Taxing Foreign Investment In U.S. Real Estate

One of the Ps buzzed me about a dividend item on a year-end brokers’ statement.

P:      “What is a Section 897 gain?”

CTG: It has to do with the sale of real estate. It is extremely unlikely to affect any of our clients.

P:      Why haven’t I ever seen this before?

CTG: Because this is new tax reporting.

We are talking about something called the Foreign Investment in Real Property Tax Act, abbreviated FIRPTA and pronounced FERP-TUH. This thing has been around for decades, and it has nothing to do with most of us. The reporting, however, is new. To power it, you need a nonresident alien – that is, someone who is not a U.S. citizen or resident alien (think green card) – and who owns U.S. real estate. FIRPTA rears its head when that person sells said real estate.

This is specialized stuff.

We had several nonresident alien clients until we decided to exit that area of practice. The rules have reached the point of absurdity – even for a tax practitioner – and the penalties can be brutal. There is an encroaching, if unspoken, presumption in tax law that international assets or activities mean that one is gaming the system. Miss something – a form, a schedule, an extension, an election - and face a $10,000 penalty. The IRS sends this penalty notice automatically; they do not even pretend to have an employee review anything before mailing. The practitioner is the first live person in the chain, He/she now must persuade the IRS of reasonable cause for whatever happened, and that a penalty is not appropriate. The IRS looks at the file - for the first time, mind you - says “No” and demands $10,000.

And that is how a practitioner gets barreled into a time-destroying gyre of appealing the penalty, getting rejected, requesting reconsideration, getting rejected again and likely winding up in Tax Court. Combine that with the bureaucratic rigor mortis of IRSCOVID202020212022, and one can understand withdrawing from that line of work.

Back to Section 897.

The IRS wants its vig at the closing table. The general withholding is 15% of selling price, although there is a way to reduce it to 10% (or even to zero, in special circumstances). You do not want to blow this off, unless you want to assume substitute liability for sending money to the IRS.

The 15% is a deposit. The IRS is hopeful that whoever sold the real estate will file a nonresident U.S. income tax return, report the sale and settle up on taxes. If not, well the IRS keeps the deposit.

You may wonder how this wound up on a year-end brokers’ tax statement. If someone sells real estate, the matter is confined to the seller, buyer and title company, right? Not quite. The real estate might be in a mutual fund, or more likely a REIT. While you are a U.S. citizen, the mutual fund or REIT does not know whether its shareholders are U.S. citizens or resident aliens. It therefore reports tax information using the widest possible net, just in case.

Receiving An IRS Lock-In Letter

 

A client recently picked up his personal tax return. He asked to see me.

There was tax due with the return. I thought he had adjusted his withholding to increase his take-home pay, as he had spoken to me of financial stress. I am not a fan of doing this, as tax is due whether one withholds or not.   

He could not have tax due with his return, he explained, as he had received a lock-in letter from the IRS.

There is something I do not often see.

There are two versions of the lock-in letter: one sent to the employee and another to the employer. The IRS is telling both that it wants additional withholding from each paycheck, commonly meaning single withholding with no dependents.

The lock-in surprised me, as my client is not one to game the system. What he did was fall behind on his taxes due to a failed business. There are liens – IRS and private - that he is working through.

The IRS sends the employee a letter informing him/her that his/her withholdings are too low. The IRS wants the employee to self-adjust by increasing their withholding.

If that fails, the IRS sends the employer a letter. An employer has 60 days from the date of the letter to unilaterally adjust the employee’s withholdings.

The employee can quit, but the lock is good for 12 months. The employee will have to go somewhere else for a year before returning if he/she wishes to avoid the lock.

The 60 days has two purposes:

(1)  To allow the employer time to make the changes, and 

(2)  To prompt the employee to contact the IRS. If so – and if the employee can persuade the IRS – the IRS may modify the lock.

If the employee keeps his/her nose clean, he/she can request the IRS remove the lock-in. Figure that it will take about three years of tax returns, however, so it is best to avoid the lock altogether.

The employer is extremely unlikely to buck the IRS, as the employer might then draw surrogate liability. One might be a valued employee, but one is not that valued. 

Let’s look at a case.

Charles G worked for Volvo Trucks North America (VTNA). He submitted a W-4 to VTNA claiming that he was exempt from income tax withholding. He also requested VTNA to stop withholding social security taxes.

VTNA was surprisingly tolerant. It spotted Charles a 99-dependent W-4 (affecting income tax withholding), although it could not do anything about the social security.

Charles went a couple of years or so before the IRS contacted him. He blew it off, so the IRS sent VTNA a lock-in letter.

Charles went ballistic.

Charles accused the IRS and VTNA of “acting in violation of the Racketeer Influenced and Corrupt Organizations Act (RICO).”

Wow. I wonder how it went come employee review time.

The Court of course dismissed Charles’ claim against VTNA. In general, an employer must follow an employee’s request concerning withholding. If the employee asserts that he/she is exempt from withholding, then the employer must comply with such request unless certain situations occur. A lock-in letter is one of those situations.

It sounds rather self-evident, truthfully.

It also sounds like Charles was a bit of a tax protestor. A word of advice: don’t go there with Charles. Your chances of success are between zero and none, and the list of dead bodies on that hill stretches interminably. Several years ago, we represented a business having an officer the IRS considered a protestor. I did not agree with the IRS on this, but I admit that he was getting close to the line.  The audit was … unpleasant. There was no question that school was in session, and the IRS was looking to teach a lesson.

Our case this time was Giles v Volvo Trucks of North America, 551 F. Supp 2^nd 359.

What Is Unclaimed Property?

I was reading an IRS Revenue Ruling that made me laugh, albeit in a cynical way.

Here is the issue:

If an IRA is being sent to a state unclaimed property fund, can the IRS force the trustee to withhold and remit taxes?

There are several things going on here, beginning with: what is an unclaimed property fund?

An easy example is a deceased person’s bank account. Take Florida. If someone dies in Florida without a will and without requiring probate, you as an inheritor are going to have difficulties getting to their bank account – unless you name is also on the account. You likely have to hire an attorney to obtain a court letter to provide the bank stating that you are a valid inheritor of said bank account.

How many folks do think just leave the bank account unclaimed because it isn’t worth the cost of an attorney?

It is not just bank accounts. Unclaimed funds can include uncashed dividend or payroll checks, utility security deposits, safety deposit boxes, retirement accounts and a hundred variations thereon. The concept is that you are holding somebody else’s money, and that somebody disappears. It is referred to as dormancy, and the definition is what you would expect: there has been no activity in the account or contact with the owner for a while; account statements are returned because of an invalid address; phone numbers are no longer active.

The “while” depends on the state and the type of asset. In Ohio, an uncashed payroll check is considered dormant after one year whereas a customer overpayment requires three years.

Who reports this?

The business, of course. The business is supposed to try to locate the account owner, but sometimes there simply is no one to contact. When the dormancy period is up, the business then transfers the monies with its best available information to the state. The state holds the property until the owner comes forward to claim it.

The legal reasoning behind unclaimed property goes back to common law and real property. If one abandons real property, there is a legitimate public concern that it soon might become blighted. That concern prompts the transfer (the nerd term is “escheat”) of the abandoned property to the Crown – or, these days, to the State.

Unclaimed property is not technically taxation, but its laws operate similarly to tax statutes.

Many states have used unclaimed property as a means to fund their coffers. Delaware is one of the most egregious offenders, with unclaimed property being its third-largest source of state revenues. Delaware can do this because it is home to so many banks.

Here is a link if you are interested in your own unclaimed property search:

https://www.unclaimed.org/

Back to the IRS Revenue Ruling. Here is a short paragraph from the lead-in:

Under the facts presented, is the payment of Trustee Y of Individual C's interest in IRA O to the State J unclaimed property fund, as required by State J law, subject to federal income tax withholding under Section 3405 of the Internal Revenue Code?”

A bracing read, isn’t it? I couldn’t put it down.

Anyway, how do you think the IRS answered this question?

Pretty much the way you would expect. The IRS is getting its cut at some point, and this is as good a point as any. Send the IRS its money, Trustee Y.

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.

No Job Is Worth This Penalty

A few years ago someone asked me to “run their payroll.” This particular place had enough issues to fuel multiple seasons of Game of Thrones, among the least of which was an inability or unwillingness to pay their payroll on time.  It was just a matter of time until someone reported them to a government agency. I was to timely process the payroll, transfer funds, make tax deposits and so on.

My answer?

Not a chance.

I have no problem processing a payroll. The one thing I will not do however is involve myself with making payroll tax deposits.

Why?

There is an IRS penalty out there called the “responsible person” penalty, which we have previously referred to as the “big boy” penalty. This is gallows humor, and you want nothing to do with this boy. The IRS becomes very grim when one withholds payroll taxes and fails to remit them to the government. They consider it theft. The IRS roots around to learn who in the company had control over cash – that is, who decides who to pay, who can sign checks, that type of thing. If that person is you, you may be a “responsible person,” meaning that you are also liable for the payroll taxes. The IRS can chase the company, it can chase you, it can chase both of you. You have stepped into someone else’s problem.

Where have I seen this? Mostly it stems from severe cash flow pressures, such as after the 2008 business crash. My last responsible person penalty client was a contractor on the Kentucky side of Cincinnati. What made it frightening was the IRS interviewing the controller/office manager in addition to the owners. Why? Because, once in a blue moon, she would write a check, mostly if there was no one else available to sign. That woman was understandably terrified.

I am reading a District Court decision coming out of Virginia. From 1990 to 2000 Brenda Horne was the office manager for a medical practice. Her duties included:

·       Billing customers

·       Collecting accounts receivable

·       Making bank deposits

·       Writing checks

·       Preparing, signing and filing payroll tax returns

·       Decisions about hiring, firing and employee compensation

The company stopped making payroll tax deposits in 2006.  Brenda continued writing and signing checks to everyone but the IRS.

The IRS came in. The company owed over $2.8 million in back payroll taxes.

And now, so does Ms. Horne.

Perhaps she was part of this. Perhaps she was under-informed and went along in order to keep her job. She wouldn’t be the first. The fatal fact? That she could decide who to pay, who not to pay, and could sign checks accordingly. The IRS did not get paid, and they held her responsible.

Granted, the owners of the company are responsible long before an office manager is, but that is not the way the IRS approaches this. The IRS is happy to have several responsible persons. That increases the odds of collecting from someone. Theoretically, she could sue the medical practice and its owners for restitution if the IRS compelled her to pay. Considering that the company did not – or could not – pay the taxes when due, I am skeptical that it could pay Brenda Horne now.

It does not matter what she was paid for being an office manager. It cannot approach $2.8 million.

And the company’s loyalty to her?

She got fired at the end of 2010.