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.

Cincinnati Reds, Tax And Bobbleheads

Did you hear about the recent tax case concerning the Cincinnati Reds?

It has to do with sales and use tax. This area is considered dull, even by tax pros, who tend to have a fairly high tolerance for dull. But it involves the Reds, so let’s look at it.

The Reds bought promotional items - think bobbleheads - to give away. They claimed a sales tax exemption for resale, so the vendor did not charge them sales tax.

Ohio now wants the Reds to pay use tax on the promotional items.

COMMENT: Sales tax and use tax are (basically) the same thing, varying only by who is remitting the tax. If you go to an Allen Edmunds store and buy dress shoes, they will charge you sales tax and remit it to Ohio on your behalf. Let’s say that you buy the shoes online and are not charged sales tax. You are supposed to remit the sales tax you would have paid Allen Edmunds to Ohio, except that now it is called a use tax. 

The amount is not insignificant: about $88 grand to the Reds, although that covers 2008 through 2010.

What are the rules of the sales tax game?

The basic presumption is that every sale of tangible personal property and certain services within Ohio is taxable, although there are exemptions and exceptions. Those exemptions and exceptions had better be a tight fit, as they are to be strictly construed.

The Reds argued the following:

·      They budget their games for a forthcoming season in determining ticket prices.

·      All costs are thrown into a barrel: player payroll, stadium lease, Marty Brennaman, advertising, promotional items, etc.

·      They sell tickets to the games. Consequently, the costs – including the promotional items – have been resold, as their cost was incorporated in the ticket price.

·      Since there is a subsequent sale via a game ticket, the promotional items were purchased for resale and qualify for an exemption.

Ohio took a different tack:

·      The sale of tangible personal property is not subject to sales tax only if the buyer’s purpose is to resell the item to another buyer. Think Kroger’s, for example. Their sole purpose is to resell to you.

·      The purpose of the exemption is meant to delay sales taxation until that final sale, not to exempt the transaction from sales tax forever. There has to be another buyer.

·      The bobbleheads and other promotions were not meant for resale, as evidenced by the following:

o   Ticket prices remain the same throughout the season, irrespective of whether there is or isn’t a promotional giveaway.

o   Fans are not guaranteed to receive a bobblehead, as there is normally a limited supply.

o   Fans may not even know that they are purchasing a bobblehead, as the announcement may occur after purchase of the ticket.

The Ohio Board of Appeals rejected the Reds argument.

The critical issue was “consideration.”

Let’s say that you went to a game but arrived too late to get a bobblehead. You paid the same price as someone who did get a bobblehead, so where is the consideration? Ohio argued and the Board agreed that the bobbleheads were not resold but were distributed for free. There was no consideration. Without consideration one could not have a resale.

Here is the Board:

The evidence in the record supports our conclusion that the cost of the subject promotional items is not included in the ticket price.”

The Reds join murky water on the issue of promotional items. The Kansas City Royals, for example, do not pay use tax on their promotional items, but the Milwaukee Brewers do. Sales tax varies state by state.

Then again perhaps the Reds will do as the Cavaliers did: charge higher ticket prices for promotional giveaway games.

This is (unsurprisingly) heading to the Ohio Supreme Court. We will hear of The Cincinnati Reds, LLC v Commissioner again.

Deducting a Divorce

I am looking at two points on a case:

(1)  The IRS wanted $1,760,709; and

(2)  The only issue before the Court was a deduction for legal and professional fees.

That is one serious legal bill.

The taxpayer was a hedge fund manager. The firm had three partners who provided investment advisory services to several funds. For this they received 1.5% of assets under management as well as 20% of the profits (that is, the “carry”). The firm decided to defer payment of the investment and performance fees from a particular fund for 2006, 2007 and 2008.

2008 brought us the Great Recession and taxpayer’s spouse filing for divorce.

By 2009 the firm was liquidating.

The divorce was granted in 2011.

Between the date of filing and the date the divorce was granted, taxpayer received over $47 million in partnership distributions from the firm.

You know that point came up during divorce negotiations.

To be fair, not all of the $47 million can be at play. Seems to me the only reachable part would be the amount “accrued” as of the date of divorce filing.

He hired lawyers. He hired a valuation expert.

Turns out that approximately $4.7 million of the $47 million represented deferred compensation and was therefore a marital asset. That put the marital estate at slightly over $15 million.

Upon division, the former spouse received a Florida house and over $6.6 million in cash.

He in turn paid approximately $3 million in professional fees. Seems expensive, but they helped keep over $42 million out of the marital estate.

He deducted the $3 million.

Which the IRS bounced.

What do you think is going on here?

The issue is whether the professional fees are business related (in which case they are deductible) or personal (in which case they are not). Taxpayer argued that the fees were deductible because he was defending a claim against his distributions and deferred compensation from the hedge fund. He was a virtual poster boy for a business purpose.

He has a point.

The IRS fired back: except for her marriage to taxpayer, the spouse would have no claim to the deferred compensation. Her claim stemmed entirely because of her marriage to him. The cause of those professional fees was the marriage, which is about as personal as an event can be. The tax Code does not allow for the deduction of personal expenses.

The IRS has a point.

The tax doctrine the IRS argued is called origin-of-the-claim. It has many permutations, but the point is to identify what caused the mess in the first place. If the cause was business or income-producing, you may have a deduction. If the cause was personal, well, thanks for playing.

But a divorce can have a business component. For example, there is a tax case involving control over a dividend-paying corporation; there is another where the soon-to-be-ex kept interfering in the business. In those cases, the fees were deductible, as there was enough linkage to the business activity.

The Court looked, but it could not find similar linkage in this case.

In the divorce action at issue, petitioner was neither pursuing alimony from Ms [ ] nor resisting an attempt to interfere with his ongoing business activities.

Petitioner has not established that Ms [ ] claim related to the winding down of [the hedge fund]. Nor has petitioner established that the fees he incurred were “ordinary and necessary” to his trade or business.

While the hedge fund fueled the cash flow, the divorce action did not otherwise involve the fund. There was no challenge to his interest in the fund; he was not defending against improper interference in fund operations; there was no showing that her action led to his winding down of the fund.

Finding no business link, the Court determined that the origin of the claim was personal.

Meaning no deduction for the professional fees.

NOTE: While this case did not involve alimony, let us point out that the taxation of alimony is changing in 2019. For many years, alimony – as long as the magic tax words were in the agreement – was deductible by the payor and taxable to the recipient. It has been that way for my entire professional career, but that is changing. Beginning in 2019, only grandfathered alimony agreements will be deductible/taxable, with “grandfathered” meaning the alimony agreement was in place by December 31, 2018.

Mind you, this does not mean that there will be no alimony for new divorces. What it does mean is that one will not get a deduction for paying alimony if one divorces in 2019 or later. Conversely, one will not be taxed upon receiving alimony if one divorces in 2019 or later.

The Congressional committee reports accompanying the tax change noted that alimony is frequently paid from a higher-income to a lower -income taxpayer, resulting in a net loss to the Treasury. Changing the tax treatment would allow the Treasury to claw back to the payor’s higher tax rate. Possible, but I suspect it more likely that alimony payments will eventually decrease by approximately 35% - the maximum federal tax rate – as folks adjust to the new law.

Our case this time was Sky M Lucas v Commissioner.