The IRS Does Not Believe You Made A Loan

The issue came up here at command center this past week. It is worth discussing, as the issue is repetitive and – if the IRS aims it your way – the results can be brutal.

We are talking about loans.

More specifically, loans to/from yourself and among companies you own.

What’s the big deal, right? It is all your money.

Yep, it’s your money. What it might not be, however, is a loan.

Let’s walk through the story of James Polvony.

In 1996 he joined his wife’s company, Archetone Limited (Limited) as a 49% owner. Limited was a general contractor.

In 2002 he started his own company, Povolny Group (PG). PG was a real estate brokerage.

The real estate market died in 2008. Povolny was looking for other sources of income.

He won a bid to build a hospital for the Algerian Ministry of Health.

He formed another company, Archetone International LLC (LLC), for this purpose.

The Algerian job required a bank guaranty. This created an issue, as the best he could obtain was a line of credit from Wells Fargo. He took that line of credit to a UK bank and got a guarantee, but he still had to collateralize the US bank. He did this by borrowing and moving monies around his three companies.

The Algerian government stopped paying him. Why? While the job was for the Algerian government, it was being funded by a non-Algerian third party. This third party wanted a cut of the action. Povolny did not go along, and – shockingly – progress payments, and then actual job progress, ceased.

The deal was put together using borrowed money, so things started unravelling quickly.

International was drowning. Povolny had Limited pay approximately $241,000 of International’s debts.

PG also loaned International and Limited approximately $70 grand. PG initially showed this amount as a loan, but PG amended its return to show the amount as “Cost of Goods Sold.”

COMMENT: PG was making money. Cost of goods sold is a deduction, whereas a loan is not, at least not until it becomes uncollectible. I can see the allure of another deduction on a profitable tax return. Still, to amend a return for this reason strikes me as aggressive.

Limited also deducted its $241 grand, not as cost-of-goods-sold but as a bad-debt deduction.

Let’s regroup here for a moment.

• Povolny moved approximately $311 grand among his companies, and
• He deducted the whole thing using one description or another.

This caught the IRS’ attention.

Why?

Because it matters how Polvony moved monies around.

A loan can result in a bad debt deduction.

A capital contribution cannot. Granted, you may have a capital loss somewhere down the road, but that loss happens when you finally shut down the company or otherwise dispose of your stock or ownership interest.

Timing is a BIG deal in this area.

If you want the IRS to respect your assertion of a loan, then be prepared to show the incidents of a loan, such as:

• A written note
• An interest rate
• A maturity date
• Repayment schedule
• Recourse if the debtor does not perform (think collateral)

Think of yourself as SunTrust or Fifth Third Bank making a loan and you will get the idea.

The Court made short work of Povolny:

·       The $241 thousand loan did not have a written note, no maturity date and no required interest payments.

·       Ditto for the $70 grand.

The Court did not find the commercially routine attributes of debt, so it decided that there was no debt.

Povolny was moving his own capital around.

He as much said so when he said that he “didn’t see the merit” in creating written notes, interest rates and repayment terms.

The Polvony case is not remarkable. It happens all the time. What it does, however, is to tentpole how important it is to follow commercially customary banking procedures when moving monies among related companies.

But is it all your money, isn’t it?

Yep, it is. Be lax and the IRS will take you at your word and figure you are just moving your own capital around.

And there is no bad debt deduction on capital.

Our case this time was Povolny Group, Incorporated et al v Commissioner, TC Memo 2018-37.

Blowing Up An IRA

I am not a fan of using retirement funds to address day-to-day financial stresses.

That is not to downplay financial stresses; it is instead to point out that using retirement funds too easily can open yet another set of problems.

Those who have followed me for a while know that I disapprove of using retirement funds to start a business: the so-called Rollovers as Business Startups, whose humorous acronym is ROBS. I know that – in a seminar setting – it is possible to mitigate the tax risks that ROBS pose. I do not however practice in a seminar setting. Heck, I am lucky if a client calls in advance to discuss whatever he/she is getting ready to do.

Let me give you a couple of ROBS pitfalls:

(1) You have your IRA buy a fourplex. You spend time cleaning, doing maintenance and repairs and routinely running to Home Depot.

Question: Is there a tax risk here?

(2) You have your IRA buy a business. You have your son and daughter run the business. You work there part-time and draw a paycheck.

Question: Is there a tax risk here?

The answer to both is yes. Consider:

(1) You are buying stuff at Home Depot, stuff that the IRA should have been buying - as the IRA owns the fourplex, not you. If you are over age 50, you can contribute $6,500 to the IRA annually. Say that you have already written that check for the year. You are now overfunding the IRA every time you go to Home Depot. Granted, one trip is not a big deal, but make routine trips – or incur a major repair – and the facts change. That triggers a 6% penalty – every year - until you take the money back out.

(2) There are restrictions on direct and indirect benefits from an IRA. You are receiving a paycheck from an asset the IRA owns. While arguable, I am confident that your paycheck is a prohibited benefit.

I am looking a Tax Court case where the taxpayer had her IRA lend $40,000 to her dad in 2005. A few years went by and she had the IRA lend $60,000 to a friend.

In 2013 she changed IRA custodians. The new custodian saw those two loans, and she had problems. Perhaps the custodian could not transfer the promissory notes. Perhaps there were no notes. Perhaps the custodian realized that a loan to one’s dad is not allowed. This part of the case is not clear.

COMMENT: It is possible to have an IRA lend money. I have a client who does so on a regular basis. Think however of acting like a bank, with due diligence, promissory notes, periodic interest and lending to nonrelated independent third-parties.

The IRS saw easy money:

(1)  There was a taxable distribution in 2013;

(2)  … and a 10% penalty for early distribution;

(3)  … and the “substantial understatement” penalty because the tax numbers changed enough to rise to the level of “substantial.”

How do you think it turned out for our tax protagonist?

Go back to the dates.

She loaned money to her dad in 2005.

Let’s glance over IRC Section 408(e)(2)

 (2)  Loss of exemption of account where employee engages in prohibited transaction.

(A)  In general. If, during any taxable year of the individual for whose benefit any individual retirement account is established, that individual or his beneficiary engages in any transaction prohibited by section 4975 with respect to such account, such account ceases to be an individual retirement account as of the first day of such taxable year.

The loan was a prohibited transaction. She blew up her IRA as of January 1, 2005. This means that she should have reported ALL of her IRA as taxable income in 2005, of which we can be quite sure she did not.

Can the IRS assess taxes for 2005?

Nope. Too many years have gone by. The standard statute of limitations for assessments is three years.

So, the IRS will tag her in 2013, right?

Nope, they cannot. For one thing, the prohibited transaction did not occur in 2013, and the IRS is not allowed to time-travel just because it serves their purpose.

But there is a bigger reason. Read the last part of Sec 408(e)(2) again.

There was no IRA in 2013. There could be no distribution, no 10% penalty, none of that, as “that” would require the existence of an IRA.

And there was no IRA.

The name of the case for the home gamers is Marks v Commissioner.

Vanguard's Whistleblower Tax Case

Can the IRS go after you for not making enough profit?

There is a whistleblower case against Vanguard, the mutual fund giant. Even though there is a tax angle, I had previously sidestepped the matter. Surely it must involve some mind-numbing arcana, and –anyway- why enable some ex-employee with a grudge? 

And then I saw a well-known University of Michigan tax professor supporting the tax issues in the whistleblower case.

Now I had to look into the matter.

My first reaction is that this case represents tax law gone wild. It happens. Sometimes tax law is like the person looking down at his/her cell phone and running into you in the hall. They are too self-absorbed to look up and get a clue.

What sets this up is the management company: Vanguard Group, Inc. (VGI). Take a look at other mutual fund companies and you will see that the management company is separately and independently owned from the mutual funds themselves.  The management company provides investment, financial and other services, and in turn it receives fees from the mutual funds.  

The management company receives fees irrespective of whether the funds are doing well or poorly. In addition, the ownership of the management company is likely different from the ownership of the funds. You can invest in the management company for T. Rowe Price (TROW), for example, even if you do not own any T. Rowe Price funds.

Vanguard however has a unique structure. Its management company – VGI – is owned by the funds themselves. Why? It goes back to Jack Bogle and the founding of Vanguard: he believed there was an inherent conflict of interest when a mutual fund is advised by a manager not motivated by the same financial interests as fund shareholders.  Since the management company and the funds are essentially one-and-the-same, there is little motivation for the management company to maximize its fees. This in turn has allowed Vanguard funds to provide some of the lowest internal costs in the industry

My first thought is that every mutual fund family should be run this way.

VGI and all the funds are C corporations under the tax Code. The funds themselves are more specialized and are “registered investment companies” under Subchapter M. Because the funds own VGI, the “transfer pricing” rules of IRC Section 482 apply.

COMMENT: The intent of Section 482 is to limit the ability of related companies to manipulate the prices they charge each other. Generally speaking, this Code section has not been an issue for practitioners like me, as we primarily serve entrepreneurs and their closely-held companies. This market tends to be heavily domestic and unlikely to include software development, patent or other activity which can easily be moved overseas and trigger transfer pricing concerns. 

Practitioners are however starting to see states pursue transfer pricing issues. Take Iowa, with its 12% corporate tax rate as an example. Let’s presume a multistate client with significant Iowa operations. Be assured that I would be looking to move profitability from Iowa to a lower taxed state. From Iowa’s perspective, this would be a transfer pricing issue. From my perspective it is common sense.

Section 482 wants to be sure that related entities are charging arm’s-length prices to each other. There are selected exceptions for less-than-arm’s-length prices, such as for providing routine, ministerial and administrative services. I suppose one could argue that the maintenance and preparation of investor statements might fit under this exception, but it is doubtful that the provision of investment advisory services would.  Those services involve highly skilled money managers, and are arguably far from routine and ministerial.

So VGI must arguably show a profit, at least for its advisory services. How much profit?

Now starts the nerds running into you in the hall while looking down at their cell phones.

We have to look at what other fund families are doing: Janus, Fidelity, Eaton Vance and so on. We know that Vanguard is unique, so we can anticipate that their management fees are going to be higher, potentially much higher. An analysis of Morningstar data indicates as much as 0.5 percent higher. It doesn’t sound like much, until you consider that Vanguard has approximately $3 trillion under management. Multiply any non-zero number by $3 trillion and you are talking real money.

It is an interesting argument, although it also appears that the IRS was not considering Vanguard’s fact pattern when it issued Regulations. Vanguard has been doing this for 40 years and the IRS has not concerned itself, so one could presume that there is a détente of sorts. Perhaps the IRS realized how absurd it would be to force the management company to charge more to millions of Vanguard investors.

That might attract the attention of Congress, for example, which already is not the biggest fan of the IRS as currently administrated.

Not to mention that since the IRS issued the Regulations, the IRS can change the Regulations.

And all that presumes that we are correctly interpreting an arcane area of tax law.

The whistleblower is a previous tax attorney with Vanguard, and he argues that Vanguard has been underpaying its income taxes by not charging its fund investors enough.

Think about that for a moment. Who is the winner in this Alice-in-Wonderland scenario?

The whistleblower says that he brought his concerns to the attention of his superiors (presumably tax attorneys themselves), arguing that the tax structure was illegal. They disagreed with him. He persisted until he was fired.

He did however attract the attention of the SEC, IRS and state of New York.

I had previously dismissed the whistleblower argument as a fevered interpretation of the transfer pricing rules and the tantrum of an ex-employee bent on retribution.  I must now reevaluate after tax law Professor Reuven S. Avi-Yonah has argued in favor of this case.

I am however reminded of my own experience. There is a trust tax provision that entered the Code in 1986. In the aughts I had a client with that tax issue. The IRS had not issued Regulations, 20 years later. The IRS had informally disclosed its internal position, however, and it was (of course) contrary to what my client wanted. I in turn disagreed with the IRS and believed they would lose if the position were litigated. I advised the client that taking the position was a concurrent decision to litigate and should be addressed as such.

I became extremely unpopular with the client. Even my partner was stressed to defend me. I was basing professional tax advice on chewing gum and candy wrappers, as there was nothing else to go on.

And eventually someone litigated the issue. The case was decided in 2014, twenty eight years after the law was passed. The taxpayer won.

Who is to say that Vanguard’s situation isn’t similar?

What does this tax guy think?

I preface by saying that I respect Professor Avi-Yonah, but I am having a very difficult time accepting the whistleblower argument. Vanguard investors own the Vanguard funds, and the funds in turn own the management company. I may not teach law at the University of Michigan, but I can extrapolate that Vanguard investors own the management company – albeit indirectly – and should be able to charge themselves whatever they want, subject to customary business-purpose principles. Since tax avoidance is not a principal purpose, Section 482 should not be sticking its nose under the tent.

Do you wonder why the IRS would even care? Any income not reported by the management company would be reported by fund investors. The Treasury gets its pound of flesh - except to the extent that the funds belong to retirement plans. Retirement plans do not pay taxes. On the other hand, retirement plan beneficiaries pay taxes when the plan finally distributes.  Treasury is not out any money; it just has to wait. Oh well.

It speaks volumes that someone can parse through the tax Code and arrive at a different conclusion. If fault exists, it lies with the tax Code, not with Vanguard.

Then why bring a whistleblower case? The IRS will pay a whistleblower up to 30% of any recovery, and there are analyses that the Vanguard management company could be on the hook for approximately $30 billion in taxes. Color me cynical, but I suspect that is the real reason.

When A Good Cause Is Not Enough

Let’s talk about the tax issues of tax-exempt entities. It sounds like a contradiction, doesn’t it?

It actually is its own area of practice. Several years ago I was elbow-deep working with nonprofits, and I attended a seminar presented by a specialist from Washington, D.C. All he did was nonprofits. At least he was in the right town for it.

There are the big-picture tax-exempt issues. For example, a 501(c)(3) has to be publicly-supported. You know there is a tractor-trailer load of rules as to what “publicly supported” means.

Then there are more specialized issues. One of them is the unrelated business income tax. The concept here is that a nonprofit cannot conduct an ongoing business and avoid tax because of its exemption. A museum may be a great charitable cause, for example, but one cannot avoid tax on a chain of chili restaurants by having the museum own them.

That is not what museums do. It is unrelated to “museum-ness,” and as such the chili restaurants will be taxed as unrelated business income.

Sometimes it can get tricky. Say that you have a culinary program at a community college. As part of the program, culinary students prepare meals, which are in turn sold on premises to the students, faculty and visitors. A very good argument can be made that this activity should not be taxed.  

What is the difference? In the community college’s case, the activity represents an expansion of the underlying (and exempt) culinary education program. The museum cannot make this argument with its chili restaurants.

However, what if the museum charges admission to view its collection of blue baby boots from Botswana? We are now closer to the example of culinary students preparing meals for sale. Exhibiting collections is what museums do.

I am looking a technical advice memorandum (TAM) on unrelated business income. This is internal IRS paperwork, and it means that an IRS high-level presented an issue to the National Office for review.

Let’s set it up.

There is a community college.

The community college has an alumni association. The association has one voting member, which is a political subdivision of the state.

The alumni association has a weekly farmers market, with arts and crafts and music and food vendors. It sounds like quite the event. It uses the parking areas of the community college, as well as campus rest rooms and utilities. Sometimes the college charges the alumni association; sometimes it does not.

The alumni association in turn rents parking lot space to vendors at the market.

All the money from the event goes to the college. Monies are used to fund scholarships and maintain facilities, such as purchasing a computer room for the library and maintaining the football field.

OBSERVATION: The tax Code does not care that any monies raised are to be used for a charitable purpose. The Code instead focuses on the activity itself. Get too close to a day-in-and-day-out business and you will be taxed as a business. Granted, you may get a charitable deduction for giving it away, but that is a different issue.

From surveys, the majority of visitors to the farmers market are age 55 and above.

There was an IRS audit. The revenue agent thought he spotted an unrelated business activity. The file moved up a notch or two at the IRS and a bigwig requested a TAM.

The association immediately conceded that the event was a trade or business regularly carried on. It had to: it was a highly-organized weekly activity.

The association argued instead that the event was its version of “museum-ness,” meaning the event furthered the association’s exempt purpose. It presented three arguments:

(1) The farmers market contributed to the exempt purpose of the college by drawing potential students and donors to campus, helping to develop civic support.

(2) The farmers market lessened the burden of government (that is, the college).

(3) The farmers market relieved the distress of the elderly.

The IRS saw these arguments differently:

(1) Can you provide any evidence to back that up? A mere assertion is neither persuasive nor dispositive.

COMMENT: The association should have taken active steps – year-after-year – to obtain and accumulate supporting data. It may have been worth hiring someone who does these things. Not doing so made it easy for the IRS to dismiss the argument as self-serving.

(2) At no time did the community college take on the responsibility for a farmers market, and the college is the closest thing to a government in this conversation. Granted, the college benefited from the proceeds, but that is not the test. The test is whether the association is (1) taking on a governmental burden and (2) actually lessening the burden on the government thereby.  As the government (that is, the college) never took on the burden, there can be no lessening of said burden.

COMMENT: This argument is interesting, as perhaps – with planning – something could have been arranged. For example, what if the college sponsored the weekly event, but contracted out event planning, organization and execution to the alumni association? 

(3) While the market did provide a venue for the elderly to gather and socialize, that is not the same as showing that the market was organized and worked with the intent of addressing the special needs of the elderly. 

COMMENT: Perhaps if the association had done things specifically for the elderly – transportation to/from retirement homes or free drink or meal tickets, for example – there would have been an argument. As it was, the high percentage of elderly was a happenstance and not a goal of the event.

There was no “museum-ness” there.

And then the association presented what I consider to be its best argument:

(4) We charged rent. Rent is specifically excluded as unrelated business income, unless special circumstances are present – which are not.

Generally speaking, rent is not taxable as unrelated business income unless there is debt on the property. The question is whether the payments the association received were rent or were something else.

What do I mean?

We would probably agree that leasing space at a strip mall is a textbook definition of rent. Let’s move the needle a bit. What would you call payment received for a hospital room? That doesn’t feel like rent, does it? What has changed? Your principal objective while in a hospital is medical attention; provision of the room is ancillary. The provision of space went from being the principal purpose of the transaction to being incidental.

The IRS saw the farmers’ market/arts and craft/et cetera as something more than a parking lot. The vendors were not so much interested in renting space as they were in participating (and profiting) from a well-organized destination and entertainment event. Landlords provide space. Landlords do not provide events. 

The IRS decided this was not rent.  

You ask why I thought this was the association’s best argument? Be fair, I did not say it was a winning argument, only that it was the best available.

The alumni association still has alternatives. Examination requested the TAM, so there will be no mercy there. That leaves Appeals and then possibly going to Court. A Court may view things differently.

And I am unhappy with the alumni association. I suspect that the farmers’ market went from humble origins to a well-organized, varied and profitable event. As a practitioner, however, I have to question whether they ever sought professional advice when this thing started generating pallet-loads of cash. Granted, the activity may have evolved to the point that no tax planning could save it, but we do not know that. What we do know is that little – if any – planning occurred. 

Pushing Accounting Methods Too Far

Way back when, when I was attending a one-room tax schoolhouse, some of the earliest tax principles we learned was that of accounting methods and accounting periods. An accounting method is the repetitious recording of the same underlying transaction – recording straight-line depreciation on equipment purchases, for example. An accounting period is a repetitious year-end. For example, almost all individual taxpayers in the U.S. use a December 31 year-end, so we say they use a calendar accounting period.

Introduce related companies, mix and match accounting methods and periods and magical things can happen.  Accountants have played this game since the establishment of the tax Code, and the IRS has been pretty good at catching most of the shenanigans.

Let’s talk about one.

Two brothers own two companies, India Music (IM) and Houston-Rakhee Imports (HRI). Mind you, one company does not own the other. Rather the same two people own two separate companies. We call this type of relationship as a brother-sister (as opposed to a parent-subsidiary, where one company owns another). IM sold sheet music. It used the accrual method of accounting, which meant it recorded revenues when a sale occurred, even if there was a delay in receiving payment. It bought its sheet music from its brother-sister HRI. Under accrual accounting, it recorded a cost of sale for the sheet music to HRI, whether it had paid HRI or not.

Let’s flip the coin and look at HRI. It used the cash basis of accounting, which meant it recorded sales only when it received cash, and it recorded cost of sales only when it paid cash. It is the opposite accounting from IM.

Both companies are S corporations, which means that their taxable income lands on the personal tax return of their (two) owners. The owners then commingle the business income with their other personal income and pay income taxes on the sum.

From 1998 to 2003 IM accrued a payable to HRI of over $870,000. This meant that its owners got to reduce their passthrough business income by the same $870,000.

But….

Remember that the other side to this is HRI, which would in turn have received $870,000 in income. That of course would completely offset the deduction to IM. There would be no tax “bang” there.

What to do, what to do?

Eureka! The two brothers decided NOT to pay HRI. That way HRI did not receive cash, which meant it did not have income. Brilliant!

The IRS thought of this accounting trick back when the tax Code was in preschool. Here is code Section 267:

             (a) In general

(1) Deduction for losses disallowed

No deduction shall be allowed in respect of any loss from the sale or exchange of property, directly or indirectly, between persons specified in any of the paragraphs of subsection (b). The preceding sentence shall not apply to any loss of the distributing corporation (or the distributee) in the case of a distribution in complete liquidation.

(2) Matching of deduction and payee income item in the case of expenses and interest

If—

(A) by reason of the method of accounting of the person to whom the payment is to be made, the amount thereof is not (unless paid) includible in the gross income of such person, and

(B) at the close of the taxable year of the taxpayer for which (but for this paragraph) the amount would be deductible under this chapter, both the taxpayer and the person to whom the payment is to be made are persons specified in any of the paragraphs of subsection (b),  then any deduction allowable under this chapter in respect of such amount shall be allowable as of the day as of which such amount is includible in the gross income of the person to whom the payment is made (or, if later, as of the day on which it would be so allowable but for this paragraph). For purposes of this paragraph, in the case of a personal service corporation (within the meaning of section 441 (i)(2)), such corporation and any employee-owner (within the meaning of section 269A (b)(2), as modified by section 441 (i)(2)) shall be treated as persons specified in subsection (b).

What the Code does is delay the deduction until the related party recognizes the income. It is an elegant solution from a simpler time.

Our two brothers were audited for 2004, and the IRS immediately brought Section 267 to their attention. The IRS disallowed that $870,000 deduction to IM, and it now wanted $295 thousand in taxes and $59 thousand in penalties.

The brothers said “No way.” Some of those tax years were closed under the statute of limitations. “You cannot come back against us after three years,” they said.

What do you think? Do the brothers have a winning argument?

Let me add one more thing. To a tax practitioner, there are a couple of ways to increase income in a tax audit:

(1)  An adjustment

This is a one-off. You deducted your vacation and should not have. The IRS adds it back to income. There is no concurrent issue of repetition: that is, no  issue of an accounting method.

(2)  An accounting method change

There is something repetitious going on, and the IRS wants to change your accounting method for all of it.

The deadly thing about an accounting method change is that the IRS can force all of it on you in that audit year. In our case, the IRS forced IM to give back all of its $870,000 for 2004. It did not matter that the $870,000 had accreted pell mell since 1998.

With that sidebar, do you now think the brothers have a winning argument?

You can pretty much guess that the brothers were arguing that the IRS adjustment was a category (1): a one-off. The IRS of course argued that it was category (2): an accounting method change.

The case went to the Tax Court and then to the Fifth Circuit. The brothers were determined. They were also wrong. The brothers advanced some unconvincing technical arguments that the Court had little difficulty dismissing . The Court decided this was in fact an accounting method change. The IRS could make the catch-up adjustment. The brother owed big dollars in tax, as well as penalties.

The case was Bosamia v Commissioner, by the way.

My thoughts?

The brothers never had a chance .  Almost any tax practitioner could have predicted this outcome, especially since Section 267 has a long history and is relatively well known. This is not an obscure Code section.

The question I have is how the brothers found a tax practitioner who would sign off on the tax returns. The IRS can bring a CPA up on charges (within the IRS, mind you, not in court) for unprofessional conduct. The IRS could then suspend – or bar – that CPA from practice before the IRS. To a tax CPA – such as me – that is tantamount to a career death sentence. I would never have signed those tax returns. It would have been out of the question.