Helping Out A Family Member’s Business

Let’s say that you have a profitable business. You have a family member who has an unprofitable business. You want to help out the family member. You meet with your tax advisor to determine if there is tax angle to consider.

Here is your quiz question and it will account for 100% of your grade:

What should you to maximize the chances of a tax deduction?

Let’s discuss Espaillat and Lizardo v Commissioner.

Mr. Jose Espaillat was married to Ms. Mirian Lizardo. Jose owned a successful landscaping business in Phoenix for a number of years. In 2006 his brother (Leoncio Espaillat) opened a scrap metal business (Rocky Scrap Metal) in Texas. Rocky Scrap organized as a corporation with the Texas secretary of state and filed federal corporate tax returns for 2008 and 2009.

Being a good brother, Jose traveled regularly to help out Leoncio with the business. Regular travel reached the point where Jose purchased a home in Texas, as he was spending so much time there.

Rocky Scrap needed a big loan. The bank wanted to charge big interest, so Jose stepped in. He lent money; he also made direct purchases on behalf of Rocky Scrap. In 2007 and 2008 he contributed at least $285,000 to Rocky Scrap. Jose did not charge interest; he just wanted to be paid back.

Jose and Mirian met with their accountant to prepare their 2008 individual income tax return. Jose’s landscaping business was a Schedule C proprietorship/sole member LLC, and their accountant recommended they claim the Rocky Scrap monies on a second Schedule C. They would report Rocky Scrap the same way as they reported the landscaping business, which answer made sense to Jose and Mirian. Inexplicably, the $285,000 somehow became $359,000 when it got on their tax return.

In 2009 Rocky Scrap filed for bankruptcy. I doubt you would be surprised if I told you that Jose paid for the attorney. At least the bankruptcy listed Jose as a creditor.

In 2010 Jose entered into a stock purchase agreement with Leoncio. He was to receive 50% of the Rocky Scrap stock in exchange for the aforementioned $285,000 – plus another $50,000 Jose was to put in.

In 2011 Jose received $6,000 under the bankruptcy plan. It appears that the business did not improve all that much.

In 2011 Miriam and their son (Eduan) moved to Texas to work and help at Rocky Scrap. Jose stayed behind in Phoenix taking care of the landscaping business.

Then the family relationship deteriorated. In 2013 a judge entered a temporary restraining order prohibiting Jose, Miriam and Eduan from managing or otherwise directing the business operations of Rocky Scrap.  

Jose, Miriam and Eduan walked away. I presume they sold the Texas house, as they did not need it anymore.

The IRS looked at Jose and Mirian’s 2008 and 2009 individual tax returns.  There were several issues with the landscaping business and with their itemized deductions, but the big issue was the $359,000 Schedule C loss.

The IRS disallowed the whole thing.

On to Tax Court they went. Jose and Mirian’s petition asserted that they were involved in a business called “Second Hand Metal” and that the loss was $285,000. What happened to the earlier number of $359,000? Who knows.

What was the IRS’ argument?

Easy: there was no trade or business to put on a Schedule C. There was a corporation organized in Texas, and its name was Rocky Scrap Metals. It filed its own tax return.  The loss belonged to it. Jose and Mirian may have loaned it money, they may have worked there, they may have provided consulting expertise, but at no time were Jose and Mirian the same thing as Rocky Scrap Metal.

Jose and Mirian countered that they intended all along to be owners of Rocky Scrap. In fact, they thought that they were. They would not have bought a house in Texas otherwise. At a minimum, they were in partnership or joint venture with Rocky Scrap if they were not in fact owners of Rocky Scrap.

Unfortunately thinking and wanting are not the same as having and doing. It did not help that Leoncio represented himself as the sole owner when filing the federal corporate tax returns or the bankruptcy paperwork. The Court pointed out the obvious: they were not shareholders in 2008 and 2009. In fact, they were never shareholders.

OBSERVATION: Also keep in mind that Rocky Scrap filed its own corporate tax returns. That meant that it was a “C” corporation, and Jose and Mirian would not have been entitled to a share of its loss in any event. What Jose and Mirian may have hoped for was an “S” corporation, where the company passes-through its income or loss to its shareholders, who in turn report said income or loss on their individual tax return. 

 

The Court had two more options to consider.

First, perhaps Jose made a capital investment. If that investment had become worthless, then perhaps … 

Problem is that Rocky Scrap continued on. In fact, in 2013 it obtained a restraining order against Jose, Miriam and Eduan, so it must have still been in existence.  Granted, it filed for bankruptcy in 2009. While bankruptcy is a factor in evaluating worthlessness, it is not the only factor and it was offset by Rocky Metal continuing in business.  If Rocky Scrap became worthless, it did not happen in 2009.

Second, what if Jose made a loan that went uncollectible?

The Court went through the same reasoning as above, with the same conclusion.

OBSERVATION: In both cases, Jose would have netted only a $3,000 per year capital loss. This would have been small solace against the $285,000 the IRS disallowed.

The Court decided there was no $285,000 loss.

Then the IRS – as is its recent unattractive wont – wanted a $12,000 penalty on top of the $60-plus-thousand-dollar tax adjustment it just won. Obviously if the IRS can find a different answer in 74,000+ pages of tax Code, one must be a tax scofflaw and deserving of whatever fine the IRS deems appropriate.

The Court decided the IRS had gone too far on the penalty.

Here is the Court:

He [Jose] is familiar with running a business and keeping records but has a limited knowledge of the tax code. In sum, Mr. Espaillat is an experienced small business owner but not a sophisticated taxpayer.”

Jose and Mirian relied on their tax advisor, which is an allowable defense to the accuracy-related penalty. Granted, the tax advisor got it wrong, but that is not the same as Jose and Mirian getting it wrong. The point of seeing a dentist is not doing the dentistry yourself.

What should the tax advisor done way back when, when meeting with Jose and Mirian to prepare their 2008 tax return?

First, he should have known the long-standing doctrine that a taxpayer devoting time and energy to the affairs of a corporation is not engaged in his own trade or business. The taxpayer is an employee and is furthering the business of the corporation.

Granted Jose and Mirian put-in $285,000, but any tax advantage from a loan was extremely limited – unless they had massive unrealized capital gains somewhere. Otherwise that capital loss was releasing a tax deduction at the rate of $3,000 per year. One should live so long.

The advisor should have alerted them that they needed to be owners. Retroactively. They also needed Rocky Scrap to be an S corporation.  Retroactively. It would also have been money well-spent to have an attorney draw up corporate minutes and update any necessary paperwork.

That is also the answer to our quiz question: to maximize your chance of a tax deduction you and the business should become one-and-the-same. This means a passthrough entity: a proprietorship, a partnership, an LLC or an S corporation. You do not want that business filing its own tax return.  The best you could do then is have a worthless investment or uncollectible loan, with very limited tax benefits.

The Income Awakens

Despite the chatter of politicians, we are not soon filing income taxes on the back of a postcard. A major reason is the calculation of income itself. There can be reasonable dispute in calculating income, even for ordinary taxpayers and far removed from the rarified realms of the ultra-wealthy or the multinationals.    

How? Easy. Say you have a rental duplex. What depreciation period should you use for the property: 15 years? 25? 35? No depreciation at all? Something else?

And sometimes the reason is because the taxpayer knows just enough tax law to be dangerous.

Let’s talk about a fact pattern you do not see every day. Someone sells a principal residence – you know, a house with its $500,000 tax exclusion. There is a twist: they sell the house on a land contract. They collect on the contract for a few years, and then the buyer defaults. The house comes back.  

How would you calculate their income from a real estate deal gone bad?

You can anticipate it has something to do with that $500,000 exclusion.

Marvin DeBough bought a house on 80 acres of land. He bought it back in the 1960s for $25,000. In 2006 he sold it for $1.4 million. He sold it on a land contract.

COMMENT: A land contract means that the seller is playing bank. The buyer has a mortgage, but the mortgage is to the seller. To secure the mortgage, the seller retains the deed to the property, and the buyer does not receive the deed until the mortgage is paid off. This is in contrast to a regular mortgage, where the buyer receives the deed but the deed is subject to the mortgage. The reason that sellers like land contracts is because it is easier to foreclose in the event of nonpayment.

 

 DeBough had a gain of $657,796.

OBSERVATION: I know: $1.4 million minus $25,000 is not $657,796. Almost all of the difference was a step-up in basis when his wife passed away.  

DeBough excluded $500,000 of gain, as it was his principal residence. That resulted in taxable gain of $157,796. He was to receive $1.4 million. As a percentage, 11.27 cents on every dollar he receives ($157,796 divided by $1,400,000) would be taxable gain.

He received $505,000. Multiply that by 11.27% and he reported $56,920 as gain.

In 2009 the buyers defaulted and the property returned to DeBough. It cost him $3,723 in fees to reacquire the property. He then held on to the property.

What is DeBough’s income?

Here is his calculation:

Original gain		157,796
Reported to-date		(56,920)
Cost of foreclosure		(3,723)
		97,153

I don’t think so, said the IRS. Here is their calculation:

Cash received		505,000
Reported to-date		(56,920)
		448,080

DeBough was outraged. He wanted to know what the IRS had done with his $500,000 exclusion.

The IRS trotted out Section 1038(e):

         (e)  Principal residences.

If-

(1) subsection (a) applies to a reacquisition of real property with respect to the sale of which gain was not recognized under section 121 (relating to gain on sale of principal residence); and

(2)  within 1 year after the date of the reacquisition of such property by the seller, such property is resold by him,

then, under regulations prescribed by the Secretary, subsections (b) , (c) , and (d) of this section shall not apply to the reacquisition of such property and, for purposes of applying section 121 , the resale of such property shall be treated as a part of the transaction constituting the original sale of such property.

DeBough was not happy about that “I year after the date of the reacquisition” language. However, he pointed out, it does not technically say that the $500,000 is NOT AVAILABLE if the property is NOT SOLD WITHIN ONE YEAR.

I give him credit. He is a lawyer by temperament, apparently.  DeBough could find actionable language on the back of a baseball card.

It was an uphill climb. Still, others have pulled it off, so maybe he had a chance.

The Court observed that there is no explanation in the legislative history why Congress limited the exclusion to sellers who resell within one year of reacquisition. Still, it seemed clear that Congress did in fact limit the exclusion, so the “why” was going to have to wait for another day.

DeBough lost his case. He owed tax.

And the Court was right. The general rule – when the property returned to DeBough – is that every dollar DeBough received was taxable income, reduced by any gain previously taxed and limited to the overall gain from the sale. DeBough was back to where he was before, except that he received $505,000 in the interim. The IRS wanted its cut of the $505,000.

Yes, Congress put an exception in there should the property be resold within one year. The offset – although unspoken – is that the seller can claim the $500,000 exclusion, but he/she claims it on the first sale, not the second. One cannot keep claiming the $500,000 over and over again on the same property.

Since Debough did not sell within one year, he will claim the $500,000 when he sells the property a second time.

When you look at it that way, he is not out anything. He will have his day, but that day has to wait until he sells the property again.

And there is an example of tax law. Congress put in an exception to a rule, but even the Court cannot tell you what Congress was thinking.

Losing An Alimony Tax Deduction

There are certain tax topics that repeat – weekly, monthly, ceaselessly and without end. One such is the tax issues surrounding divorce. I have often wondered why this happens, as divorce is surely one of the most lawyered life events an average person can experience. I will often skip divorce tax cases, as I am just tired of the topic.

But a recent one caught my eye.

The spouses were trying to work something out between them. It was clear to me that they solicited no tax advice, as they plunged off the bridge without checking the depth of the water below.

John and Beatrix were married. They legally separated in 2008 and divorced in 2013. In the interim John agreed to make 48 monthly maintenance payments of $2,289. There was a clause stipulating that payments were to be taxable to her and deductible by him, and the payments were to cease upon her remarriage or death.

John found himself unemployed. His payments were to begin in 2010. Presumably concerned about his financial situation, he and Beatrix agreed in 2009 to transfer his IRA worth $38,913.

John did not deduct the IRA as an alimony payment on his 2009 tax return.

Why not? Because Beatrix was to start withdrawing $2,289 monthly from the IRA the following year, presumably until the $38,913 was exhausted. It made more sense to John that those monthly payments would trigger the alimony.

There is some rhyme or reason to his thinking.

It appears his finances improved, as in 2010 he was able to directly pay Beatrix $6,920.  

In 2010 he deducted $27,468 ($2,289 times 12) as alimony.

The IRS disallowed all but $6,920.

Off to Tax Court they went.

There are four key statutory requirements before any payment can be deductible as alimony:

(1)  The payment must be required under a divorce or separation decree.

(2) The decree cannot say that the payments are not deductible/taxable.

(3)  The two individuals cannot be members of the same household.

(4) There cannot be any requirement to continue the payments after the death of the payee spouse.

It is amazing how often someone will fail one of these. A common story is one spouse beginning payments before the court issues the order, or a spouse paying more than the court order. Do that and the payment is not “required.” Another story is presuming that the payment is deductible because the decree says that it is. The IRS does not consider itself bound because one included such language in the decree.

Then there are the softer, non-key requirements.

For example, only cash payments will qualify as alimony.

If you think about this one for a moment, it makes sense. The Code already allows spouses to transfer property in a divorce without triggering tax (Code section 1041). This allows spouses to transfer the house, for example, as well as retirement benefits under a QDRO order. The Code views these transactions as property settlements – meaning the ex-spouses are simply dividing into separate ownership what they previously owned together.

COMMENT: It is highly debatable whether John’s IRA is “cash.”  Granted, there may be cash in the IRA, but that not is not the same as saying the IRA is cash or a cash equivalent. It would make more sense to say that it is the equivalent of stocks or mutual funds. This would make it property, not cash.

Let’s next go back to rule (4) above. A way to rephrase that rule is that the payee spouse cannot be enriched after death. Obviously, if maintenance payments were to continue after death, then the payee-spouse’s estate would be enriched. That is not allowed.

In our situation, Beatrix now owned an IRA. Granted, the expectation may have been that she would outlive any balance in the IRA, but that expectation is not controlling. If she passed away, the balance in the IRA would be hers to transfer pursuant to her beneficiary designation.

She was enriched. She had something that continued past her (albeit hypothetical) death.

Another issue was whether John should get credit for IRA withdrawals by Beatrix in 2010. Why?  John transferred the IRA to her in 2009. The account was no longer his. It was hers, and he could no longer piggyback on anything the IRA did. If he was going to deduct anything, he would have had to deduct it in 2009.

Which, by the way, he could not because of rule (1): it was not required under the decree. The decree called for payments beginning in 2010, not in 2009.

The Tax Court decided that John had a 2010 alimony deduction for $6,920, the amount he paid Beatrix directly.

Why did John do it this way? 

If John was less than 59 1/2, so he could not get into his IRA without penalty.  He could QDRO, but that is just a property settlement. John wanted an alimony deduction. If he kept the IRA, he would have income on the withdrawal and a deduction for the alimony. That is a push - except for the 10% penalty on the early withdrawal. John was in a tough spot.

Then again, maybe he didn't think of tax matters at all.

So What If You Do Not File A Gift Tax Return?

Let’s talk a little federal estate and gift tax.

It is unlikely that you or I will ever be subject to the federal estate tax, as the filing exemption is $5,430,000 for decedents passing away in 2015. If I was approaching that level of net worth, I would reduce my practice to part-time and begin spending my kid’s inheritance.

Let’s say that you and I are very successful and will be subject to the federal estate tax. What should we know about it?

The first thing is the $5,430,000 exemption we mentioned. If you are married, your spouse receives the same exemption amount, resulting in almost $11 million that you and your spouse can accumulate before there is any federal tax.

The second thing is that the federal estate tax is unified with the federal gift tax. That means that – at death - you have to add all your reportable lifetime gifts to your net worth (at death) to determine whether an estate return is required. As an easy example, say that you gift $5,400,000 over your lifetime, and you pass away single and with a net worth of $1 million.

·        If you just looked at the $ 1 million, you would say you have no need to file. That would be incorrect, however.

·        You have to add your lifetime gifts and your net worth at death. In this example, that would be $6,400,000 ($5,400,000 plus $1,000,000). Your estate would have to file a federal estate tax return.

Q: How would the IRS know about your lifetime gifts? 

A: Because you are required to file a gift tax return if you make a gift large enough to be considered “reportable.”

Q: What is large enough?

A: Right now, that would be more than $14,000 per person. If you gifted $20,000 to your best friend, for example, you would have a reportable gift.

Q: Does that mean I have a gift tax?

A: Nah. It just means that you start using up some of the $5,430,000 lifetime exemption.

Q: Does that mean that gifts under $14,000 can be ignored?

A: Not quite. It depends on the gift.

Q: Do you tax people take a course on hedging your answers?

A: Hey, that’s not…, well …. yes. 

Many advisors will separate a straightforward gift (like a check for $20,000) from something not so straightforward (like an interest in a limited partnership) valued at $20,000. 

The reason has to do with discounts. For example, let’s say I put $2 million in a limited partnership. I then give 100 people a 1% interest in the partnership. Would you pay $20,000 for a 1% interest?

Let me add one more thing: any distribution of money would require a majority vote. Therefore, if you wanted to take money out, you would have to get the approval of enough other partners that they – combined with your 1% - represented at least 51%. 

Would you pay $20,000 for that?

I wouldn’t.  Life would be easier to simply stash the money in a mutual fund. I could then access it without having to round up 50 other people and obtain their vote. The only way I would even think about it would require a discount. A big discount.

That discount is referred to as a minority discount. 

Let’s go a different direction: what if you just sold that interest instead of rounding-up 50 other partners?

Then the buyer would have to round-up 50 other partners. If I were the buyer, I would not pay you full price for that thing. Again, mutual fund = easier. You are going to have to offer a discount.

That discount is referred to as a liquidity discount.

Normal practice is to claim both control and liquidity discounts when gifting non-straightforward assets such as limited partnership interests or stock in the family company. 

Let’s use a 15% minority discount, a 15% liquidity discount and a gift before any discount of $20,000. The gift after the discount would be $14,000 ($20,000 * (15% + 15%)). No gift tax return is required unless the gift is more than $14,000, right?

Well, yes, but consider the calculus in getting to that $14,000. If the IRS disagreed, perhaps by arguing that the discounts should have been 10% +10%, then the gift would have been more than $14,000 and should have been reported.

Q: This is getting complicated. Why not skip a return altogether unless the gift is clearly more than $14,000?

A: Why? Because if you prepare the return correctly, there is a statute of limitations on the gift. If you file a return and describe that gift in considerable detail, the IRS has 3 years to audit the gift tax return. If the 3 years pass, that gift – and that discounted value – is locked in. The IRS cannot touch it.

Do not report the gift, or do not report it in sufficient detail, and there is NO statute of limitations.

Q: If I am dead, who cares?

A: Let’s return to the estate tax return. The gift is being added-back to your estate. Without the statute of limitations, the IRS can reopen the gift and revalue it, even if the gift was made a decade or two earlier. That is what NO statute of limitations means.

Q: Is this a bogeyman story told just to frighten the children?

A: Let’s take a look at Office of Chief Counsel Memorandum 20152201F.

NOTE: This type of document is internal to the IRS. A revenue agent is examining a return and has a question. The question is technical enough to make it to the National Office. An IRS attorney there responds to the agent’s question.

The donor (now deceased) made two gifts to his daughter. There were some problems with the gift tax return, however:

1.  The taxpayer did not give the legal names of the partnerships.
2. The taxpayer gave an incorrect identification number for one partnership.
3. The taxpayer gifted partnership interests, requiring a valuation. The taxpayer got an appraisal on the land, but did not get a valuation on the partnership containing the land. 
4. Failure to get a valuation on the partnership also meant the taxpayer failed to document any discounts claimed on the partnership interest.

What was the IRS conclusion?

The Service may assess gift tax based upon those transfers at any time.”

The IRS concluded there was no statute of limitations. No surprise there. Granted, if there is enough money involved the estate has no choice but to pursue the matter. It however would have been easier – and a lot cheaper - to prepare the gift tax return correctly to start with.

Q: What is my takeaway from all this?

A: If you are gifting anything other than cash or publicly-traded stock, play it safe and file a gift tax return. Ignore the $14,000 limit.