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or contact with the owner for a while; account statements are returned because of an invalid address; phone numbers are no longer active.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.

Deducting a Divorce

I am looking at two points on a case:

(1)  The IRS wanted $1,760,709; and

(2)  The only issue before the Court was a deduction for legal and professional fees.

That is one serious legal bill.

The taxpayer was a hedge fund manager. The firm had three partners who provided investment advisory services to several funds. For this they received 1.5% of assets under management as well as 20% of the profits (that is, the “carry”). The firm decided to defer payment of the investment and performance fees from a particular fund for 2006, 2007 and 2008.

2008 brought us the Great Recession and taxpayer’s spouse filing for divorce.

By 2009 the firm was liquidating.

The divorce was granted in 2011.

Between the date of filing and the date the divorce was granted, taxpayer received over $47 million in partnership distributions from the firm.

You know that point came up during divorce negotiations.

To be fair, not all of the $47 million can be at play. Seems to me the only reachable part would be the amount “accrued” as of the date of divorce filing.

He hired lawyers. He hired a valuation expert.

Turns out that approximately $4.7 million of the $47 million represented deferred compensation and was therefore a marital asset. That put the marital estate at slightly over $15 million.

Upon division, the former spouse received a Florida house and over $6.6 million in cash.

He in turn paid approximately $3 million in professional fees. Seems expensive, but they helped keep over $42 million out of the marital estate.

He deducted the $3 million.

Which the IRS bounced.

What do you think is going on here?

The issue is whether the professional fees are business related (in which case they are deductible) or personal (in which case they are not). Taxpayer argued that the fees were deductible because he was defending a claim against his distributions and deferred compensation from the hedge fund. He was a virtual poster boy for a business purpose.

He has a point.

The IRS fired back: except for her marriage to taxpayer, the spouse would have no claim to the deferred compensation. Her claim stemmed entirely because of her marriage to him. The cause of those professional fees was the marriage, which is about as personal as an event can be. The tax Code does not allow for the deduction of personal expenses.

The IRS has a point.

The tax doctrine the IRS argued is called origin-of-the-claim. It has many permutations, but the point is to identify what caused the mess in the first place. If the cause was business or income-producing, you may have a deduction. If the cause was personal, well, thanks for playing.

But a divorce can have a business component. For example, there is a tax case involving control over a dividend-paying corporation; there is another where the soon-to-be-ex kept interfering in the business. In those cases, the fees were deductible, as there was enough linkage to the business activity.

The Court looked, but it could not find similar linkage in this case.

In the divorce action at issue, petitioner was neither pursuing alimony from Ms [ ] nor resisting an attempt to interfere with his ongoing business activities.

Petitioner has not established that Ms [ ] claim related to the winding down of [the hedge fund]. Nor has petitioner established that the fees he incurred were “ordinary and necessary” to his trade or business.

While the hedge fund fueled the cash flow, the divorce action did not otherwise involve the fund. There was no challenge to his interest in the fund; he was not defending against improper interference in fund operations; there was no showing that her action led to his winding down of the fund.

Finding no business link, the Court determined that the origin of the claim was personal.

Meaning no deduction for the professional fees.

NOTE: While this case did not involve alimony, let us point out that the taxation of alimony is changing in 2019. For many years, alimony – as long as the magic tax words were in the agreement – was deductible by the payor and taxable to the recipient. It has been that way for my entire professional career, but that is changing. Beginning in 2019, only grandfathered alimony agreements will be deductible/taxable, with “grandfathered” meaning the alimony agreement was in place by December 31, 2018.

Mind you, this does not mean that there will be no alimony for new divorces. What it does mean is that one will not get a deduction for paying alimony if one divorces in 2019 or later. Conversely, one will not be taxed upon receiving alimony if one divorces in 2019 or later.

The Congressional committee reports accompanying the tax change noted that alimony is frequently paid from a higher-income to a lower -income taxpayer, resulting in a net loss to the Treasury. Changing the tax treatment would allow the Treasury to claw back to the payor’s higher tax rate. Possible, but I suspect it more likely that alimony payments will eventually decrease by approximately 35% - the maximum federal tax rate – as folks adjust to the new law.

Our case this time was Sky M Lucas v Commissioner.

Do You Have to Disclose That?

I was recently talking with another CPA. He had an issue with an estate income tax return, and he was wondering if a certain deduction was a dead loser. I looked into the issue as much as I could (that busy season thing), and it was not clear to me that the deduction was a loser, much less a dead loser.

He then asked: does he need to disclose if he takes the deduction?

Let’s take a small look into professional tax practice.

There are many areas and times when a tax advisor is not dealing with clear-cut tax law.

Depending upon the particular issue, I as a practitioner have varying levels of responsibility. For some I can take a position if I have a one-in-five (approximately) chance of winning an IRS challenge; for others it is closer to one-in-three.

There are also issues where one has to disclose to the IRS that one took a given position on a return. The concept of one-in-whatever doesn’t apply to these issues. It doesn’t have to be nefarious, however. It may just be a badly drafted Regulation and a taxpayer with enough dollars on the line.

Then there are “those” transactions.

They used to be called tax shelters, but the new term for them is “listed transactions.” There is even a subset of listed transactions that the IRS frowns upon, but not as frowny as listed transactions. Those are called “reportable transactions.”

This is an area of practice that I try to stay away from. I am willing to play aggressive ball, but the game stays within the chalk lines. Making tax law is for the big players – think Apple’s tax department – not for a small CPA firm in Cincinnati.

Staying up on this area is difficult, too. The IRS periodically revises a list of transactions that it is scrutinizing. The IRS then updates its website, and I – as a practitioner – am expected to repeatedly visit said website patiently awaiting said update. Fail to do so and the IRS automatically shifts blame to the practitioner.

No thanks.

I am looking at a case involving a guy who sells onions. His company is an S corporation, which means that he puts the business numbers on his personal return and pays tax on the conglomeration.

His name is Vee.

He got himself into a certain type of employee benefit plan.

A benefit plan provides benefits other than retirement. It could be health, for example, or disability or severance. The tax Code allows a business to prefund (and deduct) these benefits, as long as it follows certain rules. A general concept underlying the rules is risk-taking and cost-sharing – that is, there should be a feel of insurance to the thing.

This is relatively easy to do when you are Toyota or General Mills. Being large certainly makes it easier to work with the law of large numbers.

The rules however are problematic as the business gets smaller. Congress realized this and passed Code Section 419A(f)(6), allowing small employers to join with other small employers – in a minimum group of ten – and obtain tax advantages  otherwise limited to the bigger players.

Then came the promoters peddling these smaller plans. You could offer death and disability benefits to your employees, for example, and shift the risk to an insurance company. A reasonable employer would question the use of life insurance. If the employer needed money to pay benefits, wouldn’t a mutual fund make more sense than an illiquid life insurance policy? Ah, but the life insurance policy allows for inside buildup. You could overfund the policy and have all kinds of cash value. You would just borrow from the cash value – a nontaxable transaction, by the way – to pay the benefits. Isn’t that more efficient than a messy portfolio?

Then there were the games the promoters played to diminish the risk of joining a group with nine others.

Vee got himself into one of these plans.

He funded the thing with life insurance. He later cancelled the plan, keeping the life insurance policy for himself.

The twist on his plan was the use of experience-rated life insurance.

Experience-rated does not pay well with the idea of cost-and-risk sharing. If I am experience rated, then my insurance cost is based on my experience. My insurance company does not look at you or any of the other eight employers in our group. I am not feeling the insurance on this one.

Some of these plans were outrageous. The employer would keep the plan going for a few years, overpay for the insurance, then shut down the plan and pay “value” for the underlying insurance policy. The insurance company would keep the “value” artificially low, so it did not cost the employer much to buy the policy on the way out. Then a year or two later, the cash value would multiply ten, twenty, fifty, who-knows-how-many-fold. This technique was called “springing,” and it was like finding the proverbial pot of gold.

The IRS had previously said that plans similar to Vee’s were listed transactions.

This meant that Vee had to disclose his plan on his tax return.

He did not.

That is an automatic $10,000 penalty. No excuses.

He did it four times, so he was in for $40,000.

He went to Court. His argument was simple: the IRS had not said that his specific plan was one of those abusive plans. The IRS had said “plans similar to,” but what do those words really mean? Do you know what you have forgotten? What is the point of a spice rack? Does anybody really know what time it is?

Yea, the Court felt the same way. The plan was “similar to.” They were having none of it.

He owed $40,000.

He should have disclosed.

Even better, he should have left the whole thing alone.

Getting ROBbed

I was skimming a Tax Court decision that leads with:

“… respondent issued a notice of deficiency … of $249,263.62, additions to tax … of $20,228.76 and $22,476.41, respectively and an enhanced accuracy-related penalty … of $63,918.33”

It was Roth IRA decision.

We have spoken before about putting a business in an IRA, and a Roth is just a type of IRA. This tax structure is sometimes referred to as a “ROBS” – roll-over as business start-up. 

Odds are the only one who is going to get robbed is you. I had earlier looked into and decided that I did not like the ROBS structure. There are too many ways that it can detonate. I do not practice high-wire tax.  

I have also noticed the IRS pursuing this area more aggressively. There often is complacency when a “new” tax idea takes, as the IRS may not respond immediately. That lag is not an imprimatur by the IRS, although self-interested parties may present it as such. I have been in practice long enough to have heard that sales pitch more than once.

Let’s discuss Polowniak v Commissioner.

Polowniak had over 35 years of marketing experience with Fortune 500 companies, including Proctor & Gamble, Johnson & Johnson and Kimberly Services. In 1997 he formed his own company – Solution Strategies, Inc. (Strategies). He was the sole shareholder and its only consultant.

In 2001 he received a nice contract - $680,000 – from Delphi Automotive Systems – which had him travel extensively to Europe, Asia and South America. 

Now the turn. His financial advisor recommended an attorney who pitched the idea of “privately owned Roth IRA corporations,” also known as PIRACs. These things are not rocket science. In most cases an individual already has an existing company, likely profitable or soon to be. Said individual sets up a Roth IRA. Said Roth purchases the stock of a new corporation (NewCo), which amazingly does exactly the same thing that the existing corporation did, and likely with the same customers, vendors, employee, office space and so on.

The idea of course is that NewCo is going to be very profitable, which allows the opportunity to stuff a lot of money into the Roth in a very short period of time.

So Polowniak sets up a NewCo, which he names Bevco Investments, Inc. (Bevco). There is a little flutter in the story as Bevco selects a January year-end, meaning that a sharp tax advisor may have the opportunity to move things back-and-forth between a calendar-year taxpayer and an entity that doesn’t file its tax return until a year later.

This is fairly routine tax work.

Polowniak owned 98 percent and his administrative assistant owned 2 percent.  His wife later purchased 6% of Bevco.

Strategies and Bevco entered into an agreement whereby it would receive 75% of Strategies revenues for 2002.

By the way, Delphi was never informed of Bevco. Neither was the administrative assistant.

The years passed. Polowniak let the subcontract with Bevco lapse.

And he started depositing all the Strategies revenue from Delphi into Bevco. There was no more pretense of 75 percent.

Bevco was finally dissolved in 2006.

And then came the IRS.

It went after Solutions, which did not report the $680,000 from Delhi. You remember, the same amount it was to share 75% with Bevco.

Sheesh.

It also came after Polowniak personally. The IRS wanted penalties for excess funding into a Roth.

Huh?

There are limits for funding a Roth. For example, the 2015 limit for someone age-50-and-over (ahem) is $6,500. If you go over, then there is a 6% penalty. Mind you, the 6% doesn’t sound like much, but it becomes pernicious, as it compounds on itself every year. Tax practitioners refer to this as “cascading,” and the math can be surprising.

How did he overfund?

Simple. He took existing money from Solutions and put it into Bevco. It is the equivalent of you depositing money at Key Bank rather than Fifth Third.

Polowniak’s job right now was to convince the Court that was a substantive reason for the Solutions –Bevco structure. If Bevco was just an alter ego, he was going to lose and lose big.

He trotted put Hellweg, a tax case featuring Roth IRAs and Domestic International Sales Corporations (DISCs). Whereas the taxpayer won that case, there was some arcane tax reasoning behind it, likely exacerbated by those DISCs.

The Court did not think Hellweg was on point. It thought that Repetto was much more applicable, pointing out:

·        All the services performed by Bevco had previously been performed by Polowniak through Strategies

·        Polowniak performed all the services under the contract with Delphi

·        Since he was the only person performing services, the transfer of payments between Strategies and Bevco had no substantive effect on the Delphi contract

·        Delphi did not know of the contract with Bevco; in fact, neither did the administrative assistant

·        The business dealing between Strategies and Bevco were not business-normative. For example, Bevco never kept time or accounting records of its services, nor did it ever invoice Strategies.

The Court decided against Polowniak. It did not respect the PIRAC, and as far as it was concerned all the Delphi money put into Bevco was an overfunding.

And that is how you blow through a third of a million dollars.

Is there something Polowniak could have done?

He could of course have respected business norms and treated both as separate companies with their own accounting systems, phone numbers, contracts and so forth. It would have helped had Strategies not been depositing and withdrawing monies from Bevco’s bank account.

Still, I do not think that would have been enough.

There are two major problems that I see:

(1) There was an existing contract in place with Delphi. This is not the same as starting Bevco and pounding the streets for work. There is a very strong assignment of income feel, and I suspect just about any Court would have been disquieted by it.

(2) There were not enough players on the field. If I own a company with 75 employees, I may be able to take a slice of its various activities and place it inside a PIRAC or ROBS or whatever, without the thing being seen as my alter ego. Polowniak however was a one-man show. This made it much easier for the IRS to argue substance over form, which the IRS successfully argued here.

 

My advice? Leave these things alone. There are a hundred ways that these IRA-owned companies can blow up, and the IRS has sounded the trumpet that it is pursuing them.