Amending Your Way Into A Penalty

I have a set of tax returns in my office for someone who dropped off the tax grid for years. I suspect we will be fighting penalties and requesting a payment plan in the too-near future.

It reminded me of why not filing returns is a bad idea.

Here’s one: she has refunds she cannot use because the statute period has expired.

She could have used the refunds, as she has other years with tax due.

There is another reason.

Let’s say that you file a return, but you file it late. For example, you extend the return to October, but you don’t get around to filing until the following January or February. You have a refund so you do not care.

Many tax professionals would agree with you. Penalties apply on tax due. If there is no tax due, then – voila – no penalty (generally speaking).

But you later amend the return. Or the IRS adjusts the return for you. However it happened, you now owe tax.

Consider this:

          § 6651 Failure to file tax return or to pay tax

(a)  Addition to the tax.

In case of failure-

(1)    to file any return required under authority […]on the date prescribed therefor (determined with regard to any extension of time for filing), unless it is shown that such failure is due to reasonable cause and not due to willful neglect, there shall be added to the amount required to be shown as tax on such return 5 percent of the amount of such tax if the failure is for not more than 1 month, with an additional 5 percent for each additional month or fraction thereof during which such failure continues, not exceeding 25 percent in the aggregate;

This is called the “late filing” penalty.

I am looking at a tax case from 1998. Greg Vinikoor (GK) married Melissa Vinikoor (MV). Best I can figure, her dad must have been loaded, as he was repeatedly transferring shares of stock to the newlyweds. GK graduated from college and took a job making $12 grand a year. They got everything out of that $12 grand, including:

·      trips to Hawaii, San Diego, Scottsdale and San Francisco

·      shopping trips to Saks Fifth Avenue, Neiman Marcus and Nordstrum

·      membership at the Tucson Country Club

We both know that they were not paying for this on that $12,000 salary. They were either borrowing against or selling stock that dad had transferred.

The IRS wanted to know why they were not reporting stock gains on their tax returns. There had been quite the run-up in value since dad had acquired the stock. In the case of a gift, dad’s low basis in the stock would carryover to the couple. Since gain = price – basis, that low basis meant a juicy gain, and the IRS wanted its cut.

Good question.

Uhhh…. Because we bought the stock from dad, they answered. Yeah, that’s it. We have a new – and higher! - basis because we bought the stock. We bought it on loan, and we have to pay dad back.

Fine, said the IRS. Show us the loan agreement.

Don’t have one, they replied.

Show us where you paid interest to dad.

We haven’t – not yet, they responded.

Is there a fixed repayment date?

Just an understanding, they susurrated.

How about security? Did you give any collateral for the loan?

No, not really, they murmured.

The Court was zero impressed.

After the stock rose, XXX [dad], the supposed creditor in these transactions never made any demand on petitioners for repayment, even though the value of the stock had increased substantially and petitioners were diminishing the stock with spendthrift habits.”

The Court decided this was a gift. There was gain, there was tax.

Guess who failed to file their tax return on time?

Yep, the Vinikoors.

Now they had penalties.

More specifically, that 25% penalty we talked about. It totaled over $38 grand.

And there is the trap. That late filing can haunt and hurt you if you later amend or the IRS adjusts the return to increase income. That penalty goes to back when, not the date you amended or the IRS adjusted.

File those returns on time, folks. Amend later if you do not have all the information, but at least you got the horse over the wire on time.

Our case this time – as you may have guessed – was Vinikoor v Commissioner.

Remember The Port

One thing about this blog is that it likely reflects what’s happening here at Intergalactic Command.

Here goes: it is unlikely that you will need an extensive and expensive estate tax plan, unless you (a) have unique family issues, such as a special needs child, or (b) have a tractor-trailer load of money.

Pass away in 2018 and you will not have a federal estate tax until you get to $11.2 million.

OBSERVATION: This amount increased under the new tax bill.

Folks, that excludes almost everybody.

I suppose you could live in a state with a state estate tax, like Illinois. If you do, here is some tax advice: move.

So how do you get into the federal estate tax?

It is easy enough in concept.  

Here goes:

                          Net FMV of assets you die with

                                           Plus

                    Reportable gifts made over your lifetime

BTW, notice that assets you die with and assets you gifted away are added together. The IRS is going to tax you whether you kept stuff or gave it away. The nerd term for this is “unified” tax.

There are tricks and traps to “assets you die with,” but, for the most part, it means what it says. The “net” means you get to deduct your liabilities from your assets. The “FMV” means fair market value. Take a car for example. You might get its FMV from Kelly Blue Book.

What does “reportable gifts” mean?

Let walk around the block on this. Let’s say you made a gift to a family member in 2017. Do you have to report it?

Depends on the amount. For 2017 the annual gift tax exclusion was $14,000. This means that you could gift anyone on the planet $14,000 and the government did not need to know. If you were married, then your spouse and you could double-up, meaning that together you could gift $28,000 without the government needing to know.

Let’s say that you are single. You gifted someone $50,000 in 2017. What have you got?

Easy enough: $50,000 – 14,000 = $36,000 is reportable. Yep, you went over the limit. You have to file a gift tax return.

Mind you, it is very unlikely that you will have any gift tax due on that return.

Why not?

Let’s circle back to the formula:

                             

                          Net FMV of assets you die with

                                           Plus

                    Reportable gifts made over your lifetime

You haven’t died yet, so the first line is zero.

But you still have the second line.

Remember that you can die in 2018 with $11.2 million and not be taxed.

Folks, if someone has gifted over $11.2 million (mind you, this is over a lifetime), please call or e-mail me. I want to get into that person’s will – I mean, I want to develop a lifelong friendship with a kindred soul.  

What if you fudge the numbers? You know, play down the gifts a bit? Who will know once you are gone, right?

If you are married, there could be a hitch with this.

Let’s take a look at the Estate of Sower case.

Frank Sower passed away in 2012, leaving Minnie as his surviving spouse. He filed an estate tax return, and it showed an unused estate tax exclusion of $1,250,000.         

COMMENT: Beginning in 2010, any unused estate tax exclusion of the first-to-die spouse could carryover to the surviving spouse. For example, the exclusion for 2011 was $5 million. Let’s say that the first-to-die had a taxable estate of $3.6 million. The balance - $1.4 million – could transfer to the surviving spouse.

This was a big improvement in tax practice. Previously tax professionals used trusts – “family” trusts and “marital” trusts, for example - to make sure that estate tax exclusions did not go squandered. One can still use trusts if one wants, but it is not as mandatory as it used to be. The transfer of the unused exclusion to the surviving spouse is called “portability” (“port” to the nerds) and it required (and still requires) the first-to-die to file a federal estate tax return, whether otherwise required, if only to alert the IRS that some of the exclusion is being ported.

There was however a problem with Frank’s estate return: the preparer left out $940,000 of reportable gifts. That in turn meant that the unused exclusion was overstated, as those unreported gifts would have soaked up a chunk of it.

Minnie died in 2013. Her estate showed the unused exemption ported from Frank. It was wrong, but it was there. The same tax preparer must have done her estate return, as once again her reportable gifts were left off.

The IRS audited her estate return and caught the mistake. They wondered whether Frank’s return had the same issue. It did, of course, so the IRS adjusted Frank’s ported exemption.

When the dust settled, Minnie’s estate owed another $788,165.

Ouch. Folks, the estate tax has one of the highest rates in the Code. A lot of effort goes into minimizing this thing. At least Congress has gotten away from having  taxable estates begin at $600,000, as it did in the nineties. Average folk did not consider $600,000 to be “wealthy,” no matter what Congress and the grievance mongers said.

The estate litigated. They argued that the Frank’s estate had a closing letter (think magical letter, but the estate’s letter was non-magical); that the adjustment to the port was an impermissible second review of Frank’s return; that the IRS position improperly overrode the statute of limitations, and so on. The estate lost on all counts.

What do we learn from Sower?

         

(1) It is OK to port.

(2) But the IRS can adjust the port if you get it wrong.

What did we learn from this post?

Remember the port.

Ducking Taxes With A Dynasty Trust

Dynasty trust are back in the news. Dynasty trusts are the province of the ultrawealthy, and are not likely to impact you or me much.

However, allow one or two favorable turns of fate and you or I might find ourselves interested in such things. Let’s hope for the best.

What sets up the discussion is three main issues:

(1)  Estate taxes

(2)  Generation-skipping taxes

(3)  The rule against perpetuities

Estate taxes are also called death taxes and apply to your net worth (everything you own less everything you owe) at death. If you own too much, you owe estate tax – short and sweet. Granted, it is getting harder and harder too own too much. The threshold for 2017 is $5.49 million per person, or almost $11 million per married couple.

I would say that – if you have accumulated $11 million – you have done well.

The estate tax intends for every generation to pay tax.

Let’s say that you are worth $15 million. The estate tax will apply. Your assets go to your child. Let’s presume that the assets inherited bounce back to $15 million (remember: there were taxes at your death) and the exemption remains at $5.49 million. The estate tax presumes that your child will pay tax again, repeating a virtuous cycle.

Well, an advisor can break that cycle pretty quickly: have some of the assets go to the grandkids. That skips the estate tax on (at least some of) the assets upon your child’s death.

Congress figured this out too and introduced the generation-skipping tax (GST). Its purpose was straightforward: to tax the assets that skipped tax when your child died. Those assets would otherwise have “skipped” a generation of estate tax.

A favored and common way to transfer assets across multiple generations is through use of a trust. There are more varieties of trusts than there are flavors of  Baskin Robbins ice cream. We however are looking at one trust and one only: the shy and elusive dynasty trust, which has rarely been captured on camera.

Tax archeologists believe that the dynasty trust evolved in response to state liberalization of the rule against perpetuities. Trusts themselves are created under state law, and all 50 states used to prohibit a trust from existing more than 21 years after the death of the last beneficiary who was alive when the trust was created.

To rephrase: the law (1) looked at the beneficiaries born when the trust was created; (2) took the youngest beneficiary; (3) waited until his/her death; and (4) said “All right, boys and girls, you have 21 years to finish this”

The point is that the trust had to eventually wrap up its affairs. It could not be “perpetual.”

In that context, the estate tax – GST tax value meal worked relatively well in identifying and taxing transfers of intergeneration wealth. No matter how complex, trusts simply had to give up the ghost eventually.

However, several states have since either modified or abolished their rule against perpetuities (Alaska and Nevada come to mind). A trust created in one of these jurisdictions can last for … who knows how long.

This has tax implications.

Because the trust is not required to terminate, tax planners can more easily get around the estate and GST combo that worked well enough in an earlier, simpler era.

It is relatively easy to avoid the estate tax issue: the planner simply does not give the beneficiary so much authority that the trust would be pulled into the beneficiary’s estate at death. While a minefield, it is a relatively well-trod minefield.

The GST is a bit more complicated.

I now go where many tax nerds would refuse to go: to give a quick overview of how a dynasty trust and the GST interact. We are venturing to the Mordor of tax practice.

Here goes:

(1)  You have a GST exemption equal to your estate tax exemption. Therefore, if the estate exemption is $5.49 million, your GST exemption is the same amount.

(2)  Meaning you can transfer $5.49 million across as many generations as you like without triggering the GST.

(3)  Rule (2) is not interpreted the way you expect when using a trust.

a.     One would think that trust distributions over $5.49 million to a skip beneficiary would trigger the GST tax.

b.    But not necessarily. The planner instead applies the $5.49 million test at a different point in time. Instead of waiting until the trust actually writes checks to a grandkid or great-grandkid decades from now (that is, the distribution date), the planner measures at the moment the settlor puts money into the trust.

c.     Here is an example. Say your great-grandkid is 15 months old, and you put $5.49 million into a dynasty trust. You next burn your $5.49 million GST exemption on the trust.

d.    We calculate a ratio: GST Exemption Used/Total Gift. Let’s give the ratio a name. We will call it “Jackson.” In our example, Jackson is $5.49 million/$5.49 million or “1.0.”  

e.    We next calculate a second ratio: 1.0 – Jackson. We will call this the “inclusion ratio.” Our inclusion ratio is 1.0 – 1.0 or zero (-0-).

f.      Tax nirvana is an inclusion ratio of zero (-0-).

                                                              i.     The magic to an inclusion ration of zero (-0-) is that future distributions from this trust are exempt from any more GST. That happens because you are multiplying [it doesn’t matter the number] by zero.

                                                            ii.     If the inclusion ratio was 45%, then 45% of future distributions from the trust would be subject to GST.

g.     To press the point, if the trust is worth a quantazillion dollars decades from now but has an inclusion ratio of zero (-0-), it is still exempt from GST.

                                                              i.     There are of course ways to ruin this outcome. One way is to put more money into the trust. The result would be to increase the denominator with no increase in the numerator. The resulting inclusion ratio would not be zero. A tax planner would tell you to NOT DO THAT.

To recap, the change in some states concerning the rule against perpetuities allowed planners to devise near-immortal trusts.

And the estate, gift and GST exemptions have been increasing every year and are now at $5.49 million per person. A married couple can of course double that.

Take the near-immortal trusts, stir in the big-bucks exemption, add a few spices (like family limited partnerships or remainder annuities) and you have a very nice tax tool for keeping wealth within the family across generations.

Marty McFly and Future Interests In A Trust

Let’s talk about gift taxes.

Someone: What is an annual gift tax exclusion?

Me: The tax law allows you to gift any person on the planet up to $14,000 a year for any reason without having to report the gift to the IRS. If you are married, your spouse can do the same – meaning you can team-up and gift up to $28,000 to anybody.

Someone: What if you go over $14,000 per person?

Me: It is not as bad as it used to be. The reason starts with the estate tax, meaning that you die with “too many” assets. This used to be more of an issue a few years back, but the exclusion is now north of $5.4 million. There are very few who die with more than $5.4 million, so the estate tax is not likely to impact ordinary people.

Someone: What does the gift tax have to do with this $5 million?

Me: Congress and the IRS saw gifting as the flip side of the coin to the estate tax, so the two are combined when calculating the $5.4 million. Standard tax planning is to gift assets while alive. You may as well (if you can) because you are otherwise going to be taxed at death. Gifting while alive at least saves you tax on any further appreciation of the asset.

Someone: Meaning what?

Me: You will not owe tax until your gifts while alive plus your assets at death exceed $5.4 million.

Someone losing interest: What are we talking about again?

Me: Riddle me this, Batman: you transfer a gaztrillion dollars to your irrevocable trust. It has 100 beneficiaries. Do you get to automatically exclude $1,400,000 ($14,000 times 100 beneficiaries) as your annual gift tax exclusion?

Someone yawning: Why are we talking about this?

Me: Well, because it landed on my desk.

Someone: Do you make friends easily?

Me: Look at what I do for a living. I should post warnings so that others do not follow.

Someone looking around: How about hobbies? Do you need to go home to watch a game or anything?

Me: There is a tax concept that becomes important when gifting to a trust. A transfer has to be a “present interest” to qualify for that $14,000 annual exclusion.

Someone resigned: And a “present interest” is?

Me: Think cash. You can take it, frame it, spend it, make it rain. You can fold it into a big wad, wrap a hundred-dollar bill around it and pull the wad out every occasion you can.

Someone: What is wrong with you?

Me: Maybe it’s just me that would do that.

Me: I tell you what a “present interest” is not: cash in a trust that can only be paid to you when some big, bad, mean trustee decides to pay. You cannot party this weekend with that. You may get cash, but only someday … and in the future.

Someone: Hence the “future?”

Me: Exactly, Marty McFly.

Someone surprised: Hey, there’s no need ….

Me: Have you ever heard of a Crummey power?

Someone scowling: Good name for it. Fits the conversation.

Me: That is the key to getting a gift to a trust to qualify as a present interest.

Someone humoring: What makes it crummy?

Me: Crummey. That’s the name of the guy who took the case to court. Like a disease, the technique got named after him.

Someone looking at watch: I would consider a disease right about now.

Me: The idea is that you give the trust beneficiary the right to withdraw the gift, or at least as much of the gift as qualifies for the annual exclusion. You also put a time limit on it – usually 30 days. That means – at least hypothetically – that the beneficiary can get his/her hands on the $14 grand, making it a present interest.

Someone: I stopped being interested ….

Me: Have you heard of a “in terrorem” provision?

Someone: Sounds terrifying.

Me: Yea, it’s a great name, isn’t it? The idea is that – if you behave like a jerk – the trustee can just cut you out. Hence the “terror.”

Someone: I cannot see a movie coming out of this.

Me: Let’s wait and see what Ben Affleck can do with it.

Me: I was looking at a case called Mikel, where the IRS said that the “in terrorem” provision was so strong that it overpowered the Crummey power. That meant that there was no present interest.

Someone: Can you speed this up?

Me: The transfer to the trust was over $3.2 million ….

Someone: I wish I could meet these people.

Me: The trust also had around 60 beneficiaries.

Someone: 60 kids? Who is this guy – Mick Jagger?

Me: Nah, his name is Mikel.

Someone: I was being sarcastic.

Me: Mikel was Jewish, and he put a provision in the trust that beneficiary challenges to a trustee’s decision would go to a panel of 3 persons of Orthodox Jewish faith, called a beth din.

Me: I suppose if the beth din sides with the trustees, the beneficiary could go to state court, but then the in terorrem provision would kick-in. The beneficiary would lose all rights to the trust.

Someone: So some rich person gets cut-off at the knees. Who cares?

Me: The IRS said that the in terrorem provision was strong enough to make the gift a future interest rather than a present interest. That meant there was no $14,000 annual exclusion per beneficiary. Remember that there were around 60 beneficiaries, so the IRS was after taxes on about $800 grand. Not a bad payday for the tax man.

Someone: Sounds like they can afford it.

Me: No, no. The Court disagreed with the IRS. The taxpayer won.

Someone backing away: What was the court’s hesitation?

Me: The Court felt the IRS was making too many assumptions. If the beneficiaries disagreed with the trustees, they could go to the beth din. The beth din did not trigger the in terrorem. The beneficiaries would have to go to court to trigger the in terrorem. The Court said there was no reason to believe the beth din would not decide appropriately, so it was unwilling to assume that the beneficiaries were automatically bound for state court, thereby triggering the in terrorem provision.

Someone leaving: Later Doc.

An Extreme Way To Deduct Expenses Twice

The estate tax is different from the income tax.

The latter is assessed on your income. This puts stress in defining what is income from what is not, but such is the concept.

The estate tax on assessed on what you own when you die, which is why it is also referred to as the “death” tax. If you try to give away your assets to avoid the death tax, the gift tax will step in and probably put you back in the same spot.

Granted, a tax is a tax, meaning that someone is taking your money. To a great extent, the estate tax and income tax stay out of each other’s way.

With some exceptions.

And a recent case reminds us of unexpected outcomes when these two taxes intersect.

Let’s set it up.

You may recall that – upon death – one’s assets pass to one’s beneficiaries at fair market value (FMV). This is also called the “step up,” as the deceased’s cost or basis in the asset goes away and you (as beneficiary) can use FMV as your new “basis” in the asset. There are reasons for this:

(1) The deceased already paid tax on the income used to buy the asset in the first place.

(2) The deceased is paying tax again for having died with “too many” assets, with the government deciding the definition of “too many.” It wasn’t that long ago that the government thought $600,000 was too much. Think about that for a moment.

(3) To continue using the decedent’s back-in-time cost as the beneficiary’s basis is to repetitively tax the same money. To camouflage this by saying that income tax is different from estate tax is farcical: tax is tax.

I personally have one more reason:

(4) Sometimes cost information does not exist, as that knowledge went to the grave with the deceased. Decades go by; no one knows when or how the deceased acquired the asset; government and other records are not updated or transferred to new archive platforms which allow one to research. The politics of envy does not replace the fact that sometimes simply one cannot come up with this number.

Mr. Backemeyer was a farmer. In 2010 he purchased seed, chemicals, fertilizer and fuel and deducted them on his 2010 joint return.

COMMENT: Farmers have some unique tax goodies in the Code. For example, a farmer is allowed to deduct the above expenses, even if he/she buys them at the end of the year with the intent to use them the following year. This is a loosening of the “nonincidental supplies” rule, which generally holds up the tax deduction until one actually uses the supplies.

So Mr. Backemeyer deducted the above. They totaled approximately $235,000.

He died in March, 2011.

Let’s go to our estate tax rule:

His beneficiary (his wife) receives a new basis in the supplies. That basis is fair market value at Mr. Backemeyer’s date of death ($235,000).

What does that mean?

Mr. Backemeyer deducted his year-end farming supplies in 2010. In tax-speak,” his basis was zero (-0-), because he deducted the cost in 2010. Generally speaking, once you deduct something your basis in said something is zero.

Go on.

His basis in the farming supplies was zero. Her basis in the farming supplies was $235,000. Now witness the power of this fully armed and operational step-up.

Is that a Rogue One allusion?

No, it is Return of the Jedi. Shheeessh.

Anyway, with her new basis, Mrs. Backemeyer deducted the same $235,000 again on her 2011 income tax return.

No way. There has to be a rule.

          That is what the IRS thought.

There is a doctrine in the tax Code called “economic benefit.” What sets it up is that you deduct something – say your state taxes. In a later year, you get repaid some of the money that you deducted – say a tax refund. The IRS takes the position – understandably – that some of that refund is income. The amount of income is equal to a corresponding portion of the deduction from the previous year. You received an economic benefit by deducting, and now you have to repay that benefit.

It is a great argument, except for one thing. What happened in Backemeyer was not an income tax deduction bouncing back. No, what set it up was an estate tax bouncing back on an income tax return in a subsequent year.

COMMENT: She received a new basis pursuant to estate tax rules. While there was an income tax consequence, its origin was not in the income tax.

The Court reminded the IRS of this distinction. The economic benefit concept was not designed to stretch that far. The Court explained it as follows:

(1) He deducted something in 2010.

(2) She deducted the same something in 2011.

(3) Had he died in 2010, would the two have cancelled each other out?

To which the Court said no. If he had died in 2010, he would have deducted the supplies; the estate tax rule would have kicked-in; her basis would have reset to FMV; and she could have deducted the supplies again.

It is a crazy answer but the right answer.

Is it a loophole? 

Some loophole. I do not consider tax planning that involves dying to be a likely candidate for abuse. 

Worst. Tax. Advice. Ever.

Dad owned a tool and die company. Son-in-law worked there. The company was facing severe foreign competition, and - sure enough - in time the company closed. For a couple of years the son-in-law was considerably underpaid, and dad wanted to make it up to him.

The company's accountant had dad infuse capital into the business. The accountant even recommended that the money be kept in a separate bank account. Son-in-law was allowed to tap into that account near-weekly to supplement his W-2. The accountant reasoned that - since the money came from dad - the transaction represented a gift from dad to son-in-law.

Let's go through the tax give-and-take on this.

In general, corporations do not make gifts. Now, do not misunderstand me: corporations can make donations but almost never a gift. Gifts are different from donations. Donations are deductible (within limits) by the payor and can be tax-free to the payee, if the payee has obtained that coveted 501(c)(3) status. Donations stay within the income tax system.

Gifts leave the income tax system, although they may be subject to a separate gift tax. Corporations, by the way, do not pay gift taxes, so the idea of a gift by a corporation does not make tax sense.

The classic gift case is Duberstein, where the Supreme Court decided that a gift must be made under a "detached and disinterested generosity" or "out of affection, respect, admiration, charity or like impulses." The key factor the Court was looking for is intent.

And it has been generally held that corporations do not have that "detached and disinterested" intent that Duberstein wants.  Albeit comprised of individuals, corporations are separate legal entities, created and existing under state law for a profit-seeking purpose. Within that context, it becomes quite difficult to argue that corporations can be "detached and disinterested."

It similarly is the reason - for example - that almost every job-related benefit will be taxable to an employee - unless the benefit can fit under narrow exceptions for nontaxable fringes or awards. If I give an employee a $50 Christmas debit card, I must include it in his/her W-2. The IRS sees an employer, an employee and very little chance that a $50 debit card would be for any reason other than that employment relationship.   

What did the accountant advise?

Make a cash payment to the son-in-law from corporate funds.

But the monies came from dad, you say.

It does not matter. The money lost its "dad-stamp" when it went into the business.

What about the separate bank account?

You mean that separate account titled in the company's name?

It certainly did not help that the son-in-law was undercompensated. The tax Code already wants to say that all payments to employees are a reward for past service or an incentive for future effort. Throw in an undercompensated employee and there is no hope.

The case is Hajek and the taxpayer lost. The son-in-law had compensation, although I suppose the corporation would have an offsetting tax deduction. However, remember that compensation requires FICA and income tax withholding - and no withholdings on the separate funds were remitted to the IRS - and you can see this story quickly going south. Payroll penalties are some of the worst in the tax Code.

What should the advisor have done?

Simple: have dad write the check to son-in-law. Leave the company out of it.