Gifting And The Rest of 2012

I met with a client last week who has a child with special needs. His daughter has a syndrome I cannot remember, except that it is quite rare and was named after a physician who practiced at Children’s Hospital here in Cincinnati. He is concerned about her welfare, especially after he passes away. We wound up talking about gifting and expected changes in gift tax law.

Let’s talk about the gift tax today.

There is an opportunity to gift up to $5,120,000 without paying gift tax, but this expires at the end of 2012. If you are married, then double that amount (10,240,000). If you exceed that amount, then gift tax is 35%. The $5,120,000 is set to drop to (approximately) $1,360,000 in 2013, and the 35% rate is slated to increase to 55%. If you are in or above this asset range, 2012 is a good time to think about gifting.

Here are some gifting ideas to consider:

(1)   Use up your $13,000 annual exemption per donee. This is off-the-top, before you even start counting. If you are married, you can have your spouse join in the gift, even if you made the gift from your separate funds. That makes the exempt gift $26,000 per donee.

(2)   Let’s say that gifting appeals to you, but you do not want to part with $5,120,000. Perhaps you could not continue your standard of living. I know I couldn’t. One option is to have one spouse gift up to $5,120,000 without gift splitting. This preserves the (approximately) $1,360,000 exemption for future use by the other spouse.

(3)   By the way, gifting between spouses does not count as a taxable gift. Should one spouse own the overwhelming majority of assets, then consider inter-spouse gifting to better equalize the estates. This is more of an estate planning concept, but it may regain interest if the estate tax exemption decreases next year.

(4)   Consider intrafamily loans. The IRS forces you to use an IRS-published interest rate, but those interest rates are at historic lows. For example, you can make a 9-year loan to a family member and charge only 0.92% interest. Granted, the monies have to be repaid (or gifted), but the interest is negligible.

(5)   Consider a family limited partnership. We have spoken of FLPs (pronounced “flips”) before. A key tax benefit is being able to discount the taxable value of the gift for the lack of control and marketability associated with a minority interest in the FLP.

(6)   Consider income-shifting trusts to move income and asset appreciation to younger family members. A common use is with family businesses. Say that you own an S corporation, for example. Perhaps the S issues nonvoting stock and you transfer the nonvoting stock to your children using Qualified Subchapter S trusts.

(7)   Consider a grantor retained annuity trust (GRAT). With this trust, you receive an annuity for a period of years. The shortest period I have seen is 2 years, but more commonly the period is 5 or more years. The amount you take back reduces the amount of the gift, of course, but not dollar-for-dollar. I am a huge fan of GRATs.

(8)   Consider a qualified personal residence trust (QPRT, pronounced “Q-pert”). This is a specialized trust into which you put your house. You continue to live in the house for a period of years, which occupancy reduces the value of the gift. If you outlive that period then you can continue to live in the house, but you must begin paying fair market rent to the trust.  I have seen these trusts infrequently and usually with second homes, although I also can see a use with a principal residence in Medicare/Medicaid planning.

(9)   Consider a life insurance trust (ILIT, pronounced “eye-let”). This trust buys a life insurance policy on you, and its purpose is to keep life insurance out of your estate. You might pay the policy premiums on behalf of the trust, using your annual gift tax exclusion. This setup is an excellent way to fund a “skip” trust, which means the trust has beneficiaries two or more generations below you. The “skip” refers to the generation-skipping tax (GST), which is yet another tax, separate and apart from the gift tax or the estate tax.

(10)  Consider a dynasty trust if you are planning two or more generations out. This technique is geared for the very wealthy and involves an especially long-lived trust. It is one of the ways that certain families (the Kennedy’s come to mind) that family wealth can be controlled for many years. A key point to this trust is minimizing or avoiding the generation-skipping tax (GST) upon transfer to the grandchildren or great grandchildren. The GST is an abstruse area of tax law, even for many tax pros.

OBSERVATION: You could incur both a gift tax and a GST tax. That would be terribly expensive and I doubt too many people would do so intentionally.

Although not frequently mentioned, remember to consider any state tax consequence to the gift. For example, does the state impose its own gift tax? If you live in California, would the transfer of real estate reset the assessable value for property taxes?

It is frustrating to plan with so much uncertainty about tax law. We do know that – for the balance of this year – you can gift over $5 million without incurring a gift tax liability. That much is a certainty. If this is you, please think about this window in combination with your overall estate plan. This opportunity may come again – or it may not.

Tarpoff, Payroll Taxes and Responsible Person Penalties

John Tarpoff was the head cattle buyer at Gateway Beef, LLC (Gateway). Gateway was formed in 2003 by Gateway Beef Cooperative and Brach’s Glatt Meat Markets (Glatt). Glatt was owned by Sam Brach (Brach).  The co-op sold cattle to Gateway, which then produced kosher beef for Glatt.

In addition to buying cattle, Tarpoff did the following:

·         Filed Gateway’s articles of incorporation, signing as “organizer’

·         Was a signatory on two Gateway checking accounts

o   When opening the accounts, he presented company resolutions which he signed above lines that said “secretary” or “member.”

·         With the resolutions he could open accounts and withdraw funds

Brach was the wallet and financed Gateway. The bookkeeper, Marsha Caughron (Marsha), handled accounts receivable and payable, payroll, and some sales. She received all the mail, including bills and any notices from the IRS. She would print checks, attach the bills and initially send them to Brach. He would sign some, sometimes not all, and send them back. Brach was pretty strict that nothing could be paid without his permission.

Procedures changed and Tarpoff started signing all Gateway checks from January to May 2004 and most checks after that through July 2004. Once again, he signed nothing without Brach’s permission. Some of the checks he signed were for delinquent 2003 taxes, although he could not easily recognize them as such. He would review invoices to be sure they matched the check, but that was pretty much all. He did not even know whether Gateway had sufficient funds to cash the checks. Remember: he was the head cattle buyer, not the accountant.

Tarpoff explained to the Court:

            Whatever checks were given to me, I would look at them, glance at them and sign them.”

He could not recall ever refusing to write or sign a check.  

Gateway was a shooting star, living a short life and burning through a lot of money. At some point, Brach stopped paying the payroll taxes. The bookkeeper, Marsha, would calculate the taxes, attach checks and send them to Brach. Brach would not sign or return the checks. When she pressed, he told her to speak with his accountant, Michelle Weiss. Brach also instructed Marsha to fax all IRS notices to Michelle. Tarpoff was unaware of these faxes.

Tarpoff wrote at least 10 checks that bounced. One (for approximately $49,000) must have been pretty important, as he tried to get it paid. Meeting with resistance, he paid it out of personal funds. He said this was the only bad check he was aware of. He was never repaid his $49,000 and ultimately had to refinance his home because of it.

Gateway finally folded in July 2004. Tarpoff left. After learning that some vendors had not been paid, he suspected shenanigans with the payroll taxes. He was informed that Brach had not paid the taxes and the bookkeeper (Marsha) told him she had been receiving IRS notices. That was the first he learned of the matter.

The IRS came in. They wanted the payroll taxes. They also wanted almost $67,000 in penalties from Tarpoff for quarters March and June, 2004.

The IRS said that Tarpoff was responsible because:

·         He held himself out as secretary or manager.

·         He attended board of directors meetings.

·         He was the organizer of Gateway Beef, LLC.

·         He could open accounts and withdraw funds.

·         He signed over 1,800 checks.

·         He could hire and fire employees.

·         He could refuse to sign checks.

·         He invested approximately $50,000.

·         He knew the government had not been paid.

·         Even if he did not know the government had not been paid, he could have deduced it. He had paid payroll taxes in the past (at another company), and he signed enough checks to realize that all taxes had not been remitted.

·         The company was losing money; he was in a position to know and review the books and records to be sure taxes were being paid.

·         He used monies to pay creditors ahead of the government

                       

The Court held the following:

·         Other than puffery, the only evidence of officer status was preprinted checks. He did not write any business title himself.

·         He never attended a board of directors meeting.

·         He only looked at the checks and invoices to see that they matched. He could not pay anything without Brach’s permission.

·         He could interview prospective employees and he handled relations with the union, but he could not hire or fire without Brach’s permission.

·         Perhaps he could have refused to write checks, but Brach would have signed instead. Brach had previously signed checks.

·         He did not “invest” $50,000. To the contrary, he had so little control he could not get his own money back.

·         He did not know about the payroll issues and did not receive IRS notices. They went instead to the bookkeeper and then to Brach’s accountant.

·         Saying that he knew in general about an employer’s responsibilities over payroll taxes is not the same as saying he willfully and consciously failed to remit Gateway taxes.

·         There was no evidence he knew the company was losing money, and he did not have authority to look at the company books.

·         He paid creditors ahead of the government because he did not know about the payroll taxes until after he left Gateway.

Tarpoff finally won, but in Court and after much time and expense.

I am curious why the IRS did not go after Brach. From reading the case it seemed quite clear that he had more control than Tarpoff. The IRS thought they saw the fact pattern they like: looks like an officer, makes business decisions, pays bills, writes checks, decides who gets paid, “in the loop” enough to know that the IRS is getting ignored.

From what I see Tarpoff was in a terrible position. He was associated with a money pit, had responsibility but no authority, was intimidated by a boss (Brach), reached into his own wallet (I can only imagine he was preserving his business reputation) and lost the money, and at the end was hounded by the IRS. Frankly, I am cynical about Brach’s behavior in this matter, as I sense that Tarpoff was set-up as a “fall guy.”

If there was a truck or dog or past girlfriend in the story, one could write a country song.

Seriously, be very careful if you have some of the “sexy” fact patterns the IRS likes and you are somehow associated with payroll at a struggling company. The IRS has a track record on this issue. You do not want to run on this track. In some areas you can work with the IRS. This is not one of them.

An S Corporation and a Bankruptcy Trustee

The Kenrob case is a bankruptcy case and not a tax case. It presented such an unusual argument, though, that it caught my eye and my disbelief. Let’s talk about it.

Kenrob Information Technology Solutions, Inc. (Kenrob) was an S corporation. By agreement between the shareholders and the corporation, the corporation was obligated to reimburse the shareholders for the additional taxes attributable to its pass-through income. This is extremely common, although many times the agreement is not reduced to writing. The corporation distributed in April, 2007.  It did so again in April, 2008.

Kenrob goes into bankruptcy. The bankruptcy trustee wants the shareholders to pay the monies back, arguing that the disbursements were a fraudulent conveyance.

The trustee argues the following:

(1)   The only agreement that can be found between the corporation and the shareholders is a redlined agreement. A finalized, signed and dated copy cannot be found.

(2)   There was no consideration given by the shareholders for the distributions.

(3)   The value of the S election cannot be accurately measured. Had Kenrob been taxed as a C corporation, it may have taken different tax positions and strategies.

(4)   The agreement, if agreement there is, was made years before and is not binding.

The court decides the following:

(1)   The corporation and the shareholders have always followed an agreement. That it cannot be found does not mean that the agreement did not exist, especially since it has been fully performed on a continuous basis.

(2)   There was consideration to the corporation, as the shareholders did not take out all the distributable income. Rather they took out enough to pay taxes, leaving the excess with the corporation. This was of value to the company.

(3)   The court refused to engage in "what if” over corporate taxes.

(4)   There is no need for the agreement to be contemporaneous. The agreement was continuous and of lasting benefit.

The bankruptcy court decided in favor of the shareholders and that there was no fraudulent conveyance.

My take: A fraudulent conveyance. Really? As though the corporation would have paid no tax, or less tax, had it been taxed as a C rather than an S? The charge is so outlandish I have to wonder whether there were other factors – perhaps personal dislike – at play here. Otherwise that trustee’s driveway doesn’t quite reach the street.

The IRS refers to it as the “responsible person” penalty.  It applies to failure to remit withheld federal payroll taxes.  You can think of federal withholding taxes as having five pieces, as follows:

·         Federal income tax withheld

·         Social security withheld

·         Medicare withheld

·         Employer match of social security

·         Employer match of Medicare

Here is the concept: the IRS considers the first three to be the employees’ money, which the employer holds in trust. When the employer fails to remit these, it is not only tax noncompliance but also theft. The IRS is very harsh on this issue and will impose one of its harshest penalties: the “responsible person” penalty. This penalty is 100%. Yes, you read that correctly.

You never want to be “responsible” for this purpose. The IRS can chase to ground anyone it considers responsible and assess the penalty. It doesn’t matter whether you own the company, or are an officer, or even still work there. 

Think about the math for a moment. The company falls behind on its payroll taxes. The IRS will proceed against the company for the taxes. If it then chooses to assess penalties, it does so against the responsible person. That penalty is 100%. The company pays. The responsible person pays. The IRS is paid twice.

Let’ go over a quick example: Let’s say that the amounts are as follows:

·         Federal income tax                 $1,800

·         Social security withheld         $   336

·         Medicare withheld                 $   116

·         Employer social security        $   496

·         Employer Medicare                $   116

When the IRS goes against the company, it will want a check for $2,864 ($1,800 + 336 + 116 + 496 + 116).

NOTE: The employer social security is higher than the employee withholding because of the 2-point reduction in employee social security for 2012.  The employer percentage remained at 6.2% whereas the employee share was reduced to 4.2%.  This was part of the effort to stimulate (or at least not de-stimulate) the economy. It is also slated to expire at the end of 2012.

If the IRS assesses the responsible person, that penalty will be $2,252 ($ 1,800 + 336 + 116). Notice that the employer share doesn’t count for purposes of this penalty. Small consolation.

There are two major tests that the IRS will consider to determine if someone will be charged with the “responsible person” penalty:

(1)   Did the person have a responsibility to collect, account for and pay the trust fund taxes; and

(2)   Did the person willfully fail to perform this duty?

Let’s break down the first test. What if you are a payroll manager, responsible for running payroll and correctly accounting for withholding taxes? Are you responsible? No, not by itself, because you do not have authority to pay bills and write checks. What if you are the treasurer, with authority to write checks? Are you responsible? You will have the IRS’ attention, but the technical answer is no, not by itself. In our next blog we will discuss a taxpayer who wrote over 1,800 checks but argued that he was not a responsible person. The IRS did not believe him, of course, so off they went to court.

On to the second test. We are presently representing a responsible person client on the issue of willfulness. Willful means that one voluntarily and intentionally paid, or continued to pay, other creditors while knowing that the company failed to pay over withheld funds to the government. The IRS in the past has argued that payments to a creditor – mind you, any payments to any creditor – could be sufficient to show willfulness.

Fortunately the courts have slowed down the IRS. Let’s say the check writer was unaware of the lapsed payroll deposits, for example. How? One way is lack of financial sophistication. What if the bookkeeper “took care of it,” and the bookkeeper suddenly took ill, became disabled or left town? The business owner or manager could well need time to ramp-up, whether that means payroll, using QuickBooks or any other duty previously performed by the bookkeeper. Can one say there is “willful” intent while the owner or manager is struggling through the learning curve? Let’s swing the other way and say the check writer was financially sophisticated. What is your opinion if told that the check writer wrote checks only infrequently, and that when the primary signor was on vacation or otherwise unavailable? What if the check writer was unaware of any payroll problems? What if the check writer is authorized pay to vendor payables but excluded from any payroll responsibilities? What if the check writer was intimidated by his/her boss?

This area is of concern because of the poor economy in the last several years. There is great temptation to consider payroll taxes as yet another funding source, reasoning that the IRS can wait like any other creditor. That is not true. The IRS is not just any other creditor. The IRS can assess and collect tax for 10 years past the assessment date, and longer than that if it reduces the assessment to a judgment. And do not assume this is automatically dischargeable in bankruptcy court.  This is called “expensive money.”

Next blog: we will talk about Tarpoff and his responsible person penalty.

An easy way to reinstate nonprofit status will expire at the end of 2012.

You may recall that the IRS recently required nonprofits to file annually. This was a sea change from prior practice, where the smallest nonprofits were not required to file at all. Under the new rules, everyone has to file. To make it less burdensome, the smallest can file Form 990-N, also called the “postcard.” Nonprofits were alerted that three successive years of nonfiling would now result in revocation of nonprofit status. The IRS held true to its word and revoked the status of numerous nonprofits.

To recover tax-exempt status, the nonprofit must (again) file an application (Form 1023). A key issue here is that the nonprofit also has to present “reasonable cause” why it did not previously comply with IRS requirements.  The IRS can be harsh on what it considers to be “reasonable cause.” For example, let’s say that your CPA takes ill and, as a consequence, your tax returns are filed late. Many if not most people would consider that to constitute “reasonable cause” for late filing. The IRS disagrees. They argue that you could have hired another tax professional to prepare the return on time.

If you are small nonprofit (defined as gross receipts of $50,000 or less) the IRS will automatically deem you to have “reasonable cause.” You still have to file Form 1023, be careful to include certain prescribed language and attach a $100 check.

What is very, very important is that you do this by December 31, 2012. Starting in 2013 all nonprofits, whether large or small, must present reasonable cause when resubmitting for tax-exempt status.

Have You Received an IRS Notice About Your Roth?

It came to our attention that the IRS is sending erroneous notices on 2010 Roth conversions. If this is you, you may remember that you were allowed to spread the tax cost of converting your regular IRA to a Roth IRA over two years.  The notice states that you owe tax for 2010, which you would had you not spread the tax over two years.

You do need to respond to the notice. The IRS is aware of the software glitch, however, so we expect these notices to be resolved expeditiously.

Reviewing Two ObamaCare Taxes Springing Up in 2013

We are beginning over here to re-review the tax aspects of ObamaCare after the Supreme Court’s decision last week. There are several tax changes, but today we will revisit the new investment income tax and the new earned income tax. These will happen in 2013, so let’s go over them.

Investment Income

If you are single, you will owe a new investment tax if your adjusted gross income (AGI) is over $200,000. If you are married, you will owe the new tax if your AGI is over $250,000. (I know, twice $200,000 is considerably more than $250,000. I did not write the law). If this is you, will owe a brand-new 3.8% tax on your investment income.

Let’s be clear: it is not necessarily ALL your investment income. Rather it will be on investment income over $200,000 or $250,000, as the case may be. If you are married and retired and your entire adjusted gross income of $250,000 is interest and dividends, you will owe no NEW tax. You will owe plenty of OLD tax, though.

What is investment income? Let’s go with the easy examples: dividends, interest, capital gains (short-term and long-term), royalties and annuities outside retirement plans

NOTE:  Net investment income is also defined to include income from a passive activity. This concerns me, as the rental of a duplex is a passive activity, as is passthrough income to a “passive” member in an LLC. Under Section 469, these activities were considered “trades or businesses,” although the activity could be further tagged as “passive” or “nonpassive.” They were not however tagged as “investment.” This new tax appears to use the language differently from Section 469 and equates “passive” with “investment.” The IRS unfortunately has yet to issue formal guidance in this area.

How can this tax surprise you? Here are a few ways:

(1)   You sell your business.

(2)   You get married.

(3)   You sell your principal residence, and the gain exceeds the $250,000/$500,000 exclusion.

(4)   You inherit and sell stock from a parent’s estate.

Earned Income

If you are single, you will pay an extra 0.9% Medicare tax on your earned income over $200,000. If married, that threshold changes to $250,000.

What is earned income? The easiest way is to ask whether you paid or will pay social security or self-employment tax on the income. If the answer is “yes”, you have earned income. Note that this definition excludes your pension, 401(k) and IRA distributions.

Let’s go over a few examples.

EXAMPLE 1: A married couple filing jointly has $360,000 of adjusted gross income—$240,000 of wages plus $120,000 of interest, dividends and capital gains. They have $110,000 of investment income` over the $250,000 threshold. They will owe an extra 3.8% of that $110,000, or $4,180, in tax.

EXAMPLE 2: In the following year, the same couple has $400,000 of income, the difference being a $40,000 bonus. All their investment income is now above the threshold amount. Their new investment income tax will be $4,560. In addition, since their earned income is now above $250,000 they will owe the new earned income tax of $270 ((280,000- 250,000) times 0.9%).

EXAMPLE 3:  After many years, you move from Purchase, New York. You sell your house for $920,000 and are single.  Your exclusion amount on the sale is $250,000 so the taxable gain is 670,000. Assuming that you earned income is over $200,000, the new investment income tax will be $25,460 ((920,000 – 250,000) times 3.8%).

We will discuss other tax changes in a future blog. Some are delayed (such as the employer penalty) and others are already in place but are somewhat esoteric (the prescription drug fee).