The Problem-Child Client: Recidivist

 

It happens: the problem-child client.

Let’s talk about one type of problem child: the recidivist.

Thomas Kelly was a securities broker in New York City. We have three tax years at play - 2013 to 2015. Thomas had not been filing his returns or paying his taxes.

On December 22, 2017, he filed 2013, reporting adjusted gross income of $1.9 million. The tax was approximately $690 grand.

A few days later (December 26, 2017) he filed 2014, reporting AGI of almost $1.5 million and tax of approximately $515 grand.

Keeping the streak going, on January 17, 2018, he filed 2015, reporting AGI of $1.2 million and tax over $400 grand.

Got it. Thomas fell out of the system and was now trying to get back in. Maybe there had been familial or medical setbacks. He was trying to correct his mistakes. Everybody likes a comeback story.

Let’s jump forward over a year and a half to September 2019. Thomas owed the IRS over $2.5 million for years 2013 through 2015.

Late file penalties. Late pay penalties. Interest on everything. Yep, it gets expensive.

The IRS issued three notices:

* Two for liens

* Another for a levy

Thomas requested a CDP (Collection Due Process) hearing. He was after three things:

* He wanted a payment plan

* He wanted withdrawal of the liens

* He wanted abatement of the penalties

Got it. So far this is standard stuff.

The hearing was scheduled for March 2020.

Then COVID happened.

The hearing was held-up until February 2021.

At the hearing …

FIRST, Thomas wanted to pay $30,000 per month.

Problem: Thomas owed enough that $30 grand would not pay his taxes in full before the statute of limitations played out.

CTG: This is a called a partial pay plan. There are requirements in the Internal Revenue Manual (IRM), and one is that the taxpayer be current on his/her other taxes. Thomas owed approximately $250 grand on his 2019 taxes.

The IRS did not want to include 2019 in his payment plan. In addition, the IRS did not see payments on his 2020 estimated taxes.

CTG: Borrow $250 grand and a bit more for those estimated taxes, Thomas. Battle, war, and all that.

It makes sense if you think about it. Thomas was asking the IRS to accept less than a dollar-on-a-dollar for past taxes. He was then asking the same deal for his current taxes. The IRS was not going to agree to this.

Thomas dug in his heels and wanted the IRS to include 2019 and 2020 in the payment plan.

The IRS of course didn’t.

Thomas complained that the IRS settlement officer abused his discretion in denying him a payment plan.

CTG: Thomas, shut up.

SECOND, Thomas wanted the liens removed.

CTG: This one is going to be tricky. The IRS is reluctant to remove a lien, especially once you get to those dollar levels.

Thomas argued that the IRS Settlement Officer abused his discretion in refusing to withdraw the liens.

CTG: Thomas … SHUT UP!

Thomas next argued that releasing the lien would facilitate his being able to pay the tax. The lien would affect his licensing, and that effect could negatively impact his earning power.

CTG: Nice segue. We now need to go from “could” to “would,” as we need to persuade skeptical parties. Is there a cite from governing body rules and regulations we can copy and paste? Can you get a letter from your employer? We need something more than our word, as that is considered self-serving.

Nope, says Thomas. My word is good enough.

CTG: You are not taking advice well, Thomas.

THIRD, Thomas wanted the penalties abated. He had two arguments.

CTG: Bring it.

The first was that he qualified for first time abatement (FTA).

CTG: OK, but that will address 2013 only. You won’t be able to use it again for the other years.

FTA is bread-and-butter. If you have been clean for the preceding 3 years, the IRS can waive the penalty. The FTA applies to a limited number of penalties, but the good news is that limited number included Thomas’s specific penalty.

Good job, Thomas.

However, the IRS pointed out that Thomas had penalties for 2012. The … tax … year … immediately … preceding 2013.

CTG: Thomas, did you even google what FTA is?

Thomas had a second argument: he had reasonable cause.

CTG: OK, Thomas, sway me.

His wife started spending money like madwoman in 2007. This caused all matters of marital and financial problems. She filed for divorce in 2015.

CTG: Thomas …

The attorney fees were crushing. He was having financial hardship …

CTG: Thomas …

… emotional problems …

CTG: Thomas …

… battling depression.

CTG: Thomas, the Court is going to want to know how your divorce proceedings – in 2015 – affected your tax responsibilities for 2013 and 2014.

Tax Court: Yes, Thomas, please tell us.

Here are a few trenchant comments by the Court:

He successfully conducted his securities business during 2013 – 2015, earning more than $1 million annually …”

… he has a history of tax noncompliance, dating as far back as 2009.”

His allegations of financial hardship at the relevant times thus seem questionable.”

CTG: We are losing them here, Thomas.

Tax Court:

In any event, financial hardship ‘generally does not affect a person’s ability to file.’”

CTG: Going…

Tax Court:

At the time of the CDP hearing petitioner’s outstanding liabilities for 2013 - 2015 exceeded $2.5 million. Those liabilities arose from his repeated failure to file returns and pay tax, despite earning between $1 million and $2 million annually. During the hearing he refused to pay even his (comparatively modest) estimated tax liability for 2020.

CTG: Gone.

Yes, the IRS sours with a recidivist. I have seen the IRS dig in when they see someone failing to file, never paying estimates, extending with no payment, repetitively filing returns with significant balances due. This is not a matter of knowing how to navigate the IRS. One can navigate like Magellan and not get there.

Thomas could have - I believe - gotten a partial pay. Perhaps he needed to borrow to pay 2019 and 2020, but: so what? He had the earning power, and borrowing would have facilitated the (much more significant) $2.5 million at play for 2013 through 2015.

He had a shot at releasing the liens if he could show (likely) injury to his earning power. He had to show some cause, though, otherwise everyone would make this argument and the IRS would never be able to lien.   

He was hosed on penalty abatement, however. Recidivist.

He certainly did not need to fling charges of abusing discretion. The Settlement Officer was just following IRM guidelines, which Thomas (or his tax advisor) could have double-checked at any time.   

Our case this time was Thomas E Kelly v Commissioner, T.C. Memo 2022-73.

Talking Frankly About Offers In Compromise

I am reading a case involving an offer in compromise (OIC).

In general, I have become disinclined to do OIC work.

And no, it is not just a matter of being paid. I will accept discounted or pro bono work if someone’s story moves me. I recently represented a woman who immigrated from Thailand several years ago to marry an American. She filed a joint tax return for her first married year, and – sure enough – the IRS came after her when her husband filed bankruptcy. When we met, her English was still shaky, at best. She wanted to return to Thailand but wanted to resolve her tax issue first. She was terrified.   

I was upset that the IRS went after an immigrant for her first year filing U.S. taxes ever, who had limited command of the language, who was mostly unable to work because of long-term health complications and who was experiencing visible - even to me - stress-related issues.

Yes, we got her innocent spouse status. She has since returned to Thailand.

Back to offers in compromise.

There are two main reasons why I shy from OIC’s:

(1) I cannot get you pennies-on-the-dollar.

You know what I am taking about: those late-night radio or television commercials.

Do not get me wrong: it can happen. Take someone who has his/her earning power greatly reduced, say by an accident. Add in an older person, meaning fewer earning years remaining, and one might get to pennies on the dollar.

I do not get those clients.

I was talking with someone this past week who wants me to represent his OIC. He used to own a logistics business, but the business went bust and he left considerable debt in his wake. He is now working for someone else.

Facts: he is still young; he is making decent money; he has years of earning power left.

Question: Can he get an OIC?

Answer: I think there is a good chance, as his overall earning power is down.

Can he get pennies on the dollar?

He is still young; he is making decent money; he has years of earning power left. How do you think the IRS will view that request?

(2) The multi-year commitment to an OIC.

When you get into a payment plan with the IRS, there is an expectation that you will improve your tax compliance. The IRS has dual goals when it makes a deal:

(a)  Collect what it can (of course), and

(b)  Get you back into the tax system.

Get into an OIC and the IRS expects you to stay out of trouble for 5 years. 

So, if you are self-employed the IRS will expect you to make quarterly estimates. If you routinely owe, it will want you to increase your withholding so that you don’t owe. That is your end of the deal.

I have lost count of the clients over the years who did not hold-up their end of the deal.  I remember one who swung by Galactic Command to lament how he could not continue his IRS payment plan and then asked me to step outside to see his new car.

Folks, there is little to nothing that a tax advisor can do for you in that situation. It is frustrating and – frankly – a waste of time.

Let’s look at someone who tried to run the five-year gauntlet.

Ed and Cynthia Sadjadi wound up owing for 2008, 2009, 2010, and 2011.

They got an installment plan.

Then they flipped it to an OIC.

COMMENT: What is the difference? In a vanilla installment plan, you pay back the full amount of taxes. Perhaps the IRS cuts you some slack with penalties, but they are looking to recoup 100% of the taxes. In an OIC, the IRS is acknowledging that they will not get 100% of the taxes.

The Sadjadis were good until they filed their 2015 tax return. They then owed tax.

The reasoned that they had paid-off the vast majority if not all of their 2008 through 2011 taxes. They lived-up to their end of the deal. They now needed a new payment plan.

Makes sense, right?

And what does sense have to do with taxes?

The Court reminded them of what they signed way back when:

I will file tax returns and pay the required taxes for the five-year period beginning with the date and acceptance of this offer.

The IRS will not remove the original amount of my tax debt from its records until I have met all the terms and conditions of this offer.

If I fail to meet any of the terms of this offer, the IRS may levy or sue me to collect …..

The Court was short and sweet. What part of “five-year period” did the Sadjadis not understand?

Those taxes that the IRS wrote-off with the OIC?

Bam! They are back.

Yep. That is how it works.

Our case this time was Sadjadi v Commissioner, T.C. Memo 2019-58.

This Is Why We Cannot Have Nice Things

I am looking at a case involving a conservation easement.

We have talked about easements before. There is nothing innately sinister about them, but unfortunately they have caught the eye of people who have … stretched them beyond recognition.

I’ll give you an example of an easement:

·      You own land in a bucolic setting.

·      It is your intention to never part with the land.

·      It is liturgy to the beauty and awe of nature. You will never develop it or allow it to be developed.

If you feel that strongly, you might donate an easement to a charitable organization who can see to it that the land is never developed. It can protect and defend long after you are gone.

Question: have you made a donation?

I think you have. You kept the land, but you have donated one of your land-related legal rights – the right to develop the land.

What is this right worth?

That is the issue driving this area of tax controversy.

What if the land is on the flight path for eventual population growth and development? There was a time when Houston’s Galleria district, for example, was undeveloped land. Say you had owned the land back when. What would that easement have been worth?

You donated a potential fortune.

Let’s look at a recent case.

Plateau Holdings LLC (Plateau) owned two parcels of land in Tennessee. In fact, those parcels were the only things it owned. The land had been sold and resold, mined, and it took a while to reunite the surface and mineral rights to obtain full title to the land. It had lakes, overlooks, waterfalls and sounded postcard-worthy; it was also a whole lot out-of-the-way between Nashville and Chattanooga. Just to get utilities to the property would probably require the utility company to issue bonds to cover the cost.

Enter the investor.

He bought the two parcels (actually 98.99%, which is close enough) for approximately $5.8 million.

He worked out an arrangement with a tax-exempt organization named Foothills Land Conservancy. The easement would restrict much of the land, with the remainder available for development, commercial timber, hunting, fishing and other recreational use.

Routine stuff, methinks.

The investor donated the easement to Foothills eight days after purchasing the land.

Next is valuing the easement

Bring in the valuation specialist. Well, not actually him, as he had died before the trial started, but others who would explain his work. He had valued the easement at slightly over $25 million.

Needless to say, the IRS jumped all over this.

The case goes on for 40 pages.

The taxpayer argument was relatively straightforward. The value of the easement is equal to the reduction in the best and highest use value of the land before and after the granting of the easement.

And how do you value an undeveloped “low density mountain resort residential development”? The specialist was looking at properties in North Carolina, Georgia, and elsewhere in Tennessee. He had to assume government zoning, that financing would be available, that utilities and roads would be built, that consumer demand would exist.

There is a flight of fancy to this “best and highest” line of reasoning.

For example, I would have considered my best and highest professional “use” to be a long and successful career in the NFL. I probably would have been a strong safety, a moniker no longer used in today’s NFL (think tackling). Rather than playing on Sundays, I have instead been a tax practitioner for more than three decades.

According to this before-and-after reasoning, I should be able to deduct the difference between my earning power as a successful NFL Hall of Famer and my actual career as a tax CPA. I intend to donate that difference to the CTG Foundation for Impoverished Accountants.

Yeah, that is snark.

What do I see here?

·      Someone donated less than 100% of something.

·      That something cost about $6 million.

·      Someone waited a week and gave some of that something away.

·      That some of something was valued at more than four times the cost of the entire something. 

Nah, not buying it.

Neither did the Court.

Here is one of the biggest slams I have read in tax case in a while:

           We give no weight to the opinion of petitioner’s experts.”

The taxpayer pushed it too far.

Our case this time for the home gamers was Plateau Holdings LLC v Commissioner.

RERI-ng Its Ugly Head - Part Two

Let’s continue our story of Stephen Ross, the billionaire owner of the Miami Dolphins and of his indirect contribution of an (unusual) partnership interest to the University of Michigan.

What made the partnership interest unusual was that it represented a future ownership interest in a partnership owning real estate. The real estate was quite valuable because of a sweet lease. When that ship came in, the future interest was going to be worth crazy money.

That ship was a “successor member interest” or “SMI.”

We talked about the first case, which went before the Tax Court in 2014 and involved legal motions. The case then proceeded, with a final decision in July, 2017.

COMMENT: Yes, it can take that long to get a complex case through Tax Court. Go after Apple, for example, and your kid will likely be finishing high school before that tax case is finally resolved.

The SMI was purchased for $2.95 million.

Then donated to the University of Michigan for approximately $33 million.

COMMENT: This is better than FaceBook stock.

After two years, the University of Michigan sold the SMI (to someone related to the person who started this whole story) for around $2 million.

OBSERVATION: Nah, FaceBook stock would have been better.

Now RERI was in Court and explaining how something that was and will be worth either $2 or $3 million is generating a tax deduction of $33 million.

And it has to do with the SMI being “part of” of something but not “all of” something.  SMI is the “future” part in “all of” a partnership owning valuable leased real estate in California.

The concept is that someone has to value the “all of” something. Once that is done, one can use IRS tables to value the “part of” something. Granted, there are hoops and hurdles to get into those tables, but that is little obstacle to a shrewd tax attorney.

Ross found a shrewd tax attorney.

Virtually all the heavy lifting is done when valuing the “all of” part. One then dumps that number into the IRS tables, selects a number of years and an interest rate and – voila! The entrée round, my fellow tax gastronomes, featuring a $33 million tasty secret ingredient.

The pressure is on the first number: the “all of.”

This will require a valuation.

There are experts who do these things, of course.

Their valuation report will go with your tax return.  No surprise. We should be thankful they do not also have to do a slide presentation at the IRS. 

And there will be a (yet another) tax form to highlight the donation. That is Form 8283, and – in general – you can anticipate seeing this form when you donate more than $5,000 in property.

There are questions to be answered on Form 8283. We have spoken about noncash donations in the past, and how this area has become a tax minefield. Certain things have to be done a certain way, and there is little room for inattention. Sometimes the results are cruel.

Form 8283 wants, for example:

·      A description of the property

·      If a partial interest, whether there is a restriction on the property

·      Date acquired

·      How acquired

·      Appraised fair market value

·      Cost

I suspect the Court was already a bit leery with a $3 million property generating a $33 million donation.

And the Court noticed something …

The Form 8283 left out the cost.

Yep, the $3 million.

Remember: there is little room for inattention with this form.

Question is: does the number mean anything in this instance?

Rest assured that RERI was bailing water like a madman, arguing that it “substantially complied” with the reporting requirements. It relied heavily on the Bond decision, where the Court stated that the reporting requirements were:

“… directory and not mandatory”

The counterpunch to Bond was Smith:

“ the standard for determining substantial compliance under which we ‘consider whether … provided sufficient information to permit … to evaluate the reported contributions, as intended by Congress.’”

To boil this down to normal-speak: could RERI’s omission have influenced a reasonable person (read: IRS) to question or not question the deduction. After all, the very purpose of Form 8283 was to provide the IRS enough information to sniff-out stuff like this.

Here is the Court:

“The significant disparity between the claimed fair market value and the price RERI paid to acquire the SMI just 17 months before it assigned the SMI to the University, had it been disclosed, would have alerted respondent to a potential overvaluation of the SMI”

Oh oh.

“Because RERI failed to provide sufficient information on its Form 8283 to permit respondent to evaluate its purported contribution, …we cannot excuse on substantial compliance grounds RERI’s omission from the form of its basis in the SMI.”

All that tax planning, all the meetings and paperwork and yada-yada was for naught, because someone did not fill-out the tax form correctly and completely.

I wonder if the malpractice lawsuit has already started.

The Court did not have to climb onto a high-wire and juggle dizzying code sections or tax doctrines to deny RERI’s donation deduction. It could just gaze upon that Form 8283 and point-out that it was incomplete, and that its incompleteness prejudiced the interests of the government. It was an easy way out.

And that is precisely what the Court did.

RERI-ng Its Ugly Head - Part One

Here is the Court:

The action involves RERI Holdings I, LLC (RERI). On its 2003 income tax return RERI reported a charitable contribution of property worth $33,019,000. Respondent determined that RERI overstated the value of the contribution by $29,119,000.”

That is considerably more than a rounding error.

The story involves California real estate, a billionaire and a university perhaps a bit too eager to receive a donation.

The story is confusing, so let’s use a dateline as a guide.

February 6, 2002 

Hawthorne bought California real estate for $42,350,000. Technically, that real estate is in an LLC named RS Hawthorne LLC (Hawthorne), which in turn is owned by RS Hawthorne Holdings LLC (Holdings).

Holdings in turn is owned by Red Sea Tech I (Red Sea). 

February 7, 2002 

Red Sea created two types of ownership:

First, ownership for a period of time (technically a “term of years,” abbreviated TOYS).

Second, a future and successor interest that would not even come into existence until 2021. Let’s call this a “successor” member interest, or SMI. 

QUESTION: Why a delayed ownership interest? There was a great lease on the California real estate, and 2021 had significance under that lease.

March 4, 2002     

RERI was formed.

March 25, 2002

RERI bought the SMI for $2,950,000.

August 27, 2003

RERI donated the SMI to the University of Michigan.

A key player here is Stephen Ross, a billionaire and the principal investor in RERI. He had pledged to donate $5 million to the University of Michigan. 

Ross had RERI donate the SMI. 

The University agreed to hold the SMI for two years, at least, before selling.

Do you see what they have done? Start with a valuable piece of leased real estate, stick it in an LLC owned by another LLC owned by another … ad nauseum, then create an LLC ownership stake that does not even exist (if it will ever exist) until 2021.

What did RERI donate to the University of Michigan?

You got it: the thing that doesn’t exist for 18 years.

I find this hard to swallow.

“Successor” LLC interests are sasquatches. You can spend a career and never see one. The concept of “successor” makes sense in a trust context (where they are called “remaindermen”), but not in a LLC context. This is a Mary Shelly fabrication by the attorneys.

So why do it?

Technically, the SMI will someday own real estate, and that real estate is not worth zero.

RERI hired a valuation expert who determined it was worth almost $33 million. This expert argued that the lease on the property – and its reliable series of payments – allowed him to use certain IRS actuarial tables in arriving at fair market value (the approximately $33 million).

Wait. It gets better.

The two years pass. The University sells the property … to an entity INDIRECTLY OWNED by Mr. Ross for $1,940,000.

This entity was named HRK Real Estate Holdings, LLC (HRK).

More.

HRK had already prearranged to sell the SMI to someone else for $3 million.

Still more.

That someone donated the same SMI and claimed yet another deduction of $29,930,000.

REALITY CHECK: This thing sells twice for a total of approximately $5 million but generates tax deductions of approximately $63 million.

Yet more.

Who did the valuation on that second donation? Yep, the same guy who did RERI’s valuation.

The IRS disallowed RERI’s donation to zero, zip, zilch, nada. The IRS was clear: this thing is a sham.

And there begins the litigation.

How something can simultaneously be worth $33 million and $2 million?

This is all about those IRS tables.

Generally speaking, the contribution of property is at fair market value, usually described as the price arrived at between independent buyers and sellers, neither under compulsion to sell or buy and both informed of all relevant facts.

Except …

For annuities, life estates, remainders, reversions, terms of years and similar partial interests in property. They are not full interests so they then have to be carved-out and adjusted to present value using IRS-provided tables.

OBSERVATION: Right there, folks, is why the attorneys created this Frankenstein. They needed to “separate” the interests so they could get to the tables.

RERI argued that it could value that real estate 18 years out and use the tables. Since the tables are concerned only with interest rates and years, the hard lifting is done before one gets to them.

Not so fast, said the IRS.

That real estate is in an LLC, so it is the LLC that has to be valued.  There are numerous cases where the value of an asset and the value of an ownership interest in the entity owning said asset can be different – sometimes substantially so. You cannot use the tables because you started with the wrong asset.

But the LLC is nothing but real estate, so we are back where we started, countered RERI.

Not quite, said the IRS. The SMI doesn’t even exist for 18 years. What if the term owner mortgages the property, or sells it, or mismanages it? That SMI could be near worthless by the time some profligate or incompetent is done with the underlying lease.

Nonsense, said RERI. There are contracts in place to prohibit this.

How pray tell is this “prohibited?” asked the IRS.

Someone has to compensate the SMI for damages, explained RERI.

“Compensate” how? persisted the IRS.

The term owner would forfeit ownership and the SMI would become an immediate owner, clarified RERI.

So you are making the owner of a wrecked car “whole” by giving him/her the wrecked car as recompense, analogized the IRS. Can the SMI at least sue for any unrecovered losses?

Uhhhh … no, not really, answered RERI. But it doesn’t matter: the odds of this happening are so remote as to not warrant consideration.

And so it drones on. The case goes into the weeds.

Who won: the government or the billionaire?

It was decided in a later case. We will talk about it in a second post.

If I Had A Pony, I Would Ride It On My (Tug) Boat

If you have a business, and especially if that business has real estate, odds are very good that your tax advisor will talk to you about the “repair regulations” this filing season.

The IRS and taxpayers have spent decades arguing and going to court over whether an expenditure is a repair (and immediately deductible) or a capital improvement (which cannot be deducted immediately but rather must be depreciated over time). Eventually the IRS decided to pull back, review the existing court cases and develop some rhyme or reason for tax practice in this area. They were at it for years and years.

And now we have the “repair regulations.”

I debated whether to write on this topic, as one can leave the pavement and get lost in the weeds very quickly. It is like a romper room for tax nerds. Still, we have to at least discuss the high points.

Let’s set this up. Say that you have a tug boat. The boat is expected to last you approximately 40 years, if you maintain and keep it up. Every 4 or so years, you anchor the tug and give it a good overhaul, replace what needs replacing and rebuild the engine. This is going to cost you well over $100 grand.

Question: is this a repair (hence deductible) or a capital improvement (not immediately deductible but depreciable over time)?

It is not immediately clear. This costs a lot of money, so one’s first response is that it has to be capitalized and depreciated. However, regular use of a tug presumes heavy maintenance of this kind over its life. That sounds more like a repair expense.

The IRS has introduced the concept of a unit of property. We have to base the repair versus capitalization decision on the unit of property. Is the engine the unit of property (UOP) or is it the overall boat?

The main test for UOP is “functional interdependence.” The placing in service of one thing depends on the placing in service of something else.

Well, a tug boat engine without a tug boat to put it in is not of much use to anybody, so we would say that the overall boat is the unit of property.

Progress. Do we now know whether to capitalize or deduct the engine?

Nope.

Onward.

We next climb through a fence we will call the “BAR,” which stands for

·        Betterment

·        Adaptation

·        Restoration

If you get stuck on any rung of the “BAR,” you have to capitalize the cost. Sorry.

Let’s have a quick peek at which each term means:

·        Betterment

o   You made the thing larger, stronger, more efficient.

We did not turn the thing into a “monster” tug. Let’s move on.

·        Adaptation

o   You tweaked the thing for a different use or purpose.

Nope. It’s still a tug. Can’t fly it or drive it on a highway.

·        Restoration

o   Returning the thing to a usable condition after you have run it into the ground, either because you neglected it (and it fell apart) or it just got too old.      

Doesn’t sound like it. We are not neglecting the tug in any way, and it still has many years of use left.

This is looking pretty good for our tug.

Let’s go through a few more rules, just in case.

If your CPA prepares audited financial statements for you, the IRS will not challenge your deducting something up to $5,000 as a repair as long as you did the same thing on your financial statements.  

That tug thing costs way more than $5,000. Let’s continue. 

NOTE: BTW, if you do not have an audit, the IRS drops that dollar limit down to $500.

If we are talking about “materials and supplies,” the IRS will not challenge your deducting something as long as it costs $200 or less. Fuel for that tug would be considered “materials and supplies.” 

That tug work blew past $200 like it was standing still. Let’s proceed.

If you capitalize the thing on your books and records, the IRS will not argue that you should have deducted it instead.

            Downright charitable of them. Let’s move on.

If a repair is expected to be done more than once over the life of the UOP, then the IRS will not challenge your deducting it as a repair.

Whoa. We have something here. That boat is expected to last somewhere around four decades. The heavy maintenance has to be done every so many service hours, generally meaning every three or four years. Looks like we can deduct the repairs to our tug.

Let’s dock the tugboat and briefly discuss a building. Perhaps we can see our tug from our building.

The IRS is taking the position that a building is both one unit of property and more than one unit of property.

I do not make this up, folks.

The IRS wants certain systems of a building – like its HVAC or its elevators – to also be considered a separate UOP. Let’s take an example. Let’s say that you are replacing a bunch of windows on that building. You would then evaluate whether it is a repair or an improvement by reference to the building as a whole. This is a good thing, as it would take a lot to “improve” the building as a whole. This makes it more likely that the answer will be a deductible repair.

However, say that you replace an elevator. The IRS says that you have to look at elevators separately from the overall building. We’ll, it does not take much to improve an elevator if you are just comparing it to an elevator. This is a bad thing, as it makes it more likely that the result will be a capital improvement.

BTW there is a separate test if your building costs less than a $1 million when you bought it. The IRS will “spot” you a certain amount before it will challenge whether something is a repair or not. It’s for the smaller landlords, but it is something.

And there you have the highlights of the repair regulations.

Depending on your fact patterns, there may be elections and forms that you have to attach to your tax return. Your tax advisor may even request that you change your underlying bookkeeping – like expensing stuff under $5000/$500 on your general ledger, for example. Some of these will require extra work, and hence additional fees, by and from your advisor.

And there is one more thing.

Let’s go back to the tugboat.

Let’s say that you did the major overhaul four years ago and capitalized the cost. You are now deducting those repairs over time as depreciation. The new rules now allow you to deduct the cost immediately as a repair. Had we only known!

Is it too late for us? Four years back is one more year than the statute of limitations permits, so we cannot go back and amend your return.

The IRS – to their credit – realized the unfairness of this situation, and it will let you go back and apply these new rules to that old tax year. The IRS calls it a “partial disposition,” and you can deduct what’s left of that capitalized tugboat repair on your 2014 tax return. It is called a “Change in Accounting Method” and is yet another multi-page form with your return, but at least you can get the deduction. But only on 2014. Let it slip a year and you can forget about it.

If any of the above rings a bell, please discuss the “repair regulations” with your tax advisor. Seriously, after 2014 you may be stuck. Tax does not have to be fair.

Lyle Lovett - If I Had A Boat