You Sell Your Lottery Winnings

I was looking at a case where someone won the New York State Lottery.

I could have worse issues, methinks.

But there was a tax issue that is worth talking about.

Let’s say you won $17.5 million in the lottery.

You elect to receive it 26 years.

          QUESTION: How is this going to be taxed?

Easy enough: the tax Code considers lottery proceeds to be the same as gambling income. It will be taxed the same as a W-2 or an IRA distribution. You will pay ordinary tax rates. You will probably be maxing the tax rates, truthfully.

Let’s say you collected for three years and then sold the remaining amounts-to-be-received for $7.1 million.

          QUESTION: How is this going to be taxed?

I see what you are doing. You are hoping to get that $7.1 million taxed at a capital gains rate.

You googled the definition of a capital asset and find the following:

            § 1221 Capital asset defined.

(a)  In general.

For purposes of this subtitle, the term "capital asset" means property held by the taxpayer (whether or not connected with his trade or business), but does not include-

(1)  stock in trade of the taxpayer or other property of a kind which would properly be included in the inventory of the taxpayer if on hand at the close of the taxable year, or property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business;

(2) property, used in his trade or business, of a character which is subject to the allowance for depreciation provided in section 167 , or real property used in his trade or business;

(3) a patent, invention, model or design (whether or not patented), a secret formula or process, a copyright, a literary, musical, or artistic composition, a letter or memorandum, or similar property, held by-

(A)  a taxpayer whose personal efforts created such property,

(B)  in the case of a letter, memorandum, or similar property, a taxpayer for whom such property was prepared or produced, or

(C)  a taxpayer in whose hands the basis of such property is determined, for purposes of determining gain from a sale or exchange, in whole or part by reference to the basis of such property in the hands of a taxpayer described in subparagraph (A) or (B) ;

(4) accounts or notes receivable acquired in the ordinary course of trade or business for services rendered or from the sale of property described in paragraph (1) ;

(5) a publication of the United States Government (including the Congressional Record) which is received from the United States Government or any agency thereof, other than by purchase at the price at which it is offered for sale to the public, and which is held by-

(A)  a taxpayer who so received such publication, or

(B)  a taxpayer in whose hands the basis of such publication is determined, for purposes of determining gain from a sale or exchange, in whole or in part by reference to the basis of such publication in the hands of a taxpayer described in subparagraph (A) ;

(6) any commodities derivative financial instrument held by a commodities derivatives dealer, unless-

(A)  it is established to the satisfaction of the Secretary that such instrument has no connection to the activities of such dealer as a dealer, and

(B)  such instrument is clearly identified in such dealer's records as being described in subparagraph (A) before the close of the day on which it was acquired, originated, or entered into (or such other time as the Secretary may by regulations prescribe);

(7) any hedging transaction which is clearly identified as such before the close of the day on which it was acquired, originated, or entered into (or such other time as the Secretary may by regulations prescribe); or

(8) supplies of a type regularly used or consumed by the taxpayer in the ordinary course of a trade or business of the taxpayer.

Did you notice how this Code section is worded: a capital asset is property that is not …?

You don’t see anything there that looks like your lottery, and you are thinking maybe you have a capital asset. The sale of a capital asset gets one to capital gains tax, right?

You call me with your tax insight and planning.

If tax practice were only that easy.

You see, over the years the Courts have developed doctrines to fill-in the gaps in statutory Code language.

We have spoken of several doctrines before. One was the Cohan rule, named after George Cohan, who showed up at a tax audit long on deductions and short on supporting documentation.  The Court nonetheless allowed estimates for many of his expenses, reasoning that the Court knew he had incurred expenses and it would be unreasonable to allow nothing because of inadequate paperwork.

Congress felt that the Cohan rule could lead to abuses when it came to certain expenses such as meals, entertainment and travel. That is how Code section 274(d) came to be: as the anti-Cohan rule for selected expense types. No documentation means no deduction under Sec 274(d).

Back to our capital gains.

Look at the following language:

We do not see here any conversion of a capital investment. The lump sum consideration seems essentially a substitute for what would otherwise be received at a future time as ordinary income."

The substance of what was assigned was the right to receive future income. The substance of what was received was the present value of income which the recipient would otherwise obtain in the future. In short, consideration was paid for the right to receive future income, not for an increase in the value of the income-producing property."

This is from the Commissioner v PG Lake case in 1958.

The Court is describing what has come to be referred to as the “substitute for ordinary income” doctrine.

The easiest example is when you receive money right now for a future payment or series of future payments that would be treated as ordinary income when received.

Like a series of future lottery payments.

Mind you, there are limits on this doctrine. For example, one could argue that the value of a common stock is equal to its expected stream of future cash payments, whether as dividends or in liquidation. When looked at in such light, does that mean that the sale of stock today would be ordinary and not capital gain income?

The tax nerds would argue that it is not the same. You do not have the right to those future dividends until the company declares them, for example. Contrast that to a lottery that someone has already begun collecting. There is nothing left to do in that case but to wait for the mailman to come with your check.

I get the difference.

In our example the taxpayer got to pay ordinary tax rates on her $7.1 million. The Court relied on the “substitute for ordinary income” doctrine and a case from before many of us were born.

Our case this time was Prebola v Commissioner, TC Memo 2006-240.

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.