TurboTax and Penalties

I am looking at a case that deals with recourse and nonrecourse debt.

Normally I expect to find a partnership with multiple pages of related entities and near-impenetrable transactions leading up to the tax dispute.

This case had to do with a rental house. I decided to read through it.

Let’s say you buy a house in northern Kentucky. You will have a “recourse” mortgage. This means that – if you default – the mortgage company has the right to come after you for any shortfall if sales proceeds are insufficient to pay-off the mortgage.

This creates an interesting tax scenario in the event of foreclosure, as the tax Code sees two separate transactions.

EXAMPLE:

          The house cost               $290,000

          The mortgage is             $270,000

          The house is worth        $215,000

If the loan is recourse, the tax Code first sees the foreclosure:

          The house is worth        $215,000

          The house cost               (290,000)

          Loss on foreclosure       ($75,000)

The Code next sees the cancellation of debt:

          The mortgage is worth  $270,000

          The house is worth        (215,000)

          Cancellation of debt       $55,000

If the house is your principal residence, the loss on foreclosure is not tax deductible. The cancellation-of-debt income is taxable, however.

But all is not lost. Here is the Code:

§ 108 Income from discharge of indebtedness.

(a)  Exclusion from gross income.

(1)  In general.

Gross income does not include any amount which (but for this subsection) would be includible in gross income by reason of the discharge (in whole or in part) of indebtedness of the taxpayer if-

(E)  the indebtedness discharged is qualified principal residence indebtedness which is discharged-

(i)  before January 1, 2018, or

(ii)  subject to an arrangement that is entered into and evidenced in writing before January 1, 2018.

The Section 108(a)(1)(E) exclusion will save you from the $55,000 cancellation-of-debt income, if you got it done by or before the December 31, 2017 deadline.

Let’s change the state. Say that you bought your house in California.

That loan is now nonrecourse. That lender cannot hound you the way he/she could in Kentucky.

The taxation upon cancellation of a nonrecourse loan is also different. Rather than two steps, the tax Code now sees one.

Using the same example as above, we have:

          The mortgage is             $270,000

          The house cost               (290,000)

          Loss on foreclosure       ($20,000)  

Notice that the California calculation does not generate cancellation-of-debt income. As before, the loss is not deductible if it is from your principal residence.

Back to the case.

A married couple had lived in northern California and bought a residence. They moved to southern California and converted the residence to a rental. The housing crisis had begun, and the house was not worth what they had paid.

Facing a loss of over $300 grand, they got Wells Fargo to agree to a short sale. Wells Fargo then sent them a 1099-S for taking back the house and a 1099-C for cancellation-of-debt income.

Seems to me Wells Fargo sent paperwork for a sale in Kentucky. Remember: there can be no cancellation-of-debt income in California.

The taxpayer’s spouse prepared the return. She was an attorney, but she had no background in tax. She spent time on TurboTax; she spent time reading form instructions and other sources. She did her best. You know she was reviewing that recourse versus nonrecourse thing, as well as researching the effect of a rental. She may have researched whether the short sale had the same result as a regular foreclosure.

COMMENT: There was enough here to use a tax professional.

They filed a return showing around $7,000 in tax.

The IRS scoffed, saying the correct tax was closer to $76,000.

There was a lot going on here tax-wise. It wasn’t just the recourse versus nonrecourse thing; it was also resetting the “basis” in the house when it became a rental.

There is a requirement in tax law that property convert at lower of (adjusted) cost or fair market value when it changes use, such as changing from a principal residence to a rental. It can create a no-man’s land where you do not have enough for a gain, but you simultaneously have too much for a loss. It is nonintuitive if you haven’t been exposed to the concept.

Here is the Court:

This is the kind of conundrum only tax lawyers love. And it is not one we've been able to find anywhere in any case that involves a short sale of a house or any other asset for that matter. The closest analogy we can find is to what happens to bases in property that one person gives to another.”

Great. She had not even taken a tax class in law school, and now she was involved with making tax law.

Let’s fast forward. The IRS won. They next wanted penalties – about $14,000.

The Court didn’t think penalties were appropriate.

… the tax issues they faced in preparing their return for 2011 were complex and lacked clear answers—so much so that we ourselves had to reason by analogy to the taxation of sales of gifts and consider the puzzle of a single asset with two bases to reach the conclusion we did. We will not penalize taxpayers for mistakes of law in a complicated subject area that lacks clear guidance …”

They owed about $70 grand in tax but at least they did not owe penalties.

And the case will be remembered for being a twist on the TurboTax defense. Generally speaking, relying on tax software will not save you from penalties, although there have been a few exceptions. This case is one of those exceptions, although I question its usefulness as a defense. The taxpayers here strode into the tax twilight zone, and the Court decided the case by reasoning through analogy. How often will that fact pattern repeat, allowing one to use this case against the imposition of future penalties?

The case for the homegamers is Simonsen v Commissioner 150 T.C. No. 8.

RERI-ng Its Ugly Head - Part Two

Let’s continue our story of Stephen Ross, the billionaire owner of the Miami Dolphins and of his indirect contribution of an (unusual) partnership interest to the University of Michigan.

What made the partnership interest unusual was that it represented a future ownership interest in a partnership owning real estate. The real estate was quite valuable because of a sweet lease. When that ship came in, the future interest was going to be worth crazy money.

That ship was a “successor member interest” or “SMI.”

We talked about the first case, which went before the Tax Court in 2014 and involved legal motions. The case then proceeded, with a final decision in July, 2017.

COMMENT: Yes, it can take that long to get a complex case through Tax Court. Go after Apple, for example, and your kid will likely be finishing high school before that tax case is finally resolved.

The SMI was purchased for $2.95 million.

Then donated to the University of Michigan for approximately $33 million.

COMMENT: This is better than FaceBook stock.

After two years, the University of Michigan sold the SMI (to someone related to the person who started this whole story) for around $2 million.

OBSERVATION: Nah, FaceBook stock would have been better.

Now RERI was in Court and explaining how something that was and will be worth either $2 or $3 million is generating a tax deduction of $33 million.

And it has to do with the SMI being “part of” of something but not “all of” something.  SMI is the “future” part in “all of” a partnership owning valuable leased real estate in California.

The concept is that someone has to value the “all of” something. Once that is done, one can use IRS tables to value the “part of” something. Granted, there are hoops and hurdles to get into those tables, but that is little obstacle to a shrewd tax attorney.

Ross found a shrewd tax attorney.

Virtually all the heavy lifting is done when valuing the “all of” part. One then dumps that number into the IRS tables, selects a number of years and an interest rate and – voila! The entrée round, my fellow tax gastronomes, featuring a $33 million tasty secret ingredient.

The pressure is on the first number: the “all of.”

This will require a valuation.

There are experts who do these things, of course.

Their valuation report will go with your tax return.  No surprise. We should be thankful they do not also have to do a slide presentation at the IRS. 

And there will be a (yet another) tax form to highlight the donation. That is Form 8283, and – in general – you can anticipate seeing this form when you donate more than $5,000 in property.

There are questions to be answered on Form 8283. We have spoken about noncash donations in the past, and how this area has become a tax minefield. Certain things have to be done a certain way, and there is little room for inattention. Sometimes the results are cruel.

Form 8283 wants, for example:

·      A description of the property

·      If a partial interest, whether there is a restriction on the property

·      Date acquired

·      How acquired

·      Appraised fair market value

·      Cost

I suspect the Court was already a bit leery with a $3 million property generating a $33 million donation.

And the Court noticed something …

The Form 8283 left out the cost.

Yep, the $3 million.

Remember: there is little room for inattention with this form.

Question is: does the number mean anything in this instance?

Rest assured that RERI was bailing water like a madman, arguing that it “substantially complied” with the reporting requirements. It relied heavily on the Bond decision, where the Court stated that the reporting requirements were:

“… directory and not mandatory”

The counterpunch to Bond was Smith:

“ the standard for determining substantial compliance under which we ‘consider whether … provided sufficient information to permit … to evaluate the reported contributions, as intended by Congress.’”

To boil this down to normal-speak: could RERI’s omission have influenced a reasonable person (read: IRS) to question or not question the deduction. After all, the very purpose of Form 8283 was to provide the IRS enough information to sniff-out stuff like this.

Here is the Court:

“The significant disparity between the claimed fair market value and the price RERI paid to acquire the SMI just 17 months before it assigned the SMI to the University, had it been disclosed, would have alerted respondent to a potential overvaluation of the SMI”

Oh oh.

“Because RERI failed to provide sufficient information on its Form 8283 to permit respondent to evaluate its purported contribution, …we cannot excuse on substantial compliance grounds RERI’s omission from the form of its basis in the SMI.”

All that tax planning, all the meetings and paperwork and yada-yada was for naught, because someone did not fill-out the tax form correctly and completely.

I wonder if the malpractice lawsuit has already started.

The Court did not have to climb onto a high-wire and juggle dizzying code sections or tax doctrines to deny RERI’s donation deduction. It could just gaze upon that Form 8283 and point-out that it was incomplete, and that its incompleteness prejudiced the interests of the government. It was an easy way out.

And that is precisely what the Court did.

RERI-ng Its Ugly Head - Part One

Here is the Court:

The action involves RERI Holdings I, LLC (RERI). On its 2003 income tax return RERI reported a charitable contribution of property worth $33,019,000. Respondent determined that RERI overstated the value of the contribution by $29,119,000.”

That is considerably more than a rounding error.

The story involves California real estate, a billionaire and a university perhaps a bit too eager to receive a donation.

The story is confusing, so let’s use a dateline as a guide.

February 6, 2002 

Hawthorne bought California real estate for $42,350,000. Technically, that real estate is in an LLC named RS Hawthorne LLC (Hawthorne), which in turn is owned by RS Hawthorne Holdings LLC (Holdings).

Holdings in turn is owned by Red Sea Tech I (Red Sea). 

February 7, 2002 

Red Sea created two types of ownership:

First, ownership for a period of time (technically a “term of years,” abbreviated TOYS).

Second, a future and successor interest that would not even come into existence until 2021. Let’s call this a “successor” member interest, or SMI. 

QUESTION: Why a delayed ownership interest? There was a great lease on the California real estate, and 2021 had significance under that lease.

March 4, 2002     

RERI was formed.

March 25, 2002

RERI bought the SMI for $2,950,000.

August 27, 2003

RERI donated the SMI to the University of Michigan.

A key player here is Stephen Ross, a billionaire and the principal investor in RERI. He had pledged to donate $5 million to the University of Michigan. 

Ross had RERI donate the SMI. 

The University agreed to hold the SMI for two years, at least, before selling.

Do you see what they have done? Start with a valuable piece of leased real estate, stick it in an LLC owned by another LLC owned by another … ad nauseum, then create an LLC ownership stake that does not even exist (if it will ever exist) until 2021.

What did RERI donate to the University of Michigan?

You got it: the thing that doesn’t exist for 18 years.

I find this hard to swallow.

“Successor” LLC interests are sasquatches. You can spend a career and never see one. The concept of “successor” makes sense in a trust context (where they are called “remaindermen”), but not in a LLC context. This is a Mary Shelly fabrication by the attorneys.

So why do it?

Technically, the SMI will someday own real estate, and that real estate is not worth zero.

RERI hired a valuation expert who determined it was worth almost $33 million. This expert argued that the lease on the property – and its reliable series of payments – allowed him to use certain IRS actuarial tables in arriving at fair market value (the approximately $33 million).

Wait. It gets better.

The two years pass. The University sells the property … to an entity INDIRECTLY OWNED by Mr. Ross for $1,940,000.

This entity was named HRK Real Estate Holdings, LLC (HRK).

More.

HRK had already prearranged to sell the SMI to someone else for $3 million.

Still more.

That someone donated the same SMI and claimed yet another deduction of $29,930,000.

REALITY CHECK: This thing sells twice for a total of approximately $5 million but generates tax deductions of approximately $63 million.

Yet more.

Who did the valuation on that second donation? Yep, the same guy who did RERI’s valuation.

The IRS disallowed RERI’s donation to zero, zip, zilch, nada. The IRS was clear: this thing is a sham.

And there begins the litigation.

How something can simultaneously be worth $33 million and $2 million?

This is all about those IRS tables.

Generally speaking, the contribution of property is at fair market value, usually described as the price arrived at between independent buyers and sellers, neither under compulsion to sell or buy and both informed of all relevant facts.

Except …

For annuities, life estates, remainders, reversions, terms of years and similar partial interests in property. They are not full interests so they then have to be carved-out and adjusted to present value using IRS-provided tables.

OBSERVATION: Right there, folks, is why the attorneys created this Frankenstein. They needed to “separate” the interests so they could get to the tables.

RERI argued that it could value that real estate 18 years out and use the tables. Since the tables are concerned only with interest rates and years, the hard lifting is done before one gets to them.

Not so fast, said the IRS.

That real estate is in an LLC, so it is the LLC that has to be valued.  There are numerous cases where the value of an asset and the value of an ownership interest in the entity owning said asset can be different – sometimes substantially so. You cannot use the tables because you started with the wrong asset.

But the LLC is nothing but real estate, so we are back where we started, countered RERI.

Not quite, said the IRS. The SMI doesn’t even exist for 18 years. What if the term owner mortgages the property, or sells it, or mismanages it? That SMI could be near worthless by the time some profligate or incompetent is done with the underlying lease.

Nonsense, said RERI. There are contracts in place to prohibit this.

How pray tell is this “prohibited?” asked the IRS.

Someone has to compensate the SMI for damages, explained RERI.

“Compensate” how? persisted the IRS.

The term owner would forfeit ownership and the SMI would become an immediate owner, clarified RERI.

So you are making the owner of a wrecked car “whole” by giving him/her the wrecked car as recompense, analogized the IRS. Can the SMI at least sue for any unrecovered losses?

Uhhhh … no, not really, answered RERI. But it doesn’t matter: the odds of this happening are so remote as to not warrant consideration.

And so it drones on. The case goes into the weeds.

Who won: the government or the billionaire?

It was decided in a later case. We will talk about it in a second post.

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. 

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.