Keeping A Corporation Alive

Recently I received a call from a client requesting that certain records be sent to an attorney as soon as possible, hopefully before noon.

It was not a big request, just the QuickBooks files for two companies (those who know me will understand the inside joke in that sentence). Activity in recent years has been minimal, and the companies have been kept alive primarily because of a lawsuit. The companies previously experienced one of the most astounding thefts of intellectual property I have encountered. It sounds like the attorneys have now stopped playing flag and are now playing tackle, as legal discovery is turning up some rather unflattering information. We are talking retirement-level money here.

Notice what I said: the companies have been kept alive.

Why?

Because it is the companies that are suing.

Keeping the companies alive means filing tax returns, renewing annual reports with the secretary of state and whatever else one’s particular state of organization may require. It may also require the owners kicking-in money to pay those taxes, registrations and fees.

What if you do not do this? To use a rather memorable phrase: what difference does it make?

Let’s talk about the recent Timbron case.

There are two Timbrons: the parent (Timbron Holdings) and the operating company (Timbron Internation). For ease, we will call them both Timbron.

Timbron was organized in California.

Timbron did not pay state taxes.

By 2013 California has suspended corporate rights for both Timbrons.

In 2016 the IRS showed up and issued Notices of Deficiency for 2010 and 2011.

In October, 2016 Timbron filed a petition with the Tax Court.

In November, 2016 the IRS filed its response.

A couple of months later the IRS realized Timbron was no longer a corporation under California law. This is a problem, as corporations are legal entities, meaning they are created and sustained under force of law.

An attorney at the IRS earned one of the easiest paychecks he/she will ever receive.

The IRS moved to dismiss.

Timbron fought back. Someone must have invested in a legal dictionary, as we are introduced to “certificates of reviver.” Timbron continued on, arguing “vitality” and “mere irregularities.”

I am not an attorney, although I did a substantial portion of my Masters at the University of Missouri Law School. When I come across gloss and floss like “vitality” and so forth, I discern that an attorney is hard-pressed.

Here is the Court:

With respect to corporate taxpayers like petitioners, a proper filing requires taxpayers tendering petitions to the Court to have the capacity to engage in litigation before this Court.”

To no one’s surprise:

… we find that petitioners lacked capacity to timely file proper petitions.”

Timbron lost.

On the most basic of facts: it failed to maintain its corporate status under California law.

Converting A Residence To A Rental

I have a client who owns a very nice house. Too nice, in fact, at least for its neighborhood. My client used to have a contracting business, and he used his business talents and resources to improve his residence. He is now thinking of moving to another city, and it is almost assured he will lose money when he sells his house.

He is quite creative in thinking of ways to make that loss tax deductible.

The first thought is to convert it to a rental. One can deduct losses on the sale of a rental, right?

There are two significant issues with this plan. One has to do with the amount of loss one can deduct when the rental is underwater – that is, when it costs more than it is worth. The second has to do with whether there actually is rental activity.

We have previously talked about the second point, especially when one rents to family. Doing so is not fatal, but doing so on the cheap (not charging rent or enough rent) is.

Consider the following:

The Langstons purchased a residence (75^th Place) in 1997.

They lived there until 2005, when they moved to an apartment. They kept some of their possessions at 75^th Place until they could move them to storage.

Renovations to 75^th Place were completed in 2010.

In 2011 they received an unwanted telephone call from their insurance agent. Someone had to live at 75^th Place or the insurance would be terminated.

In July, 2011 Mr. Langston rented the property to a fraternity brother for $500 a month.

COMMENT: The market rent was between $2,500 and $2,800 a month, but the fraternity brother would be home about five days per month. Mr. Langston prorated the rent accordingly.

In 2013 they finally sold 75^th Place. They deducted a loss of over $400 grand.

QUESTION: Do you think they successfully converted the property to a rental?

Let’s consider a few factors.

·      What was their intent when they moved to an apartment?

If the intent was to renovate and sell, this would indicate an income-producing purpose. The problem is that the renovations went on forever.

·      They tried to rent the property

No, actually they did not. In fact, the Court thought that they rented the property only after the insurance company threatened to cut-off their insurance.

·      They actually rented the property

For much less than market value rent. The Court was not impressed by that.

·      They tried to sell the property

Eventually, after nearly a decade and after never marketing the property. They did not even seek an appraisal until a refinancing required them to do so.

The Court decided that they never converted the property to a rental. There was no deductible loss.

Zero surprise. I get the feeling that the taxpayers did whatever they wanted for however long, and near the end they wanted some tax leverage from the deal. It was a bit unfair to the tax practitioner, as some planning – any planning – might have helped.

Let’s go crazy with their planning. What can we do….? Let me think, let  me… I got it! How about actually renting the place before the insurance company is about to drop you? How about charging market rent – or at least close?  How about listing the house with a realtor? Shheeesssh.

I suspect my client is shrewder than the Langstons. He however cannot get past the second tax issue.

You see, when you have a personal asset (say your residence) which you convert to income-producing status (say a rental), you have to look at its basis and its fair market value when you convert.

Basis is a fancy word for what you paid to acquire or improve the asset. Say that my client has $1.5 million in his house.

Say he converts May 1^st, when the house is worth $1 million.

He now has a “dual basis” situation.

His basis for calculating gain is $1.5 million.

But his basis for calculating loss is $1 million.

You see what happened? He was hoping to use that $1.5 million to calculate any loss on sale. Folks, the IRS figured out this gimmick ages ago. That is how we wound up with the dual basis rule.

I suspect the Langstons had a similar situation, but they never got to first base. You see, their activity had to qualify first as a rental before the Court would have to consider the dual basis rule. The activity didn’t, so the Court didn’t.

Our case this time was Carlos and Pamela Langston, TC Memo 2019-19.

You Inherit. Can You Owe Estate Tax?

I came across an estate tax lien case the other day.

It has become unlikely that one will owe estate tax, as the lifetime exclusion has now gone over $11 million. Still, it can and does happen.

The federal estate tax is an odd beast. It is a combination of assets owned or controlled at death, increased by an addback for reportable lifetime gifts. This system is called a “unified” tax, and the intent is to not avoid the estate tax by giving property away to family over the course of a lifetime. In truth, the addback is necessary, as tax planners (including me) would drive an 18-wheeler through the estate tax if the lifetime-gift addback did not exist.

There is a potential trap if the estate tax kicks-in.

Let me give you a scenario, very loosely based on the case.  

Mr Arshem was successful. He created and funded a family limited partnership with real estate, stock and securities. He began a multi-year gifting sequence to his children, each time claiming a generous discount for lack of control and marketability. He had cumulatively gifted away $5 million in this manner.

He passed away early in 2019. He died with an estate of $6 million.

On first pass, $6 million plus $5 million equals $11 million. He is just under the threshold, so he should not have an estate tax issue – right?

Not so fast.

The IRS audits one or more of those gift tax returns. They argue that the discounts were too generous, and the reportable gifts were actually $8 million. The estate disagrees; they go to Court; the estate loses.

Now we have $8 million plus $5 million for $13 million.

There is an estate tax filing requirement.

And estate tax due.

Let’s say that the estate had been probated and closed. There no estate assets remaining.

Who pays the tax?

Look over this little beauty:

§ 6324 Special liens for estate and gift taxes.

(a)  Liens for estate tax.

Except as otherwise provided in subsection (c) -

(1)  Upon gross estate.

Unless the estate tax imposed by chapter 11 is sooner paid in full, or becomes unenforceable by reason of lapse of time, it shall be a lien upon the gross estate of the decedent for 10 years from the date of death, except that such part of the gross estate as is used for the payment of charges against the estate and expenses of its administration, allowed by any court having jurisdiction thereof, shall be divested of such lien.

(2)  Liability of transferees and others.

If the estate tax imposed by chapter 11 is not paid when due, then the spouse, transferee, trustee (except the trustee of an employees' trust which meets the requirements of section 401(a) ), surviving tenant, person in possession of the property by reason of the exercise, nonexercise, or release of a power of appointment, or beneficiary, who receives, or has on the date of the decedent's death, property included in the gross estate under sections 2034 to 2042 , inclusive, to the extent of the value, at the time of the decedent's death, of such property, shall be personally liable for such tax.

It is not the easiest of reading.

What (a)(2) means is that the IRS can after the transferees – the children of Mr Arshem in our example. There is also a sneaky twist. Income tax liens have to be recorded; estate tax liens do not. They are referred to as “silent” liens and can create unexpected – and unpleasant – surprises.  You cannot go to the courthouse and research if one exists.

What if Arshem’s children received his assets and thereafter sold them? What happens to the lien?

The children are “transferees.” They are personally liable for the estate tax.

COMMENT: There are procedures to possibly mitigate this consequence, but we will pass on their discussion in this post.

The case is U.S. v Ringling. The moral of the story is – if the estate is large enough to draw the wrath of the federal estate tax – please consult an experienced professional. Think of it as insurance.