The IRS Does Not Believe You Made A Loan

The issue came up here at command center this past week. It is worth discussing, as the issue is repetitive and – if the IRS aims it your way – the results can be brutal.

We are talking about loans.

More specifically, loans to/from yourself and among companies you own.

What’s the big deal, right? It is all your money.

Yep, it’s your money. What it might not be, however, is a loan.

Let’s walk through the story of James Polvony.

In 1996 he joined his wife’s company, Archetone Limited (Limited) as a 49% owner. Limited was a general contractor.

In 2002 he started his own company, Povolny Group (PG). PG was a real estate brokerage.

The real estate market died in 2008. Povolny was looking for other sources of income.

He won a bid to build a hospital for the Algerian Ministry of Health.

He formed another company, Archetone International LLC (LLC), for this purpose.

The Algerian job required a bank guaranty. This created an issue, as the best he could obtain was a line of credit from Wells Fargo. He took that line of credit to a UK bank and got a guarantee, but he still had to collateralize the US bank. He did this by borrowing and moving monies around his three companies.

The Algerian government stopped paying him. Why? While the job was for the Algerian government, it was being funded by a non-Algerian third party. This third party wanted a cut of the action. Povolny did not go along, and – shockingly – progress payments, and then actual job progress, ceased.

The deal was put together using borrowed money, so things started unravelling quickly.

International was drowning. Povolny had Limited pay approximately $241,000 of International’s debts.

PG also loaned International and Limited approximately $70 grand. PG initially showed this amount as a loan, but PG amended its return to show the amount as “Cost of Goods Sold.”

COMMENT: PG was making money. Cost of goods sold is a deduction, whereas a loan is not, at least not until it becomes uncollectible. I can see the allure of another deduction on a profitable tax return. Still, to amend a return for this reason strikes me as aggressive.

Limited also deducted its $241 grand, not as cost-of-goods-sold but as a bad-debt deduction.

Let’s regroup here for a moment.

• Povolny moved approximately $311 grand among his companies, and
• He deducted the whole thing using one description or another.

This caught the IRS’ attention.

Why?

Because it matters how Polvony moved monies around.

A loan can result in a bad debt deduction.

A capital contribution cannot. Granted, you may have a capital loss somewhere down the road, but that loss happens when you finally shut down the company or otherwise dispose of your stock or ownership interest.

Timing is a BIG deal in this area.

If you want the IRS to respect your assertion of a loan, then be prepared to show the incidents of a loan, such as:

• A written note
• An interest rate
• A maturity date
• Repayment schedule
• Recourse if the debtor does not perform (think collateral)

Think of yourself as SunTrust or Fifth Third Bank making a loan and you will get the idea.

The Court made short work of Povolny:

·       The $241 thousand loan did not have a written note, no maturity date and no required interest payments.

·       Ditto for the $70 grand.

The Court did not find the commercially routine attributes of debt, so it decided that there was no debt.

Povolny was moving his own capital around.

He as much said so when he said that he “didn’t see the merit” in creating written notes, interest rates and repayment terms.

The Polvony case is not remarkable. It happens all the time. What it does, however, is to tentpole how important it is to follow commercially customary banking procedures when moving monies among related companies.

But is it all your money, isn’t it?

Yep, it is. Be lax and the IRS will take you at your word and figure you are just moving your own capital around.

And there is no bad debt deduction on capital.

Our case this time was Povolny Group, Incorporated et al v Commissioner, TC Memo 2018-37.

Does The IRS Want 1099s For Your Contributions?

I have been thinking about a recent IRS notice of proposed rulemaking. The IRS is proposing rules under its own power, arguing that it has the authority to do so under existing law.

This one has to do with charitable contributions.

You already know that one should retain records to back up a tax return, especially for deductions. For most of us that translates into keeping receipts and related cancelled checks.

Contributions are different, however.

In 1993 Congress passed Code section 170(f)(8) requiring you to obtain a letter (termed “contemporaneous written acknowledgement”) from the charity to document any donation over $250.  If you do not have a letter the IRS will disallow your deduction upon examination.

Congress felt that charitable contributions were being abused. How? Here is an example: you make a $5,000 donation to the University of Kentucky and in turn receive season tickets – probably to football, as the basketball tickets are near impossible to get. People were deducting $5,000, when the correct deduction would have been $5,000 less the value of those season tickets. Being unhappy to not receive 100 percent of your income, Congress blamed the “tax gap” and instituted yet more rules and requirements.

So begins our climb on the ladder to inanity.

Soon enough taxpayers were losing their charitable deductions because they failed to obtain a letter or failed to receive one timely. There were even cases where all parties knew that donations had been made, but the charity failed to include the “magic words” required by the tax Code.

Let’s climb on.

In October, 2015 the IRS floated a proposal to allow charities to issue Forms 1099s in lieu of those letters. Mind you, I said “allow.” Charities can continue sending letters and disregard this proposal.

If the charity does issue, then it must also forward a copy of the 1099s to the IRS. This has the benefit of sidestepping the donor’s need to get a timely letter from the charity containing the magic words.

Continue climbing: for the time-being charities have to disregard the proposal, as the IRS has not designed a Form 1099 even if the charity were interested.  Let’s be fair: it is only a proposal. The IRS wanted feedback from the real world before it went down this path.

Next rung: why would you give your social security number to a charity – for any reason? The Office of Personnel Management could not safeguard more than 20 million records from a data hack, but the IRS wants us to believe that the local High School Boosters Club will?

Almost there: the proposal is limited to deductible contributions, meaning that its application is restricted to Section 501(c)(3) organizations. Only (c)(3)s can receive deductible contributions.

But there is another Section 501 organization that has been in the news for several years – the 501(c)(4). This is the one that introduced us to Lois Lerner, the resignation of an IRS Commissioner, the lost e-mails and so on. A significant difference between a (c)(3) and a (c)(4) is the list of donors. A (c)(3) requires disclosure of donors who meet a threshold. A (c)(4) requires no disclosure of donors.    

You can guess how much credibility the IRS has when it says that it has no intention of making the 1099 proposal mandatory for (c)(3)s - or eventually extending it to also include (c)(4)s.

We finally reached the top of the ladder. What started as a way to deal with a problem (one cannot deduct those UK season tickets) morphed into bad tax law (no magic beans means no deduction) and is now well on its way to becoming another government-facilitated opportunity for identity theft.

The IRS Notice concludes with the following:

Given the effectiveness and minimal burden of the CWA process, it is expected that donee reporting will be used in an extremely low percentage of cases.”

Seems a safe bet.

UPDATE: After the writing of this post, the IRS announced that it was withdrawing these proposed Regulations. The agency noted that it had received approximately 38,000 comments, the majority of which strongly opposed the rules. Hey, sometimes the system works.

Can A Land Fill Make A Charitable Donation?

I have a client on extension for their individual tax return. They donated real estate last year. I am waiting on an appraisal and a signed Form 8283 before sending in the return.  

Charitable contributions have become a “gotcha” area for the IRS. The rules border on the insane. Does it make sense to you that I need a letter from the charity for donations over $250 even if I have a cancelled check? The IRS will accept a cancelled check as proof of a travel expense or of a child-care payment, but not for proof of a donation. Fail to follow their rules and you may lose the deduction altogether.

Sure enough, someone thought they followed the rules. Let’s go through the story of Boone Operations.

Boone Operations owned a landfill (Speedway). Right next to them, the city of Tucson (Arizona) also owned a landfill (Tucson). Both were surrounded by commercial and residential development. 

Tucson must have been a mess. The flare in its collection system kept going out and water kept collecting because of poor drainage. Tucson stopped accepted waste materials, but there were issues closing the place down. The neighbors howled; hearings were held. Douglas Kennedy (Kennedy), Boone’s owner, was concerned that Tucson was going to drag him down. He offered to help. In 1996 the two parties were happy and holding hands. Boone agreed to:

·        Share the cost of an interim gas system

·        Negotiate a permanent gas system

·        Cooperate to extend Boone’s aquifer permit to Tucson

You also had the following text in an agreement the attorneys drew up:

6.  Acceptable Waste Fill and Soil Fill

[Boone] agrees to provide [Tucson] with, and [Tucson] agrees to accept, acceptable waste fill and soil.

6.1 Placement of Acceptable Waste Fill

Boone shall, at no cost to [Tucson], fill the *** with acceptable waste to the approved final grades.

Seems clear: Boone will provide waste fill.

The promising relationship between Boone and Tucson soon soured:

·        6/99 - Boone places waste on Tucson to comply with agreement

·        10/99 – the Department of Solid Waste Management wants to know why Boone placed waste on Tucson

·        11/99 – Tucson wants Boone to remove the waste  

·         03/00 – Boone sues Tucson for $20 million

·        04/01 – Tucson provides Boone a settlement offer

·        09/01  -  Tucson files civil and criminal charges

·        04/02 – Boone files with the Superior Court

Shame. They seemed like such a nice couple.

Anyway, in December 2002, they settle. Tucson agreed to a number of things, including (a) paying $450,000 for Boone to construct drainage, (b) helping with easements and (c) releasing Boone and Mr. Kennedy from lawsuits.

And then the magic words:

8.1 Prior Contribution.  [Tucson] acknowledges that as of the date of the Settlement Memorandum, it had accepted Boone’s charitable contribution of 95,000 cubic yards of Acceptable Fill.

8.2 Future Contribution.  Boone agrees to make another charitable contribution of an additional 105,000 cubic yards of Acceptable Fill.

To the uninitiated, it appears that Boone has made a contribution of 200,000 cubic yards of Acceptable Fill to Tucson, don’t you think?

Boone files tax returns showing a donation of $449,000 for one year and $706,000 for another.

The IRS disallows the deductions. It has two arguments:

           

(1)  Boone failed to obtain contemporaneous written acknowledgement.

(2)  Boone received significant cash and noncash consideration and failed to prove that the value of the fill provided exceeded the consideration received.

The IRS argued that a written acknowledgement must include the following magic words:

·        The amount of cash and a description (but not value) of any property other than cash contributed.

·        Whether the donee organization provided any goods or services in consideration, in whole or part, for any property described.

·        A description and good faith estimate of the value of any goods and services received, or, if such goods and services consist solely of intangible religious benefits, a statement to that effect.

What does Boone have? The Settlement Agreement from December 2002. Without the magic words, however, Boone does not have “written acknowledgement.”  Since the donation was over $250, no deduction is allowed without written acknowledgement.

The Court then went on the argument (2). It went through the appraisal process in painstaking detail. There appear to have been significant errors in the appraiser’s calculations, for example, leading to an overvaluation of the donated fill. The Court also pointed out that Boone and Mr. Kennedy were released from a potential lawsuit. That release could have a value. If so, should that value be taken into account?

I question why the Court did this. The Court had already disallowed the deduction for lack of written acknowledgement. Why keep going?

My thinking? The Court expects a challenge on issue [1], and it thinks it could be reversed by a superior court. The Court therefore kept going, reasoning that if was reversed on issue [1] it would be sustained on [2].

You know how this turned out: the Tax Court disallowed the charitable deductions under both arguments.

COMMENT: Please do not mess with IRS in this area. If you are thinking about a significant donation of anything other than cash, please call your tax advisor first.  Get your papers lined up and do not play “gotcha” with the IRS.

A Church Contribution Story: Durden

Our next two blogs discuss tax fails involving charitable contributions.

What each has in common is congressional resolve to address an area considered subject to tax abuse. How so? How many times has someone overvalued a Goodwill clothing donation, for example? Congress therefore placed restrictions – primarily documentation requirements – on one’s ability to deduct contributions. The general tax rule is simple: no documentation equals no deduction.  The key is to understand what Congress considers documentation, as your understanding may be different from theirs.

Let’s talk about Durden.

David and Veronda Durden contributed $25,171 in 2007 to the Nevertheless Community Church. With the exception of five checks (totaling $317), all checks were over $250.

FIRST RULE: Under Code Section 170(f)(8)(A), no deduction is allowed for any contribution of $250 or more unless taxpayer has contemporaneous written acknowledgment of the contribution by the charity organization that meets specified requirements.

The Durdens cleared the first rule, as they had a letter from the church dated January 10, 2008.

SECOND RULE: Under Code Section 170(f)(8)(B), the charity must state in the acknowledgment whether it provided any goods or services as consideration for the contributed property or cash. If so, it must include a description and good faith estimate of the value of any goods or services provided.

There is a problem: the church did not include language “no goods and services have been provided” in their letter.

The Durdens obtained a second letter dated June 21, 2009 containing the same information found in the first letter, plus a statement that no goods or services were provided in exchange for the contributions.

THIRD RULE: Code Section 170(f)(8)(C) considers the acknowledgment as contemporaneous if obtained on or before the earlier when the tax return is due or the actual filing date.

The IRS disallowed all but $317 of the charitable deduction for insufficient documentation. The Durdens go to Tax Court. Their argument is reasonable: we substantially complied with the spirit of the law. We had a letter. It might not be exactly the letter the IRS wanted, but we had a letter. When the IRS wanted more, we got them more. The IRS went too far in disallowing the deduction when everyone knows we gave to the church. We even showed them cancelled checks.  The wording in Code Section 170(f)(8)(C) is only one way – a safe harbor maybe – of meeting the “contemporaneous” standard.

The Tax Court disagreed. It noted that Congress intended to tighten the rules in this area and placed specific language in the Code requiring and defining “contemporaneous.” This was not the IRS’ doing; it was Congress’ doing.  The Court in the past had been lenient in cases involving substantial procedural compliance. This was not procedure. This was legislative compliance, and the matter was outside the Court’s hands.

The Durdens did not have the correct letter when they filed their return. That is the last possible date according to the law. There is no deduction. The Court did let them deduct $317, however. Since those individual contributions were under $250, those didn’t require a letter.

MY TAKE: I can understand Congress passing near-incomprehensible tax law to address complex and sophisticated tax issues. Those taxpayers are likely to have expert tax advisors and planners. This is not one of those issues. This is someone donating to a church. I strongly disapprove of routine activities triggering tax rules that make no sense to an average person.  

Congress should have included a “sanity” clause in this statute. They could have given the IRS discretion to accept “other but equal” documentation. True, the IRS could refuse to do so, but at least there would be a chance that the IRS – or a court reviewing the IRS – could blunt the capriciously sharp edge of this tax law.

Next time we will talk about Mohamed.