A Doctor, A Tax, An Offshore Account And A Moral

I was reading Kindred v Commissioner recently. There is not much there of technical interest, but the facts are interesting. Plus it has a moral.

Dr Kindred failed to file tax returns or make tax payments for 2001 and 2002. The IRS prepared substitutes for returns and assessed him $912,529 and $1,184,115 for 2001 and 2002 respectively. The doctor goes to court, but not to argue the amount of tax assessed.

NOTE:   Wow! This guy owes over $2 million to the IRS and is not even arguing the amount.

Dr Kindred had gotten himself involved with the Aegis Business Trust System (Aegis) out of Chicago. Aegis was a bushel of bad apples. They promoted the use of trusts – revocable, offshore - as a way to reduce taxes. The problem is that some trusts are useful and others are useless. Aegis promoted useless trusts. The IRS conducted an undercover investigation (code-named “Operation Trust Me”) which resulted in indictments and convictions for tax fraud conspiracy for the operators of Aegis.

Dr Kindred transferred money offshore to one of these Aegis trusts.

In 2003 the government indicted Aegis and froze their offshore accounts. The government seized all the accounts and kept the money, including Dr Kindred’s money.

Subsequently the doctor is contacted by the IRS, and they want $2-plus million.

The doctor’s money is gone. What is he to do?

He files a case in District Court and then Tax Court, that is what he does. His request is simple. He wants to receive “credit” for his share of the monies that were seized. After all, on the one hand he owes the government money. On the other hand the government took money that belonged to him. Seems reasonable, right?

 The district court dismisses his case. There are several issues, one of which is that the case in district court was a criminal case. No matter what, Dr Kindred was not coming out of district court with a verdict that the monies represented tax payments, mostly because the monies did not represent tax payments. Rather than make tax payments to the IRS he boxed them in an Aegis trust and shipped the monies overseas. Money yes, tax payments no.

He next goes to the Tax Court and makes the same plea. The Tax Court asked the obvious question: we are a court for taxes. We see that you owe taxes. We see that you did not pay taxes. Why are you here?

This is a worst case scenario. The doctor lost the money that he shipped offshore AND he still owes the taxes.

The moral? Wouldn’t it have been easier to just HAVE PAID THE TAXES?

New Reporting For Foreign Bank And Other Financial Accounts

I have mentioned on this blog that I have in-laws overseas (England). My wife and I have discussed buying property and retiring (some day!) overseas. She e-mailed me something recently on property in Ecuador that caught her eye. I only recall that the average temperature was not equal to the surface of the sun, which surprised me. (It’s called Ecuador because it is on the equator.)

Let’s say that my wife and I retire overseas. We would be expatriates. Nope, this is not a bad word. It means a person who lives outside his/her country of citizenship.

What tax issues should an expatriate know about? There are many, but today I want to talk about the HIRE Act, FATCA and the brand-new IRS Form 8938 Statement of Specified Foreign Financial Assets.

Congress passed the Foreign Account Tax Compliance Act ("FATCA") as part of the HIRE Act in 2010. The intent was to make it difficult for US taxpayers to evade tax by hiding assets overseas. FATCA requires US persons to file yet another form (Form 8938) to report foreign financial assets.

Form 8938 is out in draft. Interestingly, its instructions are NOT out. Form 8938 will be attached for the first time to your 2011 tax return.

Please note that this form is IN ADDITION to Form TD 90-22.1 (the "FBAR") you may already be filing with Treasury by June 30th of every year. The FBAR is required when you have more than $10,000 in foreign financial accounts.

Form 8938 is primarily geared but not necessarily limited to financial accounts.  You have to report (as I read it) foreign rental property, for example, as long as it is income-generating.  This is an issue for a couple of our clients, so I intend to go back and verify this point.

Form 8938 does have a higher reporting threshold - $50,000 – than the FBAR.

Form 8938 may require substantial time to prepare. Part I is relatively straightforward and asks you to disclose your overseas bank accounts. Part II asks you to disclose foreign financial interests (other than bank accounts) and their maximum value during the year. Depending on the financial interest, you may also have to disclose mailing addresses and other information. Part III requires the disclosure of “tax items” attributable to foreign interests previously disclosed. “Tax items” are interest, dividends, royalties and such other income, so you will (effectively) be tracing the income from the disclosed assets to a specified line on your individual income tax return.

The IRS did realize that some of this information is being disclosed on other tax filings already in their possession. Foreign corporations, for example, file Form 5471.  Foreign partnerships file Form 8865. Foreign trusts file Forms 3520 and 3520A. Part IV allows you exclude these financial interests from 8938 reporting. You do however have to provide some information on how many and what type of filings the IRS will receive on your behalf. Presumably there will be computer matching for the IRS to double-check that it has all these filings.

My take on all this? Does it seem reasonable to you that this level of reporting kicks-in at $50,000? Why not $10 or $15 million – a more reasonable threshold if in fact it is the “fat cats” that FATCA is going after?

The Value of a Family Limited Partnership

Let’s look at the Estate of Natale Giustina v Commissioner.

The Giustina family owned timberland in Oregon. As the generations passed on, some of the land came to Natale, who passed away in 2005. Natale was the trustee of the N.B. Giustina Revocable Trust.

         NOTE: Remember that a revocable trust would be included in Natale’s estate upon death.

The trust in turn owned 41.128 percent of the Giustina Land & Timber Co Limited Partnership (LP). The LP was formed in 1990 and owned 47,939 acres of timberland in the area around Eugene, Oregon. It employed between 12 and 15 people. There appeared to be no doubt what the timberland was worth – at least $143 million. A 41.128 percent share of that would be almost $59 million.

Here is today’s quizzer: what value did the estate put on its estate tax return and what did the IRS think the value should be?

If you guess $59 million, you are wrong. Here is what the two sides fought over:

                                Estate                   $12,678,117

                                IRS                         $ 35,710,000

What happened to the $59 million? This case is a good primer on valuation discounts. Let’s say that you own horseland in central Kentucky – a lot of it. Say that it is worth $20 million. You want to sell it to me. It’ worth $20 million, but I sense that time is of the essence to you. I offer $18,500,000. The faster you have to sell it, the less I am willing to offer. This is a discount, and a valuation person would refer to it is a “market” discount.

So even if you start with $59 million we could argue that the land was worth $54,750,000 to the estate.

Now let’s do something else. Let’s put the horseland in a “limited partnership.”  The limited partnership will have general partners and limited partners. The general partners make all the decisions, and the limited partners have little authority. I buy the land and put it into an limited partnership with my wife and me as general partners. Our children are the limited partners. My wife and I (the “generals”) have full control over the business of the partnership. We have the power to buy, raise, race and sell horses. We have the power to make distributions of cash or property to the partners in proportion to their respective interest in the partnership.  We have the power to buy or sell land. All decisions of the general partners must be unanimous.

The limited partners (“limiteds”) can force removal of a general by a two-thirds vote. If a general resigns or is removed, the limiteds can put in one of their own by a two-thirds vote. An additional general can be admitted if all the partners consent to the admission.

The partnership agreement does not allow my kids to transfer their interests willy-nilly. Oh no.  The partnership only allows an interest to be transferred to (1) another limited, (2) a trust for the benefit of a limited or (3) anyone else approved by the generals.  Unless you are our grandchild, it is very unlikely that the generals (my wife and I) will permit any transfer away from our kids.

How much are you willing to pay to buy the limited interest from my kid? It’s different now, isn’t it? My kid does not control her own fate with regard to the LP interest. My wife and I control. If we decide there are no distributions, then there are no distributions. If there is taxable income but no distributions with which to pay the tax … well, tough luck. I suspect you are revising your price downward the more I explain how much control my wife and I are keeping.

This is called a “control” discount.  The limited partnership allows you to introduce a control discount – if you play by the rules.

The court went through some interesting analysis of valuation methods, interest rates and discounts that is a bit inside-baseball for this blog post. At the end, however, the court found itself disagreeing with both the estate and IRS valuations and posited its own valuation of $27,454,115. This is much closer to the IRS value than to the estate.

Did the family gain anything from all this?  Let’s look at the following two values:

               
                By doing no tax planning                              $58,813,040

                The court said                                                 $27,454,115

 I would say this was good tax planning.

A Surprise for US Persons With Undeclared Canadian Retirement Plans

We have a few clients who are Canadian or lived in Canada. We have two who lived in Toronto through last year before moving to Wisconsin. Nothing like that warmer weather!

Anyway…

There is a very specific tax issue if you are Canadian and emigrating to the U.S. It has to do with Canada’s version of IRAs and 401(k)s. Canada calls them Registered Retirement Savings Plans (RSSP) or Registered Retirement Income Funds (RRIF).

In Canada these accounts are tax deferred (just like IRAs and 401(k)s in the US). In the US they are not UNLESS you make certain tax elections. The IRS otherwise considers these accounts to be just another broker’s account and will tax you annually on the interest, dividends and capital gains.

Rev Proc 2002-23 states the procedures to make an election on your US tax return. You have to make a separate election for each plan. The form you use is Form 8833 Treaty Based Return Position Disclosure. You state that you are claiming the benefit of Article XVIII(7) of the US-Canada Income Tax Convention. You’ll have to include the name of the financial institution where the account is kept, the account number of the plan, and the account balance at the beginning of the year.

If somewhere down the road you finally draw on the Canadian plan, you will owe Canadian tax. If you truly have emigrated, then Canada will consider you a nonresident and withhold – at 25%, I believe.

If you paid tax annually to the US, the US tax calculation at that moment could be hair-pulling. You would have “basis” in some of the account – to the extent you paid tax – and not have “basis” in the rest.

If this is you, please get professional advice.

Indiana Blows It But Taxpayer Has To Give Back Refund

Our ongoing search for bad state tax laws and policies takes us this time to Indiana, which is almost next door to our offices. Generally Indiana is a solid, common-sense Midwest state, but they dived into the pool of bad tax administration with Zoeller v Aisin USA Manufacturing.

Aisin filed its 2001 corporate income tax return in October, 2002. It showed the following:

                Tax due                               $1,300,367

                Payments                           $1,457,000

                Applied                               $   156,633

The Indiana Department of Revenue (“Department”) worked its voodoo and in September, 2003 issued Aisin a refund of $1,146,062.

Aisin cashed the check.

Two more years go by. In October, 2005 Aisin amends its 2001 return to show the following:

                Tax due                               $1,051,099

                Payments                           $1,457,000

                Applied                                $   156,633

                Refund                                 $   249,268

Whoa Nellie!! This is different. Normally when an accountant prepares an amended return – and there was a refund on the original return – the accountant adjusts something to show the refund. Aisin is not associating the $1,146,062 refund with its 2001 payments at all. That is aggressive.

The Department starts taking a look at Aisin’s file. Good idea. In April, 2006 the Department wanted to issue a Proposed Assessment to Aisin. It wants its money back.

                Question:            Can you see the problem a tax person would have?

I’ll give you a hint. Under Indiana Code 6-8.1-5-1(b) “… the department may not issue a proposed assessment  … more than three (3) years after the latest of the date the return is filed, or … the due date of the return.”

OK, when was the return filed? That was in October, 2002. Three years from that is … October, 2005. Can the Department even issue this Proposed Assessment? But first …

               

                Question:            Does filing an amended return affect the 3-year Indiana statute?

Here is something that will surprise you; The filing of an amended return in Indiana does not restart the limitations period (UACC Midwest, Inc n v Indiana Department State Revenue). Aisin was very slick by filing the amended within days of the statute expiring.

Back to our question. Indiana could not issue the Proposed Assessment. Indiana recognized this and pulled the assessment before it could be mailed.

Seems to me that Aisin is up by $1,146,062. It is oily, I grant you, but it is the technical reading of the law. Indiana just blew it. Or did they?

The Department next files a nontax claim against Aisin on grounds of unjust enrichment. The trial court dismisses the case and the Court of Appeals affirms. Why? Because this was a tax case, and in Indiana tax cases are heard in the Indiana Tax Court, not in Superior (that is, trial) Court.

But the Department will not be deterred. It files an appeal to the Indiana Supreme Court … which decides to hear the case! There is only one issue before the Indiana Supreme Court: is this a tax case or not?

The Court states:

“Had Aisin neither paid nor owed any income taxes but still received the check because of clerical error, the State’s action to recover would not be an action to recover any unpaid “tax” because Aisin would not have owed any tax.”

To hold that this “refund,” issued solely because of accounting or clerical errors, represents part of a tax would not serve the legislative purpose of ensuring the uniform interpretation and application of the tax laws because the tax laws are not implicated.”

Huh?

Am I to believe that Aisin left the west side of Cincinnati for a leisurely two-hour drive to Indianapolis where – like a gift from the heavens - a check in the amount of $1,146,062 floated in through an open car window? Were these the winnings from a fantasy football league? Did Aisin discover the long-lost Harry Potter manuscript at a Saturday morning yard sale? Of course this money was tax-related. The only reason that the Department even knew that Aisin existed is because Aisin was filing its taxes.

I agree with the Justices Rucker and Dickson in the dissent:

What is really at stake in this case is that the State apparently acted under the assumption that it missed a statute of limitations deadline in a tax proceeding. The State does not contest Aisin’s assertion. Instead it is reasonable to conclude that acting under the assumption that it could obtain no relief in the Tax Court by reason of a statute of limitation, the State attempted an end-run and filed this action in Superior Court. Given the lengths to which the majority was required to analyze Aisin’s various tax filings and the resultant repercussions, I agree that this a tax case and would affirm the judgment of the trial court.

It is difficult to side with Aisin, but they were right and Indiana was wrong. We all lose something when a judge or court unilaterally decides to trump the law. What we lose is predictability and the right to rely on the law.

IRS Ends Gift Tax Probes of Non-Profit Groups

On  July 7  the IRS said that it would stop its examinations of tax-exempt 501(c)(4) organizations. The IRS had quite recently been reviewing donors to these organizations for compliance with gift tax return requirements.

There is some uncertainty in the tax literature whether contributions to these organizations would be considered “gifts.” If so, and depending on the amount, there could be a gift tax return requirement. Now, when I say uncertainty, I mean that there is a classroom argument to be made. The IRS has not pursued this matter for nigh near 30 years, so it is not something that has concerned many practitioners.

The classic charity is a 501(c)(3). We are talking about (c)(4)’s, which are “social welfare” organizations. The idea is that the organization promotes the common good, although that common good can be targeted to a certain slice of the population. The AARP, for example, is a 501(c)(4), and that slice is people over age 50. A (c)(4) can even lobby, as long as it is not the primary thing the (c)(4) does. A (c)(3)  cannot go as far with lobbying as a (c)(4) can.

The big difference? Donations to a(c)(3) are deductible on your income tax return. Donations to a (c)(4) are not.

Let’s fast forward. What has changed? Well, in the last election cycle the (c)(4)s raised seven times as much money for Republican causes than for Democrat causes.

Then the IRS announced that it wanted to “look into” the (c)(4)s.

Republicans in both the House and Senate immediately questioned why the IRS was going there.

While the IRS statement is welcome, lawmakers want to find out what, if any, political muscle was used. The IRS says there was none. Republicans of course are highly skeptical.

Governor Signs Ohio Estate Tax Repeal

Governor Kasich signed the repeal of the Ohio estate tax into law on Thursday, June 30. As is common with contemporary tax bills, the law’s effective date is delayed until January 1, 2013 – approximately one and one-half years away.

There are different ways of looking at this issue. Ohio exempts the first $338,000 of the estate’s value and maxes-out at 7% on estates over a half-million. Ohio’s argument has been that it exempts the vast majority of estates in the state. In fact, over three-quarters of the tax raised is on estates over $1 million. The Ohio estate tax is peculiar because Ohio shares the estate tax with the localities in which the deceased resided. In Cincinnati, for example, this sharing amounts to almost $13 million per year. Cincinnati will, of course, face budgetary pressures.

 An alternate perspective was provided in a study from Duquesne University which estimated that state and local governments lose approximately $3 in non-estate tax revenues for every $1 increase in federal estate tax.

My perspective?

I have been in Cincinnati for over 20 years. I grew up in Florida. I can tell you that we have moved clients to Florida, but we have never moved clients to Ohio - or to Kentucky. Do taxes override all? Of course not. I would not be working in Cincinnati - where we have both state and local taxes - if that were the case.  But let's not be silly by arguing that taxes do not have an impact.