When Your Employer Bungles Your Retirement Plan Loan

I admit that I am not a fan of borrowing from an employer retirement plan, except perhaps as a next-to-last step before being evicted.

Things go wrong.

Lose your job, for example, and not only are you looking for work but you also have a tax bill on a loan you cannot pay back.

You do not even have to lose your job.

Ms. Frias participated in her company’s retirement plan. She was getting ready to go on maternity leave when she borrowed $40,000 from her 401(k). Her employer was to withhold from her paycheck (to be paid biweekly), and there was a make-up provision allowing her to correct any shortfall by the end of the following month.

COMMENT: Retirement plan proceeds are normally tax-free if repaid over a period of five years or less.

She went on leave on or around August 1^st.  She was drawing on her accumulated vacation and sick time.  Sounds pretty routine.

She returned to work October 12th.

In November, she learned that her employer had failed to withhold any monies for her 401(k) loan.

She immediately wrote a $1,000 check and increased her withholding to get caught-up.

Nonetheless, at the end of the year the plan administrator (Mutual of America Life) sent her a $40,000 Form 1099R on the loan.

They however sent it to her electronically. Having no reason to expect one, she did not realize that she had even received a 1099. Goes without saying it was not on her tax return.

You know the IRS matched this up and sent her a notice.

What do you think: does she have a tax issue?

No question her employer messed up.

And that she tried to correct it.

However, the law is strict:

Although a loan may satisfy the section 72(p) requirements, “a deemed distribution occurs at the first time that the requirements … of this section are not satisfied, in form or operation.”

Her first payment was due in August, the month following the loan. If she had a deemed distribution, it would have occurred then. A distribution – even a “deemed” one – would be taxable.

There remained hope, though:

The plan administrator may provide the plan participant with an opportunity to cure the failure, and a deemed distribution does not occur unless the participant fails to pay the delinquent payment within the cure period.”

This is a nice safety valve. If the employer gives you a “cure” period, you can still avoid having the fail and its associated tax.

What was her cure period?

The end of the following month: September.

When did she write a check?

November, when she realized that there was a problem.

Too late.

She had one last long shot: a “leave of absence” exception.

Which is Code section 72(p)(2)(C), and it provides for interruption in a loan repayment schedule if one is not drawing a paycheck or not drawing enough to meet the minimum loan payment.

Her argument? She was not receiving her “regular” paycheck. She instead was drawing on her vacation and sick time bank.

Problem: she nonetheless received a check, and the Court was unwilling to part-and-parcel its source. She was collecting enough to make the loan payments.

She was hosed.

She did nothing wrong, but her employer’s negligence cost her somewhere near $15 grand in unnecessary taxes.

It’s A Trap

Let’s talk about an IRS trap.

It has to do with procedure.

Let’s say that the you start receiving notices from the IRS. You ignore them, perhaps you are frightened, confused or unable to pay.

Granted, I would point out that this is a poor response to the chain-letter sequence you will be receiving, but it is a human response. It happens more frequently than you might think. Too many times I have been brought into these situations rather late, and sometimes options are severely limited.

The BIG notice from the IRS is called a 90-day letter, also known as a Statutory Notice of Deficiency. Tax nerds refer to it as a SNOD.

This is the final notice in the chain-letter sequence, so one would have been receiving correspondence for a while. The IRS is going to assess, and one has 90 days to file with the Tax Court.

Assessment means that the IRS has 10 years to collect from you. They can file a lien, for example, and damage your credit. They might levy or garnish, neither of which is a good place to be.

I have sometimes used a SNOD as a backdoor way to get to IRS appeals. Perhaps the taxpayer had ignored matters until it reached critical mass, or perhaps the first Appeals had been missed or botched. I had a first Appeals a few years back with a novice officer, and her lack of experience was the third party on our phone call.

Let the 90 days run out and the Tax Court cannot hear the case.

NOTE: Most times a Tax Court filing never goes to court. The Tax Court does not want to hear your case, and the first thing they do is send it back to Appeals. The Court wants to machinery to solve the issue without them getting involved.

Our case this time involves Caleb Tang. He filed pro se with the Tax Court, meaning that he represented himself. Technically Caleb does not have to go by himself – he can hire someone like me – but there are limitations.  

There is a game here, and the IRS has used the play before.

The taxpayer makes a mistake with the filing. In our story, Caleb filed but he forgot to pay the filing fee.

Technically this means the Court would not have jurisdiction.

Caleb also filed an amended return.

As I said, sometimes there are few good options.

The IRS contacted Caleb and said that they would not process his amended return unless he dropped the Tax Court petition.

Trap.

You see, Caleb was past the 90-day window. If he dropped his filing, the IRS would automatically get its assessment, and Caleb would have no assurance they would process his amended return.

Caleb would then not be able to get back to Tax Court. Procedure requires that he pay the tax and then sue in District Court or Court of Federal Claims. There is no pro se in that venue, and Caleb would have no choice but to hire an attorney.

That will weed out a lot of people.

Fortunately, the Court (Chief Judge L Paige Marvel) knew this.

He allowed Caleb additional time to pay his application fee.

Meaning that the case got into the Tax Court’s pipeline.

What happens next?

It could go three different ways:

(1) Both parties drop the case.

(2) They do not drop the case and the matter goes back to Appeals.

(3) The Court hears the case.

I suspect the IRS will process Caleb’s amended return now.

Keep It Believable

Our protagonists this time are the Ohdes from West Virginia. The issue concerns charitable contributions. The Ohdes claimed they made dozens of trips to Frederick, Maryland and donated over 20,000 distinct items in 2011.

Half of this would have been clothing. There was furniture. There also were over 3,000 books.

They did at least get that minimalist Goodwill receipt that says:

Goodwill does not return goods or services in exchange for donations of property.”

The receipt doesn’t provide detail of the items, their count or their condition, but at least it is a start.

At the end of the year they entered this information into TurboTax.

And according to TurboTax they donated over $146,000.

You know what else?

They should have expected the almost-certain notice from the IRS. Donate a piece of real estate and a $100,000-plus donation makes sense. Donate 20,000-plus items of men’s and women’s clothing – and not so much.

There are rules for noncash donations. The IRS knows the scam. The rules tighten-up as the donations get more expensive.

If you donate property worth $250 or more, you have to get “contemporaneous written acknowledgement” (CWA). This does not mean the same day, but it does mean within a reasonable time. The CWA must include a description of the property.  That Goodwill receipt should be adequate here, as it has pre-printed categories for

·      Clothing

·      Shoes

·      Media

·      Furniture

·      Household items

Go over $500 and there are more requirements. In addition to a description of the property, you also have to provide:

·      How you acquired it

·      When you acquired it

·      How much you paid for it

That Goodwill receipt is no longer enough. You are going to have to supplement it somehow. Some tax practitioners advise taking photographs and including them with the tax records for the year.

Go over $5,000 and you get into appraisal territory, unless you donated publicly-traded stocks.

Where were the Ohdes on this spectrum? Their lowest donation was $830; their highest was $14,999.

They were therefore dealing with the $500 and $5,000 rules.

What did they have?

They had that lean and skinny receipt from Goodwill. You know, the receipt that is good enough for $250 donations.

But they had no $250 donations.

They had a problem. Their paperwork was inadequate. It would help to have a sympathetic Court.

Here is the Court:

Petitioners claimed large deductions for charitable contributions of property, not only for 2011 but also for years before and after 2011.”

Where was the Court going with this?

 For 2007—2010 they claimed deductions in the aggregate amount of $292,143 for noncash charitable contributions."

Are you hearing skepticism?

For 2012-2013 they claimed deductions in the amount of $104,970 for noncash charitable contributions.”

Yep, skepticism.

The Court had a whole range of options to bounce the deduction.

Petitioners did not maintain contemporaneous records establishing any of these facts.”     

That is one option.

Stay within the lines and the Court might cut you some slack.  Deduct half a million dollars over a few years and …. Let’s just say you had better make a lot of money to even get to the realm of possible.

Many of those aggregate dollar figures are suspect on their face.”

The Court spotted them a $250 deduction.

Leaving approximately $33 grand in tax and over $6 grand in penalties.

Keep it believable, folks.

RERI-ng Its Ugly Head - Part Two

Let’s continue our story of Stephen Ross, the billionaire owner of the Miami Dolphins and of his indirect contribution of an (unusual) partnership interest to the University of Michigan.

What made the partnership interest unusual was that it represented a future ownership interest in a partnership owning real estate. The real estate was quite valuable because of a sweet lease. When that ship came in, the future interest was going to be worth crazy money.

That ship was a “successor member interest” or “SMI.”

We talked about the first case, which went before the Tax Court in 2014 and involved legal motions. The case then proceeded, with a final decision in July, 2017.

COMMENT: Yes, it can take that long to get a complex case through Tax Court. Go after Apple, for example, and your kid will likely be finishing high school before that tax case is finally resolved.

The SMI was purchased for $2.95 million.

Then donated to the University of Michigan for approximately $33 million.

COMMENT: This is better than FaceBook stock.

After two years, the University of Michigan sold the SMI (to someone related to the person who started this whole story) for around $2 million.

OBSERVATION: Nah, FaceBook stock would have been better.

Now RERI was in Court and explaining how something that was and will be worth either $2 or $3 million is generating a tax deduction of $33 million.

And it has to do with the SMI being “part of” of something but not “all of” something.  SMI is the “future” part in “all of” a partnership owning valuable leased real estate in California.

The concept is that someone has to value the “all of” something. Once that is done, one can use IRS tables to value the “part of” something. Granted, there are hoops and hurdles to get into those tables, but that is little obstacle to a shrewd tax attorney.

Ross found a shrewd tax attorney.

Virtually all the heavy lifting is done when valuing the “all of” part. One then dumps that number into the IRS tables, selects a number of years and an interest rate and – voila! The entrée round, my fellow tax gastronomes, featuring a $33 million tasty secret ingredient.

The pressure is on the first number: the “all of.”

This will require a valuation.

There are experts who do these things, of course.

Their valuation report will go with your tax return.  No surprise. We should be thankful they do not also have to do a slide presentation at the IRS. 

And there will be a (yet another) tax form to highlight the donation. That is Form 8283, and – in general – you can anticipate seeing this form when you donate more than $5,000 in property.

There are questions to be answered on Form 8283. We have spoken about noncash donations in the past, and how this area has become a tax minefield. Certain things have to be done a certain way, and there is little room for inattention. Sometimes the results are cruel.

Form 8283 wants, for example:

·      A description of the property

·      If a partial interest, whether there is a restriction on the property

·      Date acquired

·      How acquired

·      Appraised fair market value

·      Cost

I suspect the Court was already a bit leery with a $3 million property generating a $33 million donation.

And the Court noticed something …

The Form 8283 left out the cost.

Yep, the $3 million.

Remember: there is little room for inattention with this form.

Question is: does the number mean anything in this instance?

Rest assured that RERI was bailing water like a madman, arguing that it “substantially complied” with the reporting requirements. It relied heavily on the Bond decision, where the Court stated that the reporting requirements were:

“… directory and not mandatory”

The counterpunch to Bond was Smith:

“ the standard for determining substantial compliance under which we ‘consider whether … provided sufficient information to permit … to evaluate the reported contributions, as intended by Congress.’”

To boil this down to normal-speak: could RERI’s omission have influenced a reasonable person (read: IRS) to question or not question the deduction. After all, the very purpose of Form 8283 was to provide the IRS enough information to sniff-out stuff like this.

Here is the Court:

“The significant disparity between the claimed fair market value and the price RERI paid to acquire the SMI just 17 months before it assigned the SMI to the University, had it been disclosed, would have alerted respondent to a potential overvaluation of the SMI”

Oh oh.

“Because RERI failed to provide sufficient information on its Form 8283 to permit respondent to evaluate its purported contribution, …we cannot excuse on substantial compliance grounds RERI’s omission from the form of its basis in the SMI.”

All that tax planning, all the meetings and paperwork and yada-yada was for naught, because someone did not fill-out the tax form correctly and completely.

I wonder if the malpractice lawsuit has already started.

The Court did not have to climb onto a high-wire and juggle dizzying code sections or tax doctrines to deny RERI’s donation deduction. It could just gaze upon that Form 8283 and point-out that it was incomplete, and that its incompleteness prejudiced the interests of the government. It was an easy way out.

And that is precisely what the Court did.

Is There Any Point To Middle Class Entitlements?

I was reading a Bloomberg article last week titled “Those Pointless Upper-Middle-Class Entitlements.” It is - to be fair - an opinion piece, so let’s take it with a grain of salt.

The article begins:

Let’s talk about upper-middle-class entitlements, the subsidies that flow almost entirely to those in the upper fifth or even tenth of the income distribution. You know, the home mortgage interest deduction and the tax subsidies for 401(k)s, IRAs and other retirement plans.

Then we have a spiffy graph: 

I am confused with what is considered a “tax break.”

The true “tax break” here is the earned income credit. We know that this began as encouragement to transition one from nonworking to working status, and we also know that it is the font of massive tax fraud every year. The government just sends you a check, kind of like the tooth fairy. An entire tax-storefront industry has existed for decades just to churn-out EIC returns. Too often, their owners and practitioners are not as … uhh, scrupulous … as we would want.

And this is a surprise how? Give away free money to every red-headed Zoroastrian Pacific Islander and wait to be surprised by how many red-headed Zoroastrian Pacific Islanders line up at your door. Even those who are not red-headed, Zoroastrian or Pacific Islander in any way. 

Here is more:

Of course, we wouldn’t want to take away all of those tax expenditures, would we? The earned income tax credit and the Social Security exclusion, for example, are targeted at people with pretty low incomes.

Doesn’t one need to have income before receiving an INCOME TAX expenditure?

Then we have these bright shiny categories:

·       Defined contribution retirement plans

·       Defined benefit retirement plans

·       Traditional IRAs

·       Roth IRAs

Interesting. One would think that saving for retirement would be a social good, if only to lessen the stress on social security.

We read:

Wealthy people who would save for retirement in any case respond to subsidies by shifting assets into tax-sheltered accounts; the less wealthy don’t respond much at all.

It makes some sense, but don’t you feel like you are being conned? Step right up, folks; make enough money to save for retirement and you do not need a tax break to save for retirement.

When did we all become wealthy? Did someone send out letters to inform us?

Did you know that the majority of income tax breaks are claimed by people with the majority of the income?  

Think about that one for a second, folks.

This following is a pet peeve of mine:

·       Deferral of active income of controlled foreign corporations

We have discussed this issue before. Years ago, when the U.S. was predominant, it decided that U.S. corporations would pay tax on all their earnings, whether earned in the U.S. or not.

There is a problem with that: the U.S. is almost a solo act in taxing companies on their worldwide income. Almost everyone else taxes only the profit earned in their country (the nerd term is “territoriality”).

Let’s be frank: if you were the CEO of an international company, what would you do in response to this tax policy?

You would move the company – at least the headquarters - out of the U.S., that’s what you would do. And companies have been moving: that is what "inversions" are.

So, the U.S. had no choice but to carve-out exceptions, which is how we get to “deferral of active income of controlled foreign corporations.” This is not a tax break. It is a fundamental flaw in U.S. international taxation and the reason Congress is currently considering a territorial system.

By the way, how did these tax breaks come to be, Dudley?

Why do these subsidies continue nonetheless? Mainly, it seems, because they’ve been granted to a sizable, influential population who, it is feared, will fight any effort to take them away. 

Politicians giving away money. Gasp.

But mainly it’s the millions of upper-middle-class Americans who, like me and my family, are beneficiaries of tax subsidies for home mortgages, retirement accounts and/or college savings.

To state another way: It is unfair that people with more money can do more things with money than people with less money.

Profound.

What offends about this bella siracha is:

You train for a career.

You set an alarm clock daily, dress, fight traffic and do your job.

You get paid money.

You take some of this money and save for nefarious causes such as your kids’ college and your eventual retirement.

Yet you keeping your own money is the equivalent of receiving a welfare check euphemistically described as an “earned income credit.”

No, no it is not.

And the false equivalence is offensive.

I get the issue. I really do. The theory begins with all income being taxable. When it is not, or when a deduction is allowed against income, there is – arguably - a “tax break.” The criticism I have is equating one-keeping-one’s-money (for example, a 401(k)) with flat-out welfare (the earned income credit). Another example would be equating a deeply-flawed statutory tax scheme (multinational corporations) with the state income tax deduction (where approximately 30% of this tax break goes to two states: California and New York). 

And somebody please tell me what “wealthy” means anymore. It has become one of the most abused words in the English language.

Bloomberg

RERI-ng Its Ugly Head - Part One

Here is the Court:

The action involves RERI Holdings I, LLC (RERI). On its 2003 income tax return RERI reported a charitable contribution of property worth $33,019,000. Respondent determined that RERI overstated the value of the contribution by $29,119,000.”

That is considerably more than a rounding error.

The story involves California real estate, a billionaire and a university perhaps a bit too eager to receive a donation.

The story is confusing, so let’s use a dateline as a guide.

February 6, 2002 

Hawthorne bought California real estate for $42,350,000. Technically, that real estate is in an LLC named RS Hawthorne LLC (Hawthorne), which in turn is owned by RS Hawthorne Holdings LLC (Holdings).

Holdings in turn is owned by Red Sea Tech I (Red Sea). 

February 7, 2002 

Red Sea created two types of ownership:

First, ownership for a period of time (technically a “term of years,” abbreviated TOYS).

Second, a future and successor interest that would not even come into existence until 2021. Let’s call this a “successor” member interest, or SMI. 

QUESTION: Why a delayed ownership interest? There was a great lease on the California real estate, and 2021 had significance under that lease.

March 4, 2002     

RERI was formed.

March 25, 2002

RERI bought the SMI for $2,950,000.

August 27, 2003

RERI donated the SMI to the University of Michigan.

A key player here is Stephen Ross, a billionaire and the principal investor in RERI. He had pledged to donate $5 million to the University of Michigan. 

Ross had RERI donate the SMI. 

The University agreed to hold the SMI for two years, at least, before selling.

Do you see what they have done? Start with a valuable piece of leased real estate, stick it in an LLC owned by another LLC owned by another … ad nauseum, then create an LLC ownership stake that does not even exist (if it will ever exist) until 2021.

What did RERI donate to the University of Michigan?

You got it: the thing that doesn’t exist for 18 years.

I find this hard to swallow.

“Successor” LLC interests are sasquatches. You can spend a career and never see one. The concept of “successor” makes sense in a trust context (where they are called “remaindermen”), but not in a LLC context. This is a Mary Shelly fabrication by the attorneys.

So why do it?

Technically, the SMI will someday own real estate, and that real estate is not worth zero.

RERI hired a valuation expert who determined it was worth almost $33 million. This expert argued that the lease on the property – and its reliable series of payments – allowed him to use certain IRS actuarial tables in arriving at fair market value (the approximately $33 million).

Wait. It gets better.

The two years pass. The University sells the property … to an entity INDIRECTLY OWNED by Mr. Ross for $1,940,000.

This entity was named HRK Real Estate Holdings, LLC (HRK).

More.

HRK had already prearranged to sell the SMI to someone else for $3 million.

Still more.

That someone donated the same SMI and claimed yet another deduction of $29,930,000.

REALITY CHECK: This thing sells twice for a total of approximately $5 million but generates tax deductions of approximately $63 million.

Yet more.

Who did the valuation on that second donation? Yep, the same guy who did RERI’s valuation.

The IRS disallowed RERI’s donation to zero, zip, zilch, nada. The IRS was clear: this thing is a sham.

And there begins the litigation.

How something can simultaneously be worth $33 million and $2 million?

This is all about those IRS tables.

Generally speaking, the contribution of property is at fair market value, usually described as the price arrived at between independent buyers and sellers, neither under compulsion to sell or buy and both informed of all relevant facts.

Except …

For annuities, life estates, remainders, reversions, terms of years and similar partial interests in property. They are not full interests so they then have to be carved-out and adjusted to present value using IRS-provided tables.

OBSERVATION: Right there, folks, is why the attorneys created this Frankenstein. They needed to “separate” the interests so they could get to the tables.

RERI argued that it could value that real estate 18 years out and use the tables. Since the tables are concerned only with interest rates and years, the hard lifting is done before one gets to them.

Not so fast, said the IRS.

That real estate is in an LLC, so it is the LLC that has to be valued.  There are numerous cases where the value of an asset and the value of an ownership interest in the entity owning said asset can be different – sometimes substantially so. You cannot use the tables because you started with the wrong asset.

But the LLC is nothing but real estate, so we are back where we started, countered RERI.

Not quite, said the IRS. The SMI doesn’t even exist for 18 years. What if the term owner mortgages the property, or sells it, or mismanages it? That SMI could be near worthless by the time some profligate or incompetent is done with the underlying lease.

Nonsense, said RERI. There are contracts in place to prohibit this.

How pray tell is this “prohibited?” asked the IRS.

Someone has to compensate the SMI for damages, explained RERI.

“Compensate” how? persisted the IRS.

The term owner would forfeit ownership and the SMI would become an immediate owner, clarified RERI.

So you are making the owner of a wrecked car “whole” by giving him/her the wrecked car as recompense, analogized the IRS. Can the SMI at least sue for any unrecovered losses?

Uhhhh … no, not really, answered RERI. But it doesn’t matter: the odds of this happening are so remote as to not warrant consideration.

And so it drones on. The case goes into the weeds.

Who won: the government or the billionaire?

It was decided in a later case. We will talk about it in a second post.

Lawless In Seattle

Did you hear that Seattle has a new income tax?

Sort of. Eventually. But maybe not.

The tax rate is 2.25 percent and will tag you if you are (1) single and earn more than $250,000 per year or (2) married and earn more than $500,000.

This is big-bucks land, and we normally would not dwell on this except…

Washington state has no income tax.

Let us get this right: Seattle wants to have an income tax in a state that has no income tax. Washington state considered an income tax back in the 1930s, but the courts found it unconstitutional.

You or I would live within the Seattle city limits … why?

Surely there are nice suburbs we could call home. Heck, Bill Gates and Jeff Bezos do not live in Seattle; they live in the suburbs.

There appear to be legal issues with this tax.

The state constitution, for example, requires taxes to be uniform within a class of property. The pro-tax side questions whether income is “property.”

The anti-tax side provides the Power Inc v Huntley case (1951), wherein the Washington Supreme Court stated:

It is no longer subject to question in this court that income is property.”

Must be something cryptic about the wording.

Then there is a law that bans Washington cities from taxing net income.

The pro-tax side argues that they are not taxing “net” income. No sir, they are taxing “adjusted” or “modified” or “found-under-the-cushions” income instead.

The anti-tax side says: seriously?

Then you have the third issue that Washington cities must have state authority to enact taxes.

The pro-tax side says it can do this under their Licenses and Permits authority.

RCW 35A.82.020

Licenses and permits—Excises for regulation.

A code city may exercise the authority authorized by general law for any class of city to license and revoke the same for cause, to regulate, make inspections and to impose excises for regulation or revenue in regard to all places and kinds of business, production, commerce, entertainment, exhibition, and upon all occupations, trades and professions and any other lawful activity: PROVIDED, That no license or permit to engage in any such activity or place shall be granted to any who shall not first comply with the general laws of the state.

No such license shall be granted to continue for longer than a period of one year from the date thereof and no license or excise shall be required where the same shall have been preempted by the state, nor where exempted by the state, including, but not limited to, the provisions of RCW 36.71.090 and chapter 73.04 RCW relating to veterans.

I am not making this up, folks.

Here is the mayor:

This legislation will face a legal challenge.”

And green is a color.

But let me tell you something: we welcome that legal challenge. We welcome that fight.”

Then why pick a fight, Floyd?

… lowering the property tax burden …, addressing the homelessness crisis; providing affordable housing, education and transit; … creating green jobs … meeting carbon reduction goals.”

Got it: verbigeration, the new college major. It will get you to that $15 minimum wage. At least until those jobs go away because they are too expensive.

Speaking of expense: who is bankrolling this issue while it is decided in court? Has the city banked so much money that a guaranteed legal battle is worth it?

If we need to pack the courts, will you be there with me?” thundered a councilperson.

Pack the courts? Should we bring bats too?  

The pro-tax side wants to be sued, hoping that a judge will legislate from the bench.

Needless to say, the anti-tax side is resisting, with calls for “civil disobedience.”

With exhortations not to file returns.

The state chair of the Republican party is encouraging

“… non-compliance, non-violent and non-paying”

Sounds almost Gandhi-esque.

It appears that neither side has any intention to observe – heck, even acknowledge – any pretense of law.

I am at a loss to see how this is good for anybody.