The Gallenstein Rule

 

It is a tax rule that will eventually go extinct.

It came to my attention recently that it can – however – still apply.

Let’s set it up.

(1)  You have a married couple.

(2)  The couple purchased real estate (say a residence) prior to 1977.

(3)  One spouse passes away.

(4)  The surviving spouse is now selling the residence.

Yeah, that 1977 date is going to eliminate most people.

We are talking Section 2040(b).

(b)  Certain joint interests of husband and wife.

(1)  Interests of spouse excluded from gross estate.

Notwithstanding subsection (a), in the case of any qualified joint interest, the value included in the gross estate with respect to such interest by reason of this section is one-half of the value of such qualified joint interest.

(2)  Qualified joint interest defined.

For purposes of paragraph (1), the term "qualified joint interest" means any interest in property held by the decedent and the decedent's spouse as-

(A)  tenants by the entirety, or

(B)  joint tenants with right of survivorship, but only if the decedent and the spouse of the decedent are the only joint tenants.

In 1955 Mr. and Mrs. G purchased land in Kentucky. Mr. G provided all the funds for the purchase. They owned the property as joint tenants with right of survivorship.

In 1987 Mr. G died.  

In 1988 Mrs. G sold 73 acres for $3.6 million. She calculated her basis in the land to be $103,000, meaning that she paid tax on gain of $3.5 million.

Someone pointed out to her that the $103,000 basis seemed low. There should have been a step-up in the land basis when her husband died. Since he owned one-half, one-half of the land should have received a step-up.

COMMENT: You may have heard that one’s “basis” is reset at death. Basis normally means purchase cost, but not always. This is one of those “not always.” The reset (with some exceptions, primarily retirement accounts) is whatever the asset was worth at the date of death or – if one elects – six months later.  Mind you, one does not have to file an estate tax return to trigger the reset; rather, it happens automatically. That is a good thing, as the lifetime estate tax exemption is approaching $13 million these days. Very few of us are punching in that weight class.

Someone looked into Mrs. G’s situation and agreed. In May 1989 Mrs. G filed an amended tax return showing basis in the land as $1.8 million. Since the basis went up, the taxable gain went down. She was entitled to a refund.

Three months later she filed a second amended return showing basis in the land as $3.6 million. She wanted another refund.

This time she caught the attention of the IRS. They could understand the first amended but not the second. Where were these numbers parachuting from?

I am going to spare us both a technical walkthrough through the history of Code section 2040.

There was a time when joint owners had to track their separate contributions to the purchase of property, meaning that each owner would have his/her own basis. I suppose there are some tax metaphysics at play here, but the rule did not work well in real life. Sales transactions often occur decades after the purchase, and people do not magically know that they need to start precise accounting as soon as they buy property together. Realistically, these numbers sometimes cannot be recreated decades after the fact. In 1976 Congress changed the rule, saying: forget tracking for joint interests created after 1976. From now on the Code will assume that each tenant contributed one-half.

That is how we get to today’s rule that one-half of a couple’s property is included in the estate of the first-to-die. By being included in an estate, the property is entitled to a step-up in basis. The surviving spouse gets a step-up in the inherited half of the property. The surviving spouse also keeps his/her “old” basis in his/her original one-half. The surviving spouse’s total basis is therefore the sum of the “old” basis plus the step-up basis.

Mr. G died before 1977.

Meaning that Mrs. G was not subject to the new rule.

She was subject to the old rule. Since Mr. G had put up all the money, all the property (yes, 100%) was subject to a step-up in basis when Mr. G died.

That was the reason for the second amended return.

The Court agreed with Mrs. G.

It was a quirk in tax law.

The IRS initially disagreed with the decision, but it finally capitulated in 2001 after losing in court numerous times.

Mind you, the quirk still exists. However, the population it might affect is dwindling, as this law change was 47 years ago. We only live for so long.

However, if you come across someone who owned property with a spouse before 1977, you might have something.

BTW this tax treatment has come to be known by the widow who litigated against the IRS: the tax-nerds sometimes call it “the Gallenstein rule.”

Can A Business Start Before Having Revenue?

 

It is one of my least favorite issues: when does a business start?

The reason is that expenses incurred before the start-up date are considered either organizational or start-up expenses and cannot be immediately deducted. The IRS allows a small spot (of $5,000) and expenses over that amount are to be amortized over 15 years.

It used to be five years. The issue was less of a blood sport back then.

For many of us, the start-up date is easy: it is when you open your doors to customers or clients. Let’s say you are a chiropractor. Your start-up date is when the office opens. What if you do not have a patient that day? Same answer: it is the day you open the doors.

Let’s kick it up a notch.

Say you open a restaurant. When is your start date?

The day you have first serve customers, right?

Yes, with a twist. Many restaurants have a soft opening, which is a seating for a limited number of people (think family, friends and media critics) to test service and the kitchen. This might be days or weeks before the actual grand opening – that is, when doors open to the general public.  

Many tax accountants – me included – consider a restaurant’s soft opening to be the start date.

The reason we want an earlier rather than a later date is to start deducting expenses. If you are reaching into your pocket or borrowing money to pay rent, utilities, promotion and staff, you want a tax deduction now. You might consider me to be crazy man Michael were I to talk about deducting over 15 years.

Let’s kick it up another notch. Let’s talk about a web-based business.

Gregg Kellett graduated from college in 2002 and opened a website. He went corporate in 2007, and in 2011 he moved to Bloomberg, a publisher of legal and business information. While there he saw an opportunity to better aggregate and access online demographic, social and economic data. If he could pull it off, he could offer a more user-friendly interface and make a couple of bucks in the process.

So in 2013 he bought a website (vizala.com). He formed a company by the same name. He hired remote computer engineers to develop features he wanted in the website. They finished core work in March 2015 and resolved bugs through September 2015. An example of a “bug” was an interactive table that would not presently correctly in the Firefox browser.

Kellett figured to make money at least four ways:

(1)  Selling advertising space

(2)  Implementing a paywall

(3)  Selling personalized charts and other information

(4)  Licensing data

He did not pursue any of those strategies during 2015.

However, he did deduct approximately $26 grand on his 2015 return.

He also did not earn any revenue until 2019.

Sure enough, the IRS disallowed the $26 grand because Kellett was not in an “active” trade or business. They wanted him to deduct the expenses over (almost) the same period as putting a kid though grade school and then college.

Off to Tax Court.

If we pull back to the general rule – the date of first revenues – this is going to hurt.

But the website was available by September 2015. It wasn’t rocking like Netflix upon release of the 2022 season’s second half of Stranger Things, but it was available.

The Court wanted to know what happened between 2015 and 2019.

Kellett explained that maximizing his long-term profit potential required building trust among users. After that would come the advertisers. He started building trust by promoting the website to over a hundred universities and professional organizations. This was enough work that he hired a marketing professional to assist him. The work paid-off, as about 50% on the institutions added Vizala to their lists of research databases. 

The Court understood what he did. The website was available by September 2015. It was not all it could be as Kellett had plans for its long-term profitability, but that did not gainsay that the website was available. Considering that the business was the website, that meant that the business also started in September 2015. Expenses before that date were startup expenses. Expenses after that date were immediately deductible.

Revenues did not play into the decision, fortunately.

It was the website version of the chiropractor opening his/her office, albeit with no patients on the first day.

Kellett won, but it cost a visit to Tax Court.

Our case this time was Kellett v Commissioner, T.C. Memo 2022-62.

Maple Trees, Blueberries and Startup Expenses

It is one of my least favorite issues in tax law. It is not a particularly technical issue; rather, it too often imitates theology and metaphysics:

When does a business begin?

For some businesses, it is straightforward. As a CPA my business starts when I take office space or otherwise offer my services to the public. Other businesses have their rules of thumb:

·        An office building begins business when it obtains a certificate of occupancy from the appropriate municipal government.

·        A restaurant begins (usually) after its soft opening; that is, when it first opens to family, friends, possibly food reviewers and critics - and before opening to the general public.

What can make the issue difficult was a 1980 change in the tax law. It used to be that start-up costs could not be immediately deducted. Rather one had to accumulate and deduct them over a 5-year period.

Unfortunate but not ruinous.

In 1980 the law changed to allow a $5,000 deduction; the balance was to be deducted over a 15-year period.

Can you imagine the potentially fraught and tense conversations between a taxpayer and the tax advisor? Rather than injecting moderate but acceptable pain, Congress introduced dispute between a practitioner and his/her client.

Let’s look at a case involving startup costs.

James Gordon Primus lived in New York and worked as an accountant at a large accounting firm. In 2011 his mother bought 266 acres in southwest Quebec on his behalf. The property contained almost 200 acres of maple trees. The trees were mature enough to produce sap, so I suppose he could start his new business of farming.

But there were details. There are always details.

He wanted to clear the brush, as that would help with production later on. He also wanted to install a collection pipeline, for the obvious reason. He also had plans for blueberry production.

He started thinning the maple brush in 2011, right after acquiring the property.

Good.

In 2012 and 2013 he started clearing for blueberry production. 

He ordered 2,000 blueberry bushes in 2014.

In 2015 he began installing the pipeline and planted the blueberry bushes.

In 2016 he readied the barn.

In 2017 he finally collected and sold maple sap.

Got it: 6 years later.

On 2012 he deducted over $200 grand for the farm.

On 2013 he deducted another $118 grand.

That caught the attention of the IRS. They saw $318 grand of startup expenses. They would spot him $5 grand and amortize the rest over 15 years.

Not a chance argued Primus.

He started clearing in 2011, and clearing is an established farming practice. He was in the trade or business of farming by 2012.

Clearing is an accepted practice, said the Court, but that does not mean that one has gotten past the startup phase. Context in all things.

Primus offered another argument: a business can start before it generates revenues.

That is correct, responded the Court, but lack of revenue does not mean that business has started.

Here is the Court:

Petitioner’s activities during 2012 and 2013 were incurred to prepare the farm and produce sap and plant blueberries. Those are startup expenses under section 195 and may not be deducted under section 162 or 212.”

The taxpayer struck out.

Get this issue wrong and the consequences can be severe.

How would one plan for something like this?

I do not pretend to be an expert in maple farming, but I would pull back to general principles: show revenues. The IRS might dismiss the revenues as inconsequential and not determinative that a startup period has ended, but one has a not-inconsequential argument.

That leads to the next principle: once one has established a trade or business, the expenses of expanding that trade or business (think blueberries in this instance) are generally deductible.

I wonder how this would have gone had Primus tapped and sold sap in 2012. I am thinking limited production but still enough to be business-consequential. Perhaps he could market it as “rare,” “local,” “artisanal” and all the buzz words.

Perhaps he could have followed the next year with another limited production. I am trying to tamp-down an IRS “not determinative” argument.

Would it have made a difference?

An Extreme Way To Deduct Expenses Twice

The estate tax is different from the income tax.

The latter is assessed on your income. This puts stress in defining what is income from what is not, but such is the concept.

The estate tax on assessed on what you own when you die, which is why it is also referred to as the “death” tax. If you try to give away your assets to avoid the death tax, the gift tax will step in and probably put you back in the same spot.

Granted, a tax is a tax, meaning that someone is taking your money. To a great extent, the estate tax and income tax stay out of each other’s way.

With some exceptions.

And a recent case reminds us of unexpected outcomes when these two taxes intersect.

Let’s set it up.

You may recall that – upon death – one’s assets pass to one’s beneficiaries at fair market value (FMV). This is also called the “step up,” as the deceased’s cost or basis in the asset goes away and you (as beneficiary) can use FMV as your new “basis” in the asset. There are reasons for this:

(1) The deceased already paid tax on the income used to buy the asset in the first place.

(2) The deceased is paying tax again for having died with “too many” assets, with the government deciding the definition of “too many.” It wasn’t that long ago that the government thought $600,000 was too much. Think about that for a moment.

(3) To continue using the decedent’s back-in-time cost as the beneficiary’s basis is to repetitively tax the same money. To camouflage this by saying that income tax is different from estate tax is farcical: tax is tax.

I personally have one more reason:

(4) Sometimes cost information does not exist, as that knowledge went to the grave with the deceased. Decades go by; no one knows when or how the deceased acquired the asset; government and other records are not updated or transferred to new archive platforms which allow one to research. The politics of envy does not replace the fact that sometimes simply one cannot come up with this number.

Mr. Backemeyer was a farmer. In 2010 he purchased seed, chemicals, fertilizer and fuel and deducted them on his 2010 joint return.

COMMENT: Farmers have some unique tax goodies in the Code. For example, a farmer is allowed to deduct the above expenses, even if he/she buys them at the end of the year with the intent to use them the following year. This is a loosening of the “nonincidental supplies” rule, which generally holds up the tax deduction until one actually uses the supplies.

So Mr. Backemeyer deducted the above. They totaled approximately $235,000.

He died in March, 2011.

Let’s go to our estate tax rule:

His beneficiary (his wife) receives a new basis in the supplies. That basis is fair market value at Mr. Backemeyer’s date of death ($235,000).

What does that mean?

Mr. Backemeyer deducted his year-end farming supplies in 2010. In tax-speak,” his basis was zero (-0-), because he deducted the cost in 2010. Generally speaking, once you deduct something your basis in said something is zero.

Go on.

His basis in the farming supplies was zero. Her basis in the farming supplies was $235,000. Now witness the power of this fully armed and operational step-up.

Is that a Rogue One allusion?

No, it is Return of the Jedi. Shheeessh.

Anyway, with her new basis, Mrs. Backemeyer deducted the same $235,000 again on her 2011 income tax return.

No way. There has to be a rule.

          That is what the IRS thought.

There is a doctrine in the tax Code called “economic benefit.” What sets it up is that you deduct something – say your state taxes. In a later year, you get repaid some of the money that you deducted – say a tax refund. The IRS takes the position – understandably – that some of that refund is income. The amount of income is equal to a corresponding portion of the deduction from the previous year. You received an economic benefit by deducting, and now you have to repay that benefit.

It is a great argument, except for one thing. What happened in Backemeyer was not an income tax deduction bouncing back. No, what set it up was an estate tax bouncing back on an income tax return in a subsequent year.

COMMENT: She received a new basis pursuant to estate tax rules. While there was an income tax consequence, its origin was not in the income tax.

The Court reminded the IRS of this distinction. The economic benefit concept was not designed to stretch that far. The Court explained it as follows:

(1) He deducted something in 2010.

(2) She deducted the same something in 2011.

(3) Had he died in 2010, would the two have cancelled each other out?

To which the Court said no. If he had died in 2010, he would have deducted the supplies; the estate tax rule would have kicked-in; her basis would have reset to FMV; and she could have deducted the supplies again.

It is a crazy answer but the right answer.

Is it a loophole? 

Some loophole. I do not consider tax planning that involves dying to be a likely candidate for abuse. 

Business League: A Different Type Of Tax-Exempt

You may have heard about business leagues.

One very much in the news recently is the National Football League, which has been considering giving up its tax-exempt status.

In the tax world, exempt entities obtain their exempt status under Section 501(c). There is then a number, and that number is the “type” of exempt under discussion. For example, a classic charity like the March of Dimes would be a 501(c)(3). When we think of tax-exempts, we likely are thinking of (c)(3)’s, for which contributions are deductible to the donor and nontaxable to the recipient charity.

The (c)(3) is about as good as it gets.

A business league is a (c)(6). So is a trade association.

Right off the bat, payments to a (c)(6) are not deductible as contributions. They are, however, deductible as a business expense- which makes sense as they are business leagues. You and I probably could not deduct them, but then again you and I are not businesses.

There are some benefits. For example, a (c)(6) has virtually no limit on its lobbying authority, other than having to pro-rate the member dues between that portion which represents lobbying (and not deductible by anybody) and the balance (deductible as a business expense).

There are requirements to a (c)(6):

(1)  There must be members.

a.     The members must share a common business interest.

                                                              i.     Members can be individuals or businesses.

                                                            ii.     If membership is available to all, this requirement has not been met. This makes sense when you consider that the intent of the (c)(6) is to promote shared interests.

(2)  Activities must be directed to improving business conditions in a line of business.

a.     Think of it as semi-civic: to advance the general welfare by promoting a line of business rather than just the individual companies.

b.    This pretty much means that membership must include competitors.

c.     Sometimes it can be sketchy to judge. For example, the IRS denied exemption to an organization whose principal activity was publishing and distributing a directory of member names, addresses and phone numbers to businesses likely to require their services. The IRS felt this went too close to advertising and too far from the improvement of general business conditions.

(3)  The primary activities must be geared to group and not individual interests.

a.     The American Automobile Association, for example, had its application denied as it was primarily engaged in rendering services to members and not improving a line of business.

(4)  The main purpose cannot be to run a for-profit business.

a.     This requirement is standard in the not-for-profit world. You can run a coffee shop, but you cannot be Starbucks.

b.    For example, a Board of Realtors normally segregates its MLS activities in another – and separate – company. The Board itself would be a (c)(6), but the MLS is safely tucked away in a for-profit entity – less it blow-up the (c)(6).

(5)  Must be not-for-profit.

a.     Meaning no dividends to shareholders or distributions rights if the entity ever liquidates.

b.    BTW – and to clarify – a not-for-profit can show a profit. Hypothetically it could show a profit every year, although it is debatable whether it could rock the profit level of Apple or Facebook and keep its exemption. The idea here is that profits – if any – do not “belong” to shareholders or investors.

(6)  There must be no private inurement or private benefit to key players or a restricted group of individuals.

a.     Again, this requirement is standard in the not-for-profit world.

b.    This issue has been levelled against the NFL. Roger Goodell (the NFL Commissioner) has been paid over $44 million a year for his services. It does not require a PhD in linguistics to ask at what point this compensation level becomes an “inurement” or “benefit” disallowed to a (c)(6).

There is litigation around (4) and (6). The courts have allowed some business activity and some benefit to the members, as long as it doesn’t get out of hand. The courts refer to this as “incidental benefit.”

Which can lead to interesting follow-up issues. Take a case where the organization runs a business (within acceptable limits) and then uses the profit to subsidize something for its members. Can this amount to private inurement? The members are – after all - receiving something at a lower cost than nonmembers.

Let’s take a look at a recent application. I think you know enough now to anticipate how the IRS decided.

(1)  The (c)(6) members are convenience stores and franchisees of “X.”

(2)  Revenues will be exclusively from member fees.

(3)  One-quarter of member fees will be remitted annually to the national franchisee (that is, the franchise above “X”)

(4)  Member franchisees will elect the Board.

(5)  The (c)(6) will educate and assist with franchise policies.

(6)  The (c)(6) will facilitate resolution between members and executives of “X.”

How did it go?

The IRS bounced the application.

Why?

We could have stopped at (1). There is no “line of business” happening here. Members are limited to franchisees of “X.” Granted, “X” participates in an industry but “X” does not comprise an industry. 

The organization tried to clean-up its application after being rejected but it was too little too late.

The organization was not promoting the industry as a whole. It rather was promoting the interest of the franchisee-owners. 

Nothing wrong with that. You just cannot get a tax exemption for it.