Checks Not Cashed In Time Includible In Taxable Estate

 

Let’s talk about an issue concerning gifts.

We are not talking about contributions – such as to a charity - mind you. We are talking gifts to individuals, as in gift taxation.

The IRS spots you a $16,000 annual gift tax exemption. This means that you can gift anyone you want – family, friend, stranger – up to $16,000 and there is no gift tax involved. Heck, you don’t even have to file a return for such a straightforward transaction, although you can if you want. Say that you give $16,000 to your kid. No return, no tax, nothing. Your spouse can do the same, meaning $32,000 per kid with no return or tax.

That amount covers gifting for the vast majority of us.

What if you gift more than $16,000?

Easy answer: you now have to file a return but it is unlikely there will be any tax due.

Why?

Because the IRS gives you a “spot.”

A key concept in estate and gift taxation is that the gift tax and the estate tax are combined for purposes of the arithmetic.

One adds the following:

·      The gifts you have reported over your lifetime

·      The assets you die with

One subtracts the following:

·      Debts you die with

·      Certain spousal transfers and charitable bequests we will not address here.

If this number is less than $12.06 million, there is no tax – gift or estate.

Folks, it is quite unlikely that the average person will get to $12.06 million. If you do, congrats. Chances are you have been working with a tax advisor for a while, at least for your income taxes. It is also more likely than not that you and your advisor have had conversations involving estate and gift taxes.

Let’s take a look at the Estate of William E. DeMuth, Jr.

In January, 2007 William DeMuth (dad) gave a power of attorney to his son (Donald DeMuth). Donald was given power to make gifts (not exceeding the annual exclusion) on his dad’s behalf. Donald did so from 2007 through 2014.

In summer, 2015, dad’s health began to fail.

Donald starting writing checks for gift in anticipation that his dad would pass away.

Dad did pass away on September 11.

Donald had written eleven checks for $464,000.

QUESTION: Why did Donald do this?

ANSWER: In an attempt to reduce dad’s taxable estate by $464,000.

Problem: Only one of the eleven checks was cashed before dad passed away.

Why is this a problem?

This is an issue where the income tax answer is different from the gift tax answer.

If I write a check to a charity and put it in the mail late December, then income tax allows me to claim a contribution deduction in the year I mailed the check. One could argue that the charity could not receive the check in time to deposit it the same tax year, but that does not matter. I parted with dominion and control when I dropped the check in the mail.

Gift tax wants more from dominion and control. One is likely dealing with family and close friends, so the heightened skepticism makes sense.

When did dad part with dominion and control over the eleven checks?

Gift tax wants to see those checks cashed. Until then, dad had not parted with dominion and control.

Only one of the checks had cleared before dad passed away. That check was allowed as a gift. The other ten checks totaled $436,000 and potentially includible in dad’s estate.

But there was a technicality concern an IRS concession, and the $436,000 was reduced to $366,000.

Still, multiply $366,000 by a 40% tax rate and the issue got expensive.

Our case this time was the Estate of William E DeMuth, Jr., T.C. Memo 2022-72.

Your 2020 Tax Return and the Stimulus Payments

 

Let’s talk about your 2020 personal tax return and the two stimulus payments that you (may have) received.

The first round of stimulus checks was up to $1,200 for each spouse and $500 for each qualifying child.

The second round was up to $600 for each spouse and qualifying child.

So, if you have two qualifying kids and qualified for the maximum, you would have received $5,800 ($3,400 plus $2,400) between the two rounds.

How do you not qualify for the maximum?

One way is easy: you had too much income.

The second way is nonintuitive: the child was over age 16. A qualifying child means a child under the age of 17. Seems odd to me to exclude a high school senior, but there it is.

Let’s talk about the first non-qualification: income.

Let’s use a married couple with two qualifying children as our example.

The income limit for marrieds is $150,000. Past that point the stimulus check goes away by a nickel on the dollar. The maximum for two spouses is $2,400, so we can calculate this as follows:

                      $2,400 divided by .05 = $ 48,000

                      $150,000 plus 48,000 = $198,000

All right, the stimulus for marrieds burns-out at $198,000, right?

Nope.

Why?

Because of the qualifying children.

Each of the kids adds another $10,000 to the phaseout range.

We have two kids. That means $20,000 added to the $198,000, totaling $218,000 before we burn-out of stimulus altogether.

Are we stilling phasing-out at a nickel on the dollar?

Let’s check.

           $218,000 – 150,000 = $68,000

           $3,400 divided by 68,000 equals $0.05.

Yep, nickel on the dollar.

You received the first stimulus check in April, 2020. Remember that tax returns were automatically extended until July 15, 2020 because of COVID. The odds were extremely good that the IRS was not basing its calculations on your 2019 return, because your 2019 return had not been prepared, much less filed. For most of us, the IRS was looking at our 2018 tax return.

Let’s continue.

You received your second stimulus check very late in December, 2020 or (more likely) January, 2021 – but the income phaseout range was the same.

What did change was the tax year the IRS was looking at. By December, 2020 you would have filed your 2019 tax return (let’s skip paper filings that may not have been processed by then, or we are going to drive ourselves crazy).

If your income went up from 2018 to 2019, you would have climbed the phaseout range. You might have received a first stimulus check, for example, but not qualified for a second one. It could have gone the other way, of course, if your income went down in 2019. 

Now your 2020 tax return lands on my desk and we need to settle-up on the stimulus.

How do we settle-up?

We run through the income phaseout range … again.

Using your 2020 tax return this time.

Did you notice we are doing the calculation three times using income from three different tax years?

Yep, it’s a pain.

Mind you, if you have modest income, I know that you received the maximum stimulus.

Conversely, if you made bank, I know that you received no stimulus.

Fall in between – or have wildly varying income – and I you need to tell me the amount of your stimulus checks.

Let’s go through a quick example, using our married couple with two qualifying children.

Their 2018 adjusted gross income was 201,000.

Here is the first stimulus:

phaseout start			150,000.00
phaseout end		198,000.00
add: 2 children		20,000.00
			218,000.00
				68,000.00
2018 AGI			201,000.00
				51,000.00
First stimulus		2,400.00
		1,000.00
			3,400.00	times	51,000.00	=	2,550.00
					68,000.00
			(2,550.00)
			850.00

They would have received $850.

Their 2019 adjusted gross income was $320,000.

Way over the income limit. There was no second stimulus.

Their 2020 tax return lands on my desk. Their adjusted gross income is $104,000.

Way below the income limit. Full stimulus.

Two qualifying kids. The maximum over two rounds of stimulus would be $3,400 plus $2,400 = $5,800.

They already received $850 per above.

That means a $4,950 credit on their 2020 individual tax return. I look like a hero.

But why? After all, their 2019 income was over $300 grand – way above the range for receiving any stimulus.

The quirky thing is that the stimulus is based on one’s 2020 tax return. Congress however wanted the money out as fast as possible. The stimulus had an income test, though, so the first option was to do the calculation on one’s 2019 tax return. When that option proved unworkable, the second option was to use 2018. It was messy but quick, and one would settle-up when filing the 2020 tax return.

Congress realized that settling-up could mean repaying some of the stimulus money. Since that somewhat negated the purpose of a stimulus, Congress decided that the gate would only swing one way. If one did not receive enough stimulus, then one could claim the shortfall on the 2020 return. If one was overpaid, well … one got to keep the money. 

It was a win:win.

Not so much for the accountant, though.

What Is Unclaimed Property?

I was reading an IRS Revenue Ruling that made me laugh, albeit in a cynical way.

Here is the issue:

If an IRA is being sent to a state unclaimed property fund, can the IRS force the trustee to withhold and remit taxes?

There are several things going on here, beginning with: what is an unclaimed property fund?

An easy example is a deceased person’s bank account. Take Florida. If someone dies in Florida without a will and without requiring probate, you as an inheritor are going to have difficulties getting to their bank account – unless you name is also on the account. You likely have to hire an attorney to obtain a court letter to provide the bank stating that you are a valid inheritor of said bank account.

How many folks do think just leave the bank account unclaimed because it isn’t worth the cost of an attorney?

It is not just bank accounts. Unclaimed funds can include uncashed dividend or payroll checks, utility security deposits, safety deposit boxes, retirement accounts and a hundred variations thereon. The concept is that you are holding somebody else’s money, and that somebody disappears. It is referred to as dormancy, and the definition is what you would expect: there has been no activity in the account or contact with the owner for a while; account statements are returned because of an invalid address; phone numbers are no longer active.

The “while” depends on the state and the type of asset. In Ohio, an uncashed payroll check is considered dormant after one year whereas a customer overpayment requires three years.

Who reports this?

The business, of course. The business is supposed to try to locate the account owner, but sometimes there simply is no one to contact. When the dormancy period is up, the business then transfers the monies with its best available information to the state. The state holds the property until the owner comes forward to claim it.

The legal reasoning behind unclaimed property goes back to common law and real property. If one abandons real property, there is a legitimate public concern that it soon might become blighted. That concern prompts the transfer (the nerd term is “escheat”) of the abandoned property to the Crown – or, these days, to the State.

Unclaimed property is not technically taxation, but its laws operate similarly to tax statutes.

Many states have used unclaimed property as a means to fund their coffers. Delaware is one of the most egregious offenders, with unclaimed property being its third-largest source of state revenues. Delaware can do this because it is home to so many banks.

Here is a link if you are interested in your own unclaimed property search:

https://www.unclaimed.org/

Back to the IRS Revenue Ruling. Here is a short paragraph from the lead-in:

Under the facts presented, is the payment of Trustee Y of Individual C's interest in IRA O to the State J unclaimed property fund, as required by State J law, subject to federal income tax withholding under Section 3405 of the Internal Revenue Code?”

A bracing read, isn’t it? I couldn’t put it down.

Anyway, how do you think the IRS answered this question?

Pretty much the way you would expect. The IRS is getting its cut at some point, and this is as good a point as any. Send the IRS its money, Trustee Y.

Do You HAVE To Cash That Bonus Check (To Get A Tax Deduction)?

For (very) closely-held service companies, it is common to “bonus” enough profit to bring taxable income down to zero (or very close). There are two reasons for this:

(1)  The company is a personal services company (PSC), meaning that it will face a maximum corporate tax rate on whatever profit is left in the company. This is a tremendous impetus to not leave profit in the company.

(2)   There is one owner (or very few owners) and the majority of the money is going to him/her/them anyway.

In many cases the company is also cash-basis taxpayer, and the accountant normally pays very close attention to cash in-and-out during the last few days of the tax year. With electronic bank transfers becoming more commonplace, I have seen carefully-monitored tax planning destabilized by sizeable electronic customer transfers on the last day or two. It happens, as the customer may be doing cash-basis planning themselves, and payment to my client is a tax deduction to them.

There are limitations on how far this can be pushed, though. It is not acceptable to delay depositing customer checks, for example, in order to avoid income recognition. In addition, one has to be careful about writing so many checks that it creates a bank overdraft. A common way to plan around an overdraft is to have a line of credit available. The bank would then sweep funds from the line as necessary to cover any overdraft. One might also run an overdraft if he/she knows that a deposit will arrive early the following month, as that deposit would occur during the float period of any outstanding checks.  A business owner might “know” that check is coming because said check is already in the owner’s desk drawer, but we will not speak further of such absurd examples. It is not as though I have ever seen such a thing, of course.

Let’s talk about Vanney Associates, Inc. Robert Vanney is an architect with perilously close to 40 years experience. The firm has about 25 employees, and Robert is the sole shareholder. He is – without question – the key man. His wife, Karen, is a CPA with a retired license, and she takes care of the books and records.

In 2008 Mr. Vanney received $240,000 in monthly payroll. At the end of the year, he determined and paid employee bonuses, taking as a personal bonus whatever was left over. The leftover was $815,000. The withholdings on the leftover were approximately $350,000, leaving approximately $464,000 payable to Mr. Vanney.

Problem: there was only $389 thousand in the bank.

There was enough money to pay the withholding taxes, but there wasn’t enough to also pay Mr. Vanney. What to do? The Vanney’s did not need the money, so they decided not to borrow from the bank. Mr. Vanney instead endorsed the check back to the company, and that was the end of the matter.

But it wasn’t. The IRS looked at the business tax return and decided to disallow the $815,000 bonus and almost $12,000 in related employer payroll taxes.

Why? The government got their taxes, so why should they care? 

There is a legal concept when paying with a check. A check is referred to as a “conditional payment,” because writing the check is subject to a condition subsequent. That subsequent condition is the check clearing the bank. We take it for granted, of course, so we overlook that technically there are two steps. When the check clears, the two steps unify and become as one. This is why you can send a check to a charity on December 31 and claim the deduction in the same tax year. There is no chance that the charity is receiving that check and depositing it by December 31. Still, if it clears in the normal course of business, all parties – including the IRS – consider the check as having been written on December 31.

That is not what happened here. The check never cleared the bank.

Which is unfortunate, as the IRS now could argue that the check remained conditional. Being conditional there was never payment in 2008. This was fatal, as Vanney Associates was a cash-basis taxpayer.  

And the Court agreed.

Think about this for a moment. The corporation was disallowed a 2008 deduction for the $815,000. Whereas the Court did not address this point, that bonus was included on Mr. Vanney’s 2008 Form W-2. He would have reported that W-2 on his 2008 individual tax return.

There is something seriously wrong with this picture.

I suppose Vanney Associates could amend its 2008 payroll tax returns. It could reverse that bonus, as well as the related withholding taxes. It would get a refund, but it would be amending multiple federal and state (and possibly local) payroll returns.

Mr. Vanney would then amend his personal 2008 tax return.

But that is assuming we are within the statute of limitations to amend all those returns.

When then would Vanney Associates get its $815,000 bonus deduction?

Your first response might be the following year: in 2009. I believe you would be wrong. Why? Because Mr. Vanney did not cash his check in 2009. The check remained a conditional payment in 2009. Same answer for 2010, 2011, 2012 and 2013. This case was decided September, 2014. Seems to me the first time Mr. Vanney could “cash” his check is this year – 2014.

Let me ask you another question: why didn’t the Court allow the (approximately) $350,000 in withholdings as a tax deduction? That check cashed, right?

I think I know. If the company did not “pay” the $815,000 in 2008, then there is no “bonus” for that withholding to attach to. From a tax perspective, the company overpaid its withholding taxes in 2008. The tax problem is that the overpayment is not a "deduction," as no payroll taxes were actually due. Payroll taxes attach to payroll, and there was no payroll. It was a "prepayment," waiting on Vanney to request a refund.

What is our takeaway?

Over the years I have heard more than one practitioner declare a tax outcome as “making no sense.” An unfortunate consequence is that the practitioner may not pursue a line of reasoning to conclusion. There are reasons for this, of course. First, an accountant has probably been exposed somewhere to generally accepted accounting principles. GAAP is a financial statement concept (think auditors, not tax accountants) and GAAP generally has some symmetry to it. The practitioner forgets that the IRS not bound by GAAP. The purpose of the IRS is to collect and enforce, and it does not consider itself bound by any symmetry should GAAP get in its way. The second is human: we respond to an absurd result by assuming we must have made a mistake in our reasoning. Many times we are right. In Vanney’s case, we were not.

What could Vanney have done?

Simple.

He could have had a line of credit in place. He could have cashed that check.

BTW I almost invariably recommend my cash-basis clients have a line of credit, even if they have no intention of using it. This costs them money, as the bank may charge a flat fee (say $100 or $250) annually for keeping the line of credit available. In addition, many a bank will require at least one draw over a month-end annually in order to keep the line open. This means there will be some interest expense.

Why do I recommend it? It is cheap insurance against nightmares like this.

You Want Me To E-File Your Tax Return? Then Show Me Your ID.

There are times I wonder why I do what I do.

It is difficult enough to keep up with the barrage of tax developments, pronouncements, law changes, court decisions and what not. I do not practice in all areas, so there is some fence around this field, but it is still a fairly large field.

Then you have the IRS bureaucracy, which is becoming more unwieldy every year. It used to be that I could contact a local IRS person to help with a tax problem. After a while, one got to know the local IRS employees, and they got to know me. The IRS restructuring took away our local contacts. Practitioners now contact regional offices using an 866-telephone number. Wait times have been noticeably increasing over the last two or three years.  I gave up on a call this past Thursday as it approached an hour and a half.

Folks, this is a “back door” line for CPAs and attorneys. I can only imagine what the wait time is for the general line.

This past week I was reading Publication 1345 titled “Handbook for Authorized IRS e-file Providers of Individual Income Tax Returns.” I would not recommend it unless you are a serious insomniac.  I came across the following pearl:

In-Person Transaction

The ERO must inspect a valid government picture identification; compare picture to applicant; and record the name, social security number, address and date of birth. Verify that the name, social security number, address, date of birth and other personal information on record are consistent with the information provided through record checks with the applicable agency or institution or through credit bureaus or similar databases. For in-person transactions, the record checks with the applicable agency or institution or through credit bureaus or similar databases are optional.

Examples of government picture identification (ID) include a driver’s license, employer ID, school ID, state ID, military ID, national ID, voter ID, visa or passport. 

If there is a multi-year business relationship, you should identify and authenticate the taxpayer."

Huh?

Let’s translate. An ERO is an electronic return originator. That is fancy language for someone who is authorized to file returns electronically with the IRS. My firm for example is an ERO. That makes me an ERO.

The IRS is talking about me inspecting a “valid picture identification” and so on. And when am I supposed to do this?

The IRS starts off talking about electronic signatures on a tax return. Obviously if I file your return electronically, I cannot send your fresh-ink signature at the bottom of the form. I do require from you a release authorizing me to e-file your return. That release may have your fresh-ink signature, but that release stays with me. The IRS does not get a copy.

Is the IRS talking about the e-signature on the return I file for you? Or is the IRS talking about an electronic signature on the release I obtain from you before e-filing your return? There is a big difference, and I cannot tell what the IRS meant. I suspect the IRS is talking about electronic signatures on the release. For the most part most of my clients sign their release in ink, although many clients will either fax or PDF their release to me. I am presuming the fax or PDF does not constitute an electronic signature, but I do need the IRS to be more precise in its use of the language.

Then there are the few clients. You know the ones: the computer hyper-literate. These guys can write a ditty, put music and video to it and publish the whole thing on You Tube in the time you or I would draft an e-mail. These guys are going to cause me a problem, because they know enough to sign that release with an "electronic signature.”

Let’s say they do.

The IRS now wants me to:

(1)  Inspect a valid government picture identification.

I presume we are talking about a driver’s license. It is inconvenient, but it follows what the stockbrokers have done for years.

What am I supposed to do with the kids, though, if the kids are too young to drive? 

What if mom and/or dad live with the client? Where does this end?

(2)  Record the name, social security number, address and date of birth.

No problem. We already do that.

(3)  Verify that information through record checks with the applicable agency or institution or through credit bureaus or similar databases.

Are you kidding me?

That one angers me. There is a superstructure of self-serving – and obviously incompetent - government bureaucrats and they have to recruit a tax CPA in Cincinnati to do THEIR JOB? I tell you what I want in return: I want a government salary; government benefits; all the holidays, including the make-believe ones; 6 weeks of vacation; a retirement plan; union protection so that I cannot be fired, no matter how incompetent I am.

What if I have known you for years?

If there is a multi-year business relationship, you should identify and authenticate the taxpayer."

Seriously? And what does “authenticate” mean?

Good grief. It would be less work to let these people vote. Hire me to do your taxes, however, and I have to go all Kojak on you.

How have we gotten to this point?

It has to do with identity theft. It has become a top-tier issue for the IRS. They responded in turn with Publication 1345. I am trying to be fair, I truly am, but I see a few things the IRS could immediately do before making me their Barney Fife:

(1)  Review refunds to taxpayers with a different address from last year.

(2)  Review refunds to taxpayers with a different employer from last year.

(3)  Stop issuing multiple refund checks to the same address. For example, the IRS sent 655 refund checks to the same address in Lithuania.

And what tax crook in his/her right mind is going to hire a tax CPA to do their dirty work anyway? Somebody clue the IRS that is not how those people work.

Publication 1345 addresses only individual tax returns. Is the IRS going to extend this to business returns? Will I need to confirm corporate minutes to be certain that Tom N. Jerry is in fact the CEO of that corporation and authorized to sign the corporate return? Will I need in turn to background check Tom N. Jerry himself?

And where will the time come from to do all this? I am already swamped during busy season. Even if the above takes only 5 minutes per return, multiply the 5 minutes by hundreds of clients. The IRS could easily add at least another 40 or 50 hours to my individual tax practice, time that I do not have. How will I respond? I will extend more returns. I would have to. I will charge you more. I would have to.  I would not accept electronic signatures on tax forms.

That last one is obvious.