Section 643 and MSTs

 

I came across the following recently on LinkedIn:

 

The line of tax code that 99% of CPAs can’t understand for some reason.

And because they don’t understand this they make their clients tax planning convoluted and unnecessary.

26 U.S. Code § 643

(3) Capital gains and losses
Gains from the sale or exchange of capital assets shall be excluded to the extent that such gains are allocated to corpus and are not (A) paid, credited, or required to be distributed to any beneficiary during the taxable year, or (B) paid, permanently set aside, or to be used for the purposes specified in section 642(c). 

Stop, just stop.

There is a lot of nonsense going around on social media concerning something called - among other things – a “nongrantor, irrevocable, complex, discretionary, spendthrift trust.”

I just call it a “643 trust.” It is probably unfair as Section 643 has its legitimate place in the Code, but I simply cannot repetitively spray multisyllabic spittle when referring to these.

They have many forms, but one thing is key: Section 643. I met last year with someone who was hawking these things but was unable to find a CPA with his elevated mastery of the tax Code.

Uh huh. Elevator is down the hall, pal.

Let’s walk through these trusts.

The tax Code has numerous sections. Go to Chapter 1 Subchapter J and you will find sections dealing with trusts. You will note that they all have numbers between 641 and 692.

Section 643 is between 641 and 692. We are in the right place.

Trust taxation is not the easiest thing to understand. There are weird concepts. Then there are uncommon terms, such as:

 

·       The grantor – the person who transfers assets to the trust.

·       The income beneficiary – the person entitled to income distributions.

·       The residuary beneficiary – the person entitled to the remainder of the trust when the income beneficiaries are done.

·        Irrevocable trust – a trust where the grantor cannot amend or end the trust after its creation.

·       Complex trust – a trust that can accumulate (that is, retain) its profit.

·       Trustee – the person managing trust assets for the benefit of trust beneficiaries. A trustee is required to act in the best interest of the beneficiaries.

·       Discretionary trust – a trust allowing a trustee the power to decide how and when to distribute assets (including income) to beneficiaries.

Believe it or not, there are also several definitions of income, such as:

 

·       Fiduciary accounting income – income as defined by the trust instrument and state law.

·       Distributable net income – the maximum income available to the trustee for distribution to beneficiaries.

·       Taxable income – income as defined by the tax Code.

And - yes - you can get different answers depending on which definition of income you are looking at.

Why is that?

One reason is possible tension between different beneficiary classes. Say that you create a trust for your son and daughter as income beneficiaries. Upon their death, the remaining trust assets (called corpus) goes to the grandkids, who are the residuary beneficiaries. Your kids may want something to be considered income, as they are entitled to income distributions. The grandkids may prefer something not be considered income, as that something would not be distributed and thereby remain in the trust until eventual distribution to them.

What are common friction points between income and residuary beneficiaries? Here are two repetitive ones: capital gains and depreciation.

For example, one may consider depreciation as a reserve to replace deteriorating physical assets. In that case, it makes sense to allocate depreciation to the residuary beneficiaries, as the assets will eventually go to them. Then again, accountants routinely include depreciation as a current period expense. In that case, depreciation should go to the income beneficiaries along with other current period expenses.

Back to our multisyllabic spittle trust (MST).

Look at Section 643(b):

    26 U.S. Code § 643 - Definitions applicable to subparts A, B, C, and D

(b) Income.

For purposes of this subpart and subparts B, C, and D, the term "income", when not preceded by the words "taxable", "distributable net", "undistributed net", or "gross", means the amount of income of the estate or trust for the taxable year determined under the terms of the governing instrument and applicable local law. Items of gross income constituting extraordinary dividends or taxable stock dividends which the fiduciary, acting in good faith, determines to be allocable to corpus under the terms of the governing instrument and applicable local law shall not be considered income.  

What is this Section trying to do?

Looks like it is trying to define “income” and failing rather badly at it.

Look at the last sentence:

… which the fiduciary, acting in good faith, … shall not be considered income.”

Hmmmmm.

But read the first sentence:

… when not preceded by the words “taxable ….”

Seems to me that last sentence could be the solution to the Riemann Hypothesis and it would not matter once you put the word “taxable” in front of “income.”

Let’s move on to Section 643(a):

Distributable net income.

For purposes of this part, the term “distributable net means, with respect to any taxable year, the taxable income of the estate or trust computed with the following modifications —  

(3) Capital gains and losses         

Gains from the sale or exchange of capital assets shall be excluded to the extent that such gains are allocated to corpus and are not (A) paid, credited, or required to be distributed to any beneficiary during the taxable year, or (B) paid, permanently set aside, or to be used for the purposes specified in section 642(c).  

(4) Extraordinary dividends and taxable stock dividends  

… there shall be excluded those items of gross income constituting extraordinary dividends or taxable stock dividends which the fiduciary, acting in good faith, does not pay or credit to any beneficiary by reason of his determination that such dividends are allocable to corpus under the terms of the governing instrument and applicable local law.

I see the words “shall be excluded.”

I see the extraordinary dividends and taxable stock dividends from Section 643(b). And there is new wording about gains from the sale or exchange of capital assets. Is it possible …?

I also see the words “Distributable net income” at the top.

Let’s go back to our definitions of trust income.

Section 643(a) addresses distributable net income. Think of DNI as Mint Chocolate Chip.

Section 643(b) addresses taxable income. Think of TI as Cookies and Cream.

Mint Chocolate Chip is not Cookies and Cream.

Maybe capital gains are excludable from DNI. Maybe they are not. Either way, that conundrum has nothing to do with capital gains being excludable from taxable income.

The IRS is quite aware of the game being played.

Here is AM 2023-006:

 

One is dancing on the slippery beveled edge of a possible tax shelter.

Just leave these trusts alone. If I could make income nontaxable by running it through a string-a-bunch-of-words-together trust, I would have done so years ago. I might have even retired by now.

Just Pay The Tax, Boris

I have no problem with minimizing one’s tax liability.

But then there are people who will go to extremes.

Boris Putanec is one of these. I am skimming over a 34-page Tax Court case about a tax shelter he used.

Let’s travel back in time to the dot-com era.

Putanec was one of the founders of Ariba, a business-to-business software company. The initial idea was simple: let’s replace pencil- and pen-business functions with a computerized solution. There are any number of areas in business accounting - routine, repetitious, high-volume – that were begging for an easier way to get things done.

Enter Ariba.

Which eventually went public. Which meant stock. Which meant big bucks to the founders, including Putanec.

Up to this point I am on his side.

This guy wound-up owning more than 6 million shares in a company valued (at one point) around $40 billion.

How I wish I had those problems.

You can anticipate much of the next stretch of the story.

Most of Putanec’s money was tied-up in Ariba stock. That is generally considered unwise, and just about every financial planner in the world will tell you to diversify. When 90-plus-% of your net worth is held in one stock, “diversify” means “sell.”

Now Putanec acquired his stock when the company was barely a company. That meant that he paid nothing or close to nothing to get the stock. In tax talk, that nothing is his “basis.” Were he to sell his stock, he would subtract his basis from any sales proceeds to calculate his gain. He would pay tax on the gain, of course. Well, when you subtract nothing (-0-) from something, you have the same something left over.

In his case, big something.

Meaning big tax.

Rather than just paying the tax and celebrating his good fortune, Putanec was introduced to a tax shelter nicknamed CARDS.

Sigh.

CARDS stands for “custom adjustable rate debt structure.” Yes, it sounds like BS because it is. Tax shelters tend to have one thing in common: take a tax position, pretzel it into an unrecognizable configuration and then bury the whole thing in a series of transactions so convoluted and complex that it would take a team of tax attorneys and CPAs a half-year to figure out.

Let’s go through an example of a CARDS deal.

1. Someone has a gigantic capital gain, perhaps from selling Ariba sock.
1. CARDS deals routinely started at $50 million. That threshold easily weeds out you and me.
2. There will be a foreign bank (FB) involved. 
3. There will be foreign currency involved. 
4. The promoter forms a limited liability company (LLC) somewhere. 
5. The FB loans money (let’s say $100 million) to the LLC. 
1. The LLC deposits around 85% of the money in a bank – probably the same bank (FB) that started this thing. 
2. The LLC keeps the other 15%. 
3. The FB wants collateral, so the LLC gives the FB a promissory note. 
1. That note is special. The bank probably has 85% of its money in an account by this point, but the note is for 100%. Why? It’s part of the BS. 
2. There is also something crazy about this note. It can stretch out as long as 30 years, although the bank reserves the right to call it early (probably annually).
6. We now have an LLC somewhere on the planet with an $85 million CD or savings account, a $15 million checking account, and a $100 million promissory note. Just to remind, this is all happening overseas and in foreign currency.
2. Now we leave the rails. 
1. Someone (say Putanec) assumes joint and several liability for that $100 million loan. 
1. Remember that $85 million is already sitting in a CD or likewise, so this is not as crazy as it seems.
2. The LLC will continue to pay the bank interest on the loan. Said someone is not to be bothered. Goes without saying that the bank (FB) will eventually slide the $85 million to itself and make the loan go away.
3. Said someone also takes control of the $15 million parked in that foreign checking account. 
1. In the tax universe, the conversion of that foreign currency to American dollars is a taxable event. Let’s now add gas to the fire.
4. Remember that gain = proceeds – basis.
5. Proceeds in this case are $15 million.
6. Basis in this case … 
1. Is $100 million. 
2. Huh? Yep, because that someone gets to add that $85 million promissory note to his/her $15 million paid in cash.
7. The LOSS therefore is $15 million – $100 million = $85 million.

Now, this could make sense – if said someone had to - some day - write a check to the bank for $85 million.

Not going to happen. The bank already has that $85 million tucked-away in a CD or savings account it controls. The bank never has to leave its front door to get its hands on that $85 million.

But our someone has a sweet yet nutritiously-balanced $85 million capital loss to offset a capital gain.

If only we could come up with a capital gain…. What to do? What can we …? Visualize severe forehead frown.

Got it!!

Let’s sell that Ariba stock. That will generate the gain to absorb that $85 million loss.

Call me He-Man, Tax Master of the Universe.

Yes folks, that is what the gazillion-dollars-a-year “consultants” were peddling to people to avoid paying taxes on something with a huge, latent capital gain.

 Of which Boris Putanec was one.

 The Court bounced him with the following flourish:

The deal is the stuff of tax wizardry, while the Code treats us all as mere muggles. The loan he assumed wasn’t all genuine debt, and any potential obligation he had to repay the entire loan was unlikely or at best contingent.”

I suppose winning the lottery was not enough.

Just pay the tax, Boris.

A Tax Shelter In The Making

Have you ever heard of a “captive” insurance company?

They have become quite cachet. They have also drawn the IRS’ attention, as people are using these things for reasons other than insurance and risk management.

Let’s walk through this.  

Let’s say that you and I found a company manufacturing sat-nav athletic shoes

COMMENT: Sat-nav meaning satellite navigation. That’s right: you know you want a pair. More than one.

We make a million of them, and we have back orders for millions more. We are on the cover of Inc. magazine, meet Jim Cramer and get called to the White House to compliment us for employing America again.

Sweet.

Then tax time.

We owe humongous taxes.

Not sweet.

Our tax advisor (I am retired by then) mentions a captive.

LET’S EXPLAIN THIS: The idea here is that we have an insurable risk. Rather than just buying a policy from whoever-is-advertising-during-a-sports-event, we set up our own (small) insurance company. Granted, we are never going to rival the big boys, but it is enough for our needs. If we can leap through selected hoops, we might also get a tax break from the arrangement.

What risks do you and I have to insure?

What is one of those shoes blows out or the satellite-navigation system shorts and electrocutes someone? What if it picks up contact from an alien civilization – or an honest political journalist? We could get sued.

Granted, that is what insurance is for. The advisor says to purchase a policy from one of the big boys with a $1.2 million deductible. We then set up our own insurance company – our “captive” – to cover that $1.2 million.

We are self-insuring.

There is an election in the tax Code (Section 831(b) for the incorrigible) that waives the income tax on the first $1.2 million of premiums to the captive. It does pay tax on its investment income, but that is nickels-to-dollars.

You see that I did not pick the $1.2 million at random.

Can this get even better?

Submitted for your consideration: the You & Me ET Athletic Shoe Company will deduct the $1.2 million as “Insurance Expense” on its business return.

We skip paying tax on $1.2 million AND we deduct it on our tax return?

Easy, partner. We can still be sued. We would go through that $1.2 million in a heartbeat.

Is there a way to MacGyver this?

Got it. Three ways come quickly to mind, in fact:

(1) Let’s make the captive insurance duplicative. We buy a main policy with a reputable insurance company. We then buy a similar – but redundant -  policy from the captive.  We don’t need the captive, truthfully, as Nationwide or Allstate would provide the real insurance. We do get to stuff away $1.2 million, however – per year. We would let it compound. Then we would go swimming in our money, like Scrooge McDuck from the Huey, Dewey and Louie comics.

(2) A variation on (1) is to make the policy language so amorphous and impenetrable that it is nearly impossible to tell whether the captive is insuring whatever it is we would submit a claim for. That would make the captive’s decision to pay discretionary, and we would discrete to not pay.

(3) We could insure crazy stuff. Let’s insure for blizzards in San Diego, for example. 

a.    Alright, we will need an office in San Diego to make this look legitimate. I volunteer to move there. For the team, of course.

The tax advisor has an idea how to push this even further. The captive does not need to have the same owners as the You & Me ET Athletic Shoe Company. Let’s make our kids the shareholders of the captive. As our captive starts hoarding piles of cash, we are simultaneously doing some gifting and estate tax planning with our kids.

Heck, we can probably also put something in there for the grandkids.

To be fair, we have climbed too far out on this limb. These things have quite serious and beneficial uses in the economy. Think agriculture and farmers. There are instances where the only insurance farmers can get is whatever they can figure-out on their own. Perhaps several farms come together to pool risks and costs. This is what Section 831(b) was meant to address, and it is a reason why captives are heavily supported by rural state Senators.

In fact, the senators from Wisconsin, Indiana and Iowa were recently able to increase that $1.2 million to $2.2 million, beginning in 2017.

Then you have those who ruin it for the rest of us. Like the dentist who captived his dental office against terrorist attack.

That nonsense is going to attract the wrong kind of attention.

Sure enough, the IRS stepped in. It wants to look at these things. In November, 2016 the IRS gave notice that (some of) these captive structures are “transactions of interest.” That lingo means that – if you have one – you must file a disclosure (using Form 8886 Reportable Transaction Disclosure Statement) with the IRS by May 1, 2017.

If this describes you, this deadline is only a few months away. Make sure that your attorney and CPA are on this.

Mind you, there will be penalties for not filing these 8886s.

That is how the IRS looks at things. It is good to be king.

The IRS is not saying that captives are bad. Not at all. What it is saying is that some people are using captives for other than their intended purpose. The IRS has a very particular set of skills, skills it has acquired over a very long career. Skills that make the IRS a nightmare for people like this. If these people stop, that will be the end of it. If they do not stop, the IRS will look for them, they will find them, and they will ….

Ahem. Got carried away there.

When this is over, we can reasonably anticipate the IRS to say that certain Section 831(b) structures and uses are OK, while others are … unclear. The IRS will then upgrade the unclear structures and uses to “reportable” or “listed” status, triggering additional tax return disclosures and potential eye-watering penalties.

In the old days, listed transactions were called “tax shelters,” so that will be nothing to fool with.

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.