File A Return, Especially If You Have Carryovers

 

Please file a tax return when you have significant carryovers.

Let’s look at the Mosley case.

In 2003 Sonji Mosley bought four residential properties in North Carolina.

In 2007 she bought undeveloped land in South Carolina.

In 2009 all the properties were foreclosed.

On her 2009 return she reported approximately $20 grand of net rental expenses and a capital loss of approximately $182 grand.

On her 2014 return she claimed an (approximately) $17 thousand loss from one of the 2009 foreclosures.

On her 2015 return she claimed an (approximately) $28 thousand loss from one of the 2009 foreclosures.

On to n 2018.

It seemed an ordinary year. She worked for the city of Charlotte. She also broke two retirement accounts. The numbers were as follows: 

            Wages                                                $ 40,656

            Retirement plan distributions              $216,871

The retirement plan distributions were going to hurt as she was under 59 ½ years of age. There would be a 10% penalty for early distribution on top of ordinary income taxes.

Well, there would have been - had she filed a return.

The IRS prepared one for her. The IRS already had her W-2 and 1099s through computer matching, so they prepared something called a Substitute for Return (SFR). Taxes, penalties, and interest added to almost $60 grand. The implicit bias in the SFR is transparent: everything is taxable, nothing is deductible. The IRS wants you to see the SFR, clutch your chest and file an actual return.

To her credit, she did reply. She did not file a return, though; she replied with a letter.

COMMENT: She should have sent a return.

She explained that - yes – she should have filed a return, but the IRS was not giving her credit for prior year carryovers. If anything, she still had a credit with the IRS. She also requested the IRS to remove all penalties and interest.

COMMENT: She definitely should have sent a return.

The IRS could not understand her letter any more than you or I. They sent a Notice of Deficiency, also called a “NOD,” “SNOD,” or “90-day letter.” It is the ticket to Tax Court, as we have discussed before.

Off to Court they went.

Mosley next submitted four handwritten calculations to the IRS.

• The first showed a net operating loss (NOL) of $444,600 and a capital loss of $206,494, both originating in 2009.
• The second and third ones broke down those numbers between South and North Carolina.
• The fourth one was an updated calculation of her 2018 taxes. According to her numbers, she had a remaining NOL of $211,308 going into 2018. Since the total of her 2019 income was approximately $257 grand, she had very much separated the thorn from the stalk.

The IRS had questions. The tax impact of a foreclosure can be nonintuitive, but – in general – there are two tax pieces to a foreclosure:

(1)  The borrower may have income from the cancellation of income. That part makes sense: if the bank settles a $150,000 debt for $100 grand, one can see the $50 grand entering the conversation. Then follows a bramble of tax possibilities – one is insolvent, for example – which might further affect the final tax answer but which we will leave alone for this discussion.

(2)   Believe it or not, the foreclosure is also considered a sale of the property. There might be gain or loss, and the gain might be taxable (or not), and the loss might be deductible (or not). Again, we will avoid this bramble for this discussion.

The IRS looked at her calculations. She had calculated a 2009 NOL of $444,600 and $78,025 capital loss from her North Carolina properties. The IRS recalculated North Carolina and arrived at taxable gain of $55,575.

Not even close.

You can anticipate the skepticism the Tax Court brought to bear:

(1)  She did not file a 2009 return, yet she asserted that there were carryovers from 2009 that affected her 2018 return.

(2)  She reported the same transactions in 2009, 2014 and 2019.

(3)  The tax reporting for foreclosures can be complicated enough, but her situation was further complicated by involving rental properties. Rentals allow for depreciation, which would affect her basis in the property and thereby her gain or loss on the foreclosure of the property.

(4)  The IRS recalculations were brutal.

The Court pointed out the obvious: Mosley had to prove it. The Court did not necessarily want her to recreate the wheel, but it did want to see a wheel.

Here is the Court’s sniff at the net operating loss carryover:

It is apparent that the record is devoid of evidence to properly establish both the existence and the amount of petitioner’s NOLs in 2009.”

Here is the Court on the capital loss carryover:

“ … petitioner initially reported the foreclosure on the South Carolina land resulted in $182,343 of net long-term capital losses, and for each of 2009-17, she claimed $3,000 of that amount as a long-term capital loss deduction pursuant to section 1211(b). But on the 2015 return … petitioner also improperly claimed an ordinary loss deduction of 110,257 from the sale or exchange of the South Carolina land despite the foreclosure on that land in 2009. Thus, petitioner effectively double counted the loss …."

Mosley lost on every count, She owed tax, penalty, and interest.

And there is a lesson. If you have significant tax carryovers spilling over several years, you should file even if the result is no taxable income. The IRS wants to see the numbers play out. Get yourself in hot water and the Tax Court will want to see them play out also.

You might even catch mistakes, like double-counting things.

Our case this time was Mosely v Commissioner, T.C. Memo 2025-7.  

Is This Reasonable?

 

I have long maintained that the IRS is unreasonable by repeatedly disallowing reasonable cause exception to its numerous penalties. Their standard appears to allow little to no room for real-world variables – someone got sick, someone misunderstood the requirements (wow, how could that happen?), technology broke down, and so on.

Mind you, I say this after contacting the IRS – AGAIN – about returns we filed for two clients. In each case the IRS has misplaced the returns, failing its mission, causing needless (and incorrect) notices, and embarrassing us as practitioners. One of these returns will soon celebrate its one-year anniversary. The IRS has had plenty of time to investigate and resolve the matter. I have, and I am just one guy.

However, have a practitioner send a tax return two minutes after midnight on an extended due date and the IRS will penalize his/her tax practice to near bankruptcy. It may be that there was no electricity in the office until that very moment. No matter: there is no reasonable cause for things not functioning perfectly every time every place all the time.

The hypocrisy is almost suffocating. Let’s make the relationship reciprocal – for example, let me send the IRS an invoice for wasting my time – and see how quickly the IRS recoils in terror.

Let’s talk about RSBCO’s recent shout-out to the Supreme Court.

RSBCO was a wealth management company headquartered in Louisiana. It hired someone (let’s call him Smith) with a background in accounting to spearhead its IRS information reporting.

Smith took RSBCO successfully through one filing season.

Unbeknownst to anyone, however, Smith was fighting some dark demons, and the second filing season did not go as well.

Smith unfortunately waited until the final day to electronically file approximately 20,000 information returns using the IRS FIRE system. FIRE sent an automated e-mail that certain files had errors preventing them from being processed and RSBCO should send replacement files. The e-mail went only to Smith, so no one else at RSBCO knew.

Smith – approximately four months later – was able to resume work. He had been diagnosed with clinical depression, having suicidal ideation, and struggling to focus and complete tasks at work.

COMMENT: I am thinking Reg 301.6724-1(c):

(c) Events beyond the filer's control

(1) In general. In order to establish reasonable cause under this paragraph (c)(1), the filer must satisfy paragraph (d) of this section and must show that the failure was due to events beyond the filer's control. Events which are generally considered beyond the filer's control include but are not limited to—

(iv) Certain actions of an agent (as described in paragraph (c)(5) of this section),

Smith saw the e-mails. He corrected the information returns.

QUESTION: What were the errors about? About dashes, that’s what. The IRS wanted dashes added or removed. Approximately 99% of the problem was little more than a spelling bee.

Smith had a successful third filing season.

Except for the $579,198 penalty notice the IRS sent for the information returns from season two.

COMMENT: Methinks that is a bit harsh for not winning a spelling bee.

Smith was still battling his health issues. He hid the penalty notice in his desk.

A few months later RSBCO let Smith go.

The new hire soon found the notice and tried to contact the IRS. The contact number provided was entirely automated, so the hire could never speak with a human being.

COMMENT: Been there, pal.

The IRS – thinking they had been ignored – sent a Final Notice. RSBCO requested a Due Process Hearing.

The Hearing Officer for the CDP hearing mostly waived off RSBCO’s side of the story. After a Solomonic 15-minute reflection, the Officer did offer to abate 25% of the penalty amount.

COMMENT: It’s something.

RSBCO had to decide how to proceed. They decided to pay the IRS $579 grand and pursue the refund administratively.

In December 2018 RSBCO filed a Claim for Refund.

The IRS received it. And then lost it.

Uh huh.

In August 2019 RSBCO filed a lawsuit.

In June 2020 – after irritating the court – the IRS promised RSBCO that it would play fair if they refiled the claim.

RSBCO agreed and withdrew the lawsuit.

In September it filed its Claim for Refund … again.

And the IRS lost it … again.

COMMENT: You see what is going on here, don’t you?

In May 2021 RSBCO filed a second lawsuit in district court.

In September 2022, the jury decided that RSBCO had reasonable cause for penalty abatement.

COMMENT: Will this ever end?

The IRS processed the refund … wait … no, no … that’s wrong. The IRS appealed the district court decision to the Fifth Circuit.

The Fifth Circuit found that jury instructions were flawed. The district court stated that an employee’s mental health - by itself - did not give rise to reasonable cause. The jury was not properly instructed.

QUESTION: I guess the following by the district court judge was unclear to the IRS, which DID NOT object:

Anything else? Anybody want to put your objection [to jury charges] on the record if you’d like objecting to them?”

COMMENT: I can see the confusion. Making out this question is like trying to plumb the metaphysics of James Joyce’s Ulysses. No wonder the IRS failed to object.

In October 2023 RSBCO petitioned the Supreme Court.

Which just declined the petition.

Meaning the Fifth Circuit has the final word.

The Fifth Circuit wants a new trial.

Will this nightmare ever end?

It is … unreasonable.

Our case this time was RSBCO v U.S., US Supreme Court Docket 24-561.

Government Forces Sale to Cover Partner’s Tax Debt

 I was reading a case recently that bothered me. It involves something that – fortunately – I rarely see in practice.

Here is the Code section:

§ 7403 - Action to enforce lien or to subject property to payment of tax

(a) Filing. In any case where there has been a refusal or neglect to pay any tax, or to discharge any liability in respect thereof, whether or not levy has been made, the Attorney General or his delegate, at the request of the Secretary, may direct a civil action to be filed in a district court of the United States to enforce the lien of the United States under this title with respect to such tax or liability or to subject any property, of whatever nature, of the delinquent, or in which he has any right, title, or interest, to the payment of such tax or liability. For purposes of the preceding sentence, any acceleration of payment under section 6166(g) shall be treated as a neglect to pay tax.

(b) Parties. All persons having liens upon or claiming any interest in the property involved in such action shall be made parties thereto.

(c) Adjudication and decree. The court shall, after the parties have been duly notified of the action, proceed to adjudicate all matters involved therein and finally determine the merits of all claims to and liens upon the property, and, in all cases where a claim or interest of the United States therein is established, may decree a sale of such property, by the proper officer of the court, and a distribution of the proceeds of such sale according to the findings of the court in respect to the interests of the parties and of the United States. If the property is sold to satisfy a first lien held by the United States, the United States may bid at the sale such sum, not exceeding the amount of such lien with expenses of sale, as the Secretary directs.

(d) Receivership. In any such proceeding, at the instance of the United States, the court may appoint a receiver to enforce the lien, or, upon certification by the Secretary during the pendency of such proceedings that it is in the public interest, may appoint a receiver with all the powers of a receiver in equity.

And here is where you leave your tax CPA and hire a tax attorney.

Section 7403 permits a court to authorize the sale of property when a delinquent person owns property with a nondelinquent person. The IRS cannot do this on its own power, however; it must first go to district court and obtain approval.

To be fair, one is deep into the IRS Collection machinery before Section 7403 is even an issue. I would be screaming at you – and likely fired you as a client – long before we got here, unless bad fortune was involved. If there was bad fortune, we likely would be submitting an offer in compromise.

The heavyweight case in this area is United States v Rodgers. Rodgers was a Texas gambler who died, leaving a $900,000 tax debt. He (well, now his estate) and his wife owned their home. Under Texas law the surviving spouse had a lifetime right to live in the home. The government of course wanted its money.

The case went all the way to the Supreme Court, which identified four issues before the government could force any sale to collect taxes.

 (1) Statutory authority

Does the taxpayer have any “right, title or interest” to the property in question?

 

In Rodgers, yes. The deceased had the same rights to the entire home as did the widow.

 

The type of ownership can have a drastic effect on the government’s ability to reach the asset. A tenancy by the entirety, for example, might result in a different answer from a tenancy in common (which we will see below). 

            (2) Constitutional authority

This goes back to eminent domain. The government is not an ordinary creditor in this situation; rather it is exercising the prerogatives of a sovereign. Think of the government as a super creditor.

            (3) Practical undercompensation

Think actuarial calculations. For example, one could think that a 50/50 split of marital assets is fair. However, the value of a life estate to a surviving spouse aged fifty can be up to 95% of the home’s sales price. The spread between 95% and 50% is referred to as “practical undercompensation.”

            (4) Four-factor balancing test

             (a)  Will a non-sale prejudice the government?

   (b) Does the spouse have a legally recognized expectation of the house not being sold?

   (c)  Will the spouse suffer prejudice from practical undercompensation and dislocation costs?

   (d)  What are the relative characters and values of the two ownership interests?

Subsequent application of Rodgers focuses on these four factors.

Let’s move on to Driscoll.

Thomas Driscoll was a dentist. He owned a dental practice with Dr Vockroth. Together they also owned the building in which the dental practice was located.

Common enough.

Dr Driscoll became substantially delinquent with his tax obligations.

In April 2023, the government filed a motion for forced sale of both the practice and the building.

Meanwhile. Dr V had no tax issues. He may have made the mistake of partnering with someone who did, but that was the extent of his culpability.

The government – to its credit – allowed additional time to sell both assets.

But there were issues: trying to sell a dental practice in a small town and a building housing said practice in said small town. Let’s just say there was limited interest in buying either.

The government now wanted a forced sale.

Let’s go through the Rodgers four factors:

One

The Court decided Dr V could not show that the government would not be prejudiced by going after 50% rather than 100% of the practice and building.

Yes, the double negative is a bit difficult to follow.

This was a practice in a small town. It was going to be tough enough to sell without trying to sell half rather than the whole.

         The court decided that factor one weighed in favor of a sale.

         Two

Was Dr V as a tenant in common subject to a forced sale?

Here is the Court discussing the real estate:

This conclusion is also supported by the fact that, unlike tenants by the entirety or joint tenants, tenants in common enjoy no protections from forced sales or partition actions.”

Tough to be a tenant in common in New Jersey.

The court decided factor two weighed in favor of a sale.

Three

 Was there prejudice to Dr V in terms of personal dislocation of costs and undercompensation of interest?

Here is the Court:

 Dr Vockroth asserts that he will be ‘forced to lay off all of [his] employees,’ and that he will ‘no longer be able to see [his]  patients.'”

OK, Dr V may be laying it on thick, but that does not mean there is no truth here. Relocating a practice costs money. There are – for example - additional electrical and plumbing needs before a building can house a dental practice. Patients may not follow. Employees may not follow. The court is playing cavalierly with other people’s lives.

Here is the court in its best Frasier Crane voice:

 Furthermore, even if Dr Vockroth is negatively affected by the LLC in some way, this is not an undue prejudice of a magnitude to prevent a forced sale. It is axiomatic that LLCs and partnerships change, fail, dissolve and are bought and sold with regularity. Partners die or sell their shares The reality is simply part of being in business, and Dr. Vockroth is not exempt from this fact, especially when he fails to offer any reliable evidence to support his contentions.”

What is Dr V to do: poll his patients and employees to see whether they would follow? Oh, that will go swimmingly.

BTW the sale of a dental practice will certainly include a noncompete, meaning that Dr V could not open a dental practice within so many miles of the existing practice. Well, he could, but he would be sued.

One would think a judge would know that.

Four

  The relative character and value of the property owned by the two owners.

There was not much play here as both doctors owned 50%.

The court decided that the government could foreclose on both the practice and the real estate.

Technically right, but lousy law. Consider this menacement from Rodgers:

We do emphasize, however, that the limited discretion accorded by § 7403 should be exercised rigorously and sparingly, keeping in mind the Government's paramount interest in prompt and certain collection of delinquent taxes.

Section 7403 is not taxpayer friendly.

Our case this time was United States v Driscoll, 2025 BL 2655, D.N.J. No. 3:18-cv-11762, 1/6/25.

Section 643 and MSTs

 

I came across the following recently on LinkedIn:

 

The line of tax code that 99% of CPAs can’t understand for some reason.

And because they don’t understand this they make their clients tax planning convoluted and unnecessary.

26 U.S. Code § 643

(3) Capital gains and losses
Gains from the sale or exchange of capital assets shall be excluded to the extent that such gains are allocated to corpus and are not (A) paid, credited, or required to be distributed to any beneficiary during the taxable year, or (B) paid, permanently set aside, or to be used for the purposes specified in section 642(c). 

Stop, just stop.

There is a lot of nonsense going around on social media concerning something called - among other things – a “nongrantor, irrevocable, complex, discretionary, spendthrift trust.”

I just call it a “643 trust.” It is probably unfair as Section 643 has its legitimate place in the Code, but I simply cannot repetitively spray multisyllabic spittle when referring to these.

They have many forms, but one thing is key: Section 643. I met last year with someone who was hawking these things but was unable to find a CPA with his elevated mastery of the tax Code.

Uh huh. Elevator is down the hall, pal.

Let’s walk through these trusts.

The tax Code has numerous sections. Go to Chapter 1 Subchapter J and you will find sections dealing with trusts. You will note that they all have numbers between 641 and 692.

Section 643 is between 641 and 692. We are in the right place.

Trust taxation is not the easiest thing to understand. There are weird concepts. Then there are uncommon terms, such as:

 

·       The grantor – the person who transfers assets to the trust.

·       The income beneficiary – the person entitled to income distributions.

·       The residuary beneficiary – the person entitled to the remainder of the trust when the income beneficiaries are done.

·        Irrevocable trust – a trust where the grantor cannot amend or end the trust after its creation.

·       Complex trust – a trust that can accumulate (that is, retain) its profit.

·       Trustee – the person managing trust assets for the benefit of trust beneficiaries. A trustee is required to act in the best interest of the beneficiaries.

·       Discretionary trust – a trust allowing a trustee the power to decide how and when to distribute assets (including income) to beneficiaries.

Believe it or not, there are also several definitions of income, such as:

 

·       Fiduciary accounting income – income as defined by the trust instrument and state law.

·       Distributable net income – the maximum income available to the trustee for distribution to beneficiaries.

·       Taxable income – income as defined by the tax Code.

And - yes - you can get different answers depending on which definition of income you are looking at.

Why is that?

One reason is possible tension between different beneficiary classes. Say that you create a trust for your son and daughter as income beneficiaries. Upon their death, the remaining trust assets (called corpus) goes to the grandkids, who are the residuary beneficiaries. Your kids may want something to be considered income, as they are entitled to income distributions. The grandkids may prefer something not be considered income, as that something would not be distributed and thereby remain in the trust until eventual distribution to them.

What are common friction points between income and residuary beneficiaries? Here are two repetitive ones: capital gains and depreciation.

For example, one may consider depreciation as a reserve to replace deteriorating physical assets. In that case, it makes sense to allocate depreciation to the residuary beneficiaries, as the assets will eventually go to them. Then again, accountants routinely include depreciation as a current period expense. In that case, depreciation should go to the income beneficiaries along with other current period expenses.

Back to our multisyllabic spittle trust (MST).

Look at Section 643(b):

    26 U.S. Code § 643 - Definitions applicable to subparts A, B, C, and D

(b) Income.

For purposes of this subpart and subparts B, C, and D, the term "income", when not preceded by the words "taxable", "distributable net", "undistributed net", or "gross", means the amount of income of the estate or trust for the taxable year determined under the terms of the governing instrument and applicable local law. Items of gross income constituting extraordinary dividends or taxable stock dividends which the fiduciary, acting in good faith, determines to be allocable to corpus under the terms of the governing instrument and applicable local law shall not be considered income.  

What is this Section trying to do?

Looks like it is trying to define “income” and failing rather badly at it.

Look at the last sentence:

… which the fiduciary, acting in good faith, … shall not be considered income.”

Hmmmmm.

But read the first sentence:

… when not preceded by the words “taxable ….”

Seems to me that last sentence could be the solution to the Riemann Hypothesis and it would not matter once you put the word “taxable” in front of “income.”

Let’s move on to Section 643(a):

Distributable net income.

For purposes of this part, the term “distributable net means, with respect to any taxable year, the taxable income of the estate or trust computed with the following modifications —  

(3) Capital gains and losses         

Gains from the sale or exchange of capital assets shall be excluded to the extent that such gains are allocated to corpus and are not (A) paid, credited, or required to be distributed to any beneficiary during the taxable year, or (B) paid, permanently set aside, or to be used for the purposes specified in section 642(c).  

(4) Extraordinary dividends and taxable stock dividends  

… there shall be excluded those items of gross income constituting extraordinary dividends or taxable stock dividends which the fiduciary, acting in good faith, does not pay or credit to any beneficiary by reason of his determination that such dividends are allocable to corpus under the terms of the governing instrument and applicable local law.

I see the words “shall be excluded.”

I see the extraordinary dividends and taxable stock dividends from Section 643(b). And there is new wording about gains from the sale or exchange of capital assets. Is it possible …?

I also see the words “Distributable net income” at the top.

Let’s go back to our definitions of trust income.

Section 643(a) addresses distributable net income. Think of DNI as Mint Chocolate Chip.

Section 643(b) addresses taxable income. Think of TI as Cookies and Cream.

Mint Chocolate Chip is not Cookies and Cream.

Maybe capital gains are excludable from DNI. Maybe they are not. Either way, that conundrum has nothing to do with capital gains being excludable from taxable income.

The IRS is quite aware of the game being played.

Here is AM 2023-006:

 

One is dancing on the slippery beveled edge of a possible tax shelter.

Just leave these trusts alone. If I could make income nontaxable by running it through a string-a-bunch-of-words-together trust, I would have done so years ago. I might have even retired by now.