Like-Kind Exchange? Bulk Up Your Files

I met with a client a couple of weeks ago. He owns undeveloped land that someone has taken an interest in. He initially dismissed their overtures, saying that the land was not for sale or – if it were – it would require a higher price than the potential buyer would be interested in paying.

Turns out they are interested.

The client and I met. We cranked a few numbers to see what the projected taxes would be. Then we talked about like-kind exchanges.

It used to be that one could do a like-kind exchange with both real property and personal property. The tax law changed recently and personal property no longer qualifies. This doesn’t sound like much, but consider that the trade-in of a car is technically a like-kind exchange. The tax change defused that issue by allowing 100% depreciation (hopefully) on a business vehicle in the year of purchase. Eventually Congress will again change the depreciation rules, and trade-ins of business vehicles will present a tax issue.

There are big-picture issues with a like-kind exchange:

(1)  Trade-down, for example, and you will have income.

(2)  Walk away with cash and you will have income.

(3)  Reduce the size of the loan and (without additional planning) you will have income.

I was looking at a case that presented another potential trap.

The Brelands owned a shopping center in Alabama.

In 2003 they sold the shopping center. They rolled-over the proceeds in a like-kind exchange involving 3 replacement properties. One of those properties was in Pensacola and becomes important to our story.

In 2004 they sold Pensacola. Again using a like-kind, they rolled-over the proceeds into 2 properties in Alabama. One of those properties was on Dauphin Island.

They must have liked Dauphin Island, as they bought a second property there.

Then they refinanced the two Dauphin Island properties together.

Fast forward to 2009 and they defaulted on the Dauphin Island loan. The bank foreclosed. The two properties were sold to repay the bank

This can create a tax issue, depending on whether one is personally liable for the loan. Our taxpayers were. When this happens, the tax Code sees two related but separate transactions:

(1) One sells the property. There could be gain, calculated as:

Sales price – cost (that is, basis) in the property

(2) There is cancellation of indebtedness income, calculated as:

Loan amount – sales price

There are tax breaks for transaction (2) – such as bankruptcy or insolvency – but there is no break for transaction (1). However, if one is being foreclosed, how often will the fair market value (that is, sales price) be greater than cost? If that were the case, wouldn’t one just sell the property oneself and repay the bank, skipping the foreclosure?

Now think about the effect of a like-kind exchange and one’s cost or basis in the property. If you keep exchanging and the properties keep appreciating, there will come a point where the relationship between the price and the cost/basis will become laughingly dated. You are going to have something priced in 2019 dollars but having basis from …. well, whenever you did the like-kind exchange.

Heck, that could be decades ago.

For the Brelands, there was a 2009 sales price and cost or basis from … whenever they acquired the shopping center that started their string of like-kind exchanges.

The IRS challenged their basis.

Let’s talk about it.

The Brelands would have basis in Dauphin Island as follows:

(1)  Whatever they paid in cash

(2)  Plus whatever they paid via a mortgage

(3)  Plus whatever basis they rolled over from the shopping center back in 2003

(4)  Less whatever depreciation they took over the years

The IRS challenged (3).  Show us proof of the rolled-over basis, they demanded.

The taxpayers provided a depreciation schedule from 2003. They had nothing else.

That was a problem. You see, a depreciation schedule is a taxpayer-created (truthfully, more like a taxpayer’s-accountant-created) document. It is considered self-serving and would not constitute documentation for this purpose.

The Tax Court bounced item (3) for that reason.

What would have constituted documentation?

How about the closing statement from the sale of the shopping center?

As well as the closing statement when they bought the shopping center.

And maybe the depreciation schedules for the years in between, as depreciation reduces one’s basis in the property.

You are keeping a lot of paperwork for Dauphin Island.

You should also do the same for any and all other properties you acquired using a like-kind exchange.

And there is your trap. Do enough of these exchanges and you are going to have to rent a self-storage place just to house your paperwork.

Our case this time was Breland v Commissioner, T.C. Memo 2019-59.

Fewer Like-Kind Exchanges in 2018

The new tax bill changed like-kind exchanges.

This is Section 1031, which was and is a tax provision that allows one to defer taxes on a property sale - if one follows the rules.

I suspect that almost every practicing tax accountant has met with a client who said the following:

·      I sold property last year,

·      I hear that there is a tax break if I buy another piece of property

Well, yes there MIGHT be a tax break, but you have to follow the rules from the beginning, not just months later when you meet with your accountant.

The normal sequence is to sell the property first. It doesn’t have to be that way – you can start with the buy – but that is unusual. The tax nerds refer to that as a “reverse.”

There are ropes:

(1)  You want the money held by a third party, such as an attorney or title company;

(2)  You have to identify the replacement property within 45 days (there is some latitude in identifying replacement properties); and

(3)  You have to complete the whole transaction – sell and buy – within 180 days.

(4) Anticipate that you will be buying-up: buy more than what you sold.

(5)  Debt is tricky. To be safe, increase your debt, at least a little bit.  

(6)  You never want to receive cash from the deal. Cash is income – period.

If you wait to until you meet with your accountant, then you have probably blown requirement (1).

The most common like-kind that I see – I kid you not – is vehicle trade-ins. They happen every day, to the point that we do not even pay them attention. In the tax world, however, trade-ins are like-kind exchanges.

The next most common are real estate exchanges. I have probably seen at least one a year for the last couple of decades. Those usually go through a title company or attorney, and I have the pleasure of looking over a binder of paperwork that would weigh down a Clydesdale.

There are others. One can like-kind exchange personal property, for example. The rules are stricter than the rules for real estate, and for the most part I have not seen a lot of those.

The new tax bill made a big change to like-kind exchanges.

How?

Because personal property no longer qualifies for like-kind treatment.

So much for trade-ins.

But there is another kind that I thought of recently.

Think sports.

Yep, back in 1966 the IRS considered player contracts – if done correctly – to be property qualifying for like-kind.

I am unsure how professional sports will work-around this change. It is not an area I practice, although I would have loved to.

Why did Congress mess with this?

It wasn’t about player contracts. It rather had to do with art and collectibles. It had become de rigueur to like-kind exchange in the art world, as buyers had come to view art as just another tradable commodity. Think stocks, but with the option of delaying taxes until the end of time. This reached the attention of the Obama administration, which began the push to eliminate them.

It took another White House, but it finally got done.

Can Payroll Taxes Put You In Jail?

Can you go to jail for not remitting payroll taxes?

Let’s set this up:

• You have a temporary nursing staffing agency in Minnesota.
• You treat your nurses as independent contractors.
• You had a predecessor company which the IRS charged with willfully misclassifying workers and failing to remit payroll taxes.  You survived that occasion by settling with the IRS, but the settlement included language similar to the following:

 “... with respect to any other business similar to the ... entities that he might own, operate or control in the future, he would treat as employees for tax purposes all workers who performed functions or duties that were the same or similar as the function or duties performed by the nurses and nursing assistants who worked for the ... entities. In other words, defendant ... was obligated to withhold and pay over employment taxes for the nursing professionals who worked for any of his entities.”

• Minnesota has a law requiring nursing staffing agencies to certify that they are treating their nurses as employees and not as independent contractors. You have made this certification to Minnesota.

So, can you go to jail for not remitting the nurses’ payroll taxes?

A too-common problem is a cash-strapped business falling behind on depositing their payroll taxes. You can fall behind on many types of taxes and still be able to work something out. You fall behind with payroll taxes, however, and the IRS can be very harsh. The reason is that the IRS (and the states also) considers it stealing. You pay an employee $700 and withhold $200 for taxes. That $200 is not your money: it is the employee’s money that you now hold as agent for remittance to the IRS. The IRS reserves one of its most frightening penalties for this: it is called the trust fund recovery penalty. This penalty is 100% (you read that right), and it attaches to you as an individual. You cannot shed that penalty by leaving or bankrupting the business, because the penalty applies to you. It follows you like a bad haircut.

That penalty however is not what we have here. What we have here is Francis Leroy McLain (U.S. v McLain). The case was appealed to the Eight Circuit from the District Court of Minnesota.

The IRS looked at two entities owned by McLain, Kind Hearts and Kirpal Nurses, and came to the conclusion that the nurses were employees.

OBSERVATION: The IRS will almost always say that someone is an employee, whether they are or not. They want the payroll taxes, of course.

McLain owed about $340,000 in payroll taxes. He had been down this path before, and the IRS had not forgotten. They dusted off Section 7202, a very special tax gem for someone who pushes the sled too far:

Any person required ... to collect, account for, and pay over any tax imposes by this title who willfully fails to collect or truthfully account for and pay over such tax shall, in addition to the other penalties provided by law, be guilty of a felony and, upon conviction thereof, shall be fined not more than $10,000, or imprisoned not more than 5 years, or both, together with the cost of prosecution.”

McLain left the shores of the responsible person penalty far behind. He sailed into the deep waters of going to jail. He is now dealing with CID, the criminal side of the IRS.

NOTE: A word to the wise: you never want to deal with CID. These guys have badges. They have guns. And they will put you in jail. I know. I had a client who had gone to jail courtesy of CID, and I know a tax practitioner in northern Kentucky who will be going.

As a tax guy, I am hoping that McLain has some serious technical arguments to make in his defense. I am expecting a ferocious goal-line stand. Here comes his first play:

(1)   McLain referred to the two agencies, King Hearts and Kirpal Nurses, as “Kirpal.” He argued that Kirpal was the employer, and, as the employer, only Kirpal had a duty to account and pay over taxes on its employees.

COMMENT: McLain starts off by irritating me. There was a case on this issue before I even came out of school. The case is Slodov v United States. It was a Supreme Court case and included the following language:

“Sections 6672 and 7202 were designed to assure compliance by the employer with its obligation to withhold and pay the sums withheld, by subjecting the employer’s officials responsible for the employer’s decisions regarding withholding and payment to civil and criminal penalties ...”

            McLain was an officer. What part of this did he not get?

            SCORE: IRS (1) McLain (0)

(2)   McLain argues that he had a good faith belief that the nurses were not employees. The lawyers refer to this as “mens rea,” and he argued that his state of mind did not rise to “willful.” Without willfulness, McLain cannot come under Section 7202.

COMMENT: I like this argument. Unfortunately, he had a prior run-in with the IRS on this very same point, which greatly diluted the argument’s persuasiveness.

            SCORE: IRS (2) McLain (0)

(3)   McLain argues that the IRS has to pursue a civil penalty before it can pursue a criminal penalty, and the civil penalty requires a written notice. He received no written notice, so the IRS cannot proceed with criminal prosecution.

COMMENT: I noticed that the Court reminded McLain’s attorney that he “has an independent obligation, regardless of what his client may demand, to refrain from filing frivolous motions.”

            SCORE: IRS (3) McLain (0)

(4)   McLain moved to dismiss the charges because (1) he is a “natural human being” and the United States does not have authority over him.

COMMENT: McLain’s attorney blanched here, and McLain fired him. McLain represented himself from this point on.

A tax protest argument? Seriously?

SCORE: IRS (4) McLain (0)

McLain lost soundly.

This type of action by the IRS is rare. I can assure that – in almost all cases – the IRS does not want to put anyone in jail. They want your money, and being in jail impedes you getting the IRS any money. And all parties in the system – the IRS, the courts and judges, responsible practitioners – are tired of the tax protest siren song.

I am sympathetic to arguments that our tax system left the world of rational thought years ago, but that does not mean the income tax is illegal. It can be irrational, immoral, confiscatory, divisive and destimulative without being illegal.

McLain has taken what could have been a civil penalty – albeit a stiff one – and morphed it into a multi-year stay at Club Fed. There likely is a fairly impressive fine also. He did however enter the tax literature, primarily for being a blockhead.