TurboTax and Penalties

I am looking at a case that deals with recourse and nonrecourse debt.

Normally I expect to find a partnership with multiple pages of related entities and near-impenetrable transactions leading up to the tax dispute.

This case had to do with a rental house. I decided to read through it.

Let’s say you buy a house in northern Kentucky. You will have a “recourse” mortgage. This means that – if you default – the mortgage company has the right to come after you for any shortfall if sales proceeds are insufficient to pay-off the mortgage.

This creates an interesting tax scenario in the event of foreclosure, as the tax Code sees two separate transactions.

EXAMPLE:

          The house cost               $290,000

          The mortgage is             $270,000

          The house is worth        $215,000

If the loan is recourse, the tax Code first sees the foreclosure:

          The house is worth        $215,000

          The house cost               (290,000)

          Loss on foreclosure       ($75,000)

The Code next sees the cancellation of debt:

          The mortgage is worth  $270,000

          The house is worth        (215,000)

          Cancellation of debt       $55,000

If the house is your principal residence, the loss on foreclosure is not tax deductible. The cancellation-of-debt income is taxable, however.

But all is not lost. Here is the Code:

§ 108 Income from discharge of indebtedness.

(a)  Exclusion from gross income.

(1)  In general.

Gross income does not include any amount which (but for this subsection) would be includible in gross income by reason of the discharge (in whole or in part) of indebtedness of the taxpayer if-

(E)  the indebtedness discharged is qualified principal residence indebtedness which is discharged-

(i)  before January 1, 2018, or

(ii)  subject to an arrangement that is entered into and evidenced in writing before January 1, 2018.

The Section 108(a)(1)(E) exclusion will save you from the $55,000 cancellation-of-debt income, if you got it done by or before the December 31, 2017 deadline.

Let’s change the state. Say that you bought your house in California.

That loan is now nonrecourse. That lender cannot hound you the way he/she could in Kentucky.

The taxation upon cancellation of a nonrecourse loan is also different. Rather than two steps, the tax Code now sees one.

Using the same example as above, we have:

          The mortgage is             $270,000

          The house cost               (290,000)

          Loss on foreclosure       ($20,000)  

Notice that the California calculation does not generate cancellation-of-debt income. As before, the loss is not deductible if it is from your principal residence.

Back to the case.

A married couple had lived in northern California and bought a residence. They moved to southern California and converted the residence to a rental. The housing crisis had begun, and the house was not worth what they had paid.

Facing a loss of over $300 grand, they got Wells Fargo to agree to a short sale. Wells Fargo then sent them a 1099-S for taking back the house and a 1099-C for cancellation-of-debt income.

Seems to me Wells Fargo sent paperwork for a sale in Kentucky. Remember: there can be no cancellation-of-debt income in California.

The taxpayer’s spouse prepared the return. She was an attorney, but she had no background in tax. She spent time on TurboTax; she spent time reading form instructions and other sources. She did her best. You know she was reviewing that recourse versus nonrecourse thing, as well as researching the effect of a rental. She may have researched whether the short sale had the same result as a regular foreclosure.

COMMENT: There was enough here to use a tax professional.

They filed a return showing around $7,000 in tax.

The IRS scoffed, saying the correct tax was closer to $76,000.

There was a lot going on here tax-wise. It wasn’t just the recourse versus nonrecourse thing; it was also resetting the “basis” in the house when it became a rental.

There is a requirement in tax law that property convert at lower of (adjusted) cost or fair market value when it changes use, such as changing from a principal residence to a rental. It can create a no-man’s land where you do not have enough for a gain, but you simultaneously have too much for a loss. It is nonintuitive if you haven’t been exposed to the concept.

Here is the Court:

This is the kind of conundrum only tax lawyers love. And it is not one we've been able to find anywhere in any case that involves a short sale of a house or any other asset for that matter. The closest analogy we can find is to what happens to bases in property that one person gives to another.”

Great. She had not even taken a tax class in law school, and now she was involved with making tax law.

Let’s fast forward. The IRS won. They next wanted penalties – about $14,000.

The Court didn’t think penalties were appropriate.

… the tax issues they faced in preparing their return for 2011 were complex and lacked clear answers—so much so that we ourselves had to reason by analogy to the taxation of sales of gifts and consider the puzzle of a single asset with two bases to reach the conclusion we did. We will not penalize taxpayers for mistakes of law in a complicated subject area that lacks clear guidance …”

They owed about $70 grand in tax but at least they did not owe penalties.

And the case will be remembered for being a twist on the TurboTax defense. Generally speaking, relying on tax software will not save you from penalties, although there have been a few exceptions. This case is one of those exceptions, although I question its usefulness as a defense. The taxpayers here strode into the tax twilight zone, and the Court decided the case by reasoning through analogy. How often will that fact pattern repeat, allowing one to use this case against the imposition of future penalties?

The case for the homegamers is Simonsen v Commissioner 150 T.C. No. 8.

What’s Fair Got To Do With It?

I am reading a tax case with an unfortunate result.

It does not seem that difficult to me to have planned for a better outcome.

I have to wonder: why didn’t they?

Let’s set it up.

We have a law firm in New York. There is a “heavy” partner and the other partners, which we will call “everybody else.” The firm faced hard times, and “everyone else” kept-up their bleed rate (the rate at which they withdraw cash), with the result that their capital accounts went negative.

COMMENT: A capital account is increased by the partner’s share of the income and reduced by cash withdrawn by said partner. When income goes down but the cash withdrawn does not, the capital account can (and eventually will) go negative. 

Let’s return to our heavy partner.

He was concerned about the viability of the firm. He was further concerned that New York law imposed on him a fiduciary responsibility to assure that the firm be able to pay its bills. I applaud his sense of responsibility, but I have to point out that any increased uncertainty over the firm’s capacity to pay its bills might have something to do with “everybody else” taking out too much cash.

Just sayin’.

Our partner’s share of firm income was almost $500 grand.

Problem is that the cash did not follow the income. His “share” of the income may have been $500 grand, but he left around $400 grand in the firm to make-up for the slack of his partners.

And you have one of those things about partnership taxation:   

·      The allocation of income does not have to follow the allocation of cash.

There are limits to how far one can push this, of course.

Sometimes the effect is beneficial to the partner:

·      A partner tales out more cash than his/her share of the income because the partnership owns something with big-time depreciation. Depreciation is a non-cash expense, so it doesn’t affect his/her distribution of cash.

Sometimes the effect is deleterious to the partner:

·      Our guy took out considerably less cash than the $500K income.

Our guy did not draw enough cash to even pay the taxes on his share of the income.

OBSERVATION: That’s cra-cra.

What did he do?

He reported $75K of income on his tax return. Seeing how did not receive the cash, he thought the reduction was “fair.”

Remember: his partnership K-1 reported almost half a million.

The number on his personal return did not match what the partnership reported.

COMMENT: By the way, there is yet one more form to your tax return when you do not use a number reported by a partnership. The IRS wants to know. He might as well just have booked the audit.

Sure enough, the IRS sent him a notice for over $140,000 tax and $28,000 in penalties.

Off to Tax Court they went.

And he had … absolutely … no … chance.

Partnerships have incredibly flexible tax law. There is a reason why the notorious tax shelters of days past were structured around partnerships. One could send income here, losses there, money somewhere else and muddy the waters so much that you could not see the bottom.

In response, Congress and the IRS tightened up, then tightened some more. This area is now one of the most horrifying, unintelligible stretches in the tax Code.  It can – with little exaggeration – be said that all the practitioners who truly understand partnership tax law can fit into your family room.

Back to our guy.

The Court did not have to decide about New York law and fiduciary responsibility to one’s law firm or any of that. It just looked at tax law and said:

Your income did not match your cash. You set this scheme up, and – if you did not like it – you could have changed it. Once decided, however, live with your decision.

Those are my words, by the way, and not a quote.

Our law partner owed the tax and penalties.

Ouch and ouch.

I must point out, however, that the law firm’s tax advisors warned our guy that his “fiduciary” theory carried no water and would be disregarded by the IRS, but he decided to proceed nonetheless. He brought much of this upon himself.

What would I have recommended?

For goodness’ sake, people, change the partnership agreement so that the “everybody else” partners reported more income and our guy reported less. It is fairly common in more complex partnerships to “tier” (think steps in a ladder or the cascade of a fountain) the distribution of income, with cash being the second – if not the first – step in the ladder. The IRS is familiar with this structure and less likely to challenge it, as the movement of income would make sense.

Another option of course would be to close down the law firm and allow “everybody else” to fend for themselves.

I would argue that my recommendation is less harsh.

What Is A Quintile?

A quintile is one of five equal groups into which a population can be divided. If the top 20% of taxpayers pay 94% of the income tax, then isn't it fair that they receive 94% of any tax breaks? Isn't it unfair if they don't?