Is There a Danger From A Nondirect IRA Rollover?

I have come to the conclusion that I do not like for folks to receive a check when they do an IRA rollover.

What are we talking about?

Say that you have an IRA at Fidelity and you want to transfer it to Vanguard. Another example is that you have a 401(k) with a previous employer, and you have decided to move out of the 401(k). In each case you are transferring money into an IRA, whether from another IRA or from an employer plan.  

There are two ways to do this:

(1)  Instruct Fidelity to send the monies directly to Vanguard. This is sometime referred to as a “trustee-to-trustee” or a “direct” rollover. Notice that you ever see the money, although you may feel the breeze as it rushes by.

(2)  Instruct Fidelity to send you a check and then you in turn will send the money to Vanguard.

Option two is fraught with danger, beginning with convincing Fidelity not to withhold taxes. They do not “know” that you are actually rolling the monies, and they do not want to be holding the bag if the IRS comes looking. If they withhold $1,000, as an example, you are going to have to reach into your wallet to transfer the full amount to Vanguard. Otherwise you will be $1,000 short, meaning that $1,000 will be taxable to you when it is time to file your taxes.

An equal or bigger danger is that the IRS allows you only 60 days to send that check on to Vanguard. Miss that deadline and the IRS will say that you flubbed the rollover, taxes (and perhaps penalties) are due and thanks for playing.

How do you get out of it? Well, you are going to have to formally ask the IRS for a waiver, and wait on the IRS to give it. This process is referred to as a “private letter ruling.” The IRS is issuing a ruling to you, and it is to you and you only (that is, “private.”)

Is expensive? It can be, not the least for a CPA’s time in drafting the thing. Depending upon the issue, the IRS might also charge you money, and that cost can go into the thousands.

How can you miss the 60 days? There seems to be an endless variety. One can get sick, have family emergencies, the financial institution can make a mistake. I have lost track of how many of these I have read over the years.

And now I am reading another. Let’s talk about it, as I can see this story sneaking up on someone.

The taxpayer – by the way, taxpayers in private letter rulings are anonymous. We need to give “anonymous” a name for this discussion, so we will call him Sam.

Anyway, Sam wants to move his IRA. He meets with an advisor, who cautions him that the “new” IRA trustee will charge for rolling the IRA. Sam would be much better off having the old trustee reduce everything to cash, and then sending the cash to the new trustee.

OBSERVATION: While the PLR does not dwell on it, there obviously are some difficult-to-sell assets in Sam’s IRA. It does not have to be anything esoteric – like platinum-plated gold from the moon. It could be something as simple as a non-traded REIT.

Sam contacts a representative of the old trustee and explains that he is rolling over his IRA.  He has opted to pursue option (2) above, and would they be so kind as to help him with the process. Not a problem, they say, although it might take a few months to reduce the IRA to cash.

And there is the first big red flag.

Sure enough, old trustee sends Sam checks – plural. Six checks in total, over a period of more than 60 days.

Second red flag.

Sam was clever though. Sam did not cash any of the checks, figuring that if he did not cash the check then the 60-day period did not start.

Sam finally sends all the checks over to new trustee, who realizes that there is a problem. What problem? The problem that the 60-day period does not work the way Sam thought.

New trustee contacts old trustee and requests that they issue a stop payment on the checks.

Good job.

You see, the stop payment means that the checks could not be cashed, rendering them not much of a check at all. Since they could not be cashed, the monies could never leave Sam’s old IRA, and the issue of a rollover becomes null and void.

There is one more step: getting the IRS to agree with the above line of reasoning.

Which Sam did with his private letter ruling (PLR).

And I suspect that the professional and filing fees for the PLR may approximate what the new trustee was going to charge for handling the transfer in the first place.

By the way, do you know how this should have been handled? By instructing the old trustee not to send a check until everything has been reduced to cash, and then to send one and only one check for the entirety of the account.

I know that, and you know that. But somewhere sometime someone will repeat this story. Which brings me to the conclusion that people should not do option (2) rollovers unless there is no other alternative.

It just isn’t worth the risk.

Why Does The IRS Want A Disabled Veteran To Work Faster?

Sometimes I read a tax case and ask myself “why did the IRS chase this?”

Lewis is one of those cases.

Let’s explain the context to understand what the IRS was after.

It will soon be three decades that Congress gave us the “passive activity” (PAL) rules. A PAL is a trade or business that you do not sufficiently participate in – that is, you are “passive” in the business. This means more when you have losses from the activity, as income is going to be taxed in any event. It was Congress’ intention to take the legs out from the tax shelters, and with PALs they have been largely successful.

The PAL rules got off to a rocky start. One of the early problems was Congress’ decision to classify real estate activities as passive activities. Now, that concept may make sense if one own a duplex a few streets over, but it doesn’t work so well if one is a home builder or property manager.

Say, for example, that a developer builds a hundred condo units. The real estate market reverses, and he/she cannot sell them as quickly as planned. The developer rents the units, waiting for the market to improve.

Most of us would see one activity. Congress saw two, as the rental had to be segregated. There was no harm if both were profitable. There was harm if only the development was profitable, however, as the rental loss would just hang in space until there was rental income to absorb it.

That was the point of the passive activity rules – to disallow the use of passive losses against nonpassive income.

Real estate professionals screamed about the unfairness of the law as it applied to their industry.

And Congress changed the law by making an exception for real estate people who:

(1) Work more than 750 hours during the year in real estate, and

(2) More than one-half of all hours worked were in real estate.

If you meet both of the above tests, you can deduct losses from your real estate activities to your heart’s content.

Bill Lewis is a Vietnam veteran. He took injuries as a Marine, retaining 50 percent use of his right arm and 70 percent of his feet, requiring him to wear orthopedic shoes. The military gave him a disability pension. He now needs knee surgery, and he has difficulty seeing. He is married.

He and his wife own a triplex next door to their residence. The property also has a washhouse, although I am uncertain what a washhouse is. There are six 64-gallon recycling bins, and several large walnut trees. Mr. Lewis does not ask anyone to take care of his property. He takes care of it himself.

1.  Every morning he walks around and inspects for trash, as they are located very close to a homeless area.  This takes him about a half hour daily.
2. Also on Mondays he scrubs down the washhouse. That requires him to haul water and takes him about three hours. 
3. On Tuesdays and Thursdays he landscapes, cleans the outside of the buildings and the garbage cans and rakes the yard. This takes about two hours on each day.
4. Depending on the season, he has more raking to do, as he has walnut trees on the property.
5. On Wednesdays he takes the recycling bins out to the curb. One by one, as he has mobility issues.
6. On Thursdays he returns the recycling bins. Same mobility issues.
7. He prefers to do repairs himself. If he needs outside help, he schedules and meets with that person. 
8. He follows a set routine, rarely if ever taking a vacation.

The Lewis’ claimed rental losses for 2010 and 2011. The IRS disallowed the losses and wanted almost $11,000 in taxes in return. The IRS said this was the classic passive activity.

The IRS should have also taken candy from a child and kicked a dog and made this a trifecta of bad choices.

Mr. Lewis was disabled. He did not have a job. As a consequence, he did not have to worry about spending more than half of his work hours in real estate. For him, all of his work hours were in real estate.

But Mr. Lewis ran into two issues:

(1)  He did not keep a journal, log or record of his activities and hours; and

(2)  The IRS did not believe it could possibly take more than 750 hours to do what he did.

Issue (1) is classic IRS. I have run into it myself in practice. The IRS wants contemporaneous records, and few people keep time sheets for their real estate activities. The IRS then jumps on after-the-fact records as “self-serving.” The IRS has been aided by people who truly could not have spent the hours they claimed (because, for example, they have a full-time job) as well as repetitively fabulist time records, and the courts now routinely side with the IRS on this issue.

But not this time. The judge was persuaded by the Lewis’ testimony and the few records they could provide. This was a rare win for the taxpayer.

The IRS had a second argument though: it should not have taken as long as it took Mr. Lewis to perform the tasks described.

The judge dismissed this point curtly:

Petitioner husband and petitioner wife testified credibly that because of petitioner husband’s disabilities all of the activities took him significantly longer than might ordinarily be expected.”

The Lewis’ won and the IRS lost.

Good.

These were very unique facts, though. Unless one truly works in the real estate industry, many if not most are going to lose when the IRS presses on contemporaneous records for the 750 hours. Mr. Lewis was a sympathetic party, and the judge clearly gravitated to his side.

Which raises the question: why did the IRS pursue this? They were anything but sympathetic chasing a disabled veteran for taking too long while performing his landlord responsibilities.

Yes, I am sympathetic to Mr. Lewis too.

What Does It Take To Exclude Foreign Income?

At this point of the tax season I usually lament not having won the lottery since last year’s tax season. I would travel extensively, most likely overseas.

That would put me out of the country, and you may have heard that there is a tax “break” for people who work outside the country.  I sincerely doubt it would apply to me in my imaginary lottery-fueled world, but let’s talk about it.

If you work overseas, you get to exclude up to $100,800 of earned income – such as salary – from U.S. tax. This sounds like a great deal, and usually it is, but remember that you would have been allowed a credit for income taxes paid the other country. If the foreign taxes are the same or higher than the U.S. taxes, the effect of the income exclusion is likely a push. If the other country has lower taxes than the U.S., however, this could be a very sweet deal for you.

There are ropes to claiming this exclusion. You have to meet one of two tests. The first test is being outside the U.S. for at least 330 days during the year. Think about this for a second. You take a job in Japan for a couple of years, but your family stays in the U.S. This means that you can see them up to 35 days a year – or forfeit the exclusion. I suppose they could travel to Japan instead, but you get the idea.

There is a second way, and that is to be a “bona fide” resident of the foreign country. This is hard to do, as it means that your home is there and not here. “Home” in this context does not just mean a place where you hang clothes and keep food in the refrigerator. The tax Code wants more: it wants your “main” home to be overseas.

Does this happen much? You bet. Think an American expatriate – perhaps retired military or someone who married overseas. I have family for example who have lived in England for decades. They have gone to school, worked, married and raised children there. They would easily qualify for the foreign income exclusion under the bona fide test.

What if one works overseas but still maintains ties to the U.S.? Can one also be a bona fide citizen of another country?

You can expect the IRS to be skeptical, especially if you leave a house or family behind. This is the IRS equivalent of New York Department of Revenue not believing you when you tell them you moved to Florida.

Let’s look at one someone who recently tried to make the bona fide argument.

Joel Evans took a job on Sakhalin Island in Russia, which has to count as going to the end of the world. He was working the oil rigs, both on land and offshore. His normal schedule was 30 days on followed by 30 days off. A 30- day stretch gave him the flexibility to return frequently to the U.S.  

He had a house in Louisiana, and somewhere in there he got divorced. His daughter moved into his house for a while. He returned to Louisiana whenever he could. He eventually married a second time, and his wife moved into, and his daughter moved out of, his house in Louisiana.

He claimed the foreign income exclusion for years 2007 through 2010. The IRS said no and wanted over $31,000 in back taxes from him

He had absolutely no chance under test one, as he spent way more than 35 days annually in the U.S. He argued instead that he was a bona fide resident of Russia.

I give him credit, I really do. It was his only argument. He spent a lot of time in Russia. He learned a little Russian. He fixed up a place to stay. He made friends. He even dated some Russian women, which I presume he ceased doing when he got remarried.

But that isn’t the test, is it?

The test is where his main home was. He pretty much gave his hand away when he kept returning to Louisiana almost every thirty days.

The Tax Court agreed with the IRS and disallowed his foreign income exclusion. He was not a bona fide resident of Russia, and he could not exclude his foreign earned income. He had failed both tests.

Let’s state the obvious: he had no chance winning this one.

In my practice, almost everyone relies on the 35-day test, and it is common to monitor the 35 days like a hawk. I suppose if I were an expat (that is, living overseas) preparing taxes for other expats, I would see the bona fide test more frequently. There are not too many bona fides who would need my services in Cincinnati.

Which rule – the 35 day or the bona fide – would trip me up when I hit the lottery?

Neither. It takes earned income – think self-employment or a salary – to power the foreign earned income exclusion. I have no intention of working.

An Interim Report On Tax Season

I was speaking with a colleague earlier this week who wants to set up a tax storefront. That means a place that prepares taxes, probably only individual taxes and only for a few months a year. Think H&R Block, but without a franchise involved. I suspect he would be successful, but like any business start-up the cash drain is difficult to pull off.

And he asked me if tax seasons are getting “harder.” Yes, he is younger than me. I am getting to that age.

I hesitated on his question, as my long-standing position is that the accounting firm determines the difficulty of the season for its employees. Some firms do a good job, and other firms simply do not care. It is one of the reasons that the average career of an accountant in a CPA firm is little more than that of an NFL player.

Bet you did not know that.

Still, there are issues for tax practitioners that did not exist a few years ago – or even last year.

I was speaking this week with a good friend about whether it was safe for him to prepare his personal tax return on TurboTax. Depending upon the year and other factors, he prepares a draft return and I review it for him. Last year he changed jobs and states, so I expect I will review his return this year.

Why TurboTax? It turns out that a number of states experienced suspicious electronic filing activity this year and, upon investigation, in many cases the electronic return was filed using TurboTax.

Let’s be fair, though. That does not mean that the information came from TurboTax. There have enough recent breeches of data security that the information may have come from elsewhere.

Intuit, the parent of TurboTax, responded aggressively to this development, as you would imagine. A number of states, including Kentucky and Minnesota, temporarily halted the processing of electronically filed returns.  Meanwhile TurboTax encouraged its customers to log-in and review their accounts. They instructed their customers to review their direct-deposit information specifically.

Makes sense.

Why the states? In the past, fraudsters have targeted the IRS rather heavily. The IRS responded with stricter identity measures, including lockdowns on any tax refunds and the required use of security passwords. Florida was so hard-hit, for example, that one can request a federal security PIN number under a pilot program – even if one was not the victim of identity theft.

It may be that the fraudsters saw easier picking elsewhere.

Then we have the information documents to prepare a tax return.

I am reading that the federal health insurance marketplace has sent out approximately 800,000 erroneous Forms 1095-A. This is not insignificant and represents approximately one-in-five people using the marketplace. These forms are new and are issued by the exchanges to individuals who purchased insurance there. They include information on any government subsidy, so they are an important tax document.  For example, even if you are not otherwise required to file a tax return, you must file if you received a subsidy.

The error concerns the “benchmark plan” premium and doesn’t concern the amount of subsidy itself. The “benchmark plan”” is the second lowest cost silver plan for where one lives, and it is part of the arithmetic to settle-up whether one received too much or too little subsidy. As you know, if you received too much subsidy you have to pay it back.

Taxpayers who received Forms 1095-A are encouraged to wait until March before filing their individual tax returns. Not a problem. Surely these are people who do even meet with their tax advisors until March.

Meanwhile, it has finally dawned on some politicians that people may not realize the effect of ObamaCare on them until they file their 2014 taxes. There will be rude surprises for those who did not acquire insurance and now have to pay the penalty. Perhaps they acquired insurance but were over-subsidized, and now they have to repay the excess subsidy.

Wait until they learn that the penalty will go up every year.

Then there is a problem with the timing of obtaining health insurance. ObamaCare requires everyone to have insurance in place by February 15 – which of course is two months earlier than April 15, when taxes are due. That may be the first time people understand this Rube Goldberg contraption foisted 50-shades-of-grey style upon society. What happens then? Well, in addition to owing the penalty for 2014 it would appear that one would also owe a penalty for some part of 2015 – at least until one can acquire health insurance. The penalty goes month by month.

Many politicos – not the brightest class emerging from natural selection – are now up in arms, demanding that deadlines be changed, penalties ameliorated and so on. I suppose there is a nuance there, but it escapes me. 

Somewhat on cue, on February 20 the Center for Medicare and Medicaid Services declaimed that the enrollment period shall reopen from March 15 to April 30.

To which I have two questions:

1. What happened to the period from February 15 to March 15?
2. Why is the Center for Medicare and Medicaid Services changing the law?

On February 13 - which seems a lifetime ago at this point - the IRS finally provided some guidance on how to comply with the new repair Regulations effective with the 2014 tax returns. Considering that their first pass at the Regulations required almost everyone with real estate or other depreciable property to file for a change in accounting method - a change which the IRS mandated, by the way - the IRS then had the temerity to say that we also had to formally ask them for permission to change. I had and have a stack of real estate partnership returns in my office waiting on their guidance. Forests have been felled by tax practitioners divining for weeks and months what the IRS wanted from us this year in order to comply with their new Regulations. 

Do you ever wonder if our government is suffocating under the weight of people who - having accomplished little more than going to a name school or playing at politics - think they now have the chops to bludgeon those of us who actually accomplish something every day? 

Back to our initial question though: are tax seasons getting “harder?”

I don’t think “harder” is the word I would use for for it.