Do You Have to Disclose That?

I was recently talking with another CPA. He had an issue with an estate income tax return, and he was wondering if a certain deduction was a dead loser. I looked into the issue as much as I could (that busy season thing), and it was not clear to me that the deduction was a loser, much less a dead loser.

He then asked: does he need to disclose if he takes the deduction?

Let’s take a small look into professional tax practice.

There are many areas and times when a tax advisor is not dealing with clear-cut tax law.

Depending upon the particular issue, I as a practitioner have varying levels of responsibility. For some I can take a position if I have a one-in-five (approximately) chance of winning an IRS challenge; for others it is closer to one-in-three.

There are also issues where one has to disclose to the IRS that one took a given position on a return. The concept of one-in-whatever doesn’t apply to these issues. It doesn’t have to be nefarious, however. It may just be a badly drafted Regulation and a taxpayer with enough dollars on the line.

Then there are “those” transactions.

They used to be called tax shelters, but the new term for them is “listed transactions.” There is even a subset of listed transactions that the IRS frowns upon, but not as frowny as listed transactions. Those are called “reportable transactions.”

This is an area of practice that I try to stay away from. I am willing to play aggressive ball, but the game stays within the chalk lines. Making tax law is for the big players – think Apple’s tax department – not for a small CPA firm in Cincinnati.

Staying up on this area is difficult, too. The IRS periodically revises a list of transactions that it is scrutinizing. The IRS then updates its website, and I – as a practitioner – am expected to repeatedly visit said website patiently awaiting said update. Fail to do so and the IRS automatically shifts blame to the practitioner.

No thanks.

I am looking at a case involving a guy who sells onions. His company is an S corporation, which means that he puts the business numbers on his personal return and pays tax on the conglomeration.

His name is Vee.

He got himself into a certain type of employee benefit plan.

A benefit plan provides benefits other than retirement. It could be health, for example, or disability or severance. The tax Code allows a business to prefund (and deduct) these benefits, as long as it follows certain rules. A general concept underlying the rules is risk-taking and cost-sharing – that is, there should be a feel of insurance to the thing.

This is relatively easy to do when you are Toyota or General Mills. Being large certainly makes it easier to work with the law of large numbers.

The rules however are problematic as the business gets smaller. Congress realized this and passed Code Section 419A(f)(6), allowing small employers to join with other small employers – in a minimum group of ten – and obtain tax advantages  otherwise limited to the bigger players.

Then came the promoters peddling these smaller plans. You could offer death and disability benefits to your employees, for example, and shift the risk to an insurance company. A reasonable employer would question the use of life insurance. If the employer needed money to pay benefits, wouldn’t a mutual fund make more sense than an illiquid life insurance policy? Ah, but the life insurance policy allows for inside buildup. You could overfund the policy and have all kinds of cash value. You would just borrow from the cash value – a nontaxable transaction, by the way – to pay the benefits. Isn’t that more efficient than a messy portfolio?

Then there were the games the promoters played to diminish the risk of joining a group with nine others.

Vee got himself into one of these plans.

He funded the thing with life insurance. He later cancelled the plan, keeping the life insurance policy for himself.

The twist on his plan was the use of experience-rated life insurance.

Experience-rated does not pay well with the idea of cost-and-risk sharing. If I am experience rated, then my insurance cost is based on my experience. My insurance company does not look at you or any of the other eight employers in our group. I am not feeling the insurance on this one.

Some of these plans were outrageous. The employer would keep the plan going for a few years, overpay for the insurance, then shut down the plan and pay “value” for the underlying insurance policy. The insurance company would keep the “value” artificially low, so it did not cost the employer much to buy the policy on the way out. Then a year or two later, the cash value would multiply ten, twenty, fifty, who-knows-how-many-fold. This technique was called “springing,” and it was like finding the proverbial pot of gold.

The IRS had previously said that plans similar to Vee’s were listed transactions.

This meant that Vee had to disclose his plan on his tax return.

He did not.

That is an automatic $10,000 penalty. No excuses.

He did it four times, so he was in for $40,000.

He went to Court. His argument was simple: the IRS had not said that his specific plan was one of those abusive plans. The IRS had said “plans similar to,” but what do those words really mean? Do you know what you have forgotten? What is the point of a spice rack? Does anybody really know what time it is?

Yea, the Court felt the same way. The plan was “similar to.” They were having none of it.

He owed $40,000.

He should have disclosed.

Even better, he should have left the whole thing alone.

Taxation of Disability Insurance

I was recently reviewing an individual tax return. There was something on there that distresses me.

This client walked into a tax trap, and that trap has gone off.  Unfortunately, there is nothing that can be done.

Let’s talk about disability insurance.

This client is a personal friend. You and I would agree that he is a high-incomer. He works for a large employer on the Kentucky side. One of the advantages of a large employer is the benefits. One of the benefits his provides is employer-funded long-term disability insurance.

He got hurt and hurt badly. He is now collecting on the disability insurance, and probably will be for a long time.  

Did you know that disability insurance can be taxable?

How?

There is extensive tax law on the taxation of disability insurance, and there are different answers depending upon who is paying the premiums and whether it is a group or individual policy. There is an overarching theme, though:

Disability benefits are taxable to the extent that the premiums were not included in income.

His long-term insurance was 100% employer-paid and 100% excluded from W-2 income. While this was beneficial to him then, it is the worst-case scenario now.

Long-term policies can be expensive. Take someone who is pushing the top tax brackets, and a recommendation to pay tax can mean thousands of extra dollars. Combine that with an all-too-human “it cannot happen to me” response, and it is easy to understand the reluctance.

And that is assuming the tax advisor is even aware of what is happening. Employer-provided disability insurance would not necessarily appear on any documents one would be reviewing. There are good odds that you and your tax advisor will be learning about your disability insurance together.

And so he has to pay tax on disability at the same time that his earning power is reduced.

Is there a compromise?

I think so, but – again – it has to be done upfront. I have no problem with short-term disability being taxable, whether because the premiums are employer-paid or because you run the premiums through your cafeteria plan. This is the insurance you buy from Aflac, for example, and it pays you for six months or a year if you get hit by the proverbial bus. Yes, it would stink to have to pay taxes, but it would only be for a short period of time. The expectation of this insurance is that you will heal and get back to work.

But long-term disability is different enough to warrant a different answer. You almost surely want to make sure this is paid with after-tax monies. If you are unfortunate enough to collect on this type of insurance, you do not need to compound the misfortune by having taxes as part of your household budget.

Vacation Or Business Deduction?

Let’s say that we work together. I cannot attend an appointment with a new client first thing in the morning. You volunteer to cover for me.

By the way, welcome to tax practice. Believe me, it is not the glitz and glamour that Hollywood makes it out to be. I know: hard to believe.

You meet the Fishers. They are both attorneys, he as partner in a firm and she as a sole practitioner. They have three children, all under the age of 10. She takes her kids to work periodically for the customary reason: the cost of day care and family members unable to care for the kids at the time.

She had an opportunity to represent a client in the Czech Republic for a few weeks, and she took it. It turned out however that he was unable to watch the kids. Seeing herself in a jam, she took the kids with her but came up with a novel twist:

She would write a travel book about the Czech Republic. It would be written to and for kids and would lessen their tedium while travelling.

She had no previous writing experience, so this was new territory. It occurred to her that other parents might be interested in such books – and this could be a business opportunity for a sharp and motivated person.

She has kept this up now for three years. She has now taken the kids to Disney World as well as to several cities in Europe.

You talk to her about the IRS and its “hobby loss” rules. She is an attorney, not a writer; there is a gigantic personal enjoyment factor present, ….

She cuts you off. Remember: she is an attorney. She has read up on this area of tax law, and she thinks she meets the requirements. For example,

·        She consulted with one of her clients, a published author, who gave her advice on both writing and publishing.

·        That person introduced her to a book distributor, who suggested she hire a graphic designer. She did so.

·        She also consulted with a friend who works at HarperCollins; the friend recommended she hire an agent. She has not done that yet.

·        She completed four prototype books, but has not submitted them for publication. She has instead self-published. Sales however have been minimal.

The Fishers need to file returns for the last three years. Her combined loss from the book-writing activity is approximately $75,000.

They ask whether you can prepare their returns and claim the book-writing loss.

What do you say?

The big issue is whether the activity rises to the level of a tax deduction. You remember some of the factors that the IRS uses to identify a hobby:

·        Not run in a business-like fashion

·        Failure to consult experts

·        Failure to revise business plans when losses pile up

·        Profits dwarfed by the losses

But Ms. Fisher has been meeting people. She has made contacts at a publishing house. She has written prototypes. She has self-published. She seems to be getting some things right.

You don’t see a clear-cut answer. Two people can reasonably disagree. The problem of course is that the IRS has a bit more horsepower than the average person you might disagree with.

You wobble. You tell them that you want to review the literature in this area, as the issue is walking the grey lands. You will call them tomorrow.

We have a chance to talk about the meeting.

I see two things immediately:

(1)   Can we prepare and sign the return under professional standards?

(2)   If so, there is still a significant chance that they would lose the deduction on audit.

Professional standards allow a tax practitioner some leeway when confronted with certain issues. This is fortunate, or professional practice would likely grind to a near halt.  The bar can be higher or lower depending upon the particular issue under discussion. Take a “listed transaction,” for example, and the bar is pretty high. Listed transaction is jargon for tax shelter, and we are nowhere near that with the Fishers. Our bar is much lower.

However, I would say our best chance with the IRS is 50:50, and likely less than that.  We would discuss this with the client and allow them to decide. It is their return, after all. Maybe they will get another accountant’s opinion. Maybe I am wrong.

This is a real case, by the way.

The Fishers are from New York and took this issue to Tax Court.

They lost.

The Court decided that her activity was not so much a business as her investigating going into business. The Court pointed out a few things: she had not hired an agent, had not finalized a book, and had not submitted a proposal to a publishing house. Since business activity had not started, it did not have to consider whether the activity was a hobby.

No business activity = no business deduction.

What do I think?

The Court saw too much personal and not enough business. I suppose that had she been making money the Court may have relented. She had to clear the hurdle of deducting what many people would see as vacations, and that required some serious weight on the other end of the see-saw to sway the Court.

Getting ROBbed

I was skimming a Tax Court decision that leads with:

“… respondent issued a notice of deficiency … of $249,263.62, additions to tax … of $20,228.76 and $22,476.41, respectively and an enhanced accuracy-related penalty … of $63,918.33”

It was Roth IRA decision.

We have spoken before about putting a business in an IRA, and a Roth is just a type of IRA. This tax structure is sometimes referred to as a “ROBS” – roll-over as business start-up. 

Odds are the only one who is going to get robbed is you. I had earlier looked into and decided that I did not like the ROBS structure. There are too many ways that it can detonate. I do not practice high-wire tax.  

I have also noticed the IRS pursuing this area more aggressively. There often is complacency when a “new” tax idea takes, as the IRS may not respond immediately. That lag is not an imprimatur by the IRS, although self-interested parties may present it as such. I have been in practice long enough to have heard that sales pitch more than once.

Let’s discuss Polowniak v Commissioner.

Polowniak had over 35 years of marketing experience with Fortune 500 companies, including Proctor & Gamble, Johnson & Johnson and Kimberly Services. In 1997 he formed his own company – Solution Strategies, Inc. (Strategies). He was the sole shareholder and its only consultant.

In 2001 he received a nice contract - $680,000 – from Delphi Automotive Systems – which had him travel extensively to Europe, Asia and South America. 

Now the turn. His financial advisor recommended an attorney who pitched the idea of “privately owned Roth IRA corporations,” also known as PIRACs. These things are not rocket science. In most cases an individual already has an existing company, likely profitable or soon to be. Said individual sets up a Roth IRA. Said Roth purchases the stock of a new corporation (NewCo), which amazingly does exactly the same thing that the existing corporation did, and likely with the same customers, vendors, employee, office space and so on.

The idea of course is that NewCo is going to be very profitable, which allows the opportunity to stuff a lot of money into the Roth in a very short period of time.

So Polowniak sets up a NewCo, which he names Bevco Investments, Inc. (Bevco). There is a little flutter in the story as Bevco selects a January year-end, meaning that a sharp tax advisor may have the opportunity to move things back-and-forth between a calendar-year taxpayer and an entity that doesn’t file its tax return until a year later.

This is fairly routine tax work.

Polowniak owned 98 percent and his administrative assistant owned 2 percent.  His wife later purchased 6% of Bevco.

Strategies and Bevco entered into an agreement whereby it would receive 75% of Strategies revenues for 2002.

By the way, Delphi was never informed of Bevco. Neither was the administrative assistant.

The years passed. Polowniak let the subcontract with Bevco lapse.

And he started depositing all the Strategies revenue from Delphi into Bevco. There was no more pretense of 75 percent.

Bevco was finally dissolved in 2006.

And then came the IRS.

It went after Solutions, which did not report the $680,000 from Delhi. You remember, the same amount it was to share 75% with Bevco.

Sheesh.

It also came after Polowniak personally. The IRS wanted penalties for excess funding into a Roth.

Huh?

There are limits for funding a Roth. For example, the 2015 limit for someone age-50-and-over (ahem) is $6,500. If you go over, then there is a 6% penalty. Mind you, the 6% doesn’t sound like much, but it becomes pernicious, as it compounds on itself every year. Tax practitioners refer to this as “cascading,” and the math can be surprising.

How did he overfund?

Simple. He took existing money from Solutions and put it into Bevco. It is the equivalent of you depositing money at Key Bank rather than Fifth Third.

Polowniak’s job right now was to convince the Court that was a substantive reason for the Solutions –Bevco structure. If Bevco was just an alter ego, he was going to lose and lose big.

He trotted put Hellweg, a tax case featuring Roth IRAs and Domestic International Sales Corporations (DISCs). Whereas the taxpayer won that case, there was some arcane tax reasoning behind it, likely exacerbated by those DISCs.

The Court did not think Hellweg was on point. It thought that Repetto was much more applicable, pointing out:

·        All the services performed by Bevco had previously been performed by Polowniak through Strategies

·        Polowniak performed all the services under the contract with Delphi

·        Since he was the only person performing services, the transfer of payments between Strategies and Bevco had no substantive effect on the Delphi contract

·        Delphi did not know of the contract with Bevco; in fact, neither did the administrative assistant

·        The business dealing between Strategies and Bevco were not business-normative. For example, Bevco never kept time or accounting records of its services, nor did it ever invoice Strategies.

The Court decided against Polowniak. It did not respect the PIRAC, and as far as it was concerned all the Delphi money put into Bevco was an overfunding.

And that is how you blow through a third of a million dollars.

Is there something Polowniak could have done?

He could of course have respected business norms and treated both as separate companies with their own accounting systems, phone numbers, contracts and so forth. It would have helped had Strategies not been depositing and withdrawing monies from Bevco’s bank account.

Still, I do not think that would have been enough.

There are two major problems that I see:

(1) There was an existing contract in place with Delphi. This is not the same as starting Bevco and pounding the streets for work. There is a very strong assignment of income feel, and I suspect just about any Court would have been disquieted by it.

(2) There were not enough players on the field. If I own a company with 75 employees, I may be able to take a slice of its various activities and place it inside a PIRAC or ROBS or whatever, without the thing being seen as my alter ego. Polowniak however was a one-man show. This made it much easier for the IRS to argue substance over form, which the IRS successfully argued here.

 

My advice? Leave these things alone. There are a hundred ways that these IRA-owned companies can blow up, and the IRS has sounded the trumpet that it is pursuing them.