Spotting A (Tax) Dependent

Let’s talk about claiming someone as a dependent.

There are several tax “breaks” that require you to have a dependent, for example:

·        Head of household (HoH) filing status

·        A dependent exemption

·        Child credit

·        Child care credit

·        Education credit

·        Earned income credit

Some of these breaks go only so far. The head of household (HoH) filing status, for example, can get you to zero tax, but it cannot “create” a tax refund. You have to have tax withholdings before HoH can get you a refund; even then, you are getting your own money back. Not so with the child credit or the earned income credit, however.  Meet all the triggers and the EIC can refund you over $6,000, irrespective of whether you have any withholdings or not. It is a transfer payment from the government.

So what is required to claim someone as a tax dependent?

There are two overall categories of dependents. The first is your own child (or stepchild, adopted child, or descendants of the same) and is referred to as a “qualifying child.” This is the workhorse test: think a child at home with his/her parents.

There are five requirements for a “qualifying child”:

1. Are they related to you? 
2. Are they under age 19 or – if a full-time student – under age 24? 
3. Do they live with you for more than half the year?
4. Do you support them financially? 
5. Are you the only person claiming the child?

Any other type of dependent is a referred to as a “qualifying relative.” The requirements are as follows:

1. Do they live with you for more than half the year?
2. Do they make less than $3,950?
3. Do you support them financially?
4. Are you the only person claiming the child?

The term “qualifying relative” is misleading, by the way. The person does not need to be related to you at all. For example, a girlfriend could be my dependent – assuming that all the other requirements were met AND my wife allowed me to have a girlfriend.

Did you notice the age thing? A qualifying child ends at age 24 (unless we are talking permanent disability, which is a different rule). Past age 23 and the child is your dependent under the qualifying relative rules.

Which also means that an income test kicks-in. That after-age-23 child would not qualify as a dependent if he/she earned more than $3,950 for the year. This can be a cruel surprise at tax time for parents whose kids have moved back.

That answer, by the way, is the same for an over-18-under-24 child who does not go on to college.

Let’s take a little quiz on dependents. We will use the Tax Court case of James Edward Roberts v Commissioner. Here are selected facts:

1. In January, 2012 Roberts’ daughter became homeless. 
2. She had two young kids. 
3. She was pregnant with the third.

Roberts was a decent soul, and worked out a deal with a Ms. Moody, whereby he and the two children (very soon three) moved in with her. He agreed to pay 75% of the rent and utilities. He also agreed to pay 100% of the meals.

Then he did something unexpected. He wrote down the agreement, and both he and Ms. Moody signed and dated it.

Roberts and his (now three) grandchildren lived in the apartment from January until October, 2012. His daughter also lived there on-and-off. When she was not there, Ms. Moody helped take care of the kids.

When Roberts filed his 2012 tax return, he claimed the following:

(1)  Head of household

(2)  Dependent exemption for three grandchildren

(3)  Child credit

(4)  Earned income credit

The IRS bounced his return, and they wound up in Tax Court.

The IRS had an issue whether the kids were his dependents.

What do you think?

Let’s walk through it.

·        The kids are related (grandchildren) to Roberts. CHECK

·        The kids are young. CHECK

·        They lived with him from January through October, which is more than half the year. CHECK

·        He paid 75% of the rent and utilities and 100% of the food. Sounds to me like that would be over half the support for the kids. CHECK

·        The Court tells us that their mom did not claim them. CHECK

Seems that Roberts met all the requirements to claim the grandchildren as dependents for 2012. Why did the IRS press on this?

I don’t know, and the Court did not explain why. I can guess, though.

I see a person who…

·        moved

·        put three dependents on his return who were not there the prior year

·        was not living with the kids by the time the IRS contacted him

·        lived in an apartment with someone who (perhaps, who knows) might have been his girlfriend. This would raise the issue of who actually paid the expenses for rent, utilities and food – you know, the same expenses that Roberts needed to show that he supported the kids.

Roberts won his day in Court.

I suspect that written – and contemporaneously signed - agreement with Ms. Moody carried a lot of weight with the Court.

I allow that the IRS had cause to look at this return. After that, however, they should have left Mr. Roberts alone.  The IRS made a mistake on this one.

The New Israeli Trust Tax

Have you settled (that is, funded) a trust with an Israeli beneficiary?

I have not, but many have.

If this is you: heads up. The tax rules have changed, and they have changed from the Israeli side, not the U.S.

Until this year, Israel has not taxed a trust set up by a foreign person, even if there were Israeli beneficiaries. It also did not bother to tax the beneficiaries themselves. This was a sweet deal.

The deal changed this year. The Israel Tax Authority (ITA) now says that many trusts previously exempt will henceforth be taxable.

Israel is looking for a beneficiary trust, meaning that all settlors are foreign persons and at least one beneficiary is a resident Israeli.

EXAMPLE: The grandparents live in Cincinnati; the son moves to Israel, marries and has children; the grandparents fund a grandchildren’s trust.

A beneficiary trust can be either

·        A “relatives trust,” meaning the settlor is still alive and related (as defined) to the beneficiary

·        A “non-relatives trust,” meaning the settlor is not alive or not related (as defined) to the beneficiary 

EXAMPLE: The grandparents in the above trust pass away.

The tax will work as follows:

·        A relatives trust

o   Pay tax currently at 25% on the portion allocable to Israeli beneficiaries, or

o   Delay the tax until distributed to an Israeli beneficiary, at which time the tax will be 30%.

·        A non-relatives trust

o   Pay tax on income allocable to Israeli beneficiaries at regular tax rates (meaning up to 52%)

If one does nothing by the end of 2014, a relatives trust is presumed to have elected the “pay currently” regime.

The ITA has indicated verbally that any U.S. tax paid will be accepted as a tax credit against the Israeli tax, whether the tax was paid by the settlor (think grantor trust), the trust itself or the beneficiary.

The retroactive part of the tax goes back to 2006, and the ITA is allowing two ways for beneficiary trusts to settle up:

·        The trust can pay a portion of its regular tax liability, depending upon the influence on the trust by the Israeli beneficiary.

·        The trust can pay tax on the value of the trust as of December 31, 2013.

Again, the rules have changed, and – if this is you – please contact your attorney or other advisor immediately. 

Jurate Antioco's Nightmare On IRS Street

Ms. Jurate Antioco lived in Martha’s Vineyard, where she owned a bed and breakfast with her husband. The B&B was their home. In 2006 they divorced (after 27 years) and sold the B&B for almost $2 million. They used some of the money to pay off marital debt, but over $1 million went to her after she was unable to finish a Section 1031 exchange within the permitted time.

After approximately 1 year, she took the money and borrowed another $950,000 to buy a multifamily in San Francisco. She moved into one unit, moved her 90-something-year-old mother into another and rented the remaining three units as a source of income.

Ms. Antioco made a mistake concerning her taxes, though. She thought that – perhaps because the B&B had been her residence – that she would not owe any taxes. She fell behind in filing her 2006 taxes but did better with 2007. Her accountant informed her that she owed taxes on the sale for 2006. She was unprepared for this, as she had put almost all her money in the multifamily. She filed the tax returns, though.

The IRS of course assessed tax, interest and penalties. It is what they do.

In April, 2009 the IRS sends her a notice of intent to levy. Ms. Antioco has all her money tied up in the multifamily, so she filed for a collection due process (CDP) hearing.  She proposed paying $1,000 per month until she could work out a loan. She explained that her mom was having health issues, she was moving into caregiver mode, and anything more than $1,000 at the moment would cause economic hardship. As a show of good faith, she started paying $1,000 a month.

She contacted other lenders about a loan, but she soon learned that she had a problem. Even though she had considerable equity in the property, her current lender had included a nuclear option in the mortgage giving them the right to foreclose if another lien was put on the building

OBSERVATION: There is a very good reason to request a CDP, as the IRS will routinely file a lien to secure its debt. This could have been very bad for Ms. Antioco.

She goes back to the primary lender, and they tell her that they are not interested in loaning her any more money.

She has a problem.

The IRS sends her paperwork (Form 433-A) and schedules a hearing for September, 2009. The IRS tells her that she simply has to try to borrow before they will consider an installment plan. If she cannot, then proof of that must also be submitted.

She finds another lender and a better interest rate. The new lender will refinance but not lend any new money. Still, a lower payment frees-up cash, so Ms. Antioco decides to refinance. The new lender wants her to put her mom on the deed, which she does by granting her mother a joint tenancy in the property.

She sends her financial information (the Form 433-A), along with supporting bank documentation and a copy of her most recent tax return, to the IRS. She hears nothing.

In November, 2009 she received a notice from the IRS stating that they were sustaining the levy. The notice stated that she had requested a payment plan, but she had failed to provide additional financial information. In addition the IRS completely blew off her economic hardship argument.

Ms. Antioco appealed to the Tax Court. She pointed out that she was never asked for additional financial information, and –by the way – what happened to her economic hardship request?

And then something amazing happened: the IRS pulled the case, admitting to the Court that the Appeals officer had never requested additional financial information and had in fact abused her discretion.

The Court sent the matter back to IRS Appeals, hoping that the system would work better this time.

Uh, sure.

Enter Alan Owyang. The first thing he did was call Ms. Antioco to schedule a face-to-face meeting and review detailed questions. . Ms. Antioco explained that she would call back later that day, as she wanted to collect her documents to help her with the detailed questions. Owyang didn’t wait, and he kept calling her back that same day. At one point her accused her of being “uncooperative’ and that she “put your money where your mouth is.” He added that he had been a witness in her case.

Ms. Antioco was so rattled that she hired an attorney. Sounds like a great idea to me.

Mr. Owyang sent her a letter a few days later, saying that he thought Ms. Antioco had added her mother to the deed to defraud the government and that he also thought she could pay her taxes but “simply chose not to do so.” He asked for all kinds of additional paperwork, but not curiously no new financial information – the very reason the Tax Court sent the matter back to IRS Appeals. 

Her attorney submitted a bundle of information and requested another CDP hearing for April, 2011. He explained to Mr. Owyang that Ms. Antioco’s mother was declining and would (likely) not survive a sale and move from the apartment building. All Ms. Antioco wanted was time – to allow her mom to pass away or to finally get a new loan – after which she would able to pay the balance of the tax. She was willing to pay under a short-term installment plan until then.

Mr. Owyang told the attorney that he would not grant an installment agreement because Ms. Antioco had chosen to transfer the equity in the apartment building by adding her mother to the deed. He could not see another reason for it.

·        Even though he had a letter from the lender stating it wasn’t willing to lend any more money. And to include her mom on the deed if she wanted to refinance.

He refused to consider whether there was any “hardship.”

·        One of the reasons it went back to the IRS to begin with.

He also thought that all the talk about taking care of a 90-something-year-old mom was a “diversionary argument” that he “would not consider.”

·        I am stunned.

Mr. Owyang also contacted the IRS Compliance Division. He said that the government’s interest was in “jeopardy,” and he recommended that the IRS file a manual lien. There were problems with the filing, and Mr. Owyang went out of his way to follow up personally.

In May, 2011 Mr. Owyang filed a supplemental notice of determination, concluding that Ms. Antioco had “fraudulently” transferred the building to her mother. He went all Sherlock Holmes explaining how he had deduced that Ms. Antioco had committed fraud, concealed the transfer, became insolvent because of it and was left without any assets to pay the government. It was his judgement that she could have gotten a loan if she really wanted one, and that Ms. Antioco was a “won’t pay taxpayer” who was using her ailing mother as an “emotional diversion.”

This guy is a few clowns short of a circus.

They are back in Tax Court. The IRS this time sees nothing wrong with Mr. Owyang's behavior. They did however acknowledge that Mr. Owyang never ran the numbers to see if Ms. Antioco was insolvent, and that his determination of fraud was … “flawed.”

But Mr. Owyang had not abused his discretion. No sir!! Not a smidgeon.

The IRS wanted the Court to dismiss the case.

The Court instead heard the case.

The Court went through the steps, noting that the Commissioner can file liens to secure the collection of an assessed tax.  The IRS however must follow procedures, such as notifying the taxpayer, granting a collections appeal if the taxpayer requests one, and so on. The taxpayer had proposed a payment alternative, and the IRS never completed its analysis of her proposed payment plan. The IRS had also failed to consider her complaint of economic hardship.

The IRS did not follow procedure.

The Court then reviewed Mr. Owyang’s behaviors and assertions, refuting each in turn. The Court even pointed out that Ms. Antioco had paid down her tax debt by $88,000 by the time of trial, not exactly the conduct of someone looking to shirk and run. The Court was not even sure what Mr. Owyang’s real reason was for his determination, as his reasons were contradicted by documentation in file, not to mention changing over time.

The Court decided that Mr. Owyang had abused his discretion.

In February, 2013 the Court sent the case back to the IRS again, as the IRS never reviewed whether the $1,000 was a reasonable payment plan.

Back to the IRS. Introduce a new Appeals officer.

Ms. Antioco then filed suit against the IRS for wrongful action – that is, over the behavior of Mr. Owyang. This type of suit is very difficult to win. Ms. Antioco focused her arguments on Mr. Owyang’s abusive behavior.  The District Court determined that this behavior occurred while Mr. Owyang was “reviewing” collection action and not actually “conducting” collection, which barred liability under Section 7433.

OBSERVATION: No, he was “collecting.” What is a lien, if not a collection action?

In June 2013 the IRS finally agreed to an installment payment plan.

In July, 2014 the IRS filed suit to reduce Ms. Antioco’s liability to judgment. Reducing an assessment to judgment gives the IRS the ability to collect long after the 10-year statute of limitations.

Ms. Antioco filed a motion to dismiss.

Her reason for requesting dismissal? The tax Code itself. Code Section 6331(k)(3)(A) bars the IRS from bringing a proceeding in court while an installment agreement is in effect.

The IRS realized it got caught and last month agreed to dismiss.

And that is where we are as of this writing.

For a tax pro, the Jurate Antioco cases have been interesting, as they highlight the importance of following procedural steps when matters get testy with the IRS. From a human perspective, however, this is a study of a government agency run amok.  How often does the IRS get spanked twice by the Tax Court for abuse on the same case?

Ms. Antioco’s mom, by the way, is now 97 years old and suffering from congestive heart failure. Ms. Antioco is herself a senior citizen. May they both yet live for a very long time.

Is Suing Your Tax Advisor Taxable?

For those who know me or occasionally read my blog, you know that I am not a “high wire” type of tax practitioner. Pushing the edges of tax law is for the very wealthy and largest of taxpayers: think Apple or Donald Trump. This is – generally speaking - not an exercise for the average person. 

I understand the frustration. A number of years ago I was called upon to research the tax consequence for an ownership structure involving an S corporation with four trusts for two daughters. This structure predated me and had worked well in profitable years, but I (unfortunately) got called upon for a year when the company was unprofitable. The issue was straightforward: were the losses “active” or “passive” to the trusts and, by extension, to the daughters behind the trusts. There was some serious money here in the way of tax refunds – if the trusts/daughters could use the losses. This active/passive law change happened in 1986, and here I was researching during the aughts – approximately 20 years later. The IRS had refused to provide direction in this area, although there were off record comments by IRS officials that were against our clients’ interests. I strongly disagreed with those comments, by the way.

What do you do?

I advised the client that a decision to claim the losses would be a simultaneous decision to hire a tax attorney if the returns got audited and the losses disallowed. I believed there was a reasonable chance we would eventually win, but I also believed we would have to be committed to litigation. I thought the IRS was unlikely to roll on the matter, but our willingness to go to Tax Court might give them pause. 

I was not a popular guy.

But to say otherwise would be to invite a malpractice lawsuit should the whole thing go south.

And this was a fairly prosaic area of tax law, far and remote from any tax shelter. There was no “shelter” there. There was, rather, the unwillingness of the IRS to clarify a tax law that was old enough to go to college.

I am reading about a CPA firm that decided to advise a tax shelter. It went south. They got sued. It cost them $375,000.

Here is a question that we have not discussed before: is the $375,000 taxable to the (former) client?

Let’s discuss the case.

The Cosentinos and their controlled entities (G.A.C. Investments, LLC and Consentino Estates, LLC) had a track record of Section 1031 exchanges and real estate.

COMMENT: A Section 1031 is also known as a “like kind” exchange, whereby one trades one piece of property for another. If done correctly, there is no tax on the exchange.

The Consentinos played a conservative game, as they had an adult disabled daughter who would always need assistance. They accumulated real estate via Section 1031 transactions, with the intent that – upon their death – the daughter would inherit. They were looking out for her.

They were looking at one more exchange when their CPA firm presented an alternative tax strategy that would allow them to (a) receive cash from the deal and (b) defer taxes. The Consentinos had been down this road before, and receiving cash was not their understanding of a Section 1031. Nonetheless the advisors assured them, and the Consentinos went ahead with the strategy.

OBSERVATION: It is very difficult to walk away from a Section 1031 with cash in hand and yet avoid tax.

Wouldn’t you know that the strategy was declared a tax shelter?

The IRS bounced the whole thing. There was almost $600,000 in federal and state taxes, interest and penalties. Not to mention what they paid the CPA firm for structuring the transaction.

The Consentinos did what you or I would do: they sued the CPA firm. They won and received $375,000. They did not report or pay tax on said $375,000, reasoning that it was less than the tax they paid. The IRS sent them a love letter noting the oversight and asking for the tax.

Both parties were Tax Court bound.

The taxpayers relied upon several cases, a key one being Clark v Commissioner. The Clarks had filed a joint rather than a married-filing-separately return on the advice of their tax advisor. It was a bad decision, as filing-jointly cost them approximately $20,000 more than filing-separately. They sued their advisor and won.

The Court decided that the $20,000 was not income to the Clarks, as they were merely being reimbursed for the $20,000 they overpaid in taxes. There was no net increase in their wealth; rather they were just being made whole.

The Clark decision has been around since 1939, so it is “established” law as far as established can be.

The Court decided that the same principle applied to the Cosentinos. To the extent that they were being made whole, there was nothing to tax. This meant, for example:

·        To extent that anything was taxable, it shall be a fraction (using the $375,000 as the numerator and total losses as the denominator).

·        The amount allocable to federal tax is nontaxable, as the Cosentinos are merely being reimbursed.

·        The amount allocable to state taxes however will be taxable, to the extent that the Cosentinos had previously deducted state taxes and received a tax benefit from the deduction.

·        The same concept (as for state taxes) applied to the accounting fees. Accounting fees would have been deducted –meaning there was a tax benefit. Now that they were repaid, that tax benefit swings and becomes a tax detriment, resulting in tax.

There were some other expense categories which we won’t discuss.

By the way, the Court’s reasoning is referred to as the “origin of the claim” doctrine, and it is the foundation for the taxation of lawsuit and settlement proceeds.  

So the IRS won a bit, as the Cosentinos had excluded the whole amount, whereas the Court wanted a ratio, meaning that some of the $375,000 was taxable.

Are you curious what the CPA firm charged for this fiasco?

$45,000.