Using A Fancy Trust Without An Advisor

 

I am a fan of charitable remainder trusts. These are (sometimes) also referred to as split interest trusts.

What is an interest in a trust and how can you split it?

In a generic situation, an interest in a trust is straightforward:

(1) Someone may have a right to or is otherwise permitted to receive an income distribution from a trust. This is what it sounds like: if the trust has income, then someone might receive all, some or none of it – depending on what the trust is designed to do. This person is referred to as an “income” beneficiary.

(2) When there are no more income beneficiaries, the trust will likely terminate. Any assets remaining in the trust will go to the remaining beneficiaries. This person(s) is referred to as a “remainder” beneficiary.

Sounds complicated, but it does not have to be. Let me give you an example.

(1)  I set up a trust.

(2)  My wife has exclusive rights to the income for the rest of her life. My wife is the income beneficiary.

(3)  Upon my wife’s death, the assets remaining in the trust go to our kids. Our kids are the remainder beneficiaries.

(4)  BTW the above set-up is referred to as a “family trust” in the literature.

Back to it: what is a split interest trust?

Easy. Make one of those interests a 501(c)(3) charity.

If the charity is the income beneficiary, we are likely talking a charitable lead trust.

If the charity is the remainder beneficiary, then we are likely talking a charitable remainder trust.

Let’s focus solely on a charity as a remainder interest.

You want to donate to your alma mater – Michigan, let’s say. You are not made of money, so you want to donate when you pass away, just in case you need the money in life. One way is to include the University of Michigan in your will.

Another way would be to form a split interest trust, with Michigan as the charity. You retain all the income for life, and whatever is left over goes to Michigan when you pass away. In truth, I would bet a box of donuts that Michigan would even help you with setting up the trust, as they have a personal stake in the matter.

That’s it. You have a CRT.

Oh, one more thing.

You also have a charitable donation.

Of course, you say. You have a donation when you die, as that is when the remaining trust assets go to Michigan.

No, no. You have a donation when the trust is formed, even though Michigan will not see the money (hopefully) for (many) years.

Why? Because that is the way the tax law is written. Mind you, there is crazy math involved in calculating the charitable deduction.

Let’s look at the Furrer case.

The Furrers were farmers. They formed two CRATs, one in 2015 and another in 2016.

COMMENT: A CRAT is a flavor of CRT. Let’s leave it alone for this discussion.

In 2015 they transferred 100,000 bushels of corn and 10,000 bushels of soybeans to the CRAT. The CRAT bought an annuity from a life insurance company, the distributions from which were in turn used to pay the Fullers their annuity from the CRT.

They did the same thing with the 2016 CRT, but we’ll look only at the 2015 CRT. The tax issue is the same in both trusts.

The CRT is an oddball trust, as it delays - but does not eliminate – taxable income and paying taxes. Instead, the income beneficiary pays taxes as distributions are received.

EXAMPLE: Say the trust is funded with stock, which it then sells at a $500,000 gain. The annual distribution to the income beneficiary is $100,000. The taxes on the $500,000 gain will be spread over 5 years, as the income beneficiary receives $100,000 annually.

Think of a CRT as an installment sale and you get the idea.

OK, we know that the Furrers had income coming their way.

Next question: what was the amount of the charitable contribution?

Look at this tangle of words:

§ 170 Charitable, etc., contributions and gifts.

           (e)  Certain contributions of ordinary income and capital gain property.

(1)  General rule.

The amount of any charitable contribution of property otherwise taken into account under this section shall be reduced by the sum of-

(A)  the amount of gain which would not have been long-term capital gain (determined without regard to section 1221(b)(3)) if the property contributed had been sold by the taxpayer at its fair market value (determined at the time of such contribution),

This incoherence is sometimes referred to as the “reduce to basis” rule.

The Code will generally allow a charitable contribution for the fair market value of donated property. Say you bought Apple stock in 1997. Your cost (that is, your “basis”) in the stock is minimal, whereas the stock is now worth a fortune. Will the Code allow you to deduct what Apple stock is worth, even though your actual cost in the stock is (maybe) a dime on the dollar?

Yep, with some exceptions.

Exceptions like what?

Like the above “amount of gain which would not have been long-term capital gain.”

Not a problem with Apple stock, as that thing is capital gain all day long.

How about crops to a farmer?

Not so much. Crops to a farmer are like yoga pants to Lululemon. That is inventory - ordinary income in nerdspeak - as what a farmer ordinarily does is raise and sell crops. No capital gain there.

Meaning?

The Furrers must reduce their charitable deduction by the amount of income that would not be capital gain.

Well, we just said that none of the crop income would be capital gain.

I see income minus (the same) income = zero.

There is no charitable deduction.

Worst … case … scenario.

I found myself wondering how the tax planning blew up.

In July 2015, after seeing an advertisement in a farming magazine, petitioners formed the Donald & Rita Furrer Charitable Remainder Annuity Trust of 2015 (CRAT I), of which their son was named trustee. The trust instrument designated petitioners as life beneficiaries and three eligible section 501(c)(3) charities as remaindermen.”

The Furrers should have used a tax advisor. A pro may not be necessary for routine circumstances: a couple of W-2s, a little interest income, interest expense and taxes on a mortgage, for example.

This was not that. This was a charitable remainder trust, something that many accountants might not see throughout a career.

Yep, don’t do this.

Our case this time is Furrer v Commissioner, T.C. Memo 2022-100.

Starting A Business In The Desert

 

Tax has something called “startup costs.”

The idea is to slow down how quickly you can deduct these costs, and it can hurt.

Let’s take a common enough example: starting a restaurant.

You are interested in owning a restaurant. You look at several existing restaurants that may be available for purchase, but you eventually decide to renovate existing space and open your own- and new – restaurant. You lease or buy, then hire an architect for the design and a contractor for the build-out of the space.

You are burning through money.

You still do not have a tax deduction. Expenses incurred when you were evaluating existing restaurants are considered investigatory expenses. The idea here is that you were thinking of doing something, but you were not certain which something to do – or whether to do anything at all.

Investigatory expenses are a type of startup expense.

The contractor comes in. You are installing walls and windows and floors and fixtures. The equipment and furniture are delivered next.

You will depreciate these expenses, but not yet. Depreciation begins when an asset is placed in service, and it is hard to argue that assets are placed in service before the business itself begins.

You still do not have a tax deduction.

You will be the head chef, but still need your sous and line chefs, as well as a hostess, waitpersons, bartender and busboys. You have payroll and you have not served your first customer.

It is relatively common for a restaurant to have a soft launch, meaning the restaurant is open to invited guests only. This is a chance to present the menu and to shakedown the kitchen and floor staff before opening doors to the general public. It serves a couple of purposes: first, to make sure everyone and everything is ready; second, to stop the startup period. 

Think about the expenses you have incurred just to get to your soft launch: the investigatory expenses, the architect and contractor, the construction costs, the fixtures and furniture, employee training, advertising and so on.

Carve out the stuff that is depreciable, as that has its own rules. The costs that are left represent startup costs.

The tax Code – in its wisdom or jest – allows you to immediately deduct up to $5,000 of startup costs, and even that skeletal amount is reduced if you have “too many” startup costs.

Whatever remains is deductible pro-rata over 15 years.

Yes, 15 years. Almost enough time to get a kid through grade and high school.

You clearly want to minimize startup costs, if at all possible. There are two general ways to do this:

·      Start doing business as soon as possible.  Perhaps you start takeout or delivery as soon as the kitchen is ready and before the overall restaurant is open for service.

·      You expand an existing business, with expansion in this example meaning your second (or later) restaurant. While you are starting another restaurant, you are already in the business of operating restaurants. You are past startup, at least as far as restaurants go.

Let’s look at the Safaryan case.

In 2012 or 2013 Vardan Antonyan purchased 10 acres in the middle of the Mojave desert. It was a mile away from a road and about 120 miles away from where Antonyan and his wife lived. It was his plan to provide road access to the property, obtain approval for organic farming, install an irrigation system and subdivide and rent individual parcels to farmers.  

The place was going to be called “Paradise Acres.” I am not making this up.

Antonyan created a business plan. Step one was to construct a nonlivable structure (think a barn), to be followed by certification with the Department of Agriculture, an irrigation system and construction of an access road.

Forward to 2015 and Antoyan was buying building materials, hiring day laborers and renting equipment to build that barn.

Antoyan and his wife (Safaryan) filed their 2015 tax return and claim approximately $25 thousand in losses from this activity.

The IRS bounced the return.

Their argument?

The business never started.

How did the IRS get there?

Antonyan never accomplished one thing in his business plan by the end of 2015. Mind you, he started constructing the barn, but he had not finished it by year-end. This did not mean that he was not racking-up expenses. It just meant that the expenses were startup costs, to be deducted at that generous $5,00/15-year burn rate starting in the year the business actually started.

The Court wanted to see revenue. Revenue is the gold standard when arguing business startup. There was none, however, placing tremendous pressure on Antonyan to explain how the business had started without tenants or rent – when tenants and rent were the entirety of the business.  Perhaps he could present statements from potential tenants about negotiations with Antonyan – something to persuade the Court.   

He couldn’t.

Meaning he did not start in 2015.

Our case this time was Safaryan v Commissioner, T.C. Memo 2021-138.

Sell Today And Pay Tax in Thirty Years

Sometimes I am amazed to the extent people will go to minimize, defer or avoid taxes altogether.

I get it, though. When that alarm clocks goes off in the morning, there is no government bureaucrat there to prepare your breakfast or drive you to work. Fair share rings trite when yours is the only share visible for miles.

I am looking at an IRS Chief Council Advice.

Think of the Chief Counsel as the attorneys advising the IRS. The Advice would therefore be legal analysis of an IRS position on something.

This one has to do with something called Monetized Installment Sale Transactions.

Lot of syllables there.

Let’s approach this from the ground floor.

What is an installment sale?

This is a tax provision that allows one to sell approved asset types and spread the tax over the years as cash is collected. Say you sell land with the purchase price paid evenly over three calendar years. Land is an approved asset type, and you would pay tax on one-third of your gain in the year of sale, one-third the following year and the final third in the third year.

It doesn’t make the gain go away. It just allows one to de-bunch the taxation on the gain.

Mind you, you have to trust that the buyer can and will pay you for the later years. If you do not trust the buyer’s ability (or intention) to do so, this may not be the technique for you.

What if the buyer pays an attorney the full amount, and that attorney in turn pays you over three years? You have taken the collection risk off the table, as the monies are sitting in an attorney’s escrow account.

You are starting to think like a tax advisor, but the technique will almost certainly not work.

Why?

Well, an easy IRS argument is that the attorney is acting as your agent, and receipt of cash by your agent is the equivalent of you receiving cash. This is the doctrine of “constructive receipt,” and it is one of early (and basic) lessons as one starts his/her tax education.

What if you borrow against the note? You just go down to Fifth Third or Truist Bank, borrow and pledge the note as collateral.

Nice.

Except that Congress thought about this and introduced a “pledging” rule. In short, a pledge of the note is considered constructive receipt on the note itself.

Not to be deterred, interested parties noticed a Chief Council’s Memorandum from 2012 that seemed to give the OK to (at least some of) these transactions. There was a company that need cash and needed it right away. It unloaded farm property in a series of transactions involving special purpose entities, standby letters of credit and other arcane details.

The IRS went through 11 painful pages of analysis, but wouldn’t you know that – at the end – the IRS gave its blessing.

Huh?

The advisors and promoters latched-on and used this Memorandum to structure future installment sale monetization deals.

Here is an example:

(1)  Let’s say I want to sell something.

(2)  Let’s say you want to buy what I am selling.

(3)  There is someone out there (let’s call him Elbert) who is willing to broker our deal – for a fee of course.

(4)  Neither you or I are related to Elbert or give cause to consider him our agent.

(5)  Elbert buys my something and gives me a note. In our example Elbert promises to pay me interest annually and the balance of the note 30 years from now.

(6)  You buy the something from Elbert. Let’s say you pay Elbert in full, either because you have cash in-hand or because you borrow money.

(7)  A bank loans me money. There will be a labyrinth of escrow accounts to maintain kayfabe that I have not borrowed against my note receivable from Elbert.

(8)  At least once a year, the following happens:

a.    I collect interest on my note receivable from Elbert.

b.    I pay interest on my note payable to the bank.

c.    By some miraculous result of modern monetary theory, it is likely that these two amounts will offset.

(9)  I eventually collect on Elbert’s note. This will trigger tax to me, assuming someone remembers what this note is even about 30 years from now.

(10)      Having cash, I repay the bank for the loan it made 30 years earlier.

There is the monetization: reducing to money, preferably without taxation.

How much of the original sales price can I get using this technique?

Maybe 92% or 93% of what you paid Elbert, generally speaking.

Where does the rest of the money go?

Elbert and the bank.

Why would I give up 7 or 8 percent to Elbert and the bank?

To defer my tax for decades.

Do people really do this?

Yep, folks like Kimberly Clark and OfficeMax.

So what was the recent IRS Advice that has us talking about this?

The IRS was revisiting its 2012 Memorandum, the one that advisors have been relying upon. The IRS lowered its horns, noting that folks were reading too much into that Memorandum and that they might want to reconsider their risk exposure.

The IRS pointed out several possible issues, but we will address only one.

The company in that 2012 Memorandum was transacting with farmland.

Guess what asset type is exempt from the “pledging” rule that accelerates income on an installment note?

Farmland.

Seems a critical point, considering that monetization is basically a work-around the pledging prohibition.

Is this a scam or tax shelter?

Not necessarily, but consider the difference between what happened in 2012 and how the promoters are marketing what happened.

Someone was in deep financial straits. They needed cash, they had farmland, and they found a way to get to cash. There was economic reality girding the story.   

Fast forward to today. Someone has a big capital gain. They do not want to pay taxes currently, or perhaps they prefer to delay recognizing the gain until a more tax-favorable political party retakes Congress and the White House. A moving story, true, but not as poignant as the 2012 story.   

For the home gamers, this time we have been discussing CCA 2019103109421213.

Maple Trees, Blueberries and Startup Expenses

It is one of my least favorite issues in tax law. It is not a particularly technical issue; rather, it too often imitates theology and metaphysics:

When does a business begin?

For some businesses, it is straightforward. As a CPA my business starts when I take office space or otherwise offer my services to the public. Other businesses have their rules of thumb:

·        An office building begins business when it obtains a certificate of occupancy from the appropriate municipal government.

·        A restaurant begins (usually) after its soft opening; that is, when it first opens to family, friends, possibly food reviewers and critics - and before opening to the general public.

What can make the issue difficult was a 1980 change in the tax law. It used to be that start-up costs could not be immediately deducted. Rather one had to accumulate and deduct them over a 5-year period.

Unfortunate but not ruinous.

In 1980 the law changed to allow a $5,000 deduction; the balance was to be deducted over a 15-year period.

Can you imagine the potentially fraught and tense conversations between a taxpayer and the tax advisor? Rather than injecting moderate but acceptable pain, Congress introduced dispute between a practitioner and his/her client.

Let’s look at a case involving startup costs.

James Gordon Primus lived in New York and worked as an accountant at a large accounting firm. In 2011 his mother bought 266 acres in southwest Quebec on his behalf. The property contained almost 200 acres of maple trees. The trees were mature enough to produce sap, so I suppose he could start his new business of farming.

But there were details. There are always details.

He wanted to clear the brush, as that would help with production later on. He also wanted to install a collection pipeline, for the obvious reason. He also had plans for blueberry production.

He started thinning the maple brush in 2011, right after acquiring the property.

Good.

In 2012 and 2013 he started clearing for blueberry production. 

He ordered 2,000 blueberry bushes in 2014.

In 2015 he began installing the pipeline and planted the blueberry bushes.

In 2016 he readied the barn.

In 2017 he finally collected and sold maple sap.

Got it: 6 years later.

On 2012 he deducted over $200 grand for the farm.

On 2013 he deducted another $118 grand.

That caught the attention of the IRS. They saw $318 grand of startup expenses. They would spot him $5 grand and amortize the rest over 15 years.

Not a chance argued Primus.

He started clearing in 2011, and clearing is an established farming practice. He was in the trade or business of farming by 2012.

Clearing is an accepted practice, said the Court, but that does not mean that one has gotten past the startup phase. Context in all things.

Primus offered another argument: a business can start before it generates revenues.

That is correct, responded the Court, but lack of revenue does not mean that business has started.

Here is the Court:

Petitioner’s activities during 2012 and 2013 were incurred to prepare the farm and produce sap and plant blueberries. Those are startup expenses under section 195 and may not be deducted under section 162 or 212.”

The taxpayer struck out.

Get this issue wrong and the consequences can be severe.

How would one plan for something like this?

I do not pretend to be an expert in maple farming, but I would pull back to general principles: show revenues. The IRS might dismiss the revenues as inconsequential and not determinative that a startup period has ended, but one has a not-inconsequential argument.

That leads to the next principle: once one has established a trade or business, the expenses of expanding that trade or business (think blueberries in this instance) are generally deductible.

I wonder how this would have gone had Primus tapped and sold sap in 2012. I am thinking limited production but still enough to be business-consequential. Perhaps he could market it as “rare,” “local,” “artisanal” and all the buzz words.

Perhaps he could have followed the next year with another limited production. I am trying to tamp-down an IRS “not determinative” argument.

Would it have made a difference?

Almond Not-Joy

How much do you know about almond trees?

I know they are water-intensive and they come from California. I am uncertain whether they can be used for furniture. I presume they make good firewood.

So what would be a tax angle to this topic?

Growing almond trees.

Which gets us to farm taxation.

Farmers want (usually) to be cash-basis. This means that they report revenue when they receive cash and deduct expenses when they pay cash. It makes for relatively easy accounting, as one can almost get to a tax return from adding together 12 bank statements.

Then there are those issues.

I will give you one:

You buy a tractor-trailer load of seed and fertilizer late in December. Can you deduct it?

The issue here is whether you have incidental or nonincidental supplies. Incidental supplies (think printer paper to an accountant’s office) is deductible when purchased. Nonincidental supplies (think refilling an underground fuel tank of a trucking company) might be deductible only when used and not before.

Spend some big bucks on that fuel and the trucking company is keenly concerned about the answer.

Likewise, spend big bucks on seed and feed and the farmer is also keen on the answer.

Farmers have some nice tax bennies in the Code, and a large one is being able (in many cases) to use the cash basis of accounting. The Code furthermore allows farmers to deduct that year-end seed-and-feed (with some limitations) when purchased.

Nice.

That covers a lot of tax territory for row crops (that is: one growing season).

Let’s go next to orchards. Apples. Pears.

Almonds.

What new issue do we have here?

For one, orchards take years to become productive. There is no crop in the early years.

Is there any difference in the tax treatment?

Yep. It’s a sneaky one, too.

Let us talk about “uniform capitalization.” We have touched on this topic before, but never concerning almond trees. I am pretty sure about that.

The idea here is that the tax Code wants one to capitalize (that is, not immediately deduct) certain costs associated with inventory, self-produced assets any certain other specialized categories.

Almond trees are sort-of, kind-of “self-produced.”

Here is the fearsome tax beast in its canopied jungle home:

26 U.S. Code § 263A - Capitalization and inclusion in inventory costs of certain expenses

            (a) Nondeductibility of certain direct and indirect costs

(1) In general In the case of any property to which this section applies, any costs described in paragraph (2)—

(A) in the case of property which is inventory in the hands of the taxpayer, shall be included in inventory costs, and

(B) in the case of any other property, shall be capitalized.

I would argue that almond trees are “other property” per (a)(1)(B) above.

(2) Allocable costs The costs described in this paragraph with respect to any property are—

(A) the direct costs of such property, and

(B) such property’s proper share of those indirect costs (including taxes) part or all of which are allocable to such property.

Any cost which (but for this subsection) could not be taken into account in computing taxable income for any taxable year shall not be treated as a cost described in this paragraph.

The (B) above worries me. If this applies, then we have to “capitalize” real estate taxes on those trees.

Let’s look further at the definition of “property”:

(b)Property to which section applies Except as otherwise provided in this section, this section shall apply to—

(1) Property produced by taxpayer

Real or tangible personal property produced by the taxpayer.

(2) Property acquired for resale

(A) In general

Real or personal property described in section 1221(a)(1) which is acquired by the taxpayer for resale.

OK, I am getting worried. That (b)(1) sounds a lot like the almond trees. They are being “produced” (I guess) while they are growing and nonproductive.

Is there an out?

Here is something:

            (d)Exception for farming businesses

(1) Section not to apply to certain property

(A)In general This section shall not apply to any of the following which is produced by the taxpayer in a farming business:

(i) Any animal.

(ii) Any plant which has a preproductive period of 2 years or less.

I am zeroing-in on (d)(1)(A)(ii).

What is the growing (“preproductive”) period for almond trees?

Google says more than 2 years.

We are hosed.

We have to capitalize real estate taxes. 

COMMENT: Folks, that means “not deduct.” It gets expensive fast.

You know what else gets pulled-in via the gravitational pull of Sec 263A(a)(2)(B) above?

Interest.

We better not have any bank debt.

Arrggghhh! We have bank debt, meaning we have interest. We are going to have to capitalize that too.

The way this is going the only thing we are going to be able to deduct is the postage for the envelope in which we are sending a big check to the IRS.

We began the discussion by talking about how the cash basis of accounting lets farmers deduct stuff when they pay for them. Then we marched through the Code to find another section that tells us that we cannot deduct what we could deduct only a moment before.

COMMENT: I have heard a common lament over my years in practice: when to stop researching? There is no hard answer, but this case is an example of why tax practitioners fear and ask the question.

Our case this time was Wasco Real Properties I, LLC et al v Commissioner, for the home gamers.

Tax Mulligans and Tennessee Walking Horses

Here is the Court:

While a taxpayer is fee to organize [her] affairs as [she] chooses, nevertheless once having done so, [she] must accept the tax consequences of her choice, whether contemplated or not, and may not enjoy the benefit of some other route [she] might have chosen to follow but did not.”

This is the tax equivalent of “you made your bed, now lie in it.” The IRS reserves the right to challenge how you structure a transaction, but – once decided – you yourself are bound by your decision. 

Let’s talk about Stuller v Commissioner.  They were appealing a District Court decision.

The Stullers lived in Illinois, and they owned several Steak ‘n Shake franchises. Apparently they did relatively well, as they raised Tennessee walking horses. In 1985 they decided to move their horses to warmer climes, so they bought a farm in Tennessee. They entered into an agreement with a horse trainer addressing prize monies, breeding, ownership of foals and so on.

In 1992 they put the horse activity into an S corporation.

They soon needed a larger farm, so they purchased a house and 332 acres (again in Tennessee) for $800,000. They did not put the farm into the S corporation but rather kept it personally and charged the farm rent.

So far this is routine tax planning.

Between 1994 and 2005, the S corporation lost money, except for 1997 when it reported a $1,500 profit. All in all, the Stullers invested around $1.5 million to keep the horse activity afloat.

Let’s brush up on S corporations. The “classic” corporations – like McDonald’s and Pfizer – are “C” corporations. These entities pay tax on their profits, and when they pay what is left over (that is, pay dividends) their shareholders are taxed again.  The government loves C corporations. It is the tax gift that keeps giving and giving.

However C corporations have lost favor among entrepreneurs for the same reason the government loves them. Generally speaking, entrepreneurs are wagering their own money – at least at the start. They are generally of different temperament from the professional managers that run the Fortune 500. Entrepreneurs have increasingly favored S corporations over the C, as the S allows one level of income tax rather than two. In fact, while S corporations file a tax return, they themselves do not pay federal income tax (except in unusual circumstances).  The S corporation income is instead reported by the shareholders, who combine it with their own W-2s and other personal income and then pay tax on their individual tax returns.

Back to the Stullers.

They put in $1.5 million over the years and took a tax deduction for the same $1.5 million.

Somewhere in there this caught the IRS’ attention.

The IRS wanted to know if the farm was a real business or just somebody’s version of collecting coins or baseball cards. The IRS doesn’t care if you have a hobby, but it gets testy when you try to deduct your hobby. The IRS wants your hobby to be paid for with after-tax money.

So the IRS went after the Stullers, arguing that their horse activity was a hobby. An expensive hobby, granted, but still a hobby.

There is a decision grid of sorts that the courts use to determine whether an activity is a business or a hobby. We won’t get into the nitty gritty of it here, other than to point out a few examples:

·        Has the activity ever shown a profit?

·        Is the profit anywhere near the amount of losses from the activity?

·        Have you sought professional advice, especially when the activity starting losing buckets of money?

·        Do you have big bucks somewhere else that benefits from a tax deduction from this activity?

It appears the Stullers were rocking high income, so they probably could use the deduction. Any profit from the activity was negligible, especially considering the cumulative losses. The Court was not amused when they argued that land appreciation might bail-out the activity.

The Court decided the Stullers had a hobby, meaning NO deduction for those losses. This also meant there was a big check going to the IRS.

Do you remember the Tennessee farm?

The Stullers rented the farm to the S corporation. The S corporation would have deducted the rent. The Stullers would have reported rental income. It was a wash.

Until the hobby loss.

The Stullers switched gears and argued that they should not be required to report the rental income. It was not fair. They did not get a deduction for it, so to tax it would be to tax phantom income. The IRS cannot tax phantom income, right?

And with that we have looped back to the Court’s quote from National Alfalfa Dehydrating & Milling Co. at the beginning of this blog.

Uh, yes, the Stullers had to report the rental income.

Why? An S corporation is different from its shareholders. Its income might ultimately be taxed on an individual return, but it is considered a separate tax entity. It can select accounting periods, for example, and choose and change accounting methods. A shareholder cannot override those decisions on his/her personal return. Granted, 99 times out of 100 a shareholder’s return will change if the S corporation itself changes. This however was that one time.

Perhaps had they used a single-member LLC, which the tax Code disregards and considers the same as its member, there might have been a different answer.

But that is not what the Stullers did. They now have to live with the consequences of that decision.