Would You Believe?

It is a specialized issue, but I am going to write about it anyway.

Why?

Because I believe this may be the only time I have had this issue, and I have been in practice for over thirty years. There isn’t a lot in the tax literature either.

As often happens, I am minding my own business when someone – someone who knows I am a tax geek – asks:

          “Steve, do you know the tax answer to ….”

For future reference: “Whatever it is - I don’t. By the way, I am leaving the office today on time and I won’t have time this weekend to research as I am playing golf and sleeping late.”

You know who you are, Mr. to-remain-unnamed-and-anonymous-of-course-Brian-the-name-will-never-pass-my-lips.

Here it is:

Can a trust make a charitable donation?

Doesn’t sound like much, so let’s set-up the issue.

A trust is generally a three-party arrangement:

·      Party of the first part sets up and funds the trust.

·      Party of the second part receives money from the trust, either now or later.

·      Party of the third part administrates the trust, including writing checks.

The party of the third part is called the “trustee” or “fiduciary.” This is a unique relationship, as the trustee is trying to administer according to the wishes of the party of the first part, who may or may not be deceased. The very concept of “fiduciary” means that you are putting someone’s interest ahead of yours: in this case, you are prioritizing the party of the second part, also called the beneficiary.

There can be more than one beneficiary, by the way.

There can also be beneficiaries at different points in time.

For example, I can set-up a trust with all income to my wife for her lifetime, with whatever is left over (called the “corpus” or “principal”) going to my daughter.

This sets up an interesting tension: the interests of the first beneficiary may not coincide with the interests of the second beneficiary. Consider my example. Whatever my wife draws upon during her lifetime will leave less for my daughter when her mom dies. Now, this tension does not exist in the Hamilton family, but you can see how it could for other families. Take for example a second marriage, especially one later in life. The “steps” my not have that “we are all one family” perspective when the dollars start raining.

Back to our fiduciary: how would you like to be the one who decides where the dollars rain? That sounds like a headache to me.

How can the trustmaker make this better?

A tried-and-true way is to have the party of the first part leave instructions, standards and explanations of his/her wishes. For example, I can say “my wife can draw all the income and corpus she wants without having to explain anything to anybody. If there is anything left over, our daughter can have it. If not, too bad.”

Pretty clear, eh?

That is the heart of the problem with charitable donations by a trust.

Chances are, some party-of-the-second-part is getting less money at the end of the day because of that donation. Has to, as the money is not going to a beneficiary.

Which means the party of the first part had better leave clear instructions as to the who/what/when of the donation.

Our case this week is a trust created when Harvey Hubbell died. He died in 1957, so this trust has been around a while. The trust was to distribute fixed amounts to certain individuals for life. Harvey felt strongly about it, because - if there was insufficient income to make the payment – the trustee was authorized to reach into trust principal to make up the shortfall.

Upon the last beneficiary to die, the trust had 10 years to wrap up its affairs.

Then there was this sentence:

All unused income and the remainder of the principal shall be used and distributed, in such proportion as the Trustees deem best, for such purpose or purposes, to be selected by them as the time of such distribution, as will make such uses and distributions exempt from Ohio inheritance and Federal estate taxes and for no other purpose.”  

This trust had been making regular donations for a while. The IRS picked one year – 2009 – and disallowed a $64,279 donation.

Here is IRC Sec 642(c):

(c)Deduction for amounts paid or permanently set aside for a charitable purpose

(1)General rule

In the case of an estate or trust (other than a trust meeting the specifications of subpart B), there shall be allowed as a deduction in computing its taxable income (in lieu of the deduction allowed by section 170(a), relating to deduction for charitable, etc., contributions and gifts) any amount of the gross income, without limitation, which pursuant to the terms of the governing instrument is, during the taxable year, paid for a purpose specified in section 170(c) (determined without regard to section 170(c)(2)(A)). If a charitable contribution is paid after the close of such taxable year and on or before the last day of the year following the close of such taxable year, then the trustee or administrator may elect to treat such contribution as paid during such taxable year. The election shall be made at such time and in such manner as the Secretary prescribes by regulations.

The key here is the italicized part:        

“which pursuant to the terms of the governing instrument…”

The Code wants to know what the party of the first part intended, phrased in tax-speak as “pursuant to the terms of the governing instrument.”

The trustees argued that they could make donations via the following verbiage:

in such proportion as the Trustees deem best, for such purposes or purposes, to be selected by them as the time of such distribution….”

Problem, said the IRS. That verbiage refers to a point in time: the time when the trust enters its ten-year wrap-up and not before then. The trustees had to abide by the governing instrument, and said instrument did not say they could distribute monies to charity before that time.

The trustees had to think of something fast.

Here is something: there is a “latent ambiguity” in the will. That ambiguity allows for the trustees’ discretion on the charitable donations issue.

Nice argument, trustees. We at CTG are impressed.

They are referring to a judicial doctrine that cuts trustees some slack when the following happens:

(1) The terms of the trust are crystal-clear when read in the light of normal day: when it snows in Cincinnati during this winter, the trust will ….

(2) However, the terms of the trust can also be read differently in the light of abnormal day: it did not snow in Cincinnati during this winter, so the trust will ….

The point is that both readings are plausible (would you believe “possible?”).

It is just that no one seriously considered scenario (2) when drafting the document. This is the “latent ambiguity” in the trust instrument.

Don’t think so, said the Court. That expanded authority was given the trustees during that ten-year period and not before.

In fact, prior to the ten years the trustees were to invade principal to meet the annual payouts, if necessary. The trustmaker was clearly interested that the beneficiaries receive their money every year. It is very doubtful he intended that any money not go their way.

It was only upon the death of the last beneficiary that the trustees had some free play.

The Court decided there was no latent ambiguity. They were pretty comfortable they understood what the trustmaker wanted. He wanted the beneficiaries to get paid every year.

And the trust lost its charitable deduction.

For the home gamers, our case this time was Harvey C. Hubbell Trust v Commissioner.

A Mom Taking Care Of A Disabled Child And Payroll Taxes

We have a responsible person payroll tax story to tell.

You may know that I sardonically refer to this penalty as the “big-boy” penalty. It applies when you have some authority and control over the deposit of payroll withholding taxes but do not remit them to the IRS. The IRS views this as theft, and they can be quite unforgiving. The penalty alone is equal to 100% of the tax; in addition, the IRS will come after you personally, if necessary.

You do not want this penalty – for any reason.

How do people get into this situation? In many – if not most cases – it is because the business is failing. There isn’t enough cash, and it is easier to “delay” paying the IRS rather than a vendor who has you on COD. You wind up using the IRS as a bank. Now, you might be able to survive this predicament if we were talking about personal or business income taxes. Introduce payroll – and payroll withholding – and you have a different answer altogether.

Our story involves Christina Fitzpatrick (Christina). Her husband made the decision to start a restaurant in Jacksonville with James Stamps (Stamps). They would be equal partners, and Stamps would run the show. Fitzpatrick would be the silent wallet.

They formed Dey Corp., Inc to hold the franchise. The franchise was, of course, the restaurant itself.  

Sure enough, shortly after formation and before opening, Stamps was pulled to Puerto Rico for business. This left Fitzpatrick, who in turn passed on some of the pre-opening duties to his wife, Christina.

Fortunately, Stamps got back in town before the place opened. He hired a general manager, a chef and other employees. He then went off to franchise training school. Meanwhile, the employees wanted to be paid, so Stamps had Christina contact Paychex and engage their services. They would run the payroll, cut checks and make the tax deposits.

            OBSERVATION: Let’s call this IRS point (1)

He also had Christina open a business bank account and include herself as a signatory.

            OBSERVATION: IRS point (2) and (3)

Stamps and the general manager (Chislett) pretty much ran the place. Whether he was in or out of town, Stamps was in daily contact with Chislett. Chislett managed, hired and fired, oversaw purchases and so on. He was also the main contact with Paychex.

Except that …

Paychex started off by delivering paychecks weekly to the restaurant. There was a problem, though: the restaurant wasn’t open when they went by. Paychex then starting going to Christina’s house. Chislett told her to sign and drop-off the paychecks at the restaurant. Chislett could not do it because it was his day off.

            OBSERVATION: IRS point (4) and (5).

You can anticipate how the story goes from here. The restaurant lost money. Chislett was spending like a wild man, to the extent that the vendors put him on COD. Somewhen in there Paychex drew on the bank account and the check bounced. Paychex stopped making tax deposits for the restaurants because – well, they were not going to make deposits with rubber checks.

By the way, neither Stamps nor Chislett bothered to tell the Fitzpatricks that Paychex was no longer making tax deposits.

Sure enough, the IRS Revenue Officer (RO) showed up. She clued the Fitzpatricks that the restaurant was over two years behind on tax deposits.

Remember that the restaurant was short on cash. Who could the IRS chase for its money in its stead?  Let me think ….

The RO decided Christina was a responsible person and assessed big bucks (approximately $140,000) against her personally.

Off to Tax Court they went.

The Court introduces us to Christina.

·       She spent her time taking care of her disabled son, who suffered from a rare metabolic disorder. As a consequence, he had severe autism, cerebral palsy and limited mobility. He needed assistance for many basic functions, such as eating and going to the bathroom. He could not be left alone for any significant amount of time.

·       Taking care of him took its toll on her. She developed spinal stenosis from constantly having to lift him. She herself took regular injections and epidurals.

·       She truly did not have a ton of time to put into her husband’s money-losing restaurant. At start-up she had a flurry of sorts, but after that she visited maybe once a week, and that for less than an hour.

·       She could not hire or fire. She was not the bookkeeper or accountant. She did not see the bank statements.

She did, unfortunately, sign a few of the checks.

The IRS looks very closely at who has signatory authority on the bank account. As far as they are concerned, one could write a check to them as easily as a check to a vendor. Christina appears to be behind the eight ball.

The Court noted that the IRS was relying heavily on the testimony of Stamps and Chislett.

The Court did not like them:

Petitioner’s cross-examination of Mr. Stamps and Mr. Chislett revealed that their testimony was unreliable and unbelievable."

That is Court-speak to say they lied.

Mr. Stamps evaded many of the petitioner’s questions during cross-examination by repeatedly responding ‘I don’t remember.’”

Sounds like a possible presidential run in there for Stamps.

The Court was not amused with the IRS Revenue Officer either:

However, we believe that RO Wells did not conduct a thorough investigation. For instance, RO Wells made her determination before she received and reviewed the relevant bank records. She also failed to interview (or summon) Mr. Stamps, the president of the corporation.”

The IRS is supposed to interview all the corporate officers. Sounds like this RO did not.

The Court continued:

We are in fact puzzled that Mr. Stamps, the president of the corporation and a hands-on owner, an Mr. Chislett, the day-to-day manager, successfully evaded in the administrative phase any personal liability for these TFRPs.”

My, that is curious, considering they RAN the place. The use of the word “evaded” clarifies what the Court thought of these two.

But there is more required to big-boy pants than just signing a check. The Court reminded the IRS that a responsible person must have some control:

The inquiry must focus on actual authority to control, not on trivial duties.”

Here is the hammer:

Notwithstanding petitioner’s signatory authority and her spousal relationship to one of the corporation’s owners, the substance of petitioner’s position was largely ministerial and she lacked actual authority.”

The Court liked Christina. The Court did not like Stamps and Chislett. They especially did not like the IRS wasting their time. She was a responsible person they way I am a deep-sea diver because I have previously been on a boat.

The Court dismissed the case.

But we see several points about this penalty:

(1)  The IRS will chase you like Khan chased Kirk.

(2)  Note that the IRS did not chase Stamps or Chislett. This tells me those two had no money, and the IRS was chasing the wallet.

(3)  Following on the heels of (2), do not count on the IRS being “fair.” They IRS can cull one person from the herd and assess the penalty in full. There is no requirement to assess everyone involved or keep the liability proportional among the responsible parties.

We have a success story, but look at the facts that it took.

Splitting With The IRS Over Insurance

I am reading a case where the Tax Court just entered a “partial” summary judgement. This means that at least one issue has been decided but the remaining issue or issues are still being litigated.

And I think I see what the attorneys are up to.

We are talking about split-dollar life insurance. 

This had been a rather humdrum area of tax until 2002. The IRS then issued new rules which tipped the apple cart and sent planners scrambling to review – and likely revise – their clients’ split dollar arrangements (SDAs). I know because I had the misfortune of being point man on this issue at a CPA firm. There is a certain wild freedom when the IRS decides to reset an area of tax, with revisions to previous interim Notices, postponed deadlines and clients who considered you crazed.

To set-up the issue, a classic split dollar arrangement involves an employer buying a life insurance policy on an employee. The insurance is permanent – meaning cash value build-up - and the intent is for the employee to eventually walk away with the policy or for the employee’s estate to receive the death benefits. The only thing the employer wants is a return of the premiums it paid.

Find a policy where the cash value grows faster than the cumulative premiums paid and you have a tax vehicle ready to hit the highway. 

Our case involves the Morrissette family, owners of a large moving company. Grandmom (Clara Morrissette) had a living trust, to which she contributed all her company stock. She was quite concerned about the company remaining in the hands of the family. She had her attorney establish three trusts, one for each son. The sons, trusts and grandmom then entered into an agreement, whereby each son – through his trust – would buy the company stock of a deceased brother. If one brother died, for example, the remaining two would buy his stock. In the jargon, this is called a “cross purchase.”

This takes money, so each trust bought life insurance on the two other brothers.

This too takes money, which grandmom forwarded from her trust.

How much money? About $30 million for single-premium life policies.

Wow.

Obviously the moving company was extremely successful. Also obviously there must have been a life insurance person celebrating like a madman that day.

The only thing grandmom’s trust wanted was to be reimbursed the greater of the policies’ cash value or cumulative premiums paid.

Which gets us to those IRS Regulations from back when.

The IRS had decreed that henceforth SDAs would be divided into two camps:

(1) The employee owns the policy and the employer has a right to the cash value or some other amount.

This works fine until the premiums get expensive. Under this scenario the employee either has income or has a loan. Income of course is taxable, and the IRS insisted that a loan behave like a loan. The employee had to pay interest and the employer had to report interest income, with whatever income tax consequence followed.

And a loan has to be paid back. Many SDAs are set-up with the intent of the employee walking away someday. How will he/she pay back the loan at that time? This is a serious problem for the tax planners. 

(2)  The employer owns the policy and the employee has a right to something – likely the insurance in excess of the cash value or cumulative premiums paid.

The employee has income under this scenario, equal to the value of the insurance he/she is receiving annually. The life insurance companies publish tables, so practitioners can plan for this number.

But this leaves a dangerous possible tax issue: what happens once the cash value exceeds the amount to which the employer is entitled (say cumulative premiums)? Let’s say the cash value goes up by $250,000, and the employer’s share is met. Does the employee have $250,000 in income? There is a lot of lawyering on this point.

The Court decided that the grandmom had the second type – type (2) of SDA, albeit of the “family” and not the “employer” variety. The sons’ trusts had to report income equal the economic benefit of the life insurance, the same as an employee under the classic model.

This doesn’t sound like much, but the IRS was swinging for a type (1) SDA. If the sons’ trusts owned the policies, the next tax question would be the source of the money. The IRS was arguing that the grandmom trust made taxable gifts to the sons. Granted the gift and estate tax exclusion has been raised to over $5 million, but $30 million is more than $5 million and would trigger a hefty gift tax. The IRS was smelling money here.                 

The partial summary was solely on the income tax issue.

The Court will get back to the gift tax issue.

However, having won the income tax issue must make the Morrissette family feel better about winning the gift tax issue. According to the IRS’ own rules, grandmom’s trust owned the policies. What was the gift when the trust will get back all its money? The attorneys can defend from high ground, so to speak.

And there is one more thing.

Grandmom passed away. She was already in her 90s when the sons’ trusts were set up.

She died with the sons’ trusts owing her trust around $30 million.

Which her estate will not collect until the sons pass away or the SDAs are terminated. Who knows when that will be?

And what is a dollar worth X years from now? 

One thing we can agree on is that it not worth a dollar today.

Her estate valued the SDA receivables at approximately $7 million.

And the IRS is coming after her. There is no way the IRS is going to roll-over on those split dollar arrangements reducing her estate by $23 million.

You know the IRS did not think this through back in 2002 when they were writing and rewriting the split dollar rules.

Pay Payroll Taxes Or Go Out Of Business?

We have talked before about the “big boy” penalty. It is one of the harshest penalties in the tax Code.

This is a payroll related penalty. It is not because you were late with a payment or failed to send in a return on time. No sir, it kicks in when you do not send the government any money at all.

And I am reading about two guys who decided to play big boy. One of them surprised me.

The company itself was based in Rhode Island and provided wireless internet in public spaces. Think Facebook at the airport, for example.

Business tanked. Cash was tight. Vendors did not get paid, including the IRS.

The company needed help. They hired Richard Schiffmann as president in October, 2004. In October, 2005 he brought in Stephen Cummings (who had worked there previously as a consultant) to be chief financial officer.

Cummings quickly found out they had problems with back taxes.

The Board granted check-signing authority to the pair: Schiffmann up to $100,000 and Cummings up to $75,000.

The two tried; they really did. But there was nothing there. The Board fired the two in June, 2006.

You know that the IRS eventually knocked on the door. They were angry and they wanted scalps. They went after Schiffmann and Cummings for the big boy penalty.

In the literature, this is known as the trust fund recovery or responsible person penalty. It addresses the income and FICA taxes withheld from employees. Mind you, the IRS wants the employer FICA also, but it is emphasizing the employee withholding. The IRS takes the position that this was never the employer’s money, whose function was solely to transfer the money as agent for the employees to the IRS.

The penalty is 100%.

It is intended to be Defcon 1.

The IRS went after Schiffmann for $394,334 and against Cummings for $254,280.

Think about this. You got hired. You were there for nine months. I doubt you got paid anywhere near $254,280. This is the lousiest job ever.

The two fought back, although there were some procedural misses we will not discuss but which leave me scratching my head. The two for example raised the following arguments:

(1) Schiffmann argued that he did not learn of the liability until late 2005. The most he could be liable for is two or three quarters, which would not add-up to $394 thousand.

He had a point. The penalty technically goes quarter-by-quarter.

But only in a classroom or in a textbook. In the real world, the IRS will argue that – if you could write a check – then you could have written checks for both current and past payroll taxes. Those past taxes become your problem.

And Schiffmann could write checks up to $100,000. Cummings could write up to $75,000.

Gentlemen, let me introduce problem. Problem, let me introduce gentlemen.

(2) They argued that all monies were encumbered and spoken for. They remitted what they could.

This is the “I had to pay … or the business would have folded” argument.

The IRS will respect encumbrances, but there better be a legal obligation. A pinky swear is not enough. 

The IRS will not respect a responsible person prioritizing them down, when the IRS had as much right to what money may exist as anyone else.

Schiffmann and Cummings could not meet that test.

(3) The Board would not let them pay certain bills.

More specifically, the Board would not let them pay taxes.

Now we have something. The IRS looked into this. It decided that there were two directors who raised a fuss, but it also decided that those two could be outvoted by the remaining directors.

And the directors never formally voted on a resolution, so the IRS could presuppose that the two would have been outvoted.

Then the IRS made an interesting observation: EVEN IF the Board has prohibited the two from paying the taxes, the most that would have happened is that the Board would have joined them in also being subject to the penalty. It would not have gotten Schiffmann and Cummings off the hook.

The two were held responsible.

Cummings was the one who surprised me.

He used to be an IRS field auditor.