Is Suing Your Tax Advisor Taxable?

For those who know me or occasionally read my blog, you know that I am not a “high wire” type of tax practitioner. Pushing the edges of tax law is for the very wealthy and largest of taxpayers: think Apple or Donald Trump. This is – generally speaking - not an exercise for the average person. 

I understand the frustration. A number of years ago I was called upon to research the tax consequence for an ownership structure involving an S corporation with four trusts for two daughters. This structure predated me and had worked well in profitable years, but I (unfortunately) got called upon for a year when the company was unprofitable. The issue was straightforward: were the losses “active” or “passive” to the trusts and, by extension, to the daughters behind the trusts. There was some serious money here in the way of tax refunds – if the trusts/daughters could use the losses. This active/passive law change happened in 1986, and here I was researching during the aughts – approximately 20 years later. The IRS had refused to provide direction in this area, although there were off record comments by IRS officials that were against our clients’ interests. I strongly disagreed with those comments, by the way.

What do you do?

I advised the client that a decision to claim the losses would be a simultaneous decision to hire a tax attorney if the returns got audited and the losses disallowed. I believed there was a reasonable chance we would eventually win, but I also believed we would have to be committed to litigation. I thought the IRS was unlikely to roll on the matter, but our willingness to go to Tax Court might give them pause. 

I was not a popular guy.

But to say otherwise would be to invite a malpractice lawsuit should the whole thing go south.

And this was a fairly prosaic area of tax law, far and remote from any tax shelter. There was no “shelter” there. There was, rather, the unwillingness of the IRS to clarify a tax law that was old enough to go to college.

I am reading about a CPA firm that decided to advise a tax shelter. It went south. They got sued. It cost them $375,000.

Here is a question that we have not discussed before: is the $375,000 taxable to the (former) client?

Let’s discuss the case.

The Cosentinos and their controlled entities (G.A.C. Investments, LLC and Consentino Estates, LLC) had a track record of Section 1031 exchanges and real estate.

COMMENT: A Section 1031 is also known as a “like kind” exchange, whereby one trades one piece of property for another. If done correctly, there is no tax on the exchange.

The Consentinos played a conservative game, as they had an adult disabled daughter who would always need assistance. They accumulated real estate via Section 1031 transactions, with the intent that – upon their death – the daughter would inherit. They were looking out for her.

They were looking at one more exchange when their CPA firm presented an alternative tax strategy that would allow them to (a) receive cash from the deal and (b) defer taxes. The Consentinos had been down this road before, and receiving cash was not their understanding of a Section 1031. Nonetheless the advisors assured them, and the Consentinos went ahead with the strategy.

OBSERVATION: It is very difficult to walk away from a Section 1031 with cash in hand and yet avoid tax.

Wouldn’t you know that the strategy was declared a tax shelter?

The IRS bounced the whole thing. There was almost $600,000 in federal and state taxes, interest and penalties. Not to mention what they paid the CPA firm for structuring the transaction.

The Consentinos did what you or I would do: they sued the CPA firm. They won and received $375,000. They did not report or pay tax on said $375,000, reasoning that it was less than the tax they paid. The IRS sent them a love letter noting the oversight and asking for the tax.

Both parties were Tax Court bound.

The taxpayers relied upon several cases, a key one being Clark v Commissioner. The Clarks had filed a joint rather than a married-filing-separately return on the advice of their tax advisor. It was a bad decision, as filing-jointly cost them approximately $20,000 more than filing-separately. They sued their advisor and won.

The Court decided that the $20,000 was not income to the Clarks, as they were merely being reimbursed for the $20,000 they overpaid in taxes. There was no net increase in their wealth; rather they were just being made whole.

The Clark decision has been around since 1939, so it is “established” law as far as established can be.

The Court decided that the same principle applied to the Cosentinos. To the extent that they were being made whole, there was nothing to tax. This meant, for example:

·        To extent that anything was taxable, it shall be a fraction (using the $375,000 as the numerator and total losses as the denominator).

·        The amount allocable to federal tax is nontaxable, as the Cosentinos are merely being reimbursed.

·        The amount allocable to state taxes however will be taxable, to the extent that the Cosentinos had previously deducted state taxes and received a tax benefit from the deduction.

·        The same concept (as for state taxes) applied to the accounting fees. Accounting fees would have been deducted –meaning there was a tax benefit. Now that they were repaid, that tax benefit swings and becomes a tax detriment, resulting in tax.

There were some other expense categories which we won’t discuss.

By the way, the Court’s reasoning is referred to as the “origin of the claim” doctrine, and it is the foundation for the taxation of lawsuit and settlement proceeds.  

So the IRS won a bit, as the Cosentinos had excluded the whole amount, whereas the Court wanted a ratio, meaning that some of the $375,000 was taxable.

Are you curious what the CPA firm charged for this fiasco?

$45,000.

Windstream Holdings Put What Into a REIT?

Have you heard of Windstream Holdings?

They are a telecommunications company – that is, a phone company – out of Little Rock, Arkansas. They made the tax literature recently by getting IRS approval to put some of its assets in a real estate investment trust, abbreviated “REIT” and pronounced “reet.” 

So what is a REIT?

REITs entered the tax Code in 1960. For decades they have been rather prosaic tax vehicles, generally housing office buildings, apartment complexes and warehouses.

Yep, they invest in real estate.

REITS have several tax peculiarities, one of which has attracted planners in recent years. To qualify as a REIT, an entity must be organized as a corporation, have at least 100 shareholders, invest at least 75% of its assets in real estate and derive at least 75% of its income from the rental, use or sale of said real estate. Loans secured primarily by interests in real property will also qualify.

REITS must also distribute at least 90% of their taxable income in the form of shareholder dividends.

Think about this for a second. If a REIT did this, it would not have enough money left over to pay Uncle Sam its tax at the 35% corporate tax rate. What gives?

A REIT is allowed to deduct shareholder distributions from its taxable income.

Whoa.

The REIT can do away with its tax by distributing money. This is not quite as good as a partnership, which also a non tax-paying vehicle. A partnership divides its income and deductions into partner-sized slices. It reports these slices on a Schedule K-1, which amounts the partners in turn include on their personal tax returns. An advantage to a partner is that partnership income keeps its “flavor” when it passes to the partner. If a partnership passes capital gains income, then the partner reports capital gains income – and pays the capital gains rather than the ordinary tax rate.  

This is not how a REIT works. Generally speaking, REIT distributions are taxed at ordinary tax rates. They do not qualify for the lower “qualified dividend” tax rate.

Why would you invest in one, then? If you invested in Proctor & Gamble you would at least get the lower tax rate, right?

Well, yes, but REITs pay larger dividends than Proctor & Gamble. At the end of the day you have more money left in your pocket, even after paying that higher tax rate.

So what has changed in the world of REIT taxation?

The definition of “real estate.”

REITs have for a long time been the lazy river of taxation. The IRS has not updated its regulations for decades, during which time technological advances have proceeded apace. For example, American Tower Corp, a cellphone tower operator, converted to a REIT in 2012. Cell phones – and their towers – did not exist when these Regulations were issued. Tax planners thought those cell towers were “real estate” for purposes of REIT taxation, and the IRS agreed.

Now we have Windstream, which has obtained approval to place its copper and fiber optic lines into a REIT. The new Regulations provide that inherently permanent structures will qualify as REIT real estate. It turns out that that copper and fiber optic lines are considered “permanent” enough.  The IRS reasoned, for example, that the lines (1) are not designed to be moved, (2) serve a utility-like function, (3) serve a passive function, (4) produce income as consideration for the use of space, and (5) are owned by the owner of the real property.

I admit it bends my mind to understand how something without footers in soil (or the soil itself) can be defined as real estate. The technical issue here is that certain definitions in the REIT area of the tax Code migrated there years ago from the investment tax credit area of the tax Code. There is tension, however. The investment tax credit applied to personal property but not to real property. The IRS consequently had an interest in considering something to be real property rather than personal property. That was unfortunate if one wanted the investment tax credit, of course. However, let years go by … let technology advance… let a different tax environment develop … and – bam! -  the same wording gets you a favorable tax ruling in the REIT area of the Code.

Is this good or bad?

Consider that Windstream’s taxable income did not magically “disappear.” There is still taxable income, and someone is going to pay tax on it. Tax will be paid, not by Windstream, but by the shareholders in the Windstream REIT. I am quite skeptical about articles decrying this development as bad. Why - because a corporate tax has been replaced by an individual tax? What is inherently superior about a corporate tax? Remember, REIT dividends do not qualify for the lower dividends tax rate. That means that the REIT income can be taxed as high as 39.6%. In fact, it can be taxed as high as 43.4%, if one is also subject to the ObamaCare 3.8% tax on unearned income. Consider that the maximum corporate tax is 35%, and the net effect of the Windstream REIT spinoff could be to increase tax revenues to the Treasury.

This IRS decision has caught a number of tax planners by surprise. To the best of my knowledge, this is the first REIT comprised of this asset class. I doubt it will be the last.

The IRS Updates a Real Estate Professional Tax Rule

I am glad to see that the IRS has reversed course on an issue concerning real estate professionals.

You may remember that “passive losses” entered the tax Code in 1986 as retaliation against tax shelters. The IRS had previously battled tax shelters using challenges such as “at-risk,” but 1986 brought a new and updated weapon to the IRS armory.

The idea is simple: separate business activities into two buckets: one bucket for material participation and a second for passive. The classic material participation is an activity where one works more than 500 hours. Activities in the material participation bucket can offset each other; that is, losses can offset income.

Move on to the second bucket. Losses can offset income – but not beyond zero. The best one can do (with exceptions, of course) is get to zero. One cannot create a net loss to offset against net income from bucket one.

Consider that tax shelters were placed into bucket two and you understand how Congress changed the tax Code to pull the rug out from under the classic tax shelter.

It was quickly realized that the basic passive activity rules were unfair to people who made their living in real estate. For example, take a real estate developer who keeps a few self-constructed office condominiums as rentals. If one went granular separating the activities, then the real estate development would be a material participation activity but the condominium rentals would be a passive activity. This result does not make sense, as all the income in our example originated from the same “activity.”

So Congress came in with Section 469(c)(7):

   469(c)(7) SPECIAL RULES FOR TAXPAYERS IN REAL PROPERTY BUSINESS.—

469(c)(7)(A) IN GENERAL.— If this paragraph applies to any taxpayer for a taxable year—

469(c)(7)(A)(i)   paragraph (2) shall not apply to any rental real estate activity of such taxpayer for such taxable year, and

469(c)(7)(A)(ii)   this section shall be applied as if each interest of the taxpayer in rental real estate were a separate activity.

Notwithstanding clause (ii), a taxpayer may elect to treat all interests in rental real estate as one activity. Nothing in the preceding provisions of this subparagraph shall be construed as affecting the determination of whether the taxpayer materially participates with respect to any interest in a limited partnership as a limited partner.

469(c)(7)(B) TAXPAYERS TO WHOM PARAGRAPH APPLIES.— This paragraph shall apply to a taxpayer for a taxable year if—

469(c)(7)(B)(i)   more than one-half of the personal services performed in trades or businesses by the taxpayer during such taxable year are performed in real property trades or businesses in which the taxpayer materially participates, and

469(c)(7)(B)(ii)   such taxpayer performs more than 750 hours of services during the taxable year in real property trades or businesses in which the taxpayer materially participates.

Look at Section 469(c)(7)(B)(ii) and the reference to 750 hours. There was confusion on what happened to the plain-vanilla 500-hour rule. Was a real estate pro to be held to a higher standard?

Here for example is the Court in Bahas:

Mrs. Bahas misconstrues section 469. Because petitioners did not elect to aggregate their real estate rental activities, pursuant to Section 469(c)(7)(A) petitioners must treat each of these interests in the real estate as if it were a  separate activity. Thus, Mrs. Bahas is required to establish that she worked for more than 750 hours each year with respect to each of the three rental properties.”

How in the world did we get from 500 hours to 750 hours for each of Mrs. Bahas’ activities?  This is not what Section 469(c)(7) appears to say. There was a torrent of professional and academic criticism on Bahas and related decisions, but in the interim practitioners (me included) elected to aggregate all the real estate activities into one activity. Why? To make sure that one got to the 750 hours, that is why.

Academicians could argue the sequence of phrases and the intent of the law. Practitioners had to prepare annual tax returns, protect their clients and wait their time.

And now it is time.

The IRS released ILM 201427016 to discuss how the “750-hour test” works when one has multiple real estate activities. It includes the following obscuration:

However, some court opinions, while reaching the correct result, contain language which may be read to suggest that the election under Treas. Reg. 1.469-9(g) affects the determination of whether a taxpayer is a qualified taxpayer.”

The IRS finally acknowledged that the 750-hour rule is not a substitute or override for the generic 500-hours-to-materially-participate rule. A real estate taxpayer goes activity-by-activity to determine if he/she is materially participating in each activity. If it is advantageous, the taxpayer can also make an election to aggregate all real estate activities before determining material participation status.

Then, once all that is done, the IRS will look at whether the taxpayer meets the more-than-half and more-than-750-hours tests to determine whether the taxpayer is a real estate pro.

There are two separate tests. One is to determine material participation and a second to determine real estate pro status. 

A bit late for Mrs. Bahas, though.

Renting To Yourself And The "Cox" Strategy

My partner brought me a new client’s personal income tax return. He wanted me to “come up with tax ideas,” as though I am an Iron Chef deciding what to do with the show’s “secret” ingredient.

Something caught my eye. Let’s talk about it.

Let me set this up for you:

(1) Taxpayer is married.

(2) The wife is self-employed. More specifically, she is a proprietor and reports her business income on a Schedule C.

(3) The business owns a house used as offices. The business depreciates the house.

(4) As is true for Schedules C, all her profits are subject to self-employment taxes.

There you go. You have all the facts you need.

Got it yet?

It has to do with the house.

There is a tax case from the 1990s addressing self-rental between a business and its owner. Taxpayer (Cox) was an attorney who reported his practice as a sole proprietorship.  His offices were in a commercial building owned jointly by Cox and his wife. He paid himself rent of $18,000, which he deducted from the law practice and reported as rental income elsewhere on his return.

NOTE: Cox addressed the “passive activities” rules. He apparently had passive losses that he could release by generating passive income.  If so, his net rental income might zero-out, and he would still get an income tax deduction for paying himself rent. It would be a win-win – if only the self-rental rule did not prohibit it.

The IRS of course disallowed the $18,000 rent entirely.

Cox went to trial on a very interesting position. He and his wife owned the rental property as tenants by the entireties. He argued that the form of ownership made a tax difference.

The Tax Court was intrigued. It looked to Missouri property law, and it noticed two things. First, each spouse is entitled to the use and enjoyment of the entire property. Second, a spouse cannot unilaterally divest his spouse of his/her interest in the property.

In a tax venue, this meant that Mrs. Cox was entitled to half the rent, and that Mr. Cox could not divest her of that right.

And the Court allowed Mr. Cox a $9,000 deduction for rent on his Schedule C. It disallowed the other $9,000 (that is, his half) under the self-rental rule.

How does this apply to the new client?

Taxpayer and her husband own the house. She owns the business. I see a strategy… for her self-employment tax.

Did I trip you up?

Remember: all her Schedule C income is subject to self-employment tax, which currently is 15.3 percent. One way to reduce it is to take a tax deduction on her Schedule C and report the corresponding “income” somewhere else on her tax return - somewhere that is NOT subject to self-employment tax. Somewhere like a real estate rental.

The tax pros refer to this a “Cox” strategy. The strategy we are talking about may also cause additional taxes under the new Obamacare “net investment income” tax. A tax advisor would have to review the situation and run numbers.

Still, it is something, and it is all your money until they take it from you. If this applies to your business situation, please bring it to your tax advisor’s attention.