Two Brothers, An Offshore Trust And An Ignored CPA

Here is the cast of characters for today’s discussion:

Brian             orthopedic surgeon and idiot tax savant

Mark             Brian’s brother and idiot business manager

Michael         long-suffering CPA

Lynn              the “other” CPA

All right, maybe I am showing some bias.

Let us continue.

The two brothers attend a seminar about using domestic and offshore trusts to delay taxes until the monies were brought back into the United States. In the meanwhile, one could tap into the money by using a credit card.

Sure. Sounds legit.

The brothers return and are excited about this new tax technique. They ask Michael’s advice. Michael tells them that the seminar promoter was “a person to avoid” and to consult an independent tax attorney. 

Brian blew off Michael. Brian signed up for the offshore trust. He may have received a toaster with his new account.

Michael – who does the accounting - sees a $15,000 check to the promoter. He writes Brian:

I am writing to you because I am concerned for you and the risks you may inadvertently be taking.

It seems to me that the promoters are relying on an elaborate chain of complex entities to conceal taxable income. I am especially suspicious when I learned that they will provide you with a VISA card to access the money.

I am asking that you consider the worst case scenario in which the IRS takes the position that you are committing tax evasion. They have the power to assess huge penalties and interest, to prosecute you, to ruin your career, and seize your property. Is the risk worth it?”

Michael talks with Mark. He believes that the brothers have finally listened to his advice.

Meanwhile, the brothers did not listen to anything. They set up a series of interlocking companies and hired Lynn to prepare taxes for those companies. Lynn is associated with the promoters of this tax scheme.

• In year one the brothers transfer $107,388 offshore and deduct it as management fees 
• In year two they transfer and deduct $199,000 
• In year three they transfer and deduct $175,000

The IRS swoops in on the trust promoters. They take Lynn’s computer. Lynn calls Mark, explains all that, and recommends that they see a tax attorney. Maybe they should amend the tax returns.  Mark, after his many minutes of tax education, training and experience, told Lynn that he was not amending anything.

It gets better.

The promoter contacts the brothers and says that they have a NEW AND IMPROVED program that will be bulletproof against the IRS. The brothers sign on immediately.

The brothers receive their sign soon thereafter. 

• In year four they transfer and deduct $650,000

Michael is preparing this tax return. He calls Mark and asks about the “management fee.” Michael has Mark write him a letter that all was on the up-and-up.

• In year five they transfer and deduct $460,000

Michael is not preparing this tax return. He has had enough, and he has a career to protect. He wants a letter from an attorney that the transactions are above board.

Mark fires Michael.

And, in another surprise, daytime was followed by darkness.

A year later, Michael (the hero of our story) sends the brothers a press release about the “dirty dozen tax scams.” Sure enough, theirs is on the list. There is still time to send back the sign.

• In year six they transfer and deduct $180,000

In addition, Brian taps the offshore account for $270,000 for the purchase of a new home.

A couple of years later Michael receives a subpoena from the IRS for records pertaining to Brian and his company. This is when all that communication back-and-forth with Mark and Brian may have taken its toll, as Brian was virtually giving the IRS a roadmap.

The brothers, perhaps whiffing that they may have missed a key lecture in their vast tax education, decided to amend Brian's personal returns, adding most of the so-called management fees back to his income. Brian sends a big check to the government.

This case goes to Court. This is not a regular tax case. No sir, this is a fraud case. Someone is going to jail.

There was an eleven-day trial. The brothers were found guilty on all counts.

There was something interesting in here during interrogatories. The IRS never discussed the amended returns when they were presenting their fraud case. The brothers objected, but the Court sustained the government. The brothers introduced the amended returns when it was their turn.

The brothers had a point. The government was not out ALL the money, because Brian had paid a chunk of it with the amended returns. Why then did the Court sustain the government? Here is the Court:

As an initial matter, we note that the amended returns were submitted years after the false returns had been filed and months after[Michael] warned [the brothers] that their records had been subpoenaed. We have previously said that ‘there is no doubt that self-serving exculpatory acts performed substantially after a defendant’s wrongdoing is discovered are of minimal probative value as to his state of mind at the time of the alleged crime.”

Wow. There were no brownie points with this Court for doing the right thing.

By the way, Brian got 22 months at Club Fed and his brother got 14 .

But they got to keep the sign.

Cost Segregation and Buying a Business

Have you heard of cost segregation studies? This is an engineering-based study, usually conducted in tandem with an accounting firm, to break-out the cost of real estate and improvements into more tax-advantaged asset categories. For example, a sidewalk can be depreciated faster than a building. It would therefore be tax-advantageous to separate the cost of the sidewalk from that of the building and claim the faster depreciation. A virtual cottage industry has sprung up in the profession to do these cost segregation studies.

What if you buy a business and simultaneously do a cost segregation study? Sounds like the perfect time to do one. What if you buy a business and do the study later?

Let’s talk about Peco Foods Inc (Peco).

Peco is the parent of a consolidated group engaged in poultry processing. Through subsidiaries, Peco acquired its Sebastopol, Mississippi plant in 1995.  Peco and the seller agreed to allocate a $27,150,000 purchase price among 26 asset categories, including:

·         Processing plant building

·         Hatchery real property

·         Waste water treatment plant

·         Furniture and equipment

·         Machinery and equipment

Peco obtained an appraisal in connection with this acquisition. The appraisal listed more than 750 separate assets.

Peco acquired a second plant in Canton, Mississippi for $10,500,000 in 1998. This time Peco and the seller allocated the purchase price across only three asset categories:

·         Land

·         Land improvements

·         Machinery, equipment, furniture and fixtures

Peco obtained an appraisal on Canton after-the-fact. The appraisal included more than 300 separate assets. 

In 1999 Peco hired Moore Stephens Frost (MSF) for a cost segregation study of the two plants.  According to the study, Peco was entitled to additional depreciation expense of $5,258,754 from 1998 through 2002.

            NOTE: I will pass on saying that $5.2 million is not chicken feed.

Peco was now required to alert the IRS that it was changing its depreciation. It was changing what it earlier called a “building” to “machinery” or “equipment” or whatever. It had to attach a form - Form 3115 – to its tax return. Peco explained that it was breaking-out the Sebastopol and Canton depreciation schedules into more categories.

The IRS nixed the whole thing.

Why? There are special rules when someone acquires enough assets of another business to constitute the purchase of that business. This is referred to as an “applicable” asset acquisition, and the seller and buyer have to alert the IRS of how the purchase price is to be allocated. Here is Code Section 1060:

If in connection with an applicable asset acquisition, the transferee and transferor agree in writing as to the allocation of any consideration, or as to the fair market value of any of the assets, such agreement shall be binding on both the transferee and transferor unless the Secretary determines that such allocation (or fair market value) is not appropriate.

Each party’s argument is straightforward:

         IRS:    Taxpayer has to allocate according to the acquisition agreement.
           Peco:  No, I don’t because the wording is vague.          

The Court pointed out that the Sebastopol agreement used the phrase “processing plant building.” The inclusion of the word “building” was important. The Court even read the description of “building” from the Merriam Webster College Dictionary.  Equipment inside a building is not the same as the building. Why would Peco use the word “building” if it did not in fact mean a building?

The Court went through the same exercise with the Canton property.

The Court pointed out that – for it to set aside the written agreement – it would have to hold that the language was vague and ambiguous. Problem is, the Court did not think the language was vague or ambiguous at all. The Court observed that Peco had an appraisal prior to entering into one of the contracts, but it saw no need to further detail or reword its asset acquisition schedule. The second schedule was even more restrained, having only three categories. The Court observed that Peco did not seem to have any trouble with its schedules and categories until after it met Moore Stephens Frost (MSF), who clued them in on the advantages of cost segregation. The Court hinted its disapproval over retroactive tax planning, and it decided that it could not determine that the allocation was inappropriate. That meant that Peco was bound by the documents it signed. 

What is the moral of the story? The first of course is the importance of words in tax practice. Sometimes there is no room for “you know what I mean.” This is one of those areas.

The second moral is cynical. Had there been no written allocation of the assets, or even an incomplete allocation, then Peco might have won the case. Why? Because both sides would not have named every dollar in the deal. This would have left unclaimed ground, and Peco could have claimed that ground.

To be fair, the IRS is not keen on cost segregation. It is aware of the cottage industry that has sprung up after Hospital Corporation of America. It is one thing to be tracking the cost breakout as a building is being constructed or renovated. It is another to have an engineer come in and submit “what-if” numbers on an existing building or land improvement. Notice that the IRS did not contest the validity or credibility of MSF’s cost segregation study. All it did was hold Peco to its own (and) earlier cost allocation when it purchased the two businesses. That was enough.

FATCA Filing Season

This past Saturday the IRS released the final version of Form 8938, Statement of Specified Foreign Financial Assets, and on Monday released the instructions. This form is in response to FATCA, and represents a further tightening of reporting requirements for foreign income and assets.

What do you have to report? The easy answer is overseas bank accounts and securities accounts. It gets a little trickier with hedge and private equity funds. It will also pick up your loan to Grandma Gretchen. This is reporting for foreign assets, not just foreign bank accounts.

Here are the dollar amounts if you live in the U.S.:

·         If single or married filing separately

o   $50,000 on the last day of the year or $75,000 at any time during the year

·         If married filing jointly

o   $100,000 on the last day of the year or $150,000 at any time during the year

Here are the dollar amounts if you live overseas:

·         If single or married filing separately

o   $200,000 on the last day of the year or $300,000 at any time during the year

·         If married filing jointly

o   $400,000 on the last day of the year or $600,000 at any time during the year

Are the dollar thresholds ridiculously low? Of course.

Form 8938 does not replace the FBAR (TD-F 90.22.1), which is filed separately from your income tax return and is due in Detroit by June 30^th every year.

Eventually the IRS intends for Form 8938 to also apply to domestic entities, but for right now the IRS is limiting its reach to only individuals.

My take?

We used to expect that the IRS would not assess penalties unless tax was due. That in turn meant that we did not overly fear information returns - that is, returns with numbers on them but no line that said “tax due.” There were some exceptions, such as W-2s and 1099s, of course; otherwise, this rule of thumb worked reasonably well.

No longer. There are penalties to these forms even if there are no taxes due or all taxes have been reported.  Congress has taken umbrage on Americans having assets overseas. I am at a loss why a married couple (say my wife and I) would draw Congress’ attention solely by having $100,000 overseas. That is not enough money to get a starring role next to Michael Douglas in Wall Street II. It is not enough money to get me invited to a White House dinner, and certainly not enough to join a presidential vacation.

If you are even close to the dollar limits, please see a professional. Do not fool around with this, as the penalties can be severe.

The Use Of A Dynasty Trust

President Obama’s 2012 budget included a provision to limit dynasty trusts to approximately 90 years.

What is a dynasty trust? This creature exists because of estate taxes and generation-skipping taxes. Say that you and your spouse are worth $25 million. You have a daughter, and you come to me because you want to plan your estate. You think you can live on $10 million. To make this easy, say that all your wealth is in publicly-traded stocks. We call the broker and transfer $15 million in stocks to her. At the end of the year you will have a gift tax return. The gift tax exemption this year is $5 million per person, which means that you and your spouse combine for a total exemption of $10 million. You will have a gift tax, as the net gift subject to gift tax is $5,000,000 ($15,000,000 - $10,000,000).

When your daughter passes away, that $15 million will be included in her estate again and she will pay estate tax.

Ah, you say. You now understand what the estate tax is doing. What if you gift to your grandson, that way the $15 million will escape estate tax at your daughter’s death. You “skipped” a generation. Enter the generation-skipping tax, whose purpose is – you guessed it – to tax that transfer to your grandson. No skipping allowed.

Let’s tweak this a bit. Say that you gift $10 million to your daughter and $5 million to your grandson. Now you have an interesting case study. You see, the generation-skipping tax has an exemption. That exemption amount is currently $5 million per person, or $10 million for you and your spouse. You can transfer up to $10 million to your grandson, have it escape the estate tax (at the daughter’s death) and also escape the generation-skipping tax.

Let’s tweak this again. Say that your grandson receives the gift amount (at some point in the future – it doesn’t matter when). When he passes away, the $5 million is in his estate and there will be estate tax. Is there some way to skip his estate tax?

Enter the dynasty trust. You put the $5 million in a dynasty trust. Your grandson is a beneficiary and receives distributions. He does not have enough retained power to dragnet the trust into his estate upon death. The trust escapes his estate and passes on to the next tier of beneficiaries, which are presumably your great-grandchildren.

This trust is designed to never be snared by the estate or generation-skipping tax ever again. Wow!

Enter the rule against perpetuities. There is a common law principle that allows a trust to carry-on for only so long without vesting, which is about 90 years. I studied trust law at the University of Missouri Law School and, frankly, its application in practice confused me both then and now. However, there are 23 states (including Kentucky and Ohio) that have “waived” the rule against perpetuities and allow dynasty trusts. So we can employ a dynasty in Ohio, for example, and sidestep the rule against perpetuities.

Enter Obama’s proposal to limit these trusts to 90 years or so. It would do so, not by limiting the trust, but by limiting the generation-skipping exclusion. As the trust is a creature of tax policy, the effect would be the same. Do not overly worry about this happening soon, however, as Obama’s budget was voted down without dissent in the Senate. However, the proposal does provide insight into future sources of revenue that Congress may revisit.

Because of the long-lived nature of these trusts, you are (almost by default) looking at a corporate trustee. If you haven’t reviewed trustee rates recently, you may be surprised at how expensive this can be. This in turn means that you want a certain minimum amount of money to seed the trust in order to justify the fees. This tax planning is not for the middle class. You also have to be careful in how much power is reserved to the beneficiaries, as too much may result in the trust being included in a beneficiary’s estate. You have to reserve a certain minimum, of course, such as the ability to dismiss and replace a trustee that has become unproductive or overly expensive.

I see these trusts primarily as a means of asset protection against creditor claims and divorces. It may also be a means to keep family businesses under family control, such as by placing the business(es) in a family limited partnership and then placing the partnership units into the dynasty. This would also allow one to utilize gift tax discounts, further magnifying the leverage of the dynasty trust. However, I can also see that society has an interest in not bankrolling a class of nonproductive trust-fund-uberwealthies. Perhaps the President has it right on this one: maybe 90 years is enough time for this tax vehicle.