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. 

A Rollover As Business Startup Got “ROB”bed

We have talked before about ROBS. This is when one borrows money from his/her IRA to start a business.  ROBS have become increasingly popular, and I have wandered in tax Siberia by being negative on them. I know a CPA in New Jersey who even used a ROBS to start his practice. I gave him some slack (but just a little) as he is a general accounting practitioner and not a tax specialist.

Here is the question I hear: what is one’s downside if it goes south? They can’t eat me, right?

My answer: you have blown up your IRA via a prohibited transaction. A prohibited is nothing to take lightly. It contaminates your IRA. All of it. Even the monies you leave behind in the IRA. This is a severe case of terminal.

Now I have a case to share with my clients: Ellis v Commissioner.

Mr. Ellis accumulated a sizable 401(k). In 2005 he formed an LLC (CST) to sell used cars. He moved $319,500 from his 401(k) to an IRA to acquire the initial membership units of CST. He worked there as general manager and received a modest W-2. CST made a tax election to be taxed as a corporation. It did this to facilitate the ROBS tax planning.

Mr. Ellis, his wife and children also formed another LLC (CDJ LLC) in 2005 to acquire real estate. Mr. Ellis did not use his IRA to fund this transaction.

In 2006 CDJ LLC leased its real estate to CST for $21,800. No surprise.

Mr. Ellis also received a larger – but still modest – W-2 for 2006.

The IRS swooped in on 2005 and 2006. They wanted:

·        Income taxes of $135,936 for 2005

·        Alternatively, income taxes of $133,067 for 2006

·        Early distribution penalties of 10%

·        Accuracy-related penalties of $27,187 for 2005 or $26,613 for 2006

What set off the IRS?

·        Mr. Ellis engaged in “prohibited transactions” with his IRA.

·        When that happened, his IRA ceased to be an “eligible retirement plan” as of the first day of that taxable year.

·        Failure to be an “eligible retirement plan” means that that the IRA was deemed distributed to him.

·        As he was not yet 59 ½ there would be early distribution penalties in addition to income tax.

When did this happen? Take your pick:

·        When Mr. Ellis used his IRA to buy membership interests in CST in 2005

·        When CST paid him a W-2 in 2005

·        When CST paid him a W-2 in 2006

·        When CST paid CDJ LLC (an entity owned by him and his family) rent in 2006

OBSERVATION: Do you see the danger with the ROBS? Chances are that you will be giving the IRS multiple points at which to breach your tax planning. You have to defend all points. Failure to defend one – just one – means the IRS wins.

Code section 4975 defines “prohibited transactions” with respect to a retirement plan, including IRAs. Its purpose is to prevent taxpayers from self-dealing with their retirement plan. The purpose of a retirement plan is to save for retirement. The government did not allow tax breaks intending for the plan to be a piggybank or an alternative to traditional bank loans.

Self-dealing with one’s retirement plan is per-se prohibited. It is of no consequence whether the deal is prudent, in the best-interest-of or outrageously profitable. Prohibited means prohibited, and the penalties are correspondingly harsh.

The Court proceeds step-by-step:

(1) CST did not have any shares or units outstanding when Mr. Ellis invested in 2005. Fortunately, there was precedent (in Swanson v Commissioner) that a corporation without shareholders is not a disqualified person for this purpose.

Mr. Ellis won this one.

(2) Mr. Ellis, feeling emboldened, argued that Code section 4975(c) did not apply because he was paid reasonable compensation for services rendered, or for the reimbursement of expenses incurred, in the performance of his duties with the plan.

The Court dryly notes that he was paid for being the general manager of CST, not for administrating the plan. Code section 4975(c) did not apply. Ellis was a disqualified person, and transfers of plan assets to a disqualified person are prohibited.

Mr. Ellis argued that the payment was from the business and not from his plan. The Court observed that the business was such a large piece of his IRA that, in reality, the business and his IRA were the same entity.

Mr. Ellis lost this one.

(3) Having determined the W-2 a prohibited transaction, it was not necessary for the Court again to consider whether the rent payment was also prohibited.

The Court goes through the consequences of Mr. Ellis blowing-up his IRA:

(1) Whatever he moved from his 401(k) to his IRA in 2005 is deemed distributed to him. He had to pay income taxes on it.

a.     The Court did observe that – since the IRA erupted in 2005 - it couldn’t again erupt in 2006. Thank goodness for small favors.

(2) Since Mr. Ellis was not age 59 ½, the 10% early distribution penalty applied.

(3) Since we are talking big bucks, the substantial underpayment penalty also applied for 2005. Ellis could avoid the penalty by showing reasonable cause.  He didn’t.

I suppose one could avoid IRA/business unity argument by limiting the ROBS to a small portion of one’s IRA. That would likely require a very sizeable IRA, and what would “small” mean in this context?

I disagree with the Court on the reasonable cause argument. ROBS are relatively recent, and takes a while for a body of law, including case law, to be developed. I find it chilling that the Court thought that the law and its Regulations were sufficiently clear that Mr. Ellis should have known better. Whereas I disagree with many of the ROBS arguments, I acknowledge that they are reasonable arguments. The Court evidently did not feel the same.

OBSERVATION: How long do you think it will be before ROBS are a “reportable transaction,” bringing disclosure to its promoters and attention to the taxpayer?

My thoughts?  I intend to give this case to any client or potential client who is considering a ROBS. I can see situations where a ROBS can still pass muster – if the taxpayer is a true and passive investor, for example. Problem is, that is not how ROBS are promoted. They are marketed to the prematurely and involuntarily unemployed, and as a way to fund a Five Guys Burgers and Fries franchise or that accounting practice in New Jersey. Odds are you will be working there, as you are too young to retire. You will not be passive. If you were passive, why not just buy Altria or Proctor & Gamble stock? You don’t need a ROBS for that.

New Tax On Self-Funded Health Plans Due By July 31

I knew that there was a new tax on self-insured medical plans. I was surprised that it reached health reimbursement arrangements (HRA), though.

I was surprised because it makes little sense, other than as a raw money grab. Next time perhaps the government will just select names at random from a phone book and require them to send money. I suggest they start with the District of Columbia phone book.

Have you heard of a health reimbursement arrangements? We are wading into alphabet soup-land, so let’s take a moment to compare and contrast an HRA with a health savings account (HSA).

 

If your employer is large enough, you may receive an annual letter laying out your health insurance options. Perhaps you can select from standard reimbursement, HMO, preferred provider or high-deductible health plans. That high-deductible plan likely is an HSA.

The concept of an HSA is simple: combine a high-deductible health policy with a medical IRA. If one incurs routine medical costs, one is reimbursed from the IRA. If one does not, then the IRA continues to compound and accumulate. The policy is there for big expenses. For a healthy family the medical IRA can add-up to tens of thousands of dollars.

A health reimbursement arrangement (HRA) is a different animal.   A key difference is that an HRA is all employer money. The HRA can reimburse employees for medical expenses, including vision, dental and chiropractic. It can reimburse on a first-dollar basis, a deductible-first basis, a sandwich basis and any other basis the plan advisor can dream up. It can have an annual cap … or not. Chances it will have an annual cap, as otherwise the employer borders on being financially reckless.

The employee doesn’t own this money, by the way. Should an employee quit, the money reverts to the employer. In truth, many if not most HRAs do not have any money at all. The medical bills are paid directly from company funds when presented for reimbursement. There may be an accounting somewhere that shows every employee and how many dollars are in his/her “account,” but this is for bookkeeping purposes only. The term for this is “notional,” and it means make-believe. Think unicorns, fairies and the New York Jets having a NFL-caliber quarterback.

ObamaCare (technically, The Affordable Care Act) is imposing a new fee on self-funded plans, which includes HRAs. It is coming up fast. If you have an HRA whose most current plan year ended after September 30, 2012 and before July 31, 2013 (that is, virtually every HRA), the HRA will have to pay a $1 fee per participant. Next year the fee goes to $2, and thereafter it goes to who-knows-what because some government bureaucrat will decide the amount.

The tax is due by the end of this month – July 31.

This tax will be reportable on Form 720, which may be a new filing for many employers.

It also has to be paid electronically. There is no attaching a check for this one.

I am a big fan of HRAs, as it allows companies to add to their employee benefits package without bankrupting themselves in the process. The HRA can cover deductibles, pay for braces or help with medical expenses that otherwise fall through the cracks left by the main insurance policy. HRAs have gotten more expensive, however, both by the per-participant fee as well as by the tax practitioner’s fee to prepare the return.

NOLs and Self-Employment Tax

Here is another one of those tax cases where you wonder how it got so far. Let’s set this up:

(1)    say that you are self-employed, and

(2)    you lost money, so you have a net operating loss carryover; and

(3)    you fail to file a later year tax return, and

(4)    the IRS prepares one for you, and

(5)    you owe a lot of tax, and

(6)    you ignore matters until you receive the statutory notice of deficiency, and

(7)    you clue the IRS that you have an NOL carryover, which reduces but does not eliminate your tax, and

(8)    the IRS still wants some tax (both income and self-employment) from you, and

(9)    you disagree because the you think the NOL reduced both your taxable income and self-employment income, and

(10) the IRS wants to know where in the tax code it says you can do that.

To understand what is happening here, think of your income tax and your self-employment tax as side-by-side railroad tracks. You use the same numbers to calculate how much is subject to income tax and to employment tax, but there comes a point where the tracks diverge. In our situation, that point is the net operating loss. There is no question you get a deduction for the NOL on your income taxes, but what is the answer for your self-employment taxes? Remember: different tracks = different trains.

Did I mention that you are an accountant?

So you are now preparing for the Tax Court. While preparing you come across this sharp rock from the tax code:

1402(a) Net Earnings from Self-Employment – The term “net earnings from self-employment” means the gross income derived by an individual from any trade or business carried on by such individual, less the deductions allowed…; except that….

                                (4) the deduction for net operating losses provided in section 172 shall not be  allowed.

Oh no. Now what do you do? Well, our taxpayer (Joseph DeCrescenzo v Commissioner T.C. Memo 2012-51) comes up with a two-pronged attack:

               

(1)    Argue that the IRS cannot raise the issue because they did not raise the issue in the notice of deficiency. The problem with this is … that they did by including the NOL in the notice.

(2)     And even if the IRS did, it was not binding on you because you suffer from acute anxiety disorder.

You can probably guess that this did not turn out well for the taxpayer. It cost him over $70,000 in penalties (late filing, late payment and etc.) alone.

It would have been much cheaper to have hired a competent tax CPA.