Renting Real Estate And Self-Employment Tax

 

I was looking at a tax return recently. There was an issue there that I did not immediately recognize.

Let’s go over it.

The client is a new venue for cocktail parties, formal dinners, corporate meetings, bridal showers, wedding rehearsals and receptions, and other such occasions.

The client will configure the space as you wish, but you will have to use a preselected list of caterers should you want food. There is a bar, but you will have to provide your own bartender. You can decorate, but there are strict rules on affixing decorations to walls, fixtures, and such. Nonroutine decorations must be approved in advance. You will have to bring your own sound system should you want music, as no system exists. The client will clean the space at the end of the event, but you must first remove all personal items from the property.

Somewhat specialized and not a business I would pursue, but I gave it no further thought.

The question came up: is this ordinary business income or rental income?

Another way to phrase the question is whether the income would or would not be subject to self-employment tax.

Let’s say you have a duplex. One would be hard pressed to think of a reasonable scenario where you would be paying self-employment tax, as rental income from real estate is generally excepted from self-employment income.

Let’s change the facts. You own a Hyatt Hotel. Yes, it is real estate. Yes, there is rental income. This income, however, will be subject to self-employment tax.

What is the difference? Well, the scale of the activity is one, obviously. Another is the provision of additional services. You may bring in a repairman if there were a problem at the duplex, but you are not going into the unit to wash dishes, vacuum carpets, change bed linens or provide fresh towels. There is a limit. On the other hand, who knows what concierge services at a high-end hotel might be able to provide or arrange.

We are on a spectrum, it appears. It would help to have some clarification on which services are innocuous and which are taunting the bull.

IRS Chief Counsel Advice 202151005 addressed the spectrum in the context of residential rental property.

First a warning. A CCA provides insight into IRS thinking on a topic, but that thinking is not considered precedent, nor does it constitute substantial authority in case of litigation. That is fine for us, as we have no intention of litigating anything or having a tax doctrine named after us.

Here is scenario one from the CCA:

·       You are not a real estate dealer.

·       You rent beachfront property via online marketplaces (think Airbnb).

·       You provide kitchen items, Wi-Fi, recreational equipment, prepaid ride-share vouchers to the business district and daily maid service.

Here is scenario two:

·       You are not a real estate dealer.

·       You rent out a bedroom and bathroom in your home via online marketplaces.

·       A renter has access to common areas only to enter and exit.

·       You clean the bedroom and bathroom after each renter’s stay.

I am not overwhelmed by either scenario. Scenario one offers a little more than scenario two, but neither is a stay at the Hotel Jerome.

Here is the CCA walkthrough:

·       Tax law considers rental income collected by a non-dealer to be non-self- employment income.

·       However, the law says nothing about providing services.

·       Allowable services include:

o   Those clearly required to maintain the property in condition for occupancy, and

o   Are a sufficiently insubstantial portion of the rent.

·       Nonallowable services include:

o   Those not clearly required to maintain the property in condition for occupancy, and

o   Are so substantial as to comprise a material portion of the rent.

The CCA considered scenario two to be fine.

COMMENT: I would think so. The services are minimal unless you consider ingress and egress to be substantial services.

The CCA considered scenario one not to be fine.

Why not?

·       The services are for the convenience of the occupants.

·       The services are beyond those necessary to maintain the space for occupancy.

·       The services are sufficient to constitute a material portion of the rent.       

I get the big picture: the closer you get to hotel accommodations the more likely you are to be subject to self-employment tax. I am instead having trouble with the smaller picture – the details a tax practitioner is looking for – and which signal one’s location on the spectrum.

·       Is the IRS saying that services beyond the mere availability of a bed and bathroom are the path to the dark side?

·       IRS Regulations refer to services customarily provided.

o   How is one to test customarily: with reference to nearby full-service hotels or only with other nearby online rentals?

o   In truth, did the IRS look at any nearby services in scenario one?

·       What does material portion mean?

o   Would the provision of services at a lower rent situs (say Athens, Georgia) result in a different answer from the provision of comparable services at a higher rent situs (say Aspen, Colorado)?

o   What about a different time of year? Can one provide more services during a peak rental period (say the NCAA Tournament) and not run afoul of the material portion requirement??

One wonders how much this CCA has reinforced online rental policies such as running-the-dishwasher and take-out-the-trash-when-you-leave. There is no question that I would advise an Airbnb client not to provide daily services, whatever they may be.

I also suspect why our client set up their venue the way they did.

A Winter Barge and Depreciation

 

The question comes up with some frequency: when is an asset placed-in-service for tax purposes?

Generally one is talking about depreciation. Buy an expensive asset near the end of the year, allow for delivery (and perhaps installation) time and one becomes quite interested with the metaphysics of depreciation.

Let me give you a couple of situations:

·      You finish constructing an office building near the end of the year. It is ready-to-go, but your first tenant doesn’t move in until early the following year. When do you start depreciation?

·      You are a pilot and buy a plane through your business. It is delivered in the last few days of December. There is no business travel (as it is near year-end and between holidays), but you take the plane up for its shakedown flight. When do you start depreciation?

The numbers can become impressive when you consider that we presently have 100% bonus depreciation, meaning that a qualifying asset’s cost can be depreciated/deducted in full when it is placed in service.

And what do you do in COVID 2020/2021, if you buy an asset but government orders and mandates restrict or close the business?

There is a classic tax case that goes back to the 1960s. It distinguished between an asset being ready and available for use and actually being placed into use. Why the nitpicking? Because life happens. In general, a place-in-service date occurs when the asset is ready and available for use.  

Well, that rule-of-thumb would help with COVID 2020/2021 issues.

On to our case.

A company in New York bought a barge from a builder in Louisiana.

The barge made it to Rome, New York.

It was outfitted and ready to go by the end of 1957.

Winter came. The canal froze. The barge was stuck in a frozen New York canal until spring of 1958.

When was the barge placed-in-service?

You know the IRS was on the side of 1958. They had persuasive arguments in their favor, and that – plus the sheer cost of a barge – meant the matter was going to be litigated.

Here is the Court:

… the barge was ready for charter or for use in the taxpayer’s own distribution business by December 1, 1957, but could not be used until May, 1958, because it was frozen into the water of an upstate canal. This was certainly not a condition which the taxpayer desired to bring about.”

And here is the staying power of the case:

… depreciation may be taken when depreciable property is available for use ‘should the occasion arise,’ even if the property is not in fact in use.”

Common tax issue + dramatic facts = memorable tax law.

Our case this time was Sears Oil Co., Inc v Commissioner, 359 F.2^nd 191 (2d Cir 1966).

UberEats and Employer-Provided Lunches

It is 50 pages long. This is not the time of year for me to read this in detail.

I am referring to an IRS Technical Advice Memorandum. A TAM means that a taxpayer is under examination and the revenue agent has a question. The TAM answers the question.

This one has to do with excluding meals as income to employees when the meals are for the “convenience of the employer.”

I guess I long ago selected the wrong profession for this to be an issue. The instances have been few over the years where an employer has regularly brought in dinner during busy season. I had one employer who would do so on Tuesdays and Thursdays, but the offset was working until 9 p.m. or later. As I recall, one virtually needed a papal decree to deviate from their policies, and they had policies like the Colonel has chicken. At this age and stage, I would not even consider working for them, but at the time I was young and dumb.

The classic “convenience of the employer” example is a fireman: you have to be around in case of emergencies. There are other common reasons:

·      To protect employees due to unsafe conditions surrounding the taxpayer’s business premises;

·      Because employees cannot secure a meal within a reasonable meal period;

·      Because the demands of the employees' job functions allow them to take only a short meal break.

What has exacerbated the issue is not your job or mine, but the Googles and Microsofts of the world. For example, Google’s headquarter in Mountain View, California has over 15 cafeterias. Not to be overshadowed, Microsoft in Redmond, Washington has over two dozen. Why would one even bother to go to a grocery store?

Not my world. Not my reality.

The “reasonable meal period” has generally meant that there are limited dining options nearby. I have a family member who works at a nuclear facility. I do not know, but I would expect options thin-out the closer you get to said facility. That reasonable meal period is likely legit in his case.

The TAM is presented in question and answer form. Here is one of the answers:

While the availability of meal delivery is not determinative in every analysis concerning …, especially in situations where delivery options are limited, meal delivery should be a consideration in determining whether an employer qualifies under this regulation and generally when evaluating other business reasons proffered by employers as support for providing meals for the “convenience of the employer” under section 119.

So the IRS is working to incorporate the rising popularity of GrubHub and UberEats into the taxation of employer-provided meals. Wow, if you practice long enough…

I am not too worried about it, other than prompting a chuckle. Why? Because here at CTG command-center we do not provide the occasional lunch because of limited dining opportunities. Rather we bring-in lunch because of in-house training (as an example), and we want everyone there.

Think about it: we give you a sandwich and you get to hear me talk about taxes and watching paint dry.

I suspect you would rather just buy your own lunch.

The New Qualified Business Deduction

I spent a fair amount last week looking over the new IRS Regulations on the qualified business deduction. It was a breezy and compact 184 pages, although it reads longer than that.

I debated blogging on this topic. While one of the most significant tax changes in decades, the deduction is difficult to discuss without tear-invoking side riffs. 

But – if you are in business and you are not a “C” corporation (that is, the type that pays its own taxes) - you need to know about this new deduction.

Let’s swing the bat:

1.    This is a business deduction. It is 20% of something. We will get back to what that something is.

2.    There historically has been a spread between C-corporation tax rates and non-C-corporation tax rates. It is baked into the system, and tax advisors have gotten comfortable understanding its implications. The new tax law rattled the cage by reducing the C-corporation tax rate to 21%. Without some relief for non-C-corporation entities, lawyers and accountants would have had their clients folding their S corporation, partnership and LLC tents and moving them to C-corporation campgrounds.

3.    It is sometimes called a “passthrough” deduction, but that is a misnomer. It is more like a non-C-corporation deduction. A sole proprietorship can qualify, as well as rentals, farms and traditional passthroughs like S corporations, LLCs and partnerships. Heck even estates and trusts are in on the act.

4.    But not all businesses will qualify. There are two types of businesses that will not qualify:

a.     Believe it or not, in the tax world your W-2 job is considered a trade or business. It is the reason that you are allowed to deduct your business mileage (at least, before 2018 you were). Your W-2 however will not qualify for purposes of this deduction.

b.    Certain types of businesses are not invited to the party: think doctors, dentists, lawyers, accountants and similar. Think of them as the “not too cool” crowd.

                                                   i.There is however a HUGE exception.

5.   Congress wanted you to have skin in the game in order to get this 20% deduction. Skin initially meant employees, so to claim this deduction you needed Payroll. At the last moment Congress also allowed somebody with substantial Depreciable Property to qualify, as some businesses are simply not set-up with a substantial workforce in mind. If you do not have Payroll or Depreciable Property, however, you do not get to play.

a.     But just like (4)(b) above, there is a HUGE exception.

6.   Let’s set up the HUGE exception:

a.     If you do not have Payroll or Depreciable Property, you do not get to play.

b.    If you are one of “those businesses” - doctors, dentists, lawyers, accountants and similar - you do not get to play.

c.     Except …

                                                   i. … if your income is below certain limits, you still get to play.

                                                 ii. The limit is $157,500 for non-marrieds and $315,000 for marrieds.

                                              iii. Hit the limit and you provoke math:

1.    If you are non-married, there is a phase-out range of $50 grand. Get to $207,500 and you are asked to leave.

2.    If you are married, double the range to $100 grand; at $415,000 you too have to leave.

                                               iv. Let’s consider an easy example: A married dentist with household taxable income of less than $315,000 can claim the passthrough deduction, as long as the income is not from a W-2.

1.    At $415,000 that dentist cannot claim anything and has to leave.

                                                 v. Depending on the fact pattern, the mathematics are like time-travelling to a Led Zeppelin concert. The environment is familiar, but everything has a disorienting fog about it.

1.    Why?

a.     The not-too-cool crowd has to leave the party once they get to $207,500/$415,000.

b.    Simultaneously, the too-cool crowd has to ante-up either Payroll and/or Depreciable Property as they get to $207,500/$415,000. There is no more automatic invitation just because their income is below a certain level.

c.     And both (a) and (b) are going on at the same time.

                                                                                                               i.     While not Stairway to Heaven, the mathematics are … interesting.

7.    The $207,500/$415,000 entertainment finally shows up: Payroll and Depreciable Property. Queue the music.

a.     The deduction starts at 20% of the specific trade or business’s net profit.

b.    It can go down. Here is how:

                                                   i. You calculate half of your Payroll.

                                                 ii. You calculate one-quarter of your Payroll and add 2.5% of your Depreciable Assets.

                                              iii. You take the bigger number.

                                               iv. You are not done. You next take that number and compare it to the 20% number from (a).

                                                 v. Take the smaller number.

c.     You are not done yet.

                                                   i. Take your taxable income without the passthrough deduction, whatever that deduction may someday be. May we live long enough.

                                                 ii. If you have capital gains included in your taxable income, there is math. In short, take out the capital gain. Bad capital gain.

                                              iii. Take what’s left and multiply by 20%.

                                               iv. Compare that number to (7)(b)(v).

1.    Take the smaller number.

8.    Initially one was to do this calculation business by business.

a.     Tax advisors were not looking forward to this.

b.    The IRS last week issued Regulations allowing one to combine trades or businesses (within limits, of course).

                                                   i. And tax advisors breathed a collective sigh of relief.

c.     But not unsurprisingly, the IRS simultaneously took away some early planning ideas that tax advisors had come up with.

                                                   i. Like “cracking” a business between the too-cool and not-too-cool crowds.  

And there is a high-altitude look at the new qualified business deduction.

If you have a non-C-corporation business, hopefully you have heard from your tax advisor. If you have not, please call him/her. This new deduction really is a big deal.

Worst. Tax. Advice. Ever.

Dad owned a tool and die company. Son-in-law worked there. The company was facing severe foreign competition, and - sure enough - in time the company closed. For a couple of years the son-in-law was considerably underpaid, and dad wanted to make it up to him.

The company's accountant had dad infuse capital into the business. The accountant even recommended that the money be kept in a separate bank account. Son-in-law was allowed to tap into that account near-weekly to supplement his W-2. The accountant reasoned that - since the money came from dad - the transaction represented a gift from dad to son-in-law.

Let's go through the tax give-and-take on this.

In general, corporations do not make gifts. Now, do not misunderstand me: corporations can make donations but almost never a gift. Gifts are different from donations. Donations are deductible (within limits) by the payor and can be tax-free to the payee, if the payee has obtained that coveted 501(c)(3) status. Donations stay within the income tax system.

Gifts leave the income tax system, although they may be subject to a separate gift tax. Corporations, by the way, do not pay gift taxes, so the idea of a gift by a corporation does not make tax sense.

The classic gift case is Duberstein, where the Supreme Court decided that a gift must be made under a "detached and disinterested generosity" or "out of affection, respect, admiration, charity or like impulses." The key factor the Court was looking for is intent.

And it has been generally held that corporations do not have that "detached and disinterested" intent that Duberstein wants.  Albeit comprised of individuals, corporations are separate legal entities, created and existing under state law for a profit-seeking purpose. Within that context, it becomes quite difficult to argue that corporations can be "detached and disinterested."

It similarly is the reason - for example - that almost every job-related benefit will be taxable to an employee - unless the benefit can fit under narrow exceptions for nontaxable fringes or awards. If I give an employee a $50 Christmas debit card, I must include it in his/her W-2. The IRS sees an employer, an employee and very little chance that a $50 debit card would be for any reason other than that employment relationship.   

What did the accountant advise?

Make a cash payment to the son-in-law from corporate funds.

But the monies came from dad, you say.

It does not matter. The money lost its "dad-stamp" when it went into the business.

What about the separate bank account?

You mean that separate account titled in the company's name?

It certainly did not help that the son-in-law was undercompensated. The tax Code already wants to say that all payments to employees are a reward for past service or an incentive for future effort. Throw in an undercompensated employee and there is no hope.

The case is Hajek and the taxpayer lost. The son-in-law had compensation, although I suppose the corporation would have an offsetting tax deduction. However, remember that compensation requires FICA and income tax withholding - and no withholdings on the separate funds were remitted to the IRS - and you can see this story quickly going south. Payroll penalties are some of the worst in the tax Code.

What should the advisor have done?

Simple: have dad write the check to son-in-law. Leave the company out of it.

Why Audit Veterans Organizations?

I suppose that any examination of an exempt organization by the IRS nowadays is going to be viewed in harsh light.

What got me thinking about this is the controversy concerning IRS audits of veterans organizations. While it hasn’t garnered the attention of the 501(c)(4) imbroglio, there has nonetheless been harsh criticism. U.S. Senator Moran (Kansas) for example has stated:

On the heels of Americans' anger over revelations that the IRS intentionally targeted certain groups, it has been brought to my attention that the IRS is now turning their sights toward our nation's veterans. The IRS seems to be auditing veteran service organizations by requiring private member military service forms. If a post is unable or not willing to turn over this personal information, it is possible they could face a fine of $1,000 per day.

I am deeply concerned about this revelation and will insist on answers. This policy ... deserves, at a minimum, a thorough look to make certain the IRS is not overstepping bounds of privacy and respect for our nation's heroes."

For its part, the House Veterans Affairs committee has threated to investigate what the IRS is up to.

So why would the IRS – in a time of budget restraints – be auditing these groups?

A couple of reasons come to mind:

•  The IRS has to audit exempt groups occasionally, if only in the interest of enforcing tax compliance among all exempt groups.

• Veterans organizations have unique tax requirements that are relatively easy to run afoul of.

Reason (1) is easy to understand, even if we would rather have a root canal than undergo a tax audit. Reason (2) is a bit more involved.

Tax-exempt organizations come in multiple flavors, depending on what the organization does. For example, a veterans organization could qualify as a social welfare group – that is, a 501(c)(4) – given its purpose of promoting patriotism, championing the issues of veterans, assisting needy and disabled veterans and conducting social and recreational activities among its membership.   

Let’s go a step further, and you will understand how the sausage of tax law comes to be.

Let’s say the veterans organization buys a building. Let’s say it puts a kitchen and bar in said building. We may now have a social club under Sec 501(c)(7), the same as a college fraternity or private golf course. Had you and I gotten together and built our own golf course, our activity (of playing golf) would not be taxable. The tax Code acknowledges this and allows for larger groups to do what you and I could have done together if only we were multibillionaires. There could be tax consequences if we did other things, but let’s keep our discussion general.

In 1969 Congress expanded the reach of the unrelated business income tax (UBT). UBT by definition relates to tax-exempt organizations, and it means that the organization has to pay tax on profitable business activities that are not in furtherance of its tax-exempt purpose.

What does that mean? Let’s go back to that golf course you and I built. Let’s say that we rent out our course to the PGA annually for a major tournament. We of course charge the PGA big bucks for using our course. We apply as a (c)(7), albeit a small one, considering it is only you and me. The IRS is not going to let us pocket all that money and not pay tax. Why? Because it is not our exempt purpose to rent our course to the PGA.

The veterans organizations became upset with the UBT. It was not even the kitchen and bar, truthfully, as much as it was the insurances – life, health and so on – that they were offering to their members. That was a big deal, and their insurance activity was now being pulled into the orbit of the UBT because of that (c)(4) or (c)(7) status.

Congress, thinking that the answer to everything problem is yet another law, passed Code section 501(c)(19): 

(19)  A post or organization of past or present members of the Armed Forces of the United States, or an auxiliary unit or society of, or a trust or foundation for, any such post or organization—

(A)  organized in the United States or any of its possessions,

(B)  at least 75 percent of the members of which are past or present members of the Armed Forces of the United States and substantially all of the other members of which are individuals who are cadets or are spouses, widows, widowers, ancestors, or lineal descendants of past or present members of the Armed Forces of the United States or of cadets, and

(C)  no part of the net earnings of which inures to the benefit of any private shareholder or individual.

And veterans organizations now had an escape clause from the UBT – as long as they could fit into (c)(19).

It worked well enough for long enough. And now it is starting to work less well.

Why?

It’s the math. Code section (c)(19) states that at least 75% of the members must be veterans  and substantially all other members  (generally defined as 90% or more) must be spouses, widows and descendants. Let’s go through the math. To start, at least 75% of the members must be veterans. Of the remaining, 90% or more must be related to a veteran. Doing the math, only 2.5% of the total membership (25% times 10%) may consist of non-veterans or persons unelated to a veteran.

That is a tight window.

Statistics show over 19 million veterans in the United States. More than 9 million are age 65 or over. Veterans are aging, and every year there are fewer of them. Those demographics are pushing on the percentage tests of (c)(19).

Let’s point out another problem.

How do you prove the 75%? I suppose you could (and probably should) obtain documentation from the veterans. The same could be said for proving the other 90%.  It would be business- standard procedure to keep files and maintain a policy and post signs that only members and families are admitted. I suppose we could boost documentation even more by requiring sign-in books, but you get the idea.

Is it intrusive? You bet. We are talking about IDs and proof of military service, for example. The IRS aggravated the matter recently by asking for DD 214 forms, which is the paperwork accompanying military discharge. The IRS had not routinely asked for this before, so many organizations were caught flat-footed. To exacerbate the matter, the IRS then threatened $1,000 per day penalties.

Cue the resentment and anger of organizations like the American Legion. These generally are not organizations that can easily accommodate drastic changes in tax rules. Many are small, reliant on volunteers and operating on a tight budget.  One cannot approach them as though one were dealing with the tax department of an Apple or Pfizer.

What is the answer? I don’t know. The 501(c) area is a motley of tax grab-bag accreted over the years. Some (c)’s can receive tax-exempt contributions; others cannot. Some organizations are (c)’s just by existing; others have to formally apply and get approval. Some do not pay income tax unless they get carried away and flat-out run a for-profit business. Others pay tax on income “not sufficiently related” to their exempt purpose, a standard sometimes bordering on the mystical. Some are huge, own buildings and have tens of thousands of employees. Others are tiny, have space donated and do everything through volunteers.

It is maddening, but they all have to be (at least in theory) auditable by the IRS.

And there is the rub.