Do You Actually Need To Rent Before Deducting Rental Expenses?

Let’s say that you own a piece of property. You are trying to claim a rental loss from that property on your tax return. What would you say is the most important requisite in order to claim that loss?

Let’s take a look at the Meinhardt case.

Mr. Meinhardt worked full-time as an architect. His wife operated a day care center out of their home.

In 1976 they purchased 140 acres of farmland in rural Minnesota, consisting of tillable and pasture land and an eighty-year old farmhouse in need of substantial renovation. In subsequent years they sometimes farmed the land, but mostly they rented the land to neighbors for cash rent. They were successful in renting the farmland. They were not so successful in renting the farmhouse.

Thirty years go by.

On their tax returns for 2005, 2006 and 2007 they reported rent from the farmland, as well as substantial expenses for repairs to the old farmhouse. The IRS looked at the return and disallowed the repairs.

They wound up in Tax Court.

The Meinhardts had a simple argument: hey, we own a farm. We rent the farm. For the years under audit our expenses exceeded our income, and we therefore incurred farm losses.

The IRS had a different take. They saw the land being rented on a regular and repetitive basis. There wasn’t much for the IRS to challenge there.

The farmhouse was a different matter. The farmhouse never reported rental income.

That is one lousy rental.

Let’s take a breath. This is not necessarily fatal. The Meinhardts rented a farm. It doesn’t means that all parts and parcels of said farm were equally profitable. As long as it was profitable overall, right?

That, by the way, is the tax concept of aggregation when discussing passive activities, such as rentals.

The Meinhardts explained that they tried to rent the farmhouse, but nobody wanted it. They placed ads in newspapers, put up notices in local stores and spread the word that the house was for rent. The best they could get were renters who would barter for their rent, trading repairs in order to live rent-free. You cannot rent something that no one wants to rent. That doesn’t mean it wasn’t legitimately for rent, though.

The Meinhardts had a reasonable argument.

The IRS, on the other hand, felt that the farmhouse should be separated from the farmland. Hey, they tried to rent the house separate from the land. They rented the land but never rented the house. Does that sound like one rental or two rentals to you?

And there you have the tax concept of disaggregation.

Rent is rent, whether it be land or building. How was the IRS going to pull this off?

The Meinhardts helped them by never reporting rental income from the farmhouse. There was barter, but the documentation was sketchy.

Since the house had not been rented, the IRS wanted to know who had used the house over the years. The Meinhardts used it themselves, but only sporadically and usually coinciding with maintaining the property.

Other tenants included:

·        Wife’s brother (lived their seasonally)

·        Their daughter and son-in-law

·        Their son and his family

It turns out that the Meinhardts – or their family – had used the farmhouse for almost all the years.

Are you kidding me?

Did I mention that the 2005 through 2007 years were not representative, as the Meinhardts were racking up a lot of repairs to that old house? It sure would be nice to slide those expenses over to Uncle Sam.

The Tax Court decided that the farmhouse was either the Meinhardts second residence or it was a property not held for rental – you take your pick. The tax consequence is the same.

The Meinhardts, unhappy with this result, appealed to the Eight Circuit. They lost there too.

What are we to learn from this? That the Meinhardts should never have tried to rent the farmhouse separate from the farmland? That they should have automatically thrown in the farmhouse for a dollar when renting the land? That they never should have allowed the family to stay there? That at least they should have charged the family rent? (I personally think that last one is obvious).

I think we are thinking about this too hard.

Methinks that what the court could not stomach was the Meinhardts selling their house in the suburbs and moving into the farmhouse in 2010.

After fixing it up in 2005, 2006 and 2007.

And deducting it on their tax return.

Courts will “back into” a tax analysis to get the desired result. Happens all the time.

The Meinhardts failed to observe a fundamental tenet of tax strategy: never arm the other side.

Let's Talk Tax Inversions - Part Two

Last time we discussed the taxation of an inverting corporation.

There are three levels of tax severity to the corporation itself:

(1)   The IRS ignores the inversion completely and continues to tax the foreign company as if it were a U.S. company

(2)   The IRS will respect the foreign company as foreign, but woe to whoever tries to move certain assets out of the U.S. or otherwise use certain U.S. – based tax attributes for a period of 10 years.

(3)   The IRS will respect the transaction without reservation.

Then there is the toll-charge on the shareholders. If they own more than 50% of the new foreign company, the shareholders will pay tax on their shares AS IF they had sold them rather than exchanged them for stock in the new foreign parent.  The practical effect is that any inversion has to include cash to the U.S. shareholders, otherwise such shareholders would be reaching into their wallet to pay tax (and would likely vote to scuttle any inversion deal).

It was this toll charge that caught the attention of Congress. If you think about it, someone owning actual shares would be taxed, but someone having a future right to shares would not. Who would such a person be? How about corporate insiders: management and directors? Executives frequently receive stock options and other stock-based compensation. Congress felt that management and directors should also have “skin in the game,” thus the origin of Section 4985. 

One quickly realizes the parity Congress wanted:

(1)   First, Section 4985 applies only if gain is realized by any shareholder. If there is no toll charge on the shareholders, then there will be no toll charge on management and directors.

(2)   The Section 4985 tax will be the highest tax rate payable by the shareholders, which is the capital gains rate (15%)

There is some technical lingo in here. The tax Code dragnets all individuals “subject to the requirements of Section 16(a) of the Securities Exchange Act of 1934” – in short, the officers, directors and 10% shareholders. It also includes their families.

So Congress wanted insiders to also pay tax. That’s great. I wanted to play in the NFL.

Let’s take a look at another Congressional attempt to “rope in” executive pay: the golden parachute limitations of Section 280G. This tax applies to “excess” compensation payments upon a change in corporate control. The insider is allowed a base amount (defined as average annual compensation for the five years preceding the year of change in control). The excess is subject to an additional 20% excise tax – in addition to the payroll and income taxes already paid.

How does it work away from the fever swamp of Washington?

It doesn’t. Corporations routinely “gross-up” the executive compensation until the tax is shifted back to the corporation.

I suspect that every tax accountant has run into a compensation “gross up” exercise. I have done enough over the years to make my eyes cross.

Let’s return to our inversion discussion. What do you think companies are doing when their executives are subjected to the 15% Section 4985 excise tax?

Yep, the gross-up.

The mathematics of a gross-up are terrible. Let’s take the example of someone who is subject to the maximum federal tax rate (39.6%), add in the ObamaCare Medicare tax (0.9%), the Section 4985 tax itself (15%) and a state tax (say 6%), and 61.5% of every dollar is going to tax (I am leaving out the deductibility of the state tax). If I am to gross-up a payroll, I am saying that only 38.5 cents of every dollar will be available to satisfy the original Section 4985 tax liability. This means that the gross-up will have to be $2.60 (that is, 1 divided by 38.5%) for every dollar of the original Section 4985 tax.

But Congress, never willing to leave a bigger mess undone, added yet another twist to Section 4985: the corporation is not allowed to deduct the gross-up. Let’s say that the excise tax was $1 million. The gross-up would be $2.6 million, none of which is deductible by the company.

Yipes!

Medtronic is a medical device maker based in Minneapolis. It operates in more than 120 countries and employs approximately 50,000 people worldwide. It has agreed to acquire Covidien, an Irish medical device company. Since we are talking about inversions, you can surmise that the new parent will be based in Ireland. For its part, Medtronic says it will be leaving its Minneapolis-based employees in Minneapolis, which makes sense when you consider that they have employees located throughout the planet.

Medtronic will of course continue to pay U.S. tax on its U.S. income. What it won’t do is pay U.S. tax on income earned outside the U.S. This is not an unreasonable position. Think about your response if California tried to tax you because you drank Napa Valley wine.

Medtronic triggered the Section 4985 excise tax on its executive officers and directors. This tax is estimated to be approximately $24 million.

Remember the loop-the-loop involved with a gross-up. How much will it cost Medtronic to gross-up its insiders for the $24 million?

Around $63 million.

None of which Medtronic can deduct on its tax return.

Can you explain to me how this can possibly be good for the shareholders of Medtronic? It isn’t, of course.

Way to play masters of the universe, Congress.

Let's Talk Tax Inversions - Part One

You may have read recently that Burger King is acquiring Tim Hortons Inc, a Canadian coffee and donut chain. What has attracted attention is the deal is structured as an inversion, which means that the American company (Burger King) will be moving its tax residency to Canada. I suppose it was hypothetically possible that the deal could have moved Tim Hortons Inc to the U.S. (think of it as a reverse inversion), but that would not have drawn the attention of the politicians.

The combined company will be the world’s third-largest fast-food company, right behind McDonalds and Yum! Brands (think KFC and Taco Bell). While the U.S. will have by far the largest number of locations, the majority of the revenue – again by far – will be from Canada.

An issue at play is that U.S. companies face a very harsh tax system, one in which they are to pay U.S. tax on all profits, even if those profits originated overseas and may never be returned to the U.S. Combine that with the world’s highest corporate tax rate, and it becomes fairly easy to understand why companies pursue inversions. In certain industries (such as pharmaceuticals), it is virtually imperative that the some part of the company be organized overseas, as the default tax consequences would be so prohibitive as to likely render the company uncompetitive.

Let’s talk a bit about inversions.

Inversions first received significant Congressional scrutiny in the 1980s, when McDermott Inc did the following:

·        McDermott organized a foreign subsidiary, treated as a controlled foreign corporation for U.S. tax;

·        The subsidiary issued stock in exchange for all the outstanding stock of McDermott itself; and          

·        Thus McDermott and its subsidiary traded places, with the subsidiary becoming the parent.

In response Congress passed IRC Sec 1248(i), requiring any future McDermott to report dividend income – and pay tax – on all of its subsidiary’s earnings and profits (that is, its undistributed profits).

In the 1990s, Helen of Troy Corp had its shareholders exchange their stock for stock of a new foreign parent company.

In response the IRS issued Reg 1.367(a)-3(c), requiring the U.S. shareholders to be taxable on the exchange because they owned more than 50% of the foreign company after the deal was done.

In the aughts, Valeant Pharmaceuticals paid a special dividend to its shareholders immediately before being acquired by Biovail, a Canadian corporation. Valeant paid out so much money - thereby reducing its own value - that the Valeant shareholders owned less than 50% of the foreign company.

Interesting enough, this did not (to the best of my knowledge) draw a government response. There is a “stuffing” rule, which prohibits making the foreign corporation larger. There is no “thinning” rule, however, prohibiting making the U.S. company thinner.

Then there was a new breed of inversions. Cooper Industries, Nabors Industries, Weatherford International and Seagate Technologies did what are called “naked” inversions. The new foreign parent incorporated in the Cayman Islands or Bermuda, and there was no effort to pretend that the parent was going to conduct significant business there. The tax reason for the transaction was stripped for all to see – that is, “naked.”

That was a bridge too far.

Congress passed IRC Sec 7874, truly one of the most misbegotten sections in the tax Code. Individually the words make sense, but combine them and one is speaking gibberish.

Let’s break down Section 7874 into something workable. We will split it into three pieces:

(1)  The foreign company has to acquire substantially all the assets of a domestic company. We can understand that requirement.

(2)  The U.S. shareholders (referred to “legacy” shareholders) own 60% or more of the foreign parent. There are three sub-tiers:

a.     If the legacy shareholders own at least 80%, the IRS will simply declare that nothing occurred and will tax the foreign company as if it were a U.S. company;

b.     If the legacy shareholders own at least 60% but less than 80%, the IRS would continue to tax the foreign company on its “inversion gain” for 10 years.

                                                              i.      What is an “inversion gain?” It involves using assets (think licenses, for example) to allow pre-inversion U.S. tax attributes to reduce post-inversion U.S. tax. The classic tax attribute is a net operating loss carryover.

c.      If the legacy shareholders own less than 60%, then Section 7874 does not apply. The new foreign parent will generally be respected for U.S. tax purposes.

But wait! There is a trump card.

(3)  The IRS will back off altogether if the foreign company has “substantial business presence” in the new parent’s country of incorporation.

There is something about a trump card, whether one is playing bridge or euchre or structuring a business transaction. The tax planners wanted a definition. Initially the IRS said that “substantial business presence” meant 10% of assets, sales and employees. It later changed its mind and said that 10% was not enough. It did not say what would be enough, however. It said it would decide such issues on “facts and circumstances.” This sounds acceptable, but to a tax planner it is not. It is the equivalent of saying that one need not stop at a stop sign, as long as one is not “interfering” with traffic. What does that mean, especially when one has family in the car and is wondering if the other driver has any intention of stopping?

After three years the IRS said that it thought 25% was just about right. Oh, and forget about any “facts and circumstances,” as the IRS did not want to hear about it.

The 25% test was a cynical threshold, figuring that no one country – other than the U.S. – could possibly reach 25% by itself. Even the E.U. market – which could rival the U.S. – is comprised of many individual countries, making it unlikely (barring Germany, I suppose) that any one country could reach 25%.

Until Pfizer attempted to acquire AstraZeneca, a U.K. based company. The White House then proposed reducing the 80% test to a greater-than-50% test and eliminating the 60% test altogether. It also wanted to eliminate any threshold test if the foreign corporation is primarily managed from the United States.

The Pfizer deal fell through, however, and there no expectation that this White House proposal will find any traction in Congress.

And there is our short walk through the minefield of tax inversions.

There is one more thing, though. You may be wondering if the corporate officers and directors are impacted by the tax Code. Surely you jest- of course they are! There is a 15% excise tax on their stock-based compensation. How does this work out in the real world? We will talk about this in our next blog, when we will discuss the Medtronic – Covidien merger. 

Windstream Holdings Put What Into a REIT?

Have you heard of Windstream Holdings?

They are a telecommunications company – that is, a phone company – out of Little Rock, Arkansas. They made the tax literature recently by getting IRS approval to put some of its assets in a real estate investment trust, abbreviated “REIT” and pronounced “reet.” 

So what is a REIT?

REITs entered the tax Code in 1960. For decades they have been rather prosaic tax vehicles, generally housing office buildings, apartment complexes and warehouses.

Yep, they invest in real estate.

REITS have several tax peculiarities, one of which has attracted planners in recent years. To qualify as a REIT, an entity must be organized as a corporation, have at least 100 shareholders, invest at least 75% of its assets in real estate and derive at least 75% of its income from the rental, use or sale of said real estate. Loans secured primarily by interests in real property will also qualify.

REITS must also distribute at least 90% of their taxable income in the form of shareholder dividends.

Think about this for a second. If a REIT did this, it would not have enough money left over to pay Uncle Sam its tax at the 35% corporate tax rate. What gives?

A REIT is allowed to deduct shareholder distributions from its taxable income.

Whoa.

The REIT can do away with its tax by distributing money. This is not quite as good as a partnership, which also a non tax-paying vehicle. A partnership divides its income and deductions into partner-sized slices. It reports these slices on a Schedule K-1, which amounts the partners in turn include on their personal tax returns. An advantage to a partner is that partnership income keeps its “flavor” when it passes to the partner. If a partnership passes capital gains income, then the partner reports capital gains income – and pays the capital gains rather than the ordinary tax rate.  

This is not how a REIT works. Generally speaking, REIT distributions are taxed at ordinary tax rates. They do not qualify for the lower “qualified dividend” tax rate.

Why would you invest in one, then? If you invested in Proctor & Gamble you would at least get the lower tax rate, right?

Well, yes, but REITs pay larger dividends than Proctor & Gamble. At the end of the day you have more money left in your pocket, even after paying that higher tax rate.

So what has changed in the world of REIT taxation?

The definition of “real estate.”

REITs have for a long time been the lazy river of taxation. The IRS has not updated its regulations for decades, during which time technological advances have proceeded apace. For example, American Tower Corp, a cellphone tower operator, converted to a REIT in 2012. Cell phones – and their towers – did not exist when these Regulations were issued. Tax planners thought those cell towers were “real estate” for purposes of REIT taxation, and the IRS agreed.

Now we have Windstream, which has obtained approval to place its copper and fiber optic lines into a REIT. The new Regulations provide that inherently permanent structures will qualify as REIT real estate. It turns out that that copper and fiber optic lines are considered “permanent” enough.  The IRS reasoned, for example, that the lines (1) are not designed to be moved, (2) serve a utility-like function, (3) serve a passive function, (4) produce income as consideration for the use of space, and (5) are owned by the owner of the real property.

I admit it bends my mind to understand how something without footers in soil (or the soil itself) can be defined as real estate. The technical issue here is that certain definitions in the REIT area of the tax Code migrated there years ago from the investment tax credit area of the tax Code. There is tension, however. The investment tax credit applied to personal property but not to real property. The IRS consequently had an interest in considering something to be real property rather than personal property. That was unfortunate if one wanted the investment tax credit, of course. However, let years go by … let technology advance… let a different tax environment develop … and – bam! -  the same wording gets you a favorable tax ruling in the REIT area of the Code.

Is this good or bad?

Consider that Windstream’s taxable income did not magically “disappear.” There is still taxable income, and someone is going to pay tax on it. Tax will be paid, not by Windstream, but by the shareholders in the Windstream REIT. I am quite skeptical about articles decrying this development as bad. Why - because a corporate tax has been replaced by an individual tax? What is inherently superior about a corporate tax? Remember, REIT dividends do not qualify for the lower dividends tax rate. That means that the REIT income can be taxed as high as 39.6%. In fact, it can be taxed as high as 43.4%, if one is also subject to the ObamaCare 3.8% tax on unearned income. Consider that the maximum corporate tax is 35%, and the net effect of the Windstream REIT spinoff could be to increase tax revenues to the Treasury.

This IRS decision has caught a number of tax planners by surprise. To the best of my knowledge, this is the first REIT comprised of this asset class. I doubt it will be the last.