Can $2 Million Be An Honest Mistake?

 

It is a good idea to look over your tax return before hitting the “Send” button.

Why? Because things happen. Some prep software approximates a black box. It asks questions, you provide numbers and together they go someplace hidden from the eyes of man. Granted, most times the result is just fine. But there are those times ….

Let’s talk about Candice and Randall Busch.

They were preparing their 2017 tax return using a popular tax software, which shall remain nameless. They reached the point where the software wanted mortgage interest. Easy enough. They entered “21,201.25.”

So?

The software did not accept pennies.

This means that 21,201.25 went in as 2,120,125.

That, folks, is a lot of mortgage interest.

BTW one cannot deduct that much mortgage interest on a principal residence. Why? The mortgage interest deduction had been capped for many years as interest paid on the first $1 million of indebtedness. Let’s say someone paid $62,000 on $2 million of principal residence debt. The tax preparer should have caught this and limited the deduction as follows:

         62,000 * 1,000,000/2,000,000 = 32,000

The $1,000,000 cap was further reduced to $750,000 in 2017.

The tax Code has no intention of allowing an unlimited deduction for this type of interest.

Is it ever possible to get past the $1,000,000 (or $750,000) limitation? Well, yes, and it happens all the time. Borrow money on commercial real estate (say a strip mall) and there is no limitation. Borrow money on residential real estate - as long as it is not a principal residence - and there is no limitation. An example would be an apartment complex.  The limitation we are discussing is personal and involves debt on your house.

Back to the Busch’s.

They sound like average folk.

That mistake made their tax refund go through the roof.

They liked that answer.

They sent in the return.

The IRS flagged the return, which was not hard to do when the interest deduction was larger than the allowed debt for purposes of calculating the deduction itself.

The IRS wanted the excess refund back.

The Busch’s would do that.     

Then the IRS also wanted a heavy penalty (the accuracy-related penalty, for the home gamers).

The Busch’s said they wouldn’t do that. An exception to the accuracy-related penalty is reasonable cause, and they had reasonable cause all day long and three times on the weekend.

And what was that reasonable cause, asked the IRS.

It was an “honest mistake,” they replied.

Off to Tax Court they went.

The Busch’s represented themselves, the lingo for which is “pro se.”

The Court acknowledged that mistakes happen. One can get distracted and enter a wrong number, one can transpose, one can get surprised by what a software might do.

But that is not the mistake here.

The mistake here was failing to review the return before sending.

The biggest number on the return – literally – was that interest deduction. It hung over the form like a Big Texan 72-ounce steak on a normal-sized dinner plate.

Here is the Court:

A careful review of the return after it was prepared would most certainly have caught the error; actually, even as little as a quick glance at the return probably would have done so.”

The Busch’s got stuck with the penalty.

Section 1202 Stock And A House Tax Proposal

I am not a fan of fickleness and caprice in the tax law.

I am seeing a tax proposal in the House Ways and Means Committee that represents one.

It has been several years since we spoke about qualified small business stock (QSBS). Tax practice is acronym rich, and one of the reasons is to shortcut who qualifies – and does not qualify – for a certain tax provision. Section 1202 defines QSBS as stock:

·      issued by a C corporation,

·      with less than $50 million in assets at time of stock issuance,

·      engaged in an active trade or business,

·      acquired at original issuance by an eligible shareholder in exchange for either cash or services provided, and

·      held for at least five years.

The purpose of this provision is to encourage – supposedly – business start-ups.

How?

A portion of the gain is not taxed when one sells the stock.

This provision has been out there for approximately 30 years, and the portion not taxed has changed over time. Early on, one excluded 50% (up to a point); it then became 75% and is now 100% (again, up to a point).

What is that point?

The amount of gain that can be excluded is the greater of:

·      $10 million, or

·      10 times the taxpayer’s basis in the stock disposed

Sweet.

Does that mean I sell my tax practice for megabucks, all the while excluding $10 million of gain?

Well, no. Accounting practices do not qualify for Section 1202. Not to feel singled- out, law and medical practices do not qualify either.

I have seen very few Section 1202 transactions over the years. I believe there are two primary reasons for this:

                 

(a)  I came into the profession near the time of the 1986 Tax Reform Act, which single-handedly tilted choice-of-entity for entrepreneurial companies from C to S corporations. Without going into details, the issue with a C corporation is getting money out without paying double tax. It is not an issue if one is talking about paying salary or rent, as one side deducts and the other side reports income. It is however an issue when the business is sold. The S corporation allows one to mitigate (or altogether avoid) the double tax in this situation. Overnight the S corporation became the entity of choice for entrepreneurial and closely-held companies. There has been some change in recent years as LLCs have gained popularity, but the C corporation continues to be out-of-favor for non-Wall Street companies. 

 

(b)  The sale of entrepreneurial and closely-held companies is rarely done as a stock purchase, a requirement for Section 1202 stock. These companies sell their assets, not their stock. Stock acquisitions are more a Wall Street phenomenon.

So, who benefits from Section 1202?

A company that would be acquired via a stock purchase. Someone like … a tech start-up, for example. How sweet it would have been to be an early investor in Uber or Ring, for example. And remember: the $10 million cap is per investor. Take hundreds of qualifying investors and you can multiply that $10 million by hundreds.

You can see the loss to the Treasury.

Is it worth it?

There has been criticism that perhaps the real-world beneficiaries of Section 1202 are not what was intended many years ago when this provision entered the tax Code.

I get it.

So what is the House Ways and Means Committee proposing concerning Section 1202?

They propose to cut the exclusion to 50% from 100% for taxpayers with adjusted gross income (AGI) over $400 grand and for sales after September 13, 2021.

Set aside the $400 grand AGI. That sale might be the only time in life that someone ever got close to or exceeded $400 grand of income.

The issue is sales after September 13, 2021.

It takes at least five years to even qualify for Section 1202. This means that the tax planning for a 2021 sale was done on or before 2016, and now the House wants to retroactively nullify tax law that people relied upon years ago.

Nonsense like this is damaging to normal business. I have made a career representing entrepreneurs and their closely-held businesses. I have been there – first person singular - where business decisions have been modified or scrapped because of tax disincentives. Taxing someone to death clearly qualifies as a business disincentive. So does retroactively changing the rules on a decision that takes years to play out. Mind you – I say that not as a fan of Section 1202.

To me it would make more sense to change the rules only for stock issued after a certain date – say September 13, 2021 – and not for sales after that date. One at least would be forewarned.   

Should bad-faith tax proposals like this concern you?

Well, yes. If our current kakistocracy can do this, what keeps them from retroactively revoking the current tax benefits of your Roth IRA?  How would you feel if you have been following the rules for 20 years, contributing to your Roth, paying taxes currently, all with the understanding that future withdrawals would be tax-free, and meanwhile a future Congress decides to revoke that rule - retroactively?

I can tell you how I would feel.

The Nick Saban Tax

Have you heard about the “Nick Saban” tax?

Let’s set it up.

There has been a longstanding tax provision limiting the deduction for public company executive compensation to $1 million. Mind you, this is not a restriction on how much you can pay an executive; the restriction only applies to how much you can deduct on a tax return. The restriction does not apply to all executives, either; it applies to the CEO, CFO and three other most-highly-paids.

But there was an exception large enough for the Fortune 500 to drive through. The exception was for “performance.” Magically and almost overnight, virtually all executive compensation packages became based on “performance.” Options were considered performance-based, and eventually options came to be passed around like candy. Realistically, one had to refuse to do any tax planning for this provision to actually apply.

This changed with the Tax Cuts and Jobs Act passed in December, 2017. Congress tightened up this code Section (162(m)) by taking away the performance exception. The $1 million cap now has a real bite.

But Congress was still looking for money.

Congress decided to put the same $1 million compensation limit on nonprofits.

This creates a quandary, as nonprofits (generally) do not pay tax. If I were a nonprofit executive and Congress threatened to disallow my deduction, I would not be feeling the tremulous fear of my for-profit peers.

Congress thought of that. They decided that the nonprofit would pay a 21% tax on my behalf.

Whoa. Now you have my attention. Granted, the tax is not on me, but we all know how this works in the real world. Only small children and Congress believes in free. The rest of us have to pay.

Congress passed a tax provision applying the $1 million cap to the five highest- paid employees of a 501(a), which includes a 501(c)(3). Think nonprofits, certain hospitals, colleges and universities and the like.

BTW medical professors were excluded from this, so it appears clear that Congress was trying to reach the athletics programs and their coaches.

But there is a problem.

Here is Code section 4960 imposing the tax:

       (c)  Definitions and special rules.

For purposes of this section-

(1)  Applicable tax-exempt organization.

The term "applicable tax-exempt organization" means any organization which for the taxable year-

(A)  is exempt from taxation under section 501(a) ,

(B)  is a farmers' cooperative organization described in section 521(b)(1) ,

(C)  has income excluded from taxation under section 115(1) , or

(D)  is a political organization described in section 527(e)(1) .

What is that Section 115(1)?

         § 115 Income of states, municipalities, etc.

Gross income does not include-

(1)  income derived from any public utility or the exercise of any essential governmental function and accruing to a State or any political subdivision thereof, or the District of Columbia; or …

What does this mean?

Congress thought that – by extending Section 4960 to reference Section 115(1) – it would reach those entities exempt via Section 115(1).

Entities such as Alabama.

Or the University of Alabama.

Why?

Because the University of Alabama is an instrumentality of the state of Alabama.

And here the tax law goes wonky.

The Courts have looked at the interaction of Sections 115(1) and 511(which is the unrelated business income tax which applies to a nonprofit). Can a state instrumentality (say a university) run a business – say a farm-to-table restaurant chain – and avoid the unrelated business income tax because of Section 115(1)? If that were the case, then Illinois could start a chain called Outfront Steakhouse, make a zillion dollars and never pay tax because of Section 115(1).

The Courts have clarified that is not the case. There is a limit to Section 115(1).

According to that reasoning, it seems to me that Congress should be able to tax those university salaries.

But there is another argument – the doctrine of implied statutory immunity. This arises from our federalist system of government: the federal government has to respect the state government. Under this theory, if the federal government wants to tax a state, it has to say so in an unambiguous manner – that is, it cannot be “implied.”

Continuing our example, if the federal government wanted to tax Illinois for opening a steakhouse chain and locating them adjacent to every Outback Steakhouse location throughout the land, it would have to say something like:

… the [] tax will apply to an entity relying upon Section 115(1) for nontaxability of their [] business activity should that activity be the same or substantially similar to a business activity conducted by a for-profit restaurant chain.”

That is explicit. That breaches implied statutory immunity. The tax would then stick.

Is that what Congress did with the new Section 4960(c) tax?

Nowhere close, it appears.

Under that reasoning the University of Alabama will not pay the Nick Saban tax, as the tax does not reach the University of Alabama.

There are universities clearly affected by this new law: Duke, for example, or Northwestern. They have to pay up. Think of it as the difference between a “public” university and a “tax-exempt” university.

But having the state name in the university’s name, however, does not mean that the university is exempt as “public.” It depends on how the university was organized and chartered. Texas A&M will be affected by the new tax provision, but the University of Texas - Austin will not. It is enough to give one a headache.

What happens next?

The easiest path is for Congress to revise Code section 4960 and clean up the language. Without Congressional action, you can be certain the “public” universities will litigate this matter. They have to.

But the likelihood of the present Congress accomplishing anything seems unlikely, at best.

Making A Comeback: Section 1202 Stock

We are going tax-geek for this post.

Let’s blame Daryl, a financial advisor with Wells Fargo. He has been studying and asking about a particular Code section.

Code Section 1202.

This section has been a dud since 1993, but last year’s changes to the tax Code have resurrected it. I suspect we will be reading more about Section 1202 in the future.

What sets up the tension is the ongoing debate whether it is better to do business as a “C” corporation (which pays its own tax) or an “S” corporation (whose income drops onto its owners’ individual returns, who pay tax on the business as well as their other personal income).

There are two compelling factors driving the debate:

(1) The difference between corporate and individual tax rates.

For most of my career, top-end individual tax rates have exceeded top-end corporate tax rates. Assuming one is pushing the pedal to the floor, this would be an argument to be a C corporation.

(2)  Prior to 1986, there was a way to liquidate (think “sell”) a C corporation and pay tax only once. The 1986 tax act did away with this option (except for highly specialized – and usually reorganization-type – transactions). Since 1986 a C corporation has to pay tax when it liquidates (because it sold or is considered to have sold its assets). Its assets then transfer to its shareholders, who again pay tax (because they are considered to have sold their stock).

Factor (2) has pretty much persuaded most non-Fortune-500 tax advisors to recommend S corporations, to the extent that most of the C corporations many tax practitioners have worked with since 1986 have been legacy C’s. LLC’s have also been competing keenly with S corporations, and advisors now debate which is preferable. I prefer the settled tax law of S corporations, whereas other advisors emphasize the flexibility that LLCs bring to the picture.

Section 1202 applies to C corporations, and it gives you a tax break when you sell the stock. There are hoops, of course:

(1)   It must be a domestic (that is, a U.S.) C corporation.

(2)   You must acquire the stock when initially issued.

a.     Meaning that you did not buy the stock from someone else.

b.    It does not mean only the first issuance of stock. It can be the second or third issuance, as long as one meets the $ threshold (discussed below) and you are the first owner.

(3)   Corporate assets did not exceed $50 million when the stock was issued.

a.     Section 1202 is more of a west-Coast than Midwest phenomenon. That $50 million makes sense when you consider Silicon Valley.

b.    If you get cute and use a series of related companies, none exceeding $50 million, the tax Code will combine you into one big company with assets over $50 million.

c.     By the way, the $50 million is tested when the stock is issued, not when you sell the stock. Sell to Google for a zillion dollars and you can still qualify for Section 1202.

(4)   You have owned the stock for at least five years.

(5)   Not every type of business will qualify.

a.     Generally speaking, professional service companies – think law, health, accounting and so on – will not qualify. There are other lines of businesses – like restaurants and motels - that are also disqualified.

(6)   Upon a qualifying sale, a shareholder can exclude the larger of (a) $10 million or (b) 10 times the shareholder’s adjusted basis in the stock.

Folks, a minimum $10 million exclusion? That is pretty sweet.

I mentioned earlier that Section 1202 has – for most of its existence – been a dud. How can $10 million be a dud?

Because it hasn’t always been $10 million. For a long time, the exclusion was 50% of the gain, and one was to use a 28% capital gains rate on the other 50%. Well, 50% of 28% is 14%. Consider that the long-term capital gains rate was 15%, and tax advisors were not exactly doing handstands over a 1% tax savings.

In 2010 the exclusion changed to 100%. Advisors became more interested.

But it takes five years to prime this pump, meaning that it was 2015 (and more likely 2016 or 2017) by the time one got to five years.

What did the 2017 tax bill do to resurrect Section 1202?

It lowered the “C” corporation tax rate to 21%.

Granted, it also added a “passthrough” deduction so that S corporations, LLCs and other non-C-corporation businesses remained competitive with C corporations. Not all passthrough businesses will qualify, however, and – in an instance of dark humor – the new law refers to (5)(a) above to identify those businesses not qualifying for the passthrough deduction.

COMMENT: And there is a second way that Section 1202 has become relevant. A tax advisor now has to consider Section 1202 – not only for the $10-million exclusion – but also in determining whether a non-C business will qualify for the new 20% passthrough deduction. Problem is, there is next to no guidance on Section 1202 because advisors for years DID NOT CARE about this provision. We were not going to plan a multiyear transaction for a mere 1% tax savings.

Nonetheless 21% is a pretty sweet rate, especially if one can avoid that second tax. Enter Section 1202.

If the deal is sweet enough I suppose the $10 million or 10-times-adjusted-basis might not cover it all.

Good problem to have.

Obama’s $3 Million IRA Cap

We have received several calls on the proposed $3 million cap on 401(k)s and IRAs. Some of those discussions have been spirited.

What is it? Equally important, what is it not?

The proposal comes from the White House budget. Here is some text:

The budget will also show how we can provide targeted tax relief to strengthen the economy, help middle class families and small business and pay for it by eliminating tax loopholes and make the tax system more fair. The budget will include a new proposal that prohibits individuals from accumulating over $3 million in IRAs and other tax-preferred retirement accounts. Under current rules, some wealthy individuals are able to accumulate many millions of dollars in these accounts, substantially more than is needed to fund reasonable levels of retirement saving. The budget would limit an individual’s total balance across tax-preferred accounts to an amount sufficient to finance an annuity of not more than $205,000 per person per year in retirement, or about $3 million in 2013."

Let us point out several things:

(1)    The proposal would not force monies out of an existing retirement plan. It would instead prevent new monies going into a plan.

This raises a question: should one draw enough to reduce the balance below $3 million, would one be able to again contribute to the plan?

(2)    The proposal uses the term tax “preferred” rather than tax “deferred.”  This indicates that the proposal would reach Roth IRAs. Roth IRAs are not tax deferred, as there is no tax when the funds come out. They instead are tax “preferred.”

There is some rhyme or reason to this proposal. $205,000 is the current IRC Section 415 limit on funding defined benefit (think pension) plans. The idea here is that the maximum tax deduction the IRS will allow is an amount actuarially necessary to fund today a pension of $205,000 sometime down the road. The closer one is to retirement, the higher the Section 415 amount. The farther one is, the lower the Section 415 amount. This proposal is somewhat aligning limits on contribution plans with existing limits on benefit plans.

(3)    The $3 million is an arbitrary number, and presumably it would change as interest rates and actuarial life expectancies change over time. If longevity continues to increase, for example, the $3 million may be woefully inadequate. Some planners consider it inadequate right now, at least if one is trying to secure that $205,000 annual annuity.

(4)    Would the annuity amount increase with inflation? Assuming an average inflation rate of 4.5 percent, one would lose almost three-quarters of a fixed annuity’s purchasing power over 30 years.

The frustrating thing about the proposal is that it affects very few people. The Employee Benefit Research Institute estimates that only 1% of investors have enough to be subject to this rule. This of course feeds into the perceived anti-success, anti-wealth meme of this White House.

(5)    The amount of money to be raised over a decade is also chump change for  the federal government: less than $10 billion.

Something to remember is that account balances in 401(k), SEP, SIMPLE and regular IRA accounts will be taxable eventually. IRAs are subject to minimum distribution rules, for example. The larger the balances, the more the government will take in taxes. Dying will not make the tax go away. In fact, it may serve to accelerate required distributions to a beneficiary and taxes to the government.

The budget was dead on arrival at Capitol Hill. Let us hope that less ideologically rigid minds on the Hill keep it so.