I am reading
a case where the IRS wanted taxes of almost $1.5 million.
I am not
surprised to read that it involved a real estate developer.
Part of tax
practice is working within someone’s risk tolerance (including mine, by the
way). Some clients are so risk adverse that an IRS notice – on any matter for
any reason – can be interpreted as a mistake by the tax practitioner. Then you
have the gunslingers at the other end of the spectrum. These are the clients
you have to rope-in, for their own as well as your sake.
My
experience has been that real estate developers seem to cluster around the
gunslinger end of the spectrum. We have one who recently explained to me that “paying
taxes means that the tax advisor made a mistake.” That, folks, is a lot of pressure
… on my partner.
Jason Sage
is a developer in Oregon. He represented several companies, including JLS
Customs Homes. You may recall that 2008 – 2009 was a rough time for real
estate, and JLS took it in the teeth. It had three projects, dragging behind approximately
$18 million in debt.
Eventually the
real estate market collapsed. Sage had to do something. He and his advisors
decided to utilize liquidating trusts. The idea is that one transfers
everything one has into a trust, which might be owned by one’s creditors; then
again, it might not. The creditors might accept the settling of the trust (a
fancy term for putting money and assets into a trust) as discharge of the
underlying debt; then again, they might not. Each deal is its own story, and
the tax consequences can vary depending on the telling.
Our story involves
the transfer of three projects to three liquidating trusts. Since real estate
had tanked, these transfers – treated for tax purposes as sales - threw off
huge losses. These losses were so big they created overall losses - called “net
operating losses” (NOLs). Tax law at the time allowed the net operating losses to
travel back in time, meaning that Sage could recoup taxes previously paid.
COMMENT: I see nothing wrong with this. If the government wants to participate in one’s profits, then it can also participate in one’s losses. To do otherwise smacks more of robbery than taxation.
The IRS took
a look at this arrangement and immediately called foul.
Trust
taxation looks carefully at whether the trust is a separate tax entity from the
person establishing the trust, funding the trust or benefiting from the trust. There is a type called a “grantor trust” which
is disregarded as a separate tax entity altogether. The most common type of
grantor trust is probably the “living trust,” which has gained popularity as a
probate-mitigating tool. The idea behind the grantor trust is that the grantor –
say me, for example – is allowed to put money in, take money out, change
beneficiaries, even terminate the trust altogether without anyone being able to
gainsay my decision.
Tax law
considers this to be too much control over the trust, so the trust and I are
considered to be the same person for tax purposes. I would have a grantor trust. Its
tax return is combined with mine.
How do I avoid
this result? Well, I have to start with limiting my otherwise unrestricted
control over the trust. Yield enough control and the IRS will respect the trust
as separate from me.
The IRS
argued that Sage’s liquidating trusts were grantor trusts. They were not separate
tax entities, and one cannot sell and create a loss by selling to oneself.
Without that loss, there was no NOL carryover and therefore no tax refund.
Sage had to
persuade the Court that the trusts were in fact separate from him and his
companies.
After all,
the trusts were for the benefit of his creditors. One has to concede that creditors
are an adverse party, and the existence of an adverse party is an indicator that
the trust is a separate tax entity. Extrapolating, the existence of creditors
means that someone with interests adverse to Sage’s own had sway over the trusts.
It was that sway that made these non-grantor trusts.
Persuasive,
except for one thing.
Sage had
never involved the creditors when setting up the trusts.
It was hard
for them to be adverse when they did not even know the trusts were there.
Our case
this time was Sage v Commissioner.
