Renting To Yourself And The "Cox" Strategy

My partner brought me a new client’s personal income tax return. He wanted me to “come up with tax ideas,” as though I am an Iron Chef deciding what to do with the show’s “secret” ingredient.

Something caught my eye. Let’s talk about it.

Let me set this up for you:

(1) Taxpayer is married.

(2) The wife is self-employed. More specifically, she is a proprietor and reports her business income on a Schedule C.

(3) The business owns a house used as offices. The business depreciates the house.

(4) As is true for Schedules C, all her profits are subject to self-employment taxes.

There you go. You have all the facts you need.

Got it yet?

It has to do with the house.

There is a tax case from the 1990s addressing self-rental between a business and its owner. Taxpayer (Cox) was an attorney who reported his practice as a sole proprietorship.  His offices were in a commercial building owned jointly by Cox and his wife. He paid himself rent of $18,000, which he deducted from the law practice and reported as rental income elsewhere on his return.

NOTE: Cox addressed the “passive activities” rules. He apparently had passive losses that he could release by generating passive income.  If so, his net rental income might zero-out, and he would still get an income tax deduction for paying himself rent. It would be a win-win – if only the self-rental rule did not prohibit it.

The IRS of course disallowed the $18,000 rent entirely.

Cox went to trial on a very interesting position. He and his wife owned the rental property as tenants by the entireties. He argued that the form of ownership made a tax difference.

The Tax Court was intrigued. It looked to Missouri property law, and it noticed two things. First, each spouse is entitled to the use and enjoyment of the entire property. Second, a spouse cannot unilaterally divest his spouse of his/her interest in the property.

In a tax venue, this meant that Mrs. Cox was entitled to half the rent, and that Mr. Cox could not divest her of that right.

And the Court allowed Mr. Cox a $9,000 deduction for rent on his Schedule C. It disallowed the other $9,000 (that is, his half) under the self-rental rule.

How does this apply to the new client?

Taxpayer and her husband own the house. She owns the business. I see a strategy… for her self-employment tax.

Did I trip you up?

Remember: all her Schedule C income is subject to self-employment tax, which currently is 15.3 percent. One way to reduce it is to take a tax deduction on her Schedule C and report the corresponding “income” somewhere else on her tax return - somewhere that is NOT subject to self-employment tax. Somewhere like a real estate rental.

The tax pros refer to this a “Cox” strategy. The strategy we are talking about may also cause additional taxes under the new Obamacare “net investment income” tax. A tax advisor would have to review the situation and run numbers.

Still, it is something, and it is all your money until they take it from you. If this applies to your business situation, please bring it to your tax advisor’s attention. 

Killing Off The Tax Code

It will never happen.

Two months ago, Rep Bob Goodlatte (R, VA) sponsored H.R. 352, the “Tax Code Termination Act.” Since then approximately 70 additional Representatives have jumped onboard.

What does the bill propose to do?

Starting in 2018, the bill would eliminate individual, corporate, partnership and estate taxes. Payroll taxes and self-employment taxes would survive.

Congress would have until July 4, 2017 to propose and enact a new tax system to replace the current.

What is the purpose? Here is Representative Goodlatte’s explanation:

It has become abundantly clear that the tax code is no longer working in a fair manner for our nation’s citizens. Many Americans look at the dim state of our economy, and the billions of their tax dollars that are being given to private businesses and they want to know why they cannot keep more of their hard earned tax dollars. The tax code Americans are forced to comply with is unfair, discourages savings and investment, and is impossibly complex. It has become too clear that the current code is broken beyond repair and cannot be fixed, so we must start over.”  

He is not so much proposing the permanent abolition of the tax system as proposing a drop-dead date for its replacement. Why?

Although many questions remain about the best way to reform our tax system, I am certain that if Congress is forced to address the issue we can create a tax code that is simpler, fairer, and better for our economy that the one we are forced to comply with today.”

Congress won’t reach a consensus on such a contentious issue unless it is forced to do so.”

The bill is skeletal, and it does have an odd provision requiring a future Congress to meet a two-thirds majority to delay or repeal the bill.

Predictably, the very act of sponsorship has pushed the usual political suspects into a jeremiad, prophesying the end of the world as we know it.

Still, I can understand Rep Goodlatte’s premise: without prodding, the sinecured political class will not reform the tax system. Why would they? The tax code is just one more weapon they can and do wield to augment and retain power.