Pay Payroll Taxes Or Go Out Of Business?

We have talked before about the “big boy” penalty. It is one of the harshest penalties in the tax Code.

This is a payroll related penalty. It is not because you were late with a payment or failed to send in a return on time. No sir, it kicks in when you do not send the government any money at all.

And I am reading about two guys who decided to play big boy. One of them surprised me.

The company itself was based in Rhode Island and provided wireless internet in public spaces. Think Facebook at the airport, for example.

Business tanked. Cash was tight. Vendors did not get paid, including the IRS.

The company needed help. They hired Richard Schiffmann as president in October, 2004. In October, 2005 he brought in Stephen Cummings (who had worked there previously as a consultant) to be chief financial officer.

Cummings quickly found out they had problems with back taxes.

The Board granted check-signing authority to the pair: Schiffmann up to $100,000 and Cummings up to $75,000.

The two tried; they really did. But there was nothing there. The Board fired the two in June, 2006.

You know that the IRS eventually knocked on the door. They were angry and they wanted scalps. They went after Schiffmann and Cummings for the big boy penalty.

In the literature, this is known as the trust fund recovery or responsible person penalty. It addresses the income and FICA taxes withheld from employees. Mind you, the IRS wants the employer FICA also, but it is emphasizing the employee withholding. The IRS takes the position that this was never the employer’s money, whose function was solely to transfer the money as agent for the employees to the IRS.

The penalty is 100%.

It is intended to be Defcon 1.

The IRS went after Schiffmann for $394,334 and against Cummings for $254,280.

Think about this. You got hired. You were there for nine months. I doubt you got paid anywhere near $254,280. This is the lousiest job ever.

The two fought back, although there were some procedural misses we will not discuss but which leave me scratching my head. The two for example raised the following arguments:

(1) Schiffmann argued that he did not learn of the liability until late 2005. The most he could be liable for is two or three quarters, which would not add-up to $394 thousand.

He had a point. The penalty technically goes quarter-by-quarter.

But only in a classroom or in a textbook. In the real world, the IRS will argue that – if you could write a check – then you could have written checks for both current and past payroll taxes. Those past taxes become your problem.

And Schiffmann could write checks up to $100,000. Cummings could write up to $75,000.

Gentlemen, let me introduce problem. Problem, let me introduce gentlemen.

(2) They argued that all monies were encumbered and spoken for. They remitted what they could.

This is the “I had to pay … or the business would have folded” argument.

The IRS will respect encumbrances, but there better be a legal obligation. A pinky swear is not enough. 

The IRS will not respect a responsible person prioritizing them down, when the IRS had as much right to what money may exist as anyone else.

Schiffmann and Cummings could not meet that test.

(3) The Board would not let them pay certain bills.

More specifically, the Board would not let them pay taxes.

Now we have something. The IRS looked into this. It decided that there were two directors who raised a fuss, but it also decided that those two could be outvoted by the remaining directors.

And the directors never formally voted on a resolution, so the IRS could presuppose that the two would have been outvoted.

Then the IRS made an interesting observation: EVEN IF the Board has prohibited the two from paying the taxes, the most that would have happened is that the Board would have joined them in also being subject to the penalty. It would not have gotten Schiffmann and Cummings off the hook.

The two were held responsible.

Cummings was the one who surprised me.

He used to be an IRS field auditor.

Tax Mulligans and Tennessee Walking Horses

Here is the Court:

While a taxpayer is fee to organize [her] affairs as [she] chooses, nevertheless once having done so, [she] must accept the tax consequences of her choice, whether contemplated or not, and may not enjoy the benefit of some other route [she] might have chosen to follow but did not.”

This is the tax equivalent of “you made your bed, now lie in it.” The IRS reserves the right to challenge how you structure a transaction, but – once decided – you yourself are bound by your decision. 

Let’s talk about Stuller v Commissioner.  They were appealing a District Court decision.

The Stullers lived in Illinois, and they owned several Steak ‘n Shake franchises. Apparently they did relatively well, as they raised Tennessee walking horses. In 1985 they decided to move their horses to warmer climes, so they bought a farm in Tennessee. They entered into an agreement with a horse trainer addressing prize monies, breeding, ownership of foals and so on.

In 1992 they put the horse activity into an S corporation.

They soon needed a larger farm, so they purchased a house and 332 acres (again in Tennessee) for $800,000. They did not put the farm into the S corporation but rather kept it personally and charged the farm rent.

So far this is routine tax planning.

Between 1994 and 2005, the S corporation lost money, except for 1997 when it reported a $1,500 profit. All in all, the Stullers invested around $1.5 million to keep the horse activity afloat.

Let’s brush up on S corporations. The “classic” corporations – like McDonald’s and Pfizer – are “C” corporations. These entities pay tax on their profits, and when they pay what is left over (that is, pay dividends) their shareholders are taxed again.  The government loves C corporations. It is the tax gift that keeps giving and giving.

However C corporations have lost favor among entrepreneurs for the same reason the government loves them. Generally speaking, entrepreneurs are wagering their own money – at least at the start. They are generally of different temperament from the professional managers that run the Fortune 500. Entrepreneurs have increasingly favored S corporations over the C, as the S allows one level of income tax rather than two. In fact, while S corporations file a tax return, they themselves do not pay federal income tax (except in unusual circumstances).  The S corporation income is instead reported by the shareholders, who combine it with their own W-2s and other personal income and then pay tax on their individual tax returns.

Back to the Stullers.

They put in $1.5 million over the years and took a tax deduction for the same $1.5 million.

Somewhere in there this caught the IRS’ attention.

The IRS wanted to know if the farm was a real business or just somebody’s version of collecting coins or baseball cards. The IRS doesn’t care if you have a hobby, but it gets testy when you try to deduct your hobby. The IRS wants your hobby to be paid for with after-tax money.

So the IRS went after the Stullers, arguing that their horse activity was a hobby. An expensive hobby, granted, but still a hobby.

There is a decision grid of sorts that the courts use to determine whether an activity is a business or a hobby. We won’t get into the nitty gritty of it here, other than to point out a few examples:

·        Has the activity ever shown a profit?

·        Is the profit anywhere near the amount of losses from the activity?

·        Have you sought professional advice, especially when the activity starting losing buckets of money?

·        Do you have big bucks somewhere else that benefits from a tax deduction from this activity?

It appears the Stullers were rocking high income, so they probably could use the deduction. Any profit from the activity was negligible, especially considering the cumulative losses. The Court was not amused when they argued that land appreciation might bail-out the activity.

The Court decided the Stullers had a hobby, meaning NO deduction for those losses. This also meant there was a big check going to the IRS.

Do you remember the Tennessee farm?

The Stullers rented the farm to the S corporation. The S corporation would have deducted the rent. The Stullers would have reported rental income. It was a wash.

Until the hobby loss.

The Stullers switched gears and argued that they should not be required to report the rental income. It was not fair. They did not get a deduction for it, so to tax it would be to tax phantom income. The IRS cannot tax phantom income, right?

And with that we have looped back to the Court’s quote from National Alfalfa Dehydrating & Milling Co. at the beginning of this blog.

Uh, yes, the Stullers had to report the rental income.

Why? An S corporation is different from its shareholders. Its income might ultimately be taxed on an individual return, but it is considered a separate tax entity. It can select accounting periods, for example, and choose and change accounting methods. A shareholder cannot override those decisions on his/her personal return. Granted, 99 times out of 100 a shareholder’s return will change if the S corporation itself changes. This however was that one time.

Perhaps had they used a single-member LLC, which the tax Code disregards and considers the same as its member, there might have been a different answer.

But that is not what the Stullers did. They now have to live with the consequences of that decision.

Romancing The Income

Let’s discuss Blagaich, an early 2016 decision from the Tax Court. This is a procedural decision within a larger case of whether cash and property transfers represent income. 

Blagaich was the girlfriend and in 2010 was 54 years old.

Burns was the boyfriend and in 2010 was 72 years old.

Their romance lasted from November 2009 until March 2011.

It appears that Burns was fairly well heeled, as he wired her $200,000, bought her a Corvette and wrote her several checks. These added up to $343,819.

He was sweet on her, and she on him. Neither wanted to marry, but Burns wanted some level of commitment. What to do …?

On November 29, 2010 they decided to enter into a written agreement. This would formalize their “respect, appreciation and affection for each other.” They would “respect each other and … continue to spend time with each other consistent with their past practice.” Both would “be faithful to each other and … refrain from engaging in intimate or other romantic relations with any other individual.”

The agreement required Burns to immediately pay Blagaich $400,000, because nothing says love like a check you can immediately take to the bank.

Surprisingly, the relationship went downhill soon after entering into the agreement.

On March 10, 2011 Blagaich moved out of Burn’s house.

The next day Burns sent her a notice of termination of the agreement.

That same month Burns also sued her for nullification of the agreement, as she had been involved with another man throughout the entire relationship. He wanted his Corvette, his diamond ring - all of it - returned.

Somewhere in here Burns must have met with his accountant, as he/she sent Blagaich a Form 1099-MISC for $743,819.

She did not report this amount as income. The IRS of course wanted to know why.

The IRS learned that she was being sued, so they decided to hold up until the Circuit Court heard the case.

The Circuit Court decided that:

·        The Corvette, ring and cash totaling $343,819 were gifts from him to her.

·        The $400,000 was different. She was paid that under a contract. Flubbing the contract, she now had to pay it back.

Burns had passed away by this time, but his estate sent Blagaich a revised Form 1099-MISC for $400,000.

With the Circuit Court case decided, the IRS moved in. They increased her income by $743,819, assessed taxes and a crate-load of penalties. She strongly disagreed, and the two are presently in Tax Court. Blagaich moved for summary adjudication, meaning she wanted the Tax Court to decide her way without going through a full trial.

QUESTION: Do you think she has income and, if so, in what amount?

Let’s begin with the $400,000.

The Circuit Court had decided that $400,000 was not a gift. It was paid pursuant to a contract for the performance of services, and the performance of services usually means income. Additionally, since the payment was set by contract and she violated the contract terms, she had to repay the $400,000.

She argued that she could not have income when she had to pay it back. In legal-speak, this is called “rescission.”

In the tax arena, rescission runs head-on into the “claim of right” doctrine. A claim of right means that you have income when you receive an increase in wealth without a corresponding obligation to repay or a restriction on your being able to spend. If it turns out later that you in fact have to repay, then tax law will allow you a deduction – but at that later date.

Within the claim of right doctrine there is a narrow exception IF you pay the money back by the end of the same year or enter into a binding contract by the end of the same year to repay. In that case you are allowed to exclude the income altogether.

Blagaich did not do this. She clearly did not pay the $400,000 back in the same year. She also did not enter in an agreement in 2010 to pay it back. In fact, she had no intention to pay it back until the Circuit Court told her to.

She did not meet that small exception to the claim-of-right doctrine. She had income. She will also have a deduction upon repayment.

OBSERVATION: This is a problem if one’s future income goes down. Say that she returns to a $40,000/year job. Sure, she can deduct $400,000, but she can only offset $40,000 of income and the taxes thereon. The balance is wasted. Practitioners sometimes see this result with athletes who retire, leaving their sport (and its outsized paychecks) behind. It may never be possible to get back all the taxes one paid in the earlier year.

Let’s go to the $343,819.

She argued that the Circuit Court already decided that the $343,819 was a gift. To go through this again is to relitigate – that is, a double jeopardy to her. In legal-speak this is called “collateral estoppel.”

The Court clarified that collateral estoppel precludes the same parties from relitigating issues previously decided in a court of competent jurisdiction.

It also pointed out that the IRS was not party to the Circuit Court case. The IRS is not relitigating. The IRS never litigated in the first place.

She argued that the IRS knew of the case, requested and received updates, pleadings and discovery documents. The IRS even held up the tax examination until the Circuit Court case was decided.

But that does not mean that the IRS was party to the case. The IRS was an observer, not a litigant. Collateral estoppel applies to the litigants. That said, collateral estoppel did not apply to the IRS.

Blagaich lost her request for summary, meaning that the case will now be heard by the Tax Court.

What does this tax guy think?

She has very much lost the argument on the $400,000. Most likely she will have to pay tax for 2010 and then take a deduction later when she repays the money. The problem – as we pointed out – is that unless she has at least $400,000 in income for that later year, she will never get back as much tax as she is going to pay for 2010. It is a flaw in the tax law, but that flaw has been there a long time.

On the other hand, she has a very good argument with the $343,819. The Court was correct that a technical issue disallowed it from granting summary. That does not however mean that the technical issue will carry the day in full trial. That Circuit Court decision will carry a great deal of evidentiary weight.

We will know the final answer when Blagaich v Commissioner goes to full trial.

Getting A Tax Deduction From A Golf Course

Have you heard about Louis Bacon? He is the manager for the hedge fund Moore Capital Management. No, I am not mentioning his name because I am a client of his firm (I wish), but because I was reading that he donated a conservation easement, meaning that he got a (sizeable, I’m certain) tax deduction. The easement is on his Colorado ranch, Trinchera Blanca, which extends over 90,000 acres.

COMMENT: I wonder how long it takes to reach your house upon turning from the roadway when your property is 90,000 acres.      

This gives us an opportunity to talk about conservation easements. Let’s be upfront, however: this is a high-end tax strategy. This has as much to do with your or my daily life as piloting a fighter jet.  

There are three requirements if you want this deduction: 

• Qualifying real property
• Donated to a qualified organization
•  For conservation purposes

The third requirement includes:

• The preservation of land for substantial and regular use by the public for outdoor recreation or education
• The protection of natural habitat of fish, wildlife or plants
• The preservation of open space, where the preservation is for public enjoyment or pursuant to government conservation policy
• The preservation of historically important land or a certified historic structure

An easement makes sense if you think of real estate as more than just … well, real estate. Let’s say, for example, that you own the last remaining farm in a now heavily-developed suburban area. That farm is more than just soil. It is also a bucolic view, a possible watershed, the remaining redoubt for an endangered amphibian, and the source of great wealth from a potential sale to developers. It has layers, like a good lasagna.

We are going to donate one or more of those layers to a charity. We might be able to fit under the “preservation of open space” category above, for example. You could donate a restriction that the property will never be commercially developed. You still own the farm, mind you, but you have donated one of the rights which as a bundle of rights comprise your full ownership of the property.

We next have to put a value on this layer. This is where the horsepower to the conservation easement kicks in.

Let’s say that our farm has been in the family since before there were telephones. Chances are that its cost is relatively negligible.

COMMENT: Before someone comments, I know that the property’s basis would have been reset to its fair market value when it transferred at an ancestor’s death. Let’s compromise and say that the family is extremely long-lived.

Meet a few qualifications and that pennies-on-the-dollar cost has nothing to do with calculating the deduction. We instead are going to get an appraiser to value the property, and he/she is likely to value the easement as follows:

• The value of the property intact and before any donation, less
• The value of the property after the donation of the easement

The numbers can get impressive.

There is a famous case, for example, about an easement in Alabama.

The story begins with Mr. E.A. Drummond, who bought 228 acres on the Fort Morgan peninsula in 1992 for $1,050,000. Two years later he started a planned resort community featuring a 140.9 acre golf course. He started selling lots in 1995, and in 2002 he transferred the golf course to an entity known as Kiva Dunes.

He then donated a perpetual conservation easement on Kiva Dunes.

Kiva Dunes

He valued the easement at over $30 million.

Kiva Dunes also wrote a check to the charity for $35,000.

The IRS got wind of this and they were unamused. They disallowed the $30 million. They also disallowed the $35,000 cash donation, which seems odd. They must have been having a very cranky week.

The case went to Tax Court. The IRS immediately backed off on the fact of a donation, perhaps because by then they were having a better week. They argued instead on the amount of the easement donation. Mr. Drummond brought in an expert who had lived and worked in the area for decades and performed more appraisal work there than anyone else. The IRS brought an expert from Atlanta who had visited the peninsula only twice, and that was to appraise Kiva Dunes.

You can guess which appraiser was more persuasive. The Court reduced the donation to a little over $28 million, which means they effectively agreed with Mr. Drummond. It was a landmark taxpayer win.

The Administration did not like this result at all. They were quite determined to shut down golf course conservation easements, although little has occurred since. They had a point. After all, we are talking about a golf course.

The benefit of a conservation easement on a private golf course, especially in a luxury development, is likely to accrue to a limited number of people and not to the general public. You or I may not even be permitted to drive through some of these communities, much less see or otherwise enjoy the easement.

On the flip side, I have a friend who used to install golf courses in Cincinnati, primarily on the northern Kentucky side. For the locals, I helped him with one of the greens at Devou Park Golf Course, although I do not remember how he talked me into it. I presume I was temporarily insane. Nonetheless, he was very passionate about golf courses serving as respites and nature sanctuaries in otherwise developed urban environments. Kiva Dunes, for example, included broad swaths of wetlands which served as a stopover for migratory birds, as well as being home for a number of threatened species.

One can argue - if there is a socially-desirable ecological, wildlife or preservation outcome – whether it matters that the benefits will be enjoyed by the few. What is of true import here: ecology, wildlife and preservation or the politics of envy? Non-wealthy people do not donate easements. The alternative, unfortunately, is to do … nothing.  

Kiva Dunes had a point.

However, a $28 million point?

One can see the controversy.