Can $2 Million Be An Honest Mistake?

 

It is a good idea to look over your tax return before hitting the “Send” button.

Why? Because things happen. Some prep software approximates a black box. It asks questions, you provide numbers and together they go someplace hidden from the eyes of man. Granted, most times the result is just fine. But there are those times ….

Let’s talk about Candice and Randall Busch.

They were preparing their 2017 tax return using a popular tax software, which shall remain nameless. They reached the point where the software wanted mortgage interest. Easy enough. They entered “21,201.25.”

So?

The software did not accept pennies.

This means that 21,201.25 went in as 2,120,125.

That, folks, is a lot of mortgage interest.

BTW one cannot deduct that much mortgage interest on a principal residence. Why? The mortgage interest deduction had been capped for many years as interest paid on the first $1 million of indebtedness. Let’s say someone paid $62,000 on $2 million of principal residence debt. The tax preparer should have caught this and limited the deduction as follows:

         62,000 * 1,000,000/2,000,000 = 32,000

The $1,000,000 cap was further reduced to $750,000 in 2017.

The tax Code has no intention of allowing an unlimited deduction for this type of interest.

Is it ever possible to get past the $1,000,000 (or $750,000) limitation? Well, yes, and it happens all the time. Borrow money on commercial real estate (say a strip mall) and there is no limitation. Borrow money on residential real estate - as long as it is not a principal residence - and there is no limitation. An example would be an apartment complex.  The limitation we are discussing is personal and involves debt on your house.

Back to the Busch’s.

They sound like average folk.

That mistake made their tax refund go through the roof.

They liked that answer.

They sent in the return.

The IRS flagged the return, which was not hard to do when the interest deduction was larger than the allowed debt for purposes of calculating the deduction itself.

The IRS wanted the excess refund back.

The Busch’s would do that.     

Then the IRS also wanted a heavy penalty (the accuracy-related penalty, for the home gamers).

The Busch’s said they wouldn’t do that. An exception to the accuracy-related penalty is reasonable cause, and they had reasonable cause all day long and three times on the weekend.

And what was that reasonable cause, asked the IRS.

It was an “honest mistake,” they replied.

Off to Tax Court they went.

The Busch’s represented themselves, the lingo for which is “pro se.”

The Court acknowledged that mistakes happen. One can get distracted and enter a wrong number, one can transpose, one can get surprised by what a software might do.

But that is not the mistake here.

The mistake here was failing to review the return before sending.

The biggest number on the return – literally – was that interest deduction. It hung over the form like a Big Texan 72-ounce steak on a normal-sized dinner plate.

Here is the Court:

A careful review of the return after it was prepared would most certainly have caught the error; actually, even as little as a quick glance at the return probably would have done so.”

The Busch’s got stuck with the penalty.

IRS Wants Near $9 Million Penalty From A Holocaust Survivor

 

I’ll tell you what caught my eye:

This is a tax case in which the Government alleges that Defendant Walter Schik, a Holocaust survivor, failed to file a foreign bank account reporting form with the Internal Revenue Service …, which now seeks by this action to collect an almost nine-million-dollar civil penalty assessed against him for that failure.”

There are so many things wrong with that sentence.

Let’s talk about Form TD F 90-22.1, also known as the FBAR (“Eff- Bar”). The form existed before I took my first course in accounting years ago, but it has gathered steam and interest when Treasury started to chase overseas bank accounts during the aughts. If one has a foreign account, or has authority over a foreign account, which exceeds $10,000 during the taxable year, one is required to disclose on one’s individual income tax return (on Schedule B) and file Form TD F 9-22.1 with the Treasury.

Up to this point, it is just another form to file. We are drowning in forms, so what is the big deal?

The deal is the penalties for not filing the form. Let’s separate not filing the form because you did not know you had to file from knowing you had to file but deciding not to. That second one is considered “willful” (which makes sense) and can cost you a penalty from $100,000 to 50% of the account balance at the time of violation.

This is VERY expensive money.

The IRS assessed a penalty of almost $9 million against Schik for failure to file an FBAR.

Some background:

·      Mr Schik is a Holocaust survivor.

·      His education was cut short by, how shall we say this …, being in a concentration camp.

·      After the war, he immigrated to the U.S. and became a citizen.

·      After becoming a citizen, he opened a Swiss bank account where he deposited monies recovered from relatives who were slaughtered during the Holocaust.

·      He left the monies in Switzerland as he was fearful that another Holocaust-like event could occur.

·      Schik did not touch or manage the money. That was done by his son and a Swiss money manager.

·      Schik did talk with the money manager occasionally, though.

·      By 2017 one of those Swiss accounts had over $15 million.

·      His accountant never asked Schik if he had overseas bank accounts or explained the recently heightened IRS interest in the area.

I am sympathetic with the accountant. What are the odds of having a client who is a Holocaust survivor and having over $15 million in a Swiss bank account? One could go a career. I have.

The year at issue is 2007. There is a question on the individual tax return whether one has an interest or signature authority over a foreign bank account. Schik’s accountant answered it “No.” Schik did not correct his accountant. More fairly, Schik did not even notice the question.

Wouldn’t you know that Schik’s Swiss money manager got pulled into the UBS investigation?

UBS entered into a deferred prosecution arrangement with the United States. It however had to provide identities of U.S. citizens and residents who were customers of the bank.

At which point Schik submitted a voluntary disclosure to the IRS.

Which the IRS denied.

Without an alternative, Schik submitted a late FBAR.

The IRS then slapped the 50% penalty we are talking about.

Which brings us up to speed.

The penalty requires one’s behavior to be “willful.” Not surprisingly, the word has specific meaning under the law, and the Court evaluated whether Schik’s behavior was willful.

Treasury argued that “willful” means “objectively reckless.”

Got it. Ignoring an issue to an extreme degree is the same as knowing and not caring.

Schik argued that willful means “intentional disregard.”

The difference?

Schik argued that the underlying law was opaque, long-ignored and now quickly – if somewhat capriciously – conscripted into action. He no more intentionally disregarded his tax reporting obligations than he intentionally disregarded the newest developments in cosmological galaxy formation. There was no conspiracy by hundred-year-old Holocaust survivors: he just didn’t know.

And such is tax law. Nine million dollars hangs on the meaning of a word.

The Court noted that other courts – relying on records similar to those available to it - have found willfulness.

Not good for Schik. 

However, the Court was concerned about the many countervailing factors:

·      Schik was nearly 100 years old.

·      Schik had minimal formal education.

·      Schik did not manage the money.

·      Schik did not prepare his own tax returns.

·      Schik had no idea about a disclosure requirement.

·      Schik’s accountant did not explain the disclosure requirement.

·      The question answered “No” was pre-filled by the accountant’s software and did not represent any assertion made by Schik.

The Court denied the IRS summary judgement, noting there was a substantial question of fact.

I agree.

Who will review and clarify the facts?

“The Court believes that the Parties in this case would benefit from mediation. By separate order the Court will refer the Parties to the Southern District of New York’s Mediation Program. … the assigned District Judge … may determine that a case is appropriate for mediation and may order that case to mediation, with or without the consent of the parties.”

Methinks the IRS should just have allowed the voluntary disclosure.  

Was the IRS encouraging compliance, promoting education and providing a ramp to enter/reenter the tax system? Or is this something else, something with the purpose of terrifying the next person?

Our case this time was United States of America v Walter Schik, 20-cv-02211 (MKV)

Are Minimum Required Distribution Rules Changing Again?

I wonder what is going on at the IRS when it comes to IRA minimum required distributions.

You may recall that prior law allowed for something called a “stretch” IRA.  The idea was simple, but planners and advisors pushed on it so long and so hard that Congress changed the law.

An IRA (set aside Roth IRAs for this discussion) must start distributing at some point in time. The tax Code tells you the minimum you must distribute. If you want more, well, that is up to you and the tax Code has nothing further to say.  The minimum distribution uses actuarial life expectancies in its calculation. Here is an example:

                   Age of IRA Owner            Life Expectancy

                            72                                    27.4

                            73                                    26.5

                            74                                    25.5

                            75                                    24.6                                        

Let’s say that you are 75 years old, and you have a million dollars in your IRA. Your minimum required distribution (MRD) would be:

                  $1,000,000 divided by 24.6 = $40,650

There are all kinds of ancillary rules, but let’s stay with the big picture. You have to take out at least $40,650 from your IRA.

President Trump signed the SECURE Act in late 2019 and upset the apple cart. The new law changed the minimum distribution rules for everyone, except for special types of beneficiaries (such as a surviving spouse or a disabled person).

How did the rules change?

Everybody other than the specials has to empty the IRA in or by the 10^th year following the death.

OK.

Practitioners and advisors presumed that the 10-year rule meant that one could skip MRDs for years 1 through 9 and then drain the account in year 10. It might not be the most tax-efficient thing to do, but one could.

The IRS has a publication (Publication 590-B) that addresses IRA distributions. In March, 2021 it included an example of the new 10-year rule. The example had the beneficiary pulling MRDs in years 1 through 9 (just like before) and emptying the account in year 10.

Whoa! exclaimed the planners and advisors. It appeared that the IRS went a different direction than they expected. There was confusion, tension and likely some anger.

The IRS realized the firestorm it had created and revised Publication 590-B in May with a new example. Here is what it said:

For example, if the owner dies in 2020, the beneficiary would have to fully distribute the plan by December 31, 2030. The beneficiary is allowed, but not required, to take distributions prior to that date.”

The IRS, planners and advisors were back in accord.

Now I am skimming the new Proposed Regulations. Looks like the IRS is changing the rules again.

The Regs require one to separate the beneficiaries as before into two classes: those exempt from the 10-year rule (the surviving spouse, disabled individuals and so forth) and those subject to the 10-year rule.

Add a new step: for the subject-to group and divide them further by whether the deceased had started taking MRDs prior to death. If the decedent had, then there is one answer. If the decedent had not, then there is a different answer.

Let’s use an example to walk through this.

Clark (age 74) and Lois (age 69) are killed in an accident. Their only child (Jon) inherits their IRA accounts.

Jon is not a disabled individual or any of the other exceptions, so he will be subject to the 10-year rule.

One parent (Clark) was old enough to have started MRDs.

The other parent (Lois) was not old enough to have started MRDs.

Jon is going to see the effect of the proposed new rules.

Since Lois had not started MRDs, Jon can wait until the 10^th year before withdrawing any money. There is no need for MRDS because Lois herself had not started MRDs.

OK.

However, Clark had started MRDs. This means that Jon must take MRDs beginning the year following Clark’s death (the same rule as before the SECURE Act). The calculation is also the same as the old stretch IRA: Jon can use his life expectancy to slow down the required distributions – well, until year 10, of course.

Jon gets two layers of rules for Clark’s IRA:

·      He has to take MRDs every year, and

·      He has to empty the account on or by the 10^th year following death

There is a part of me that gets it: there is some underlying rhyme or reason to the proposed rules.

However, arbitrarily changing rules that affect literally millions of people is not effective tax administration.

Perhaps there is something technical in the statute or Code that mandates this result. As a tax practitioner in mid-March, this is not my time to investigate the issue.  

The IRS is accepting comments on the proposed Regulations until May 25.

I suspect they will hear some.

Taxing Foreign Investment In U.S. Real Estate

One of the Ps buzzed me about a dividend item on a year-end brokers’ statement.

P:      “What is a Section 897 gain?”

CTG: It has to do with the sale of real estate. It is extremely unlikely to affect any of our clients.

P:      Why haven’t I ever seen this before?

CTG: Because this is new tax reporting.

We are talking about something called the Foreign Investment in Real Property Tax Act, abbreviated FIRPTA and pronounced FERP-TUH. This thing has been around for decades, and it has nothing to do with most of us. The reporting, however, is new. To power it, you need a nonresident alien – that is, someone who is not a U.S. citizen or resident alien (think green card) – and who owns U.S. real estate. FIRPTA rears its head when that person sells said real estate.

This is specialized stuff.

We had several nonresident alien clients until we decided to exit that area of practice. The rules have reached the point of absurdity – even for a tax practitioner – and the penalties can be brutal. There is an encroaching, if unspoken, presumption in tax law that international assets or activities mean that one is gaming the system. Miss something – a form, a schedule, an extension, an election - and face a $10,000 penalty. The IRS sends this penalty notice automatically; they do not even pretend to have an employee review anything before mailing. The practitioner is the first live person in the chain, He/she now must persuade the IRS of reasonable cause for whatever happened, and that a penalty is not appropriate. The IRS looks at the file - for the first time, mind you - says “No” and demands $10,000.

And that is how a practitioner gets barreled into a time-destroying gyre of appealing the penalty, getting rejected, requesting reconsideration, getting rejected again and likely winding up in Tax Court. Combine that with the bureaucratic rigor mortis of IRSCOVID202020212022, and one can understand withdrawing from that line of work.

Back to Section 897.

The IRS wants its vig at the closing table. The general withholding is 15% of selling price, although there is a way to reduce it to 10% (or even to zero, in special circumstances). You do not want to blow this off, unless you want to assume substitute liability for sending money to the IRS.

The 15% is a deposit. The IRS is hopeful that whoever sold the real estate will file a nonresident U.S. income tax return, report the sale and settle up on taxes. If not, well the IRS keeps the deposit.

You may wonder how this wound up on a year-end brokers’ tax statement. If someone sells real estate, the matter is confined to the seller, buyer and title company, right? Not quite. The real estate might be in a mutual fund, or more likely a REIT. While you are a U.S. citizen, the mutual fund or REIT does not know whether its shareholders are U.S. citizens or resident aliens. It therefore reports tax information using the widest possible net, just in case.