Foreign Investment In U.S. Rental Real Estate

We have spoken about Congress’ and the IRS’ increasing reliance on penalties.

Here is one from the new Taxpayer First Act of 2019:

The minimum penalty for filing a return more than 60 days later will now be no less than the lesser of:

·        $330 or

·        100% of the amount required to be shown on the tax return.

The previous marker was $205, adjusted for inflation.

Thanks for saving the republic from near-certain extinction there, Congress.

There is another one that has caught my attention, as it impacts my practice.

By happenstance I represent a fair number of foreign nationals who own rental real estate in the U.S.

Why would a foreign national want to own rental real estate in Georgetown, KY, Lebanon, OH or Arlington, TN?

I don’t get it, truthfully, but then I am not a landlord by disposition. I certainly am not a long-distance landlord.

There is a common structure to these arrangements. The foreign national sets up an U.S.-based LLC, and the LLC buys and operates the rentals. Practitioners do not often use corporations for this purpose.

There is a very nasty tax trap here.

There is special reporting for a foreign corporation doing business in the United States. As a flip to that coin, there is also special reporting for a U.S. corporation that is 25%-or-more owned by nonresidents. We are referring to Form 5472, and it is used to highlight “reportable transactions,” with no dollar minimum.

“Reportable transactions” sounds scary. I suppose we are looking for laundering of illicit money or something similar, right?

Here is an example of a “reportable transaction”:

·        borrowing money

Here is another:

·        paying interest on borrowed money

Yep, we are going full CSI on that bad boy.

Let’s play with definitions and drag down a few unattentive tax practitioners, why don’t we?

An LLC with one owner can be considered to be the same as its owner for tax purposes.

Say that Emilio from Argentina sets up an Ohio LLC.  He is the only owner. The LLC goes on to buy rental properties in Cincinnati and Columbus.

For federal income tax purposes, the LLC is disregarded and Emilio is deemed to own the properties individually.

For purposes of information reporting, however, the IRS wants you to treat Emilio’s single-member LLC as a corporation.

A “corporation” that is more-than-25% owned by a nonresident.

Meaning that you have a Form 5472 filing requirement.

What happens if the tax practitioner doesn’t catch this wordplay?

An automatic penalty of $10,000 for not filing that 5472.

Granted, the practitioner will fight the penalty. What choice is there?

Let’s up the ante.

Buried in the new tax law for 2018 (that is, the Tax Cuts and Jobs Act), Congress increased the minimum penalty from $10,000 to $25,000.

So a foreign national buys a rental house or two in name-a-city, and somehow he/she is on par with an Alibaba or Banco Santander?

The IRS automatically charges the penalty if the form is filed late. The practitioner would have to provide reasonable cause to have the penalty abated.  

Remember next that the IRS does not consider an accountant’s error to be necessarily provide reasonable cause, and you can anticipate how this story may not turn out well.

The IRS Cryptocurrency Letter

Do you Bitcoin?

The issue actually involves all cryptocurrencies, which would include Ethereum, Dash and so forth.

A couple of years ago the IRS won a case against Coinbase, one of the largest Bitcoin exchanges. The IRS wasn’t going after Coinbase per se; rather, the IRS wanted something Coinbase had: information. The IRS won, although Coinbase also scored a small victory.

·       The IRS got names, addresses, social security numbers, birthdates, and account activity.

·       Coinbase however provided this information only for customers with cryptocurrency sales totaling at least $20,000 for years 2013 to 2015.

What happens next?

You got it: the IRS started sending out letters late last month- approximately 10,000 of them. 

Why is the IRS chasing this?

The IRS considers cryptocurrencies to be property, not money. In general, when you sell property at a gain, the IRS wants its cut. Sell it at a loss and the IRS becomes more discerning. Is the property held for profit or gain or is it personal? If profit or gain, the IRS will allow a loss. If personal, then tough luck; the IRS will not allow the loss.

The IRS believes there is unreported income here.

Yep, probably is.

The tax issue is easier to understand if you bought, held and then sold the crypto like you would a stock or mutual fund. One buy, one sell. You made a profit or you didn’t.

It gets more complicated if you used the crypto as money. Say, for example, that you took your car to a garage and paid with crypto. The following weekend you drove the car to an out-of-town baseball game, paying for the tickets, hotel and dinner with crypto. Is there a tax issue?

The tax issue is that you have four possible tax events:

(1)  The garage

(2)  The tickets

(3)  The hotel

(4)  The dinner

I suspect that are many who would be surprised that the IRS sees four possible triggers there. After all, you used crypto as money ….

Yes, you did, but the IRS says crypto is not money.

And it raises another tax issue. Let’s use the tickets, hotel and dinner for our example.

Let’s say that you bought cryptos at several points in time. You used an older holding for the tickets. 

You had a gain on that trade.

You used a newer holding for the hotel and dinner.

You had losses on those trades.

Can you offset the gains and losses?

Remember: the IRS always participates in your gains, but it participates in your losses only if the transaction was for profit or gain and was not personal.

One could argue that the hotel and dinner are about as personal as you can get.

What if you get one of these letters?

I have two answers, depending on how much money we are talking about.

·       If we are talking normal-folk money, then contact your tax preparer. There will probably be an amended return. I might ask for penalty abatement on the grounds that this is a nascent area of tax law, especially if we are talking about our tickets, hotel and dinner scenario.

·       If crazy money, talk first to an attorney. Not because you are expecting jail; no, because you want the most robust confidentiality standard available. That standard is with an attorney. The attorney will hire the tax preparer, thereby extending his/her confidentiality to the preparer.

If the IRS follows the same game plan as they did with overseas bank accounts, anticipate that they are looking for strong cases involving big fish with millions of dollars left unreported.

In other words, tax fraud.

You and I are not talking fraud. We are talking about paying Starbucks with crypto and forgetting to include it on your tax return.

Just don’t blow off the letter.

Memphian Appeals An Offer In Compromise

I am looking at a case dealing with an offer in compromise.

You know these from the late-night television and radio advertisements to “settle your IRS debts for pennies on the dollar.”

Yeah, right.

If it were so easy, I would use it myself.

Don’t get me wrong, there are fact patterns where you probably could settle for pennies on the dollar. Unfortunately, these fact patterns tend to involve permanent injury, loss of earning power, a debilitating illness or something similar.

I will just pay my dollar on the dollar, thank you.

What caught my attention is that the case involves a Memphian and was tried in Memphis, Tennessee. I have an interest in Memphis these days.

Let’s set it up.

Taxpayer filed tax returns for 2012 through 2014 but did not pay the full amount of tax due, which was about $40 grand. A big chunk of tax was for 2014, when he withdrew almost $90,000 from his retirement account.

Why did he do this?

He was sending his kids to a private high school.

I get it. I cannot tell you how many times I have heard from Memphians that one simply cannot send their kids to a public school, unless one lives in the suburbs.

In December, 2016 he received a letter from the IRS that they were going to lien.

He put the brakes on that by requesting a Collection Due Process (CDP) hearing.

Well done.

In January he sent an installment agreement to the IRS requesting payments of $300 per month until both sides could arrive at a settlement.

The following month (February) he submitted an Offer in Compromise (OIC) for $1,500.

That went to a hearing in April. The IRS transferred the OIC request to the appropriate unit.

In late August the IRS denied the OIC.

Let’s talk about an OIC for a moment. I am thinking about a full post (or two) about OICs in the future, but let’s hit a couple of high spots right now.

The IRS takes a look at a couple of things when reviewing an OIC:

(1)  Your net worth, defined as the value of assets less any liabilities thereon.

There are certain arcane rules. For example, the IRS will probably allow you to use 80% of an asset’s otherwise fair market value. The reason is that it is considered a forced sale, meaning that you might accept a lower price than otherwise.

(2) Your earning power

This is where those late-night IRS settlement mills dwell. Have no earning power and near-zero net worth and you get pennies on the dollar.

There are twists here. For example, the IRS is probably not going to spot you a monthly Lexus payment. That is not how it works. The IRS provides tables for certain categories of living expenses, and that is the number you use when calculating how much you have “left over” to pay the IRS.

Let’s elaborate what the above means. If the IRS spots you a lower amount than you are actually spending, then the IRS sees an ability to pay that you do not have in real life.

You can ask for more than the table amount, but you have to document and advocate your cause. It is far from automatic, and, in fact, I would say that the IRS is more inclined to turn you down than to approve any increase from the table amount. I had a client several years ago who was denied veterinary bills and prescriptions for his dog, for example.

The IRS workup showed that the taxpayer had monthly income of approximately $12,700 and allowable monthly expenses of approximately $11,000. That left approximately $1,700 monthly, and the IRS wanted to get paid.

But there was one expense that made up the largest share of the IRS difference. Can you guess what it was?

It was the private school.

The IRS will not spot you private school tuition, unless there is something about your child’s needs that requires that private school. A special school for the deaf, for example, would likely qualify.

That is not what we have here.

The IRS saw an ability to pay that the taxpayer did not have in real life.

Taxpayer proposed a one-time OIC of $5,000.

The IRS said No.

They went back and forth and agreed to $200 per month, eventually increasing to $700 per month.

COMMENT: This is not uncommon for OICs. The IRS will often give you a year to rework your finances, with the expectation that you will then be able to pay more.

The taxpayer then requested abatement of interest and penalties, which was denied. Generally, those requests require the taxpayer to have a clean filing history, and that was not the case here.

The mess ended up in Tax Court.

Being a court, there are rules. The rule at play here is that the Court was limited to reviewing whether the IRS exercised abuse of discretion.

Folks, that is a nearly impossible standard to meet.

Let me give you one fact: he had net assets worth approximately $43 thousand.

His tax was approximately $40 thousand.

Let’s set aside the 80% thing. It would not take a lot of earning power for the IRS to expect him to be able to repay the full $40 grand.

He lost. There really was no surprise, as least to me.

I do have a question, though.

His monthly income was closer to $13 grand than to $12 grand.

It fair to say that is well above the average American monthly household income.

Private school is expensive, granted.

But where was the money going?

Our case this time was Love v Commissioner, T.C. Memo 2019-92.

Depression And Disability

I am reading a Tax Court case where the taxpayer represented himself. This is referred to as “pro se.” Technically, it does not mean that you cannot have an attorney or advisor with you; it rather means that the attorney or advisor is not admitted to practice before the Tax Court. If I was your CPA, for example, I would field the questions-and-answers on your behalf while you sat there silent and forlorn. You would still be considered to be “pro se,” as I do not practice before the Court. Had I practiced in the D.C. area or with the national tax office of a large firm, I might have been more interested in pursuing admission to practice.

The taxpayer’s name is Walter Kowsh, and he had an incredible string of misfortune. Walter lived in New York. His wife died at age 53, leaving him with two teenage children and an elderly parent.

Then he lost several friends on the 9/11 attacks on the World Trade Center. Some of those friends had gone to his wife’s funeral.

By 2002 he could longer work because of depression and anxiety attacks.

He started taking prescriptions, including Wellbutrin and Paxil.

His depression became debilitating.

He started collecting on his private disability insurance.

He did not however apply for Social Security disability. Too bad, as there is a case (Dwyer) that accepts social security as proof of disability.

He took an early distribution from his 401(k) or IRA in 2003. He did not however file a tax return for 2003.

So the IRS tentatively prepared one for him.

After a string of IRS notices, he finally prepared and filed his 2003 return.

The IRS next wanted penalties for late filing as well as the 10% penalty on the early distribution.

Walter needed an out from both penalties. Is there way to do it?

Yep.

Disability would do it. Disability is an exception to the 10% penalty and is also reasonable cause to abate a late filing penalty.

Walter argued that he was disabled.

Question is: did Walter’s depression rise to the level of a disability?

Incredible story, said the IRS. Get us a doctor’s letter, and let’s wrap this up.

Walter could not – or would not - get a doctor’s letter. His own doctor refused to provide one.

This was a bad start.

How about a prescription history from the pharmacy? asked the IRS. They might be able to print out your history for the whole year.

Nope, said Walter.

I am already collecting disability, continued Walter. What part of “disability” do you not understand?

Walter could really have used a tax advisor at this point.

You see, collecting disability from an insurance company lends strong credibility to Walter’s claim, but disability is a medical diagnosis. The insurance reinforces the diagnosis but is not a substitute for it.

Rest assured the Court was curious why Walter’s doctor would not provide a letter, or why he refused to have another doctor provide one…

… despite numerous requests from respondent.”

Respondent means the IRS.

And I am curious myself.

I do not doubt that he was depressed. I also do not doubt that he considered himself disabled. What I don’t understand is the big pushback on what appears to be a reasonable request.

It is not personal, Walter. Stop taking it that way.

Walter lost.

You see the downside to a true pro se.

I would have been screaming at Walter for sabotaging his own case. He would have gotten that doctor’s letter or I would have fired him.

But Walter made the tax literature for the point that collecting private disability insurance, by itself and without further substantiation, does not prove disability for purposes of the tax Code.

Tax geeks will remember Walter for decades.

Deducting Something You Did Not Pay For

What caught my eye was the amount of penalties at issue:

     Year                       Amount

     2002                       $  100,000

     2003                       $  105,000

     2004                       $1,822,000

     2005                       $1,785,000

     2006                       $1,355,000

The penalties total over $5.1 million. I had to look this case over, even though it weighs in at 123 pages.

It involves Martin Knapp, a CPA. He got his license in 1983.

He had worked at the IRS. He also taught accounting and taxation at Pepperdine and Los Angeles City College.

Not a bad resume, methinks.

He did something I never did: he specialized his practice. He focused on transportation workers, including airline pilots and railroad workers. He especially focused on mariners.

As of 2004 he employed 10 people.

Sounds successful to me.

He began his mariner practice around 1993. Two of his clients wound up in Tax Court, and it is there that our story begins.

The first client was Mr. Johnson, a deep-sea mariner. He would routinely work for four months and then take a two-month vacation.

The second was Mr. Westling, a tugboat captain in and around Alaska. He would work 30-day shifts on the tugboat.

Knapp amended Johnson’s return and prepared Mr. Westling’s return for 1996. He claimed a per diem for every day they were on the boat.

So what, right?

Here is the what: The per diem included a meal allowance, and their employers provided the meals.

I do not get it. How can someone get a deduction if that someone did not incur an expense in the first place?

The IRS flagged the returns, and both went to Tax Court.

Since they presented the same issue, the cases were consolidated.

In September, 2000 the Tax Court decided that neither could deduct meal expenses but they could deduct incidental expenses.

COMMENT: The incidental portion of a per diem is for tips and miscellaneous stuff, such as mouthwash. It is only a few bucks per day and nowhere near the amount allowed for meals. In short, there was a (very) minor victory and a very large defeat.

Mr Kapp did not represent in the Tax Court case, but he did read the decisions. He contacted the attorney who represented the IRS to request a face-to-face meeting. The attorney could not do this, as Kapp was an “interested” party. I could (hypothetically) have met with the attorney (as I had nothing to do with either Johnson or Westling), but Kapp was the CPA and therefore very much an interested party.

Kapp doubled down. He kept advising his clients that they could deduct meals even if meals were provided by their employer.

He tripled down. He created websites promoting his services to mariners and asserting that he could obtain tax refunds for them.

He quadrupled down. He wrote articles for Professional Mariner and The National Public Accountant. Here is an example:

The exciting news for mariners is that two U.S. Tax Court decisions last year settled the legal issue of allowing mariners to claim an almost unlimited amount of travel deductions while working away from home, without ever having to show the IRS any receipts, just like other transportation workers.”

Enter Examining Officer Tiffany Smith, who informed Kapp that he was the target of an IRS investigation for tax shelter promotion.

He sent her a 9-page letter detailing the relevant authority for the mariner deduction and arguing that the IRS does not oppose his position.

Does not oppose…?

Kapp wrote a letter he titled “Why is IRS Harassing Me for Twice Winning in U.S. Tax Court?”

This is going south ….

The investigation was transferred to George Campos, a revenue agent investigating tax promoters and abusive tax return preparers.

There is back and forth with Kapp and his attorney. In August, 2005 Campos and Kapp meet. Campos points out that there is no deduction for something one has not paid. Kapp asserts that “it does not matter if *** receive a meal or not, they’re still entitled to a deduction.”

Campos prepared an injunction.

Kapp’s attorney started to worry. He had an associate research the issue of mariners and meal deductions and memo the same. The result was pretty much the same as the IRS position, which was a bad place to be when you represent Kapp.

In early 2006 the Department of Justice sent Kapp a letter informing him that it was considering filing a lawsuit and providing him an opportunity to call and discuss the matter.

For all that is holy, Kapp, please STOP ….

At this point we are on page 55 of a 123-page court decision, and I am going to end it.

The IRS wanted him to stop. If he stops, he may yet walk away with all limbs still attached. Continue this quixotic quest, however, and he might lose it all.

The Court decided he was wrong and hardheaded. Not being without compassion, however, the Court reduced the penalties to $3,218,000.

There goes a lifetime of savings.

Oh, why, Kapp, why?

Driving To South Africa

Our protagonist this time is Donald Durden. He is a pastor with the Seventh Day Adventist Church, and he was based out of Columbus, Ohio for the tax year at issue. His territory included part of Maryland, Ohio, western Pennsylvania, West Virginia, and a part of Virginia.

Got it. I am guessing the case has something to do with travel expenses.

The Church reimbursed his business-related travel expenses using both an accountable and nonaccountable plan.

I guessed right.

COMMENT: The big difference between an accountable and nonaccountable plan is whether you have to provide your employer with receipts and other paperwork. If you do, the plan is accountable and the employer can leave the reimbursement off your W-2. Fail to turn in paperwork and the plan becomes nonaccountable. The reimbursement then goes on your W-2. That used to mean that one would have to itemize and claim employee business expenses. The new tax law disallows employee business expenses, meaning that – beginning with 2018 - one has income with no offsetting deduction.

Pastor Burden claimed $41,950 of unreimbursed employee expenses when he filed his 2013 tax return.

Good grief!

The IRS wanted to know what made up this number. Actually, so do I. There were all kinds of travel in there as well as vehicle expenses and other stuff, including “special shoes.”

Let’s talk about his South Africa visit.

He claimed travel expenses of $10,897. When pressed, he did not present receipts or records, opting to explain that he was away from home on ministerial duties for 100 days. At $180 per day – which he described as the “conservative high-low method” - that comes to $18,000 and was way more than he actually deducted. Why was there an issue?

Folks, it does work like that. I presume that he was referring to a per diem, but a per diem refers to hotels, meals and incidental expenses; it does not mean the air fare to get there in the first place. Additionally, one still has to substantiate the business reason for the trip and document the number of days against which to multiply the per diem. I cannot vacation for two weeks in Europe and make it deductible just by wandering into an accountants’ office one afternoon in Budapest.  

Our pastor had a receipt or two. He elaborated that he visited the Apartheid Museum, the Robben Island Museum, Nelson Mandela’s and Bishop Tutu’s residences, and the botanical gardens.

Sounds like a vacation, murmured the IRS.

Not at all, corrected the pastor. I was working.

How were you working, asked the IRS hopefully.

I said a prayer of dedication during a ceremony.

And …?

I led daily devotions with the parishioners who travelled with me. There was also a naming ceremony. I chose Chloe for my name.

Can you get to any records? Daily schedules, appointments, anything to substantiate ….

For international travel to be deductible, the primary purpose of the trip has to be business related. It is somewhat harsh, but that is the rule. If the trip is 45% business, there is no deduction. You do not get to multiply the cost of the trip by 45 percent.

It was a really good prayer, gleamed the pastor.

He also went to the Dominican Republic. Twice. Turns out his wife has family there.

Of course, sighed the IRS. Let’s go over those records. Let’s start with how you got there.

I drove there, said the pastor.

Whaa…?

I have a log. You see, right here, yeah, in January, I drove there. I left on a Sunday and returned the next Wednesday. In September I also left on a Sunday and came back eight days later.

You can’t drive to …

Ah, here it is. You see, my log shows that I drove to South Africa too. That was in December, added the pastor, squinting his eyes while remembering.

And so it continued, including other items that we cannot discuss without sounding like The Onion.

The Court bounced pretty much everything.

The Court also kept the penalty.

This time we discussed Burden and Torres v Commissioner.

It may be my favorite case so far in 2019.