What Does It Mean To Rely On A Tax Pro?

You may know that permanent life insurance can create a tax trap.

This happens when the insurance policy builds up cash value. Nice thing about cash value is that you can borrow against it. If the cash value grows exponentially, you can borrow against it to fund your lifestyle, all the while not paying any income tax.

There is always a "but."

The "but" is when the policy terminates. If you die, then there is no tax problem. Many tax practitioners however consider death to be extreme tax planning, so let's consider what happens should the policy terminate while you are still alive. 

All the money you borrowed in excess of the premiums you paid will be income to you. It makes sense if you think of the policy as a savings account. To the extent the balance exceeds whatever you deposited, you have interest income. Doing the same thing inside of a life insurance policy does not change the general rule. What it does do is change the timing: instead of paying taxes annually you will pay only when a triggering event occurs.

Letting the policy lapse is a triggering event.

So you would never let the policy lapse, right?

There is our problem: the policy will require annual premiums to stay in effect. You can write a check for the annual premiums, or you can let the insurance company take it from the cash value. The latter works until you have borrowed all the cash value. With no cash value left, the insurance company will look for you to write a check.

Couple this with the likelihood that this likely will occur many years after you acquired the policy - meaning that you are older and your premiums are more expensive - and you can see the trap in its natural environment.  

The Mallorys purchased a single premium variable life insurance policy in 1987 for $87,500. The policy insured Mr. Mallory, with his wife as the beneficiary. He was allowed to borrow. If he did, he would have to pay interest. The policy allowed him two ways to do this: (1) he could write a check or (2) have the interest added to the loan balance instead.

Mallory borrowed $133,800 over the next 14 years - not including the interest that got charged to the loan.

Not bad.

The "but" came in 2011. The policy burned out, and the insurance company wanted him to write a check for approximately $26,000.

Not a chance said Mallory.

The insurance company explained to him that there would be a tax consequence.

Says you said Mallory.

The policy terminated and the insurance company sent him a 1099 for approximately $150,000.

It was now tax time 2012. The Mallorys went to their tax preparer, who gave them the bad news: a big tax check was due.

Tax preparer became ex-tax preparer.

The Mallorys did not file their 2011 tax return until 2013. They omitted the offending $150,000, but they attached the Form 1099 to their tax return with the following explanation:

Paid hundreds of $. No one knows how to compute this using the 1099R from Monarch -- IRS could not help when called -- Pls send me a corrected 1040 explanation + how much is owed. Thank you."

The IRS in turn replied that they wanted $40,000 in tax, a penalty of approximately $10,000 for filing the return late and another penalty of over $8,000 for omitting the 1099 in the first place.

The Mallorys countered that they had no debt with the insurance company. Whatever they received were just distributions, and they were under no obligation to pay them back.

In addition, since they received no cash from the insurance company in 2011, there could not possibly be any income in 2011.

It was an outside-the-box argument, I grant you. The problem is that their argument conflicted with a small mountain of paperwork accumulated over the years referring to the monies as loans, not to mention the interest on said loan.

They also argued for mitigation of the $8,000 penalty because no one could tell them the taxable portion of the insurance policy.

The Mallorys had contacted the IRS, who gave them the general answer.  It is not routine IRS policy to specifically analyze insurance company 1099s to determine the taxable amount.

They had also called random tax professionals asking for free tax advice.

COMMENT: Think about this for a moment. Let's say you receive a call asking for your thoughts on a tax question. The caller is not a client. Your first thought is likely: why get involved? Let's say that you take the call. You are then asked for advice. How specific can you be? They are not your client, and the risk is high that you do not know all the facts. The most you can tell them - prudently, at least - is the general answer.

This is, by the way, why many practitioners simply do not accept calls like this.                            

The Court did not buy the Mallory's argument. It was not true that the Mallorys were not advised: they were advised by their initial tax preparer - the one they unceremoniously fired. After that point it was a stretch to say that they received advice - as they never hired anyone. A phone call for free tax advice did not strike the Court as a professional relationship providing "reasonable cause" to mitigate the $8,000 penalty. 

The Mallorys lost across the board.

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.

Does The IRS Want 1099s For Your Contributions?

I have been thinking about a recent IRS notice of proposed rulemaking. The IRS is proposing rules under its own power, arguing that it has the authority to do so under existing law.

This one has to do with charitable contributions.

You already know that one should retain records to back up a tax return, especially for deductions. For most of us that translates into keeping receipts and related cancelled checks.

Contributions are different, however.

In 1993 Congress passed Code section 170(f)(8) requiring you to obtain a letter (termed “contemporaneous written acknowledgement”) from the charity to document any donation over $250.  If you do not have a letter the IRS will disallow your deduction upon examination.

Congress felt that charitable contributions were being abused. How? Here is an example: you make a $5,000 donation to the University of Kentucky and in turn receive season tickets – probably to football, as the basketball tickets are near impossible to get. People were deducting $5,000, when the correct deduction would have been $5,000 less the value of those season tickets. Being unhappy to not receive 100 percent of your income, Congress blamed the “tax gap” and instituted yet more rules and requirements.

So begins our climb on the ladder to inanity.

Soon enough taxpayers were losing their charitable deductions because they failed to obtain a letter or failed to receive one timely. There were even cases where all parties knew that donations had been made, but the charity failed to include the “magic words” required by the tax Code.

Let’s climb on.

In October, 2015 the IRS floated a proposal to allow charities to issue Forms 1099s in lieu of those letters. Mind you, I said “allow.” Charities can continue sending letters and disregard this proposal.

If the charity does issue, then it must also forward a copy of the 1099s to the IRS. This has the benefit of sidestepping the donor’s need to get a timely letter from the charity containing the magic words.

Continue climbing: for the time-being charities have to disregard the proposal, as the IRS has not designed a Form 1099 even if the charity were interested.  Let’s be fair: it is only a proposal. The IRS wanted feedback from the real world before it went down this path.

Next rung: why would you give your social security number to a charity – for any reason? The Office of Personnel Management could not safeguard more than 20 million records from a data hack, but the IRS wants us to believe that the local High School Boosters Club will?

Almost there: the proposal is limited to deductible contributions, meaning that its application is restricted to Section 501(c)(3) organizations. Only (c)(3)s can receive deductible contributions.

But there is another Section 501 organization that has been in the news for several years – the 501(c)(4). This is the one that introduced us to Lois Lerner, the resignation of an IRS Commissioner, the lost e-mails and so on. A significant difference between a (c)(3) and a (c)(4) is the list of donors. A (c)(3) requires disclosure of donors who meet a threshold. A (c)(4) requires no disclosure of donors.    

You can guess how much credibility the IRS has when it says that it has no intention of making the 1099 proposal mandatory for (c)(3)s - or eventually extending it to also include (c)(4)s.

We finally reached the top of the ladder. What started as a way to deal with a problem (one cannot deduct those UK season tickets) morphed into bad tax law (no magic beans means no deduction) and is now well on its way to becoming another government-facilitated opportunity for identity theft.

The IRS Notice concludes with the following:

Given the effectiveness and minimal burden of the CWA process, it is expected that donee reporting will be used in an extremely low percentage of cases.”

Seems a safe bet.

UPDATE: After the writing of this post, the IRS announced that it was withdrawing these proposed Regulations. The agency noted that it had received approximately 38,000 comments, the majority of which strongly opposed the rules. Hey, sometimes the system works.

Difference Between An Advance And A Loan

Do you remember when the Washington Redskins and the Miami Dolphins went to the Super Bowl? It was 1983, and I was living in Florida at the time. I am pretty sure I was rooting for the Florida team. The Redskins had a hard-charging fullback named John Riggins. His nickname was “Diesel” and he scored a touchdown on a forty-something yard run. Blocking for him was (among others) George Starke, an offensive tackle. The Washington offensive linemen, the ones who block for the quarterback and running back, were known as The Hogs.

George Starke is second from the left.

George was very much on the backside of his career at that point. He shortly thereafter left football and opened a car dealership in Maryland. He couldn’t help but notice that the dealership had difficulty recruiting service technicians. He helped establish a technical school to educate and train technicians. He also hoped that - by providing a realistic hope for a better life – the school would also help with the poverty and violence in the area.

He eventually sold the dealership and cofounded the Excel Institute, a nonprofit program that provided a two-year reading, writing, arithmetic and technical skills curriculum. The program was free of charge, but one had to commit.

Starke received a salary and housing allowance, as well as a credit card. He would charge business and personal expenses on the card. The personal charges were segregated on the books and records. George discontinued any personal charges in 2006, and from 2007 onward the only activity relating to the credit card was a payroll deduction to repay the balance.

There was a change in the Board, and Starke did not like the new direction of things. He stopped fundraising. He left the Excel Institute altogether in 2010.

Excel put the remaining balance due from George of $83,698 on a Form 1099, sent a copy to George, a second to the IRS and figured that was that.

George did not include the $83 grand on his individual tax return, however.

The IRS noticed and insisted that George do so. George said no.

And off to Tax Court they went.

Before proceeding, tell me: do you think George has a prayer?

As you know, forgiveness of a loan triggers income. The tax issue is whether these monies were ever a loan.

Your first thought is: of course they were! Heck, he was paying it back, wasn’t he?

Let’s walk through this.

Just because someone gives you money does not mean that there exists a loan. A loan implies that both sides anticipate the monies will be repaid. It would also be swell if there were some attention to the basic formalities, like perhaps a loan agreement and repayment terms.

And – just to dream – maybe interest could be charged on the whole affair.

There was no loan agreement. Excel itself gave mixed messages to the Court on whether it thought the monies were a loan. George told the Court that he never had any intention of paying back the money, and that he thought the payroll deductions were for health insurance or something like that.

If not a loan, then what were the monies to George?

They were advances, akin to nonrecoverable draws.

Advances are more easily understood in a draw-against-commission environment. Draws are intended to provide some predictable cash flow to the salesperson. Say that a salesperson receives commissions, and against the commissions is a $5,000 monthly draw. There are two types of draws - recoverable and nonrecoverable. A nonrecoverable draw does not have to be paid back should a saleperson fail to meet quota. A recoverable draw does have to be paid back. Granted, a salesperson who fails on a continuous basis to meet quota would soon be unemployed, but that is a different conversation.  For our purposes, the key is that a nonrecoverable draw represents income upon receipt.

Back to our courtroom drama.

The IRS pulled his 2010 tax year.

George received no advances in the 2010 tax year.

George last received advances in 2006.

There was nothing to tax in 2010 because George received no monies in 2010.

The IRS should have pursued his 2006 tax year. They did not, nor could they under the statute of limitations.

The Court dismissed the case. George won. The IRS got embarrassed.

I am curious why the IRS even bothered. The only thing I can figure is that they were hoping for a miracle play. Maybe like John Riggins running that football for a touchdown in Super Bowl XVII with George Starke blocking for him.