I was
recently talking with another CPA. He had an issue with an estate income tax
return, and he was wondering if a certain deduction was a dead loser. I looked
into the issue as much as I could (that busy season thing), and it was not
clear to me that the deduction was a loser, much less a dead loser.
He then
asked: does he need to disclose if he takes the deduction?
Let’s take a
small look into professional tax practice.
There are
many areas and times when a tax advisor is not dealing with clear-cut tax law.
Depending
upon the particular issue, I as a practitioner have varying levels of
responsibility. For some I can take a position if I have a one-in-five
(approximately) chance of winning an IRS challenge; for others it is closer to
one-in-three.
There are also
issues where one has to disclose to the IRS that one took a given position on a
return. The concept of one-in-whatever doesn’t apply to these issues. It doesn’t
have to be nefarious, however. It may just be a badly drafted Regulation and a
taxpayer with enough dollars on the line.
Then there
are “those” transactions.
They used to
be called tax shelters, but the new term for them is “listed transactions.”
There is even a subset of listed transactions that the IRS frowns upon, but not
as frowny as listed transactions. Those are called “reportable transactions.”
This is an
area of practice that I try to stay away from. I am willing to play aggressive
ball, but the game stays within the chalk lines. Making tax law is for the big
players – think Apple’s tax department – not for a small CPA firm in Cincinnati.
Staying up
on this area is difficult, too. The IRS periodically revises a list of transactions
that it is scrutinizing. The IRS then updates its website, and I – as a
practitioner – am expected to repeatedly visit said website patiently awaiting said
update. Fail to do so and the IRS automatically shifts blame to the practitioner.
No thanks.
I am looking
at a case involving a guy who sells onions. His company is an S corporation,
which means that he puts the business numbers on his personal return and pays
tax on the conglomeration.
His name is
Vee.
He got
himself into a certain type of employee benefit plan.
A benefit
plan provides benefits other than retirement. It could be health, for example,
or disability or severance. The tax Code allows a business to prefund (and
deduct) these benefits, as long as it follows certain rules. A general concept
underlying the rules is risk-taking and cost-sharing – that is, there should be
a feel of insurance to the thing.
This is
relatively easy to do when you are Toyota or General Mills. Being large certainly
makes it easier to work with the law of large numbers.
The rules
however are problematic as the business gets smaller. Congress realized this
and passed Code Section 419A(f)(6), allowing small employers to join with other
small employers – in a minimum group of ten – and obtain tax advantages otherwise limited to the bigger players.
Then came
the promoters peddling these smaller plans. You could offer death and
disability benefits to your employees, for example, and shift the risk to an
insurance company. A reasonable employer would question the use of life
insurance. If the employer needed money to pay benefits, wouldn’t a mutual fund
make more sense than an illiquid life insurance policy? Ah, but the life
insurance policy allows for inside buildup. You could overfund the policy and
have all kinds of cash value. You would just borrow from the cash value – a
nontaxable transaction, by the way – to pay the benefits. Isn’t that more
efficient than a messy portfolio?
Then there
were the games the promoters played to diminish the risk of joining a group
with nine others.
Vee got
himself into one of these plans.
He funded
the thing with life insurance. He later cancelled the plan, keeping the life
insurance policy for himself.
The twist on
his plan was the use of experience-rated life insurance.
Experience-rated
does not pay well with the idea of cost-and-risk sharing. If I am experience
rated, then my insurance cost is based on my experience. My insurance company
does not look at you or any of the other eight employers in our group. I am not
feeling the insurance on this one.
Some of
these plans were outrageous. The employer would keep the plan going for a few
years, overpay for the insurance, then shut down the plan and pay “value” for
the underlying insurance policy. The insurance company would keep the “value” artificially
low, so it did not cost the employer much to buy the policy on the way out.
Then a year or two later, the cash value would multiply ten, twenty, fifty,
who-knows-how-many-fold. This technique was called “springing,” and it was like
finding the proverbial pot of gold.
The IRS had previously
said that plans similar to Vee’s were listed transactions.
This meant
that Vee had to disclose his plan on his tax return.
He did not.
That is an
automatic $10,000 penalty. No excuses.
He did it
four times, so he was in for $40,000.
He went to
Court. His argument was simple: the IRS had not said that his specific
plan was one of those abusive plans. The IRS had said “plans similar to,” but
what do those words really mean? Do you know what you have forgotten? What is
the point of a spice rack? Does anybody really know what time it is?
Yea, the
Court felt the same way. The plan was “similar to.” They were having none of
it.
He owed
$40,000.
He should
have disclosed.
Even better,
he should have left the whole thing alone.
