Sonny Corleone’s IRA

I remember him as Sonny Corleone in The Godfather. He is James Caan, and he passed away in July 2022.

I am reading a Tax Court case involving his (more correctly: his estate’s) IRA.

There is a hedge fund involved.

For the most part, we are comfortable with “traditional” investments: money markets, CDs, stocks, bonds, mutual funds holding stocks and bonds and the mutual fund’s updated sibling: an ETF holding stocks and bonds.

Well, there are also nontraditional investments: gold, real estate, cryptocurrency, private equity, hedge funds. I get it: one is seeking additional diversification, low correlation to existing investments, enhanced protection against inflation and so forth.

For the most part, I consider nontraditional investments as more appropriate for wealthier individuals. Most people I know have not accumulated sufficient wealth to need nontraditional assets.

There are also tax traps with nontraditional assets in an IRA. We’ve talked before about gold. This time let’s talk about hedge funds.

James Caan had his cousin (Paul Caan) manage two IRAs at Credit Suisse. Paul wanted to take his career in a different direction, and he transferred management of the IRAs to Michael Margiotta. Margiotta left Credit Suisse in 2004, eventually winding up at UBS.

The wealthy are not like us. Caan, for example, utilized Philpott, Bills, Stoll and Meeks (PBSM) as his business manager. PBSM would:

·       Receive all Caan’s mail

·       Pay his bills

·       Send correspondence

·       Prepare his tax returns

·       Act as liaison with his financial advisors, attorneys, and accountants

I wish.

Caan had 2 IRAs at UBS. One was a regular, traditional, Mayberry-style IRA.

The second one owned a hedge fund.

The tax Code requires the IRA trustee or custodian to file reports every year. You probably have seen them: how much you contributed over the last year, or the balance in the IRA at year-end. Innocuous enough, except possibly for that year-end thing. Think nontraditional asset. How do you put a value on it? It depends, I suppose. It is easy enough to look up the price of gold. What if the asset is trickier: undeveloped land outside Huntsville, Alabama – or a hedge fund?

UBS had Caan sign an agreement for the IRA and its hedge fund.

The Client must furnish to the Custodian in writing the fair market value of each Investment annually by the 15th day of each January, valued as of the preceding December 31st, and within twenty days of any other written request from the Custodian, valued as of the date specified in such request. The Client acknowledges, understands and agrees that a statement that the fair market value is undeterminable, or that cost basis should be used is not acceptable and the Client agrees that the fair market value furnished to the Custodian will be obtained from the issuer of the Investment (which includes the general partner or managing member thereof). The Client acknowledges, understands and agrees that if the issuer is unable or unwilling to provide a fair market value, the Client shall obtain the fair market value from an independent, qualified appraiser and the valuation shall be furnished on the letterhead of the person providing the valuation.

Got it. You have to provide a number by January 15 following year-end. If it is a hassle, you have to obtain (and you pay for) an appraisal.

What if you don’t?

The Client acknowledges, understands and agrees that the Custodian shall rely upon the Client’s continuing attention, and timely performance, of this responsibility. The Client acknowledges, understands and agrees that if the Custodian does not receive a fair market value as of the preceding December 31, the Custodian shall distribute the Investment to the Client and issue an IRS Form 1099–R for the last available value of the Investment.

Isn’t that a peach? Hassle UBS and they will distribute the IRA and send you a 1099-R. Unless that IRA is rolled over correctly, that “distribution” is going to cost you “taxes.”

Let’s start the calendar.

March 2015		UBS contacted the hedge fund for a value.
June 2015		Margiotta left UBS for Merrill Lynch.
August 2015		Striking out, UBS contacted PBSM for a value.
October 2015		Hearing nothing, UBS sent PBSM a letter saying UBS was going to resign as IRA custodian in November.
October 2015		Margiotta had Caan sign paperwork to transfer the IRAs from UBS to Merrill Lynch.
		There was a problem: all the assets were transferred except for the hedge fund.
December 2015		UBS sent PBSM a letter saying that it had distributed the hedge fund to Caan.
January 2016		UBS sent a 1099-R.
March 2016		Caan’s accountant at PBSM sent an e-mail to Merrill Lynch asking why the hedge fund still showed UBS as custodian.
December 2016		Margiotta requested the hedge fund liquidate the investment and send the cash to Merrill Lynch.
November 2017		The IRS sent the computer matching letter wanting tax on the IRA distribution. How did the IRS know about it? Because UBS sent that 1099-R.

The IRS wanted taxes of almost $780 grand, with penalties over $155 grand.

That caught everyone’s attention.

July 2018

Caan requested a private letter ruling from the IRS.

Caan wanted mitigation from an IRA rollover that went awry. This would be a moment for PBSM (or Merrill) to throw itself under the bus: taxpayer relied on us as experts to execute the transaction and was materially injured by our error or negligence….

That is not wanted they requested, though. They requested a waiver of the 60-day requirement for rollover of an IRA distribution.

I get it: accept that UBS correctly issued a 1099 for the distribution but argue that fairness required additional time to transfer the money to Merrill Lynch.

There is a gigantic technical issue, though.

Before that, I have a question: where was PBSM during this timeline? Caan was paying them to open and respond to his mail, including hiring and coordinating experts as needed. Somebody did a lousy job.

The Court wondered the same thing.

Both Margiotta and the PBSM accountant argued they never saw the letters from UBS until litigation started. Neither had known about UBS making a distribution.

Here is the Court:

            We do not find that portion of either witness’ testimony credible.

Explain, please.

We find it highly unlikely that PBSM received all mail from UBS— statements, the Form 1099–R, and other correspondence—except for the key letters (which were addressed to PBSM). Additionally, the March 2016 email between Ms. Cohn and Mr. Margiotta suggests that both of them knew of UBS’s representations that it had distributed the P&A Interest. It seems far more likely that there was simply a lack of communication and coordination between the professionals overseeing Mr. Caan’s affairs, especially given the timing of UBS’s letters, Mr. Margiotta’s move from UBS to Merrill Lynch, and the emails between Mr. Margiotta and Ms. Cohn. If all parties believed that UBS was still the P&A Interest’s custodian, why did no one follow up with UBS when it ceased to mail account statements for the IRAs? And why, if everyone was indeed blindsided by the Form 1099–R, did no one promptly follow up with UBS regarding it? (That followup did not occur until after the IRS issued its Form CP2000.) The Estate has offered no satisfactory explanation to fill these holes in its theory.

I agree with the Court.

I think that PBSM and/or Merrill Lynch should have thrown themselves under the bus.

But I would probably still have lost. Why? Look at this word salad:

        408(d) Tax treatment of distributions.

         (3)  Rollover contribution.

An amount is described in this paragraph as a rollover contribution if it meets the requirements of subparagraphs (A) and (B).

(A)  In general. Paragraph (1) does not apply to any amount paid or distributed out of an individual retirement account or individual retirement annuity to the individual for whose benefit the account or annuity is maintained if-

(i)  the entire amount received (including money and any other property) is paid into an individual retirement account or individual retirement annuity (other than an endowment contract) for the benefit of such individual not later than the 60th day after the day on which he receives the payment or distribution; or

(ii)  the entire amount received (including money and any other property) is paid into an eligible retirement plan for the benefit of such individual not later than the 60th day after the date on which the payment or distribution is received, except that the maximum amount which may be paid into such plan may not exceed the portion of the amount received which is includible in gross income (determined without regard to this paragraph).

I highlighted the phrase “including money and any other property.” There is a case (Lemishow) that read a “same property” requirement into that phrase.

What does that mean in non-gibberish?

It means that if you took cash and property out of UBS, then the same cash and property must go into Merrill Lynch.

Isn’t that what happened?

No.

What came out of UBS?

Well, one thing was that hedge fund that caused this ruckus. UBS said it distributed the hedge fund to Caan. They even issued him a 1099-R for it.

What went into Merrill Lynch?

Margiotta requested the hedge fund sell the investment and send the cash to Merrill Lynch.

Cash went into Merrill Lynch.

What went out was not the same as what went in.

Caan (his estate, actually) was taxable on the hedge fund coming out of the UBS IRA.

Dumb. Unnecessary. Expensive.

Our case this time was Estate of James E. Caan v Commissioner, 161 T.C. No. 6, filed October 18, 2023.

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.

Foreign Mutual Funds

Let’s talk about PFICs.

It is pronounced “Pea Fick,” and it is shorthand for a passive foreign investment company. We are continuing our “foreign” theme of late.

A PFIC is a foreign mutual fund. Think about your funds at Fidelity or Vanguard and relocate them to Bonn or London. That is all you have done, but with that act you have entered a twilight world of odd tax reporting.

Why? Treasury does not like foreign mutual funds. Why? That question has several possible answers, but I believe that a large part is because Treasury cannot control the taxation. A mutual fund in the United States is a “regulated investment company.” One of the requirements is that it has to pass along its taxable income to its investors in order to preserve its tax standing. Shift that fund to Bonn, and the German fund manager may not have the same level of concern in maintaining that “regulated investment company” status. The German fund manager may do something unconscionable, such as not declare dividends or distribute income to investors. That would allow the German fund to delay tax consequence to its U.S investors, possibly for many years. Why, the U.S. investor may eventually report the income as capital gain rather than ordinary dividend income. This is clearly an unacceptable scenario.

It didn’t use to be this way. The law for PFICs changed in 1986.

You are going to be specially taxed. You however can choose one of three methods of taxation:

(1)    The Excess Distribution Method

This is the default method and is found in Section 1291 of the Internal Revenue Code.

At first glance it sounds good. You pay no tax until you either sell or receive an “excess distribution.” When you do, the IRS presumes that the income was earned ratably over the years you owned the fund. You have to pay tax at the highest marginal tax rate. It does not matter what your actual tax rate was. What if the fund lost money for 8 years, had one great year that made up for all losses and then you sold at a profit. ? Doesn’t matter. The IRS presumes that your profit was earned pro rata over 9 years. Now you are late on your taxes (remember, you did not include the profit in your prior year returns because there WAS NO PROFIT). You now have to pay tax using the highest-marginal tax rates. For 9 years. And then there is interest on the late taxes.

Oh, you may not be allowed to claim the loss if you sell the PFIC at a loss.

 You really do not want to use this method.

(2)    The Mark to Market Method

This option was added to the Code in 1997.

You mark your PFIC to market every year-end. In other words, you pay taxes on the difference between the share price on January 1^st and December 31^st. Every year.

You forfeit capital gains and losses. Whatever income or loss you report is ordinary. Sorry.

The big requirement here is that the PFIC has to have published fund prices. If the prices are not published, you simply cannot use the mark to market method.

(3)    The Qualified Electing Fund

This is the method I have normally seen. The problem is that the fund has to provide certain information annually. As that information has meaning only to a U.S. taxpayer, the fund may decide that it is not worth the time and cost and refuse to provide it. In practice, I have seen these funds go through investment houses such as Goldman Sachs. Goldman can pool enough U.S. investors to make it worthwhile to the foreign fund manager, so the fund agrees going in that it will provide this additional information annually.

A QEF is basically like a partnership. It passes-though its income to the U.S. investor – whether distributed or not – and the U.S. investor pays taxes on it. Ordinary income is taxed at ordinary rates, and capital gains at capital gains rates. What changes is that Treasury does not wait for a distribution.

A QEF should be elected in the first year you own the QEF. If so, you avoid the “excess distribution” regime altogether. If you make the election in a later year, then there is a procedure to “purge” the earlier PFIC treatment.

The QEF election is made fund by fund.

Yes, there is a special form to use with PFICs. It is Form 8621 “Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund.” It can be an intimidating three pages of tax-speak.

I saw PFICs a few years back, as we had several well-heeled clients. What I generally saw was a K-1, perhaps from a hedge fund. That fund in turn invested, and some of its investments were PFICs. The fund K-1 would arrive with its booklet of information, explanation and disclosures. The PFICs inside would further swell the page count. I remember these K-1s going on for 30 or 40 pages. These K-1s are not for young tax accountants.

As I said, Treasury really does not like foreign mutual funds.