What can go wrong?
One can flub the “negligible” requirement.
I cannot remember the last time I read about a case where someone flubbed this test, but I have recently finished reading one.
The decedent (Ms Belmont) passed way with a quarter million in her 401(k) and a condo in California. She lived in Ohio.
Alright, there is more than one state involved. It is a pain but it happens all the time.
Her brother lived in the condo. He was to receive approximately $50,000, with the bulk of the estate going to charity. He was under mental care, so there may have been a disability involved.
How can this blow up? Her brother did not want to move out of the house. He offered to exchange his $50,000 for a life estate. He really wanted to stay in that house.
The charity on the other hand did not want to be a landlord.
Her brother brought action and litigation. He argued that he had a life estate, and he was being deprived of his contractual rights. He filed with the Los Angeles County Probate Court and the California Recorder’s Office.
Meanwhile the estate fiduciary return was due. There was a big old number in there for the 401(k) distribution. The accountant – who somehow was not fully informed of developing events in California – claimed a charitable contribution deduction using the “set aside” doctrine.
The California court decided in the brother’s favor and orders a life estate to him and a remainder deed to the charity.
The estate thinks to itself, “what are the odds?” It keeps that set aside deduction on the estate fiduciary return though.
The IRS thinks otherwise. It points out that the brother was hip deep by the time the accountant prepared the return, and the argument that risks to the set aside were “negligible” were unreasonable when he was opening up all the guns to obtain that life estate.
The estate lost and the IRS won. Under Hamilton’s Third Theorem, there was a big check due.
What do I see here? There was a tax flub, but I suspect that the underlying issue was non-tax related. Likely Ms Belmont expected to outlive her brother, especially if he was disabled. It did not occur to her to plan for the contingency that she might pass away first, or that he might contest a life estate in the house where he took care of their mom up to her death while his sister was in Ohio.
Sunday, March 15, 2015
I have come to the conclusion that I do not like for folks to receive a check when they do an IRA rollover.
What are we talking about?
Say that you have an IRA at Fidelity and you want to transfer it to Vanguard. Another example is that you have a 401(k) with a previous employer, and you have decided to move out of the 401(k). In each case you are transferring money into an IRA, whether from another IRA or from an employer plan.
There are two ways to do this:
(1) Instruct Fidelity to send the monies directly to Vanguard. This is sometime referred to as a “trustee-to-trustee” or a “direct” rollover. Notice that you ever see the money, although you may feel the breeze as it rushes by.
(2) Instruct Fidelity to send you a check and then you in turn will send the money to Vanguard.
Option two is fraught with danger, beginning with convincing Fidelity not to withhold taxes. They do not “know” that you are actually rolling the monies, and they do not want to be holding the bag if the IRS comes looking. If they withhold $1,000, as an example, you are going to have to reach into your wallet to transfer the full amount to Vanguard. Otherwise you will be $1,000 short, meaning that $1,000 will be taxable to you when it is time to file your taxes.
An equal or bigger danger is that the IRS allows you only 60 days to send that check on to Vanguard. Miss that deadline and the IRS will say that you flubbed the rollover, taxes (and perhaps penalties) are due and thanks for playing.
How do you get out of it? Well, you are going to have to formally ask the IRS for a waiver, and wait on the IRS to give it. This process is referred to as a “private letter ruling.” The IRS is issuing a ruling to you, and it is to you and you only (that is, “private.”)
Is expensive? It can be, not the least for a CPA’s time in drafting the thing. Depending upon the issue, the IRS might also charge you money, and that cost can go into the thousands.
How can you miss the 60 days? There seems to be an endless variety. One can get sick, have family emergencies, the financial institution can make a mistake. I have lost track of how many of these I have read over the years.
And now I am reading another. Let’s talk about it, as I can see this story sneaking up on someone.
The taxpayer – by the way, taxpayers in private letter rulings are anonymous. We need to give “anonymous” a name for this discussion, so we will call him Sam.
Anyway, Sam wants to move his IRA. He meets with an advisor, who cautions him that the “new” IRA trustee will charge for rolling the IRA. Sam would be much better off having the old trustee reduce everything to cash, and then sending the cash to the new trustee.
OBSERVATION: While the PLR does not dwell on it, there obviously are some difficult-to-sell assets in Sam’s IRA. It does not have to be anything esoteric – like platinum-plated gold from the moon. It could be something as simple as a non-traded REIT.
Sam contacts a representative of the old trustee and explains that he is rolling over his IRA. He has opted to pursue option (2) above, and would they be so kind as to help him with the process. Not a problem, they say, although it might take a few months to reduce the IRA to cash.
And there is the first big red flag.
Sure enough, old trustee sends Sam checks – plural. Six checks in total, over a period of more than 60 days.
Second red flag.
Sam was clever though. Sam did not cash any of the checks, figuring that if he did not cash the check then the 60-day period did not start.
Sam finally sends all the checks over to new trustee, who realizes that there is a problem. What problem? The problem that the 60-day period does not work the way Sam thought.
New trustee contacts old trustee and requests that they issue a stop payment on the checks.
You see, the stop payment means that the checks could not be cashed, rendering them not much of a check at all. Since they could not be cashed, the monies could never leave Sam’s old IRA, and the issue of a rollover becomes null and void.
There is one more step: getting the IRS to agree with the above line of reasoning.
Which Sam did with his private letter ruling (PLR).
And I suspect that the professional and filing fees for the PLR may approximate what the new trustee was going to charge for handling the transfer in the first place.
By the way, do you know how this should have been handled? By instructing the old trustee not to send a check until everything has been reduced to cash, and then to send one and only one check for the entirety of the account.
I know that, and you know that. But somewhere sometime someone will repeat this story. Which brings me to the conclusion that people should not do option (2) rollovers unless there is no other alternative.
It just isn’t worth the risk.
Saturday, March 7, 2015
Sometimes I read a tax case and ask myself “why did the IRS chase this?”
Lewis is one of those cases.
Let’s explain the context to understand what the IRS was after.
It will soon be three decades that Congress gave us the “passive activity” (PAL) rules. A PAL is a trade or business that you do not sufficiently participate in – that is, you are “passive” in the business. This means more when you have losses from the activity, as income is going to be taxed in any event. It was Congress’ intention to take the legs out from the tax shelters, and with PALs they have been largely successful.
The PAL rules got off to a rocky start. One of the early problems was Congress’ decision to classify real estate activities as passive activities. Now, that concept may make sense if one own a duplex a few streets over, but it doesn’t work so well if one is a home builder or property manager.
Say, for example, that a developer builds a hundred condo units. The real estate market reverses, and he/she cannot sell them as quickly as planned. The developer rents the units, waiting for the market to improve.
Most of us would see one activity. Congress saw two, as the rental had to be segregated. There was no harm if both were profitable. There was harm if only the development was profitable, however, as the rental loss would just hang in space until there was rental income to absorb it.
That was the point of the passive activity rules – to disallow the use of passive losses against nonpassive income.
Real estate professionals screamed about the unfairness of the law as it applied to their industry.
And Congress changed the law by making an exception for real estate people who:
(1) Work more than 750 hours during the year in real estate, and
(2) More than one-half of all hours worked were in real estate.
If you meet both of the above tests, you can deduct losses from your real estate activities to your heart’s content.
Bill Lewis is a Vietnam veteran. He took injuries as a Marine, retaining 50 percent use of his right arm and 70 percent of his feet, requiring him to wear orthopedic shoes. The military gave him a disability pension. He now needs knee surgery, and he has difficulty seeing. He is married.
He and his wife own a triplex next door to their residence. The property also has a washhouse, although I am uncertain what a washhouse is. There are six 64-gallon recycling bins, and several large walnut trees. Mr. Lewis does not ask anyone to take care of his property. He takes care of it himself.
- Every morning he walks around and inspects for trash, as they are located very close to a homeless area. This takes him about a half hour daily.
- Also on Mondays he scrubs down the washhouse. That requires him to haul water and takes him about three hours.
- On Tuesdays and Thursdays he landscapes, cleans the outside of the buildings and the garbage cans and rakes the yard. This takes about two hours on each day.
- Depending on the season, he has more raking to do, as he has walnut trees on the property.
- On Wednesdays he takes the recycling bins out to the curb. One by one, as he has mobility issues.
- On Thursdays he returns the recycling bins. Same mobility issues.
- He prefers to do repairs himself. If he needs outside help, he schedules and meets with that person.
- He follows a set routine, rarely if ever taking a vacation.
The Lewis’ claimed rental losses for 2010 and 2011. The IRS disallowed the losses and wanted almost $11,000 in taxes in return. The IRS said this was the classic passive activity.
The IRS should have also taken candy from a child and kicked a dog and made this a trifecta of bad choices.
Mr. Lewis was disabled. He did not have a job. As a consequence, he did not have to worry about spending more than half of his work hours in real estate. For him, all of his work hours were in real estate.
But Mr. Lewis ran into two issues:
(1) He did not keep a journal, log or record of his activities and hours; and
(2) The IRS did not believe it could possibly take more than 750 hours to do what he did.
Issue (1) is classic IRS. I have run into it myself in practice. The IRS wants contemporaneous records, and few people keep time sheets for their real estate activities. The IRS then jumps on after-the-fact records as “self-serving.” The IRS has been aided by people who truly could not have spent the hours they claimed (because, for example, they have a full-time job) as well as repetitively fabulist time records, and the courts now routinely side with the IRS on this issue.
But not this time. The judge was persuaded by the Lewis’ testimony and the few records they could provide. This was a rare win for the taxpayer.
The IRS had a second argument though: it should not have taken as long as it took Mr. Lewis to perform the tasks described.
The judge dismissed this point curtly:
Petitioner husband and petitioner wife testified credibly that because of petitioner husband’s disabilities all of the activities took him significantly longer than might ordinarily be expected.”
The Lewis’ won and the IRS lost.
These were very unique facts, though. Unless one truly works in the real estate industry, many if not most are going to lose when the IRS presses on contemporaneous records for the 750 hours. Mr. Lewis was a sympathetic party, and the judge clearly gravitated to his side.
Which raises the question: why did the IRS pursue this? They were anything but sympathetic chasing a disabled veteran for taking too long while performing his landlord responsibilities.
Yes, I am sympathetic to Mr. Lewis too.