It’s A Cliff, Not A Slope

It is one of my least favorite areas of individual tax practice.

We are talking about health insurance. More specifically, health insurance purchased through the exchanges, coupled with advance payment of the premiums.

Why?

Because there is a nasty tax trap in there, and I saw the trap again the other day. It caught a client who gets by, but who is hardly in a position to service heavy tax debt.

Let’s set it up.

You can purchase health insurance in the private market or from government-sponsored marketplaces – also called exchanges. The exchanges were created under the Affordable Care Act, more colloquially known as Obamacare.

If you purchase health insurance through the exchange and your income is below a certain level, you can receive government assistance in paying the insurance premiums. Make very little income, for example, and it is possible that the insurance will be free to you. Make a little more and you will be expected to contribute to your own upkeep. Make too much and you are eliminated from the discussion altogether.

The trap has to do with the dividing line of “too much.”

Let’s look at the Abrego case.

Mr and Mrs Abrego lived in California. For 2015 he was a driver for disabled individuals, and he also prepared a few tax returns (between 20 and 30) every year. Mrs Abrego was a housekeeper.

They enrolled in the California exchange. They also did the following:

(1)  They provided an estimate of their income for 2015. Remember, the final subsidy is ultimately based on their 2015 income, which will not be known until 2016. While it is possible that someone would purchase health insurance, pay for it out-of-pocket and eventually get reimbursed by the IRS when filing their 2015 tax return in 2016, it is far more likely that someone will estimate their 2015 income to then estimate their subsidy. One would use the estimated subsidy to offset the very real monthly premiums. Makes sense, as long as all those estimated numbers come in as expected.

(2)  They picked a policy. The monthly premiums were $1,029.

(3)  The exchange cranked their expected 2015 numbers and determined that they could personally pay $108 per month.

(4)  The difference - $ 1,029 minus $108 = $921– was their monthly subsidy.

The Abregos kept this up for 10 months. Their total 2015 subsidy was $9,210 ($921 times 12).

Since the Abregos received a subsidy, they had to file a tax return. One reason is to compare actual numbers to the estimated numbers. If they guessed low on income, they would have to pay back some of the subsidy. If they guessed high, the government would owe them for underestimating the subsidy.

The Abregos filed their 2015 return.

They reported $63,332 of household income.

How much subsidy should they have received?

There is the rub.

The subsidy changes as income climbs. The subsidy gets to zero when one hits 400% of the poverty line.

What was the poverty line in California for 2015?

$15,730 for a married couple.

Four times the poverty line was $62,920.

They reported $63,332.

Which is more than $62,920.

By $412.

They have to pay back the subsidy.

How much do they have to pay back?

All of it - $9,210.

Folks, the tax rate on that last $412 is astronomical.

It is frustrating to see this fact pattern play out. The odds of a heads-up from the client while someone can still do something are – by the way – zero. That leaves retroactive tax planning, whose success rate is also pretty close to zero.

Our client left no room to maneuver. Why did her income go up? Because she sold something. Why did she not call CTG galactic command before selling – you know: just in case? What would we have done? Probably advised her to NOT SELL in the same year she is receiving a government subsidy.

How did it turn out for the Abregos?

They should have been toast, except for one thing.

Remember that he prepared tax returns. He did that on the side, meaning that he had a gig going. He was self-employed.

He got to claim business deductions.

And he had forgotten one.

How much was it?

$662.

It got their income below the magic $69,920 level.

They were on the sliding scale to pay back some of that subsidy. Some - not all.

It was a rare victory in this area.

Our case for the homegamers was Abrego v Commissioner.

Using A Liquidating Trust

I am reading a case where the IRS wanted taxes of almost $1.5 million.

I am not surprised to read that it involved a real estate developer.

Part of tax practice is working within someone’s risk tolerance (including mine, by the way). Some clients are so risk adverse that an IRS notice – on any matter for any reason – can be interpreted as a mistake by the tax practitioner. Then you have the gunslingers at the other end of the spectrum. These are the clients you have to rope-in, for their own as well as your sake.

My experience has been that real estate developers seem to cluster around the gunslinger end of the spectrum. We have one who recently explained to me that “paying taxes means that the tax advisor made a mistake.” That, folks, is a lot of pressure … on my partner.

Jason Sage is a developer in Oregon. He represented several companies, including JLS Customs Homes. You may recall that 2008 – 2009 was a rough time for real estate, and JLS took it in the teeth. It had three projects, dragging behind approximately $18 million in debt.

Eventually the real estate market collapsed. Sage had to do something. He and his advisors decided to utilize liquidating trusts. The idea is that one transfers everything one has into a trust, which might be owned by one’s creditors; then again, it might not. The creditors might accept the settling of the trust (a fancy term for putting money and assets into a trust) as discharge of the underlying debt; then again, they might not. Each deal is its own story, and the tax consequences can vary depending on the telling.

Our story involves the transfer of three projects to three liquidating trusts. Since real estate had tanked, these transfers – treated for tax purposes as sales - threw off huge losses. These losses were so big they created overall losses - called “net operating losses” (NOLs). Tax law at the time allowed the net operating losses to travel back in time, meaning that Sage could recoup taxes previously paid.

COMMENT: I see nothing wrong with this. If the government wants to participate in one’s profits, then it can also participate in one’s losses. To do otherwise smacks more of robbery than taxation.

The IRS took a look at this arrangement and immediately called foul.

Trust taxation looks carefully at whether the trust is a separate tax entity from the person establishing the trust, funding the trust or benefiting from the trust.  There is a type called a “grantor trust” which is disregarded as a separate tax entity altogether. The most common type of grantor trust is probably the “living trust,” which has gained popularity as a probate-mitigating tool. The idea behind the grantor trust is that the grantor – say me, for example – is allowed to put money in, take money out, change beneficiaries, even terminate the trust altogether without anyone being able to gainsay my decision.

Tax law considers this to be too much control over the trust, so the trust and I are considered to be the same person for tax purposes. I would have a grantor trust. Its tax return is combined with mine.

How do I avoid this result? Well, I have to start with limiting my otherwise unrestricted control over the trust. Yield enough control and the IRS will respect the trust as separate from me.

The IRS argued that Sage’s liquidating trusts were grantor trusts. They were not separate tax entities, and one cannot sell and create a loss by selling to oneself. Without that loss, there was no NOL carryover and therefore no tax refund.

Sage had to persuade the Court that the trusts were in fact separate from him and his companies.

After all, the trusts were for the benefit of his creditors. One has to concede that creditors are an adverse party, and the existence of an adverse party is an indicator that the trust is a separate tax entity. Extrapolating, the existence of creditors means that someone with interests adverse to Sage’s own had sway over the trusts. It was that sway that made these non-grantor trusts.

Persuasive, except for one thing.

Sage had never involved the creditors when setting up the trusts.

It was hard for them to be adverse when they did not even know the trusts were there.

Our case this time was Sage v Commissioner.

Paying Tax On Borrowed Money

I am looking at a Tax Court case where the IRS was chasing almost two-thirds of a million dollars. It involves an attorney and something called “litigation support agreements.”

There is a term you do not hear every day.

The taxpayer is a class-action lawyer.

You see, in a class action, the law firm sues on behalf of a group – or class - of affected parties. Perhaps numerous people were affected by a negligent act, for example, but there is not enough there for any one person to pursue litigation individually. Combine them, however, and you have something.

Or the lawsuit can be total malarkey and the law firm is seeking a payday, with little to no regard to the “class” it allegedly represents.

Ultimately, a class action is a tool that can be used for good or ill, and its fate depends upon the intent and will of its wielder.

Let get’s back to our taxpayer.

It takes money to pursue these cases. One has to bring in experts. There can be depositions, travel, cross-examinations. This takes money, and we already mentioned that a reason for class action is that no one person has enough reason – including money – to litigate on his/her own power.

Did you know there are people out there who will play bank with these cases? That is what “litigation support agreements” are. Yep, somebody loans money to the law firm, and – if the case hits – they get a very nice payoff on their loan. If the case fails, however, they get nothing. High risk: high reward. It’s like going to Vegas.

The taxpayer received over $1.4 million of these loans over a couple of years.

Then IRS came in.

Why?

I see two reasons, but I flat-out believe that one reason was key.

The taxpayer left the $1.4 million off his tax return as taxable income. The taxpayer thought he had a good reason for doing so: the $1.4 million represented loan monies, and it is long-standing tax doctrine that one (generally) cannot have income by borrowing money. Why? Because one has to pay it back, that is why. You are not going to get rich by borrowing money.

There are variations, though. It is also tax doctrine that one can have income when a lender forgives one’s debt. That is why banks issue Forms 1099-C (Cancellation of Debt) when they write-off someone’s credit card. How is it income? Because one is ahead by not having to pay it back.

Our taxpayer had different loan deals and agreements going, but here is representative language for one litigation support agreement:

… shall be a litigation support payment to [XXX] made on a nonrecourse basis and is used to pay for all time and expenses incurred by [XXX} in pursuant [sic] of this litigation. Said payment shall be repaid to …. at the successful conclusion of this litigation with annual interest to be paid as simple interest at the rate of …. as of the date of concluding this litigation.”

Let’s see: there is reference to repayment and an interest rate.

Good: sounds like a loan.

So where is the problem?

Let’s look at the term “nonrecourse.” In general, nonrecourse means that – if the loan fails – the lender can pursue any collateral or security under the loan. What the lender cannot do, however, is go after the borrower personally. Say I borrow a million dollars nonrecourse on a California house that subsequently declines in value to $300 grand. I can just mail the keys back to the lender and walk away without the lender able to chase me down. I am trying to divine what the broader consequence to society could possibly be if numerous people did this, but of course that is silly and could never happen.

Still, nonrecourse loans happen all the time. They should not be fatal, as I am technically still obligated on the loan - at least until the time I mail back the keys.

Let’s look at the next phrase: “successful conclusion of this litigation.”

When are you on the hook for this loan?

I would argue that you are on the hook upon “successful conclusion of this litigation.”

When are you not on the hook?

I would say any time prior to then.

The loan becomes a loan – not at the time of lending – but in the future upon occurrence of a distinguishable event.

The IRS was arguing that the taxpayer received $1.4 million for which he was not liable. He might be liable at a later time - perhaps when the universe begins to cool or the Browns win a Super Bowl – but not when that cash hit his hand.

Granted, chances are good that whoever lent $1.4 would pursue tort action if the taxpayer skipped town and sequestered on an island for a few years, but that would be a different legal action. Whoever put up the money might sue for fraud, nonperformance or malfeasance, but not because the taxpayer was liable for the debt. 

Let’s go back: what keeps one from having income when he/she borrows money?

Right: the obligation to pay it back.

So who did not have an obligation to pay it back?

The taxpayer, that’s who.

The IRS won the case. Still, what bothered me is why the IRS would go after this guy so aggressively. After all, give this arrangement a few years and it will resolve itself. The law firm receives money; the law firm spends money. When it is all said and done, the law firm will burn through all the money, leaving no “net money” for the IRS to tax.

So what fired up the IRS?

The taxpayer filed for bankruptcy.

Before burning through the money.

Meaning there was “net money” left.

He was depriving the IRS of its cut.

There is the overwhelming reason I see.

Our case this time was Novoselsky v Commisioner.

Grantor Retained Annuity Trusts In 2020

I was glancing over selected IRS interest rates and one caught my attention.

The Section 7520 rate for June, 2020 is 0.6%.

There are certain tax tools that work well in times of low interest rates. One is a grantor retained annuity trust, commonly referred to as a “GRAT.” One associates them with the fancy-pants rich, but I am thinking they can have broader appeal when the triggering interest rate is 0.6%.

Let’s talk about it. We will keep the discussion general as otherwise we would be going into a math class. Our purpose today is to understand what makes this tax tool work and why 2020 – with low interest rates and declining stock prices – are a perfect setup for a GRAT.

First, a GRAT is an irrevocable trust. Irrevocable means no take-backs.

A trust generally has three main players:

(a)  The settlor; that is, the moneybags who funds the trust. Let’s say that is me (CTG)

(b)  The trustee. That will be you.

(c)  The beneficiaries., There are two types:

a.    Income. For now, that will be me (CTG) as I receive the annuity.

b.    Remainder. That will be my grandkids (mini-CTGs), because they receive what is left over.

This trust will be taxed to me personally rather than pay taxes on its own. The nerd term for this is “grantor’ trust.

I fund the trust. Say that I put in $50 grand.

The trust will then pay me a certain amount of money for a period of time. Let’s say the amount is $10,000, and the trust will pay me for two years. I am retaining an annuity from the trust.

COMMENT: Truthfully, I think it would take at least 2 years to even qualify as an “annuity.” One payment does not an annuity make.

When the trust runs its course (two years in our example), whatever is left in the trust goes to the mini-CTGs.

If you sweep aside the details, you can see that I am making a gift to my grandkids. The GRAT is just a vehicle to get there.

Why bother?

Say that I just give $50 grand to my grandkids or to a trust on their behalf.

I made a gift.

Granted, I am not worried about gift tax on $50 grand given the current lifetime gift tax exemption of $11.5 million, but if someone moves enough money there can be gift tax.

Let’s say you can move enough money.

Congrats, by the way.

Is there a way for you to gift and also minimize the amount of gift tax?

Yep. One way is the GRAT.

Here is how the magic happens:

(1)  The tax Code backs into the amount of the gift. It does this by placing a value on the annuity. It then subtracts that value from the amount transferred into the trust ($50 grand in our example). The difference is the gift.

(2)  How can I maximize the value of the annuity?

a.    I want $10 grand. If I could get 5% interest, I would need $200,000 grand to generate that $10 grand.

b.    But I cannot get 5% in today’s economy. I might get lucky and get 1.5%. To get $10 grand, I would have to put in $666,667, which is a whole lot more than $200,000.

c.    This example is far from perfect, as I what I am describing is closer to an endowment than to an annuity. The takeaway however is valid: I have to put more money into an annuity as interest rates go down if I want to keep the payment steady.  

(3)  How does this affect the gift?

a.    Had I created the GRAT in June, 2018, I would have used a Section 7520 rate of 3.4%.

b.    It would require less money in 2018 to fund a $10,000 payment, as the money would be earning 3.4% rather than 0.6%.

c.    Flipping (b), it would require more money in 2020 to fund a $10,000 payment at 0.6% rather than 3.4%.

d.    As the value of the annuity goes up, the value of the gift goes down.

Let’s express this as a formula:

Gift = initial funding – value of annuity

e.    As the value of the annuity increased in 2020, the gift correspondingly decreased.

f.     That is how low interest rates power the GRAT as a gifting technique.

How do declining stock prices play into this?

Let’s look at Boeing stock.

Around March 1^st Boeing was trading at approximately $275.

As I write this Boeing trades around $120.

Now, I do not want to get into Boeing’s story, other than this: let’s say you believe that Boeing will bounce back and bounce much sooner than eternity. If you believe that, you could fund the GRAT with Boeing stock. The mathematics will be driven-off that $120 stock price and Section 7520 rate of 0.6%.

What happens if you are right and the stock returns to $275?

Your annuity is unchanged, your gift is unchanged, but the value of Boeing stock just skyrocketed. Your beneficiaries will do very well, and there was ZERO added gift tax to you.

Another way to say this is that you want to fund that GRAT with assets appreciating at more than 0.6%.

Folks, that is a low bar.

There however be dragons in this area.

You could fund the trust and the assets could go down in value. It happens.

Or you could die when the trust is still in existence. That would pull the trust back into your estate.

Or the trust becomes illiquid and you start pulling back assets rather than cash. That is a problem, as the assets appreciating is part of what powers this thing.

Then there are variations on the payment. One could specify a percentage rather than a dollar amount, that way the dollar amount of the annuity would increase as the assets in the trust increase.

There is a technique where one uses the annuity to fund yet another GRAT. It is called a “rolling” GRAT, and it worked when interest rates were much higher.

BTW, there is a twist on a GRAT, and it involves working the math so that the gift comes out to exactly zero. One might want to do this if one has run out of lifetime exemption, for example. The tax nerds refer to it as a “Walton” GRAT, in honor of Audrey Walton, wife of Wal-Mart cofounder Bud Walton. It took a court case to get there, but the technique has thereafter assumed the family name.

Deducting Expenses Paid With Paycheck Protection Loans

There was a case in 1931 that is influencing a public controversy today.

Let’s talk about it.

The taxpayer (Slayton) was in the business of buying, holding and selling tax-exempt bonds. He would at times borrow money to buy or to carry tax-exempt bonds he already owned.

Slayton had tax-exempt interest income coming in. That amount was approximately $65 thousand.

Slayton was also paying interest. That amount was approximately $78 thousand.

COMMENT: On first read it does not appear that dear old Slayton was the Warren Buffett of his day.

Time came to file his tax return. He omitted the $65 grand in interest received because … well, it was tax-exempt.

He deducted the $78 grand that he was paying to carry those tax-exempt securities.

The IRS said no dice.

Off to Court they went.

Slayton was hot. He made several arguments:

(1)  The government was discriminating against owners of tax-exempt securities and – in effect – nullifying their exemption from taxation.

(2)  The government was discriminating against dealers in tax-exempt bonds that had to borrow money to carry an inventory of such bonds.

(3)  The government was discriminating in favor of dealers of tax-exempt bonds who did not have to borrow to carry an inventory of such bonds.

I admit: he had a point.

The government had a point too.

(1)  The income remained tax-exempt. The issue at hand was not the interest income; rather it was the interest expense.

(2)  Slayton borrowed money for the express purpose of carrying tax-exempt securities. This was not an instance where someone owned an insubstantial amount of tax-exempts within a larger portfolio or where a business owning tax-exempts borrowed money to meet normal business needs.

The link between the bonds and the loans to buy them was too strong in this case. The Court disallowed the interest expense. Since then, tax practitioners refer to the Slayton issue as the “double-dip.”  The dip even has its own Code section:

        § 265 Expenses and interest relating to tax-exempt income.

(a)  General rule.

No deduction shall be allowed for-

(1)  Expenses.

Any amount otherwise allowable as a deduction which is allocable to one or more classes of income other than interest (whether or not any amount of income of that class or classes is received or accrued) wholly exempt from the taxes imposed by this subtitle, or any amount otherwise allowable under section 212 (relating to expenses for production of income) which is allocable to interest (whether or not any amount of such interest is received or accrued) wholly exempt from the taxes imposed by this subtitle.

Over the years the dip has evolved to include income other than tax-exempt interest, but the core concept remains: one cannot deduct expenses with too strong a tie to nontaxable income.

Let’s fast forward almost 90 years and IRS Notice 2020-32.

To the extent that section 1106(i) of the CARES Act operates to exclude from gross income the amount of a covered loan forgiven under section 1106(b) of the CARES Act, the application of section 1106(i) results in a “class of exempt income” under §1.265- 1(b)(1) of the Regulations. Accordingly, section 265(a)(1) of the Code disallows any otherwise allowable deduction under any provision of the Code, including sections 162 and 163, for the amount of any payment of an eligible section 1106 expense to the extent of the resulting covered loan forgiveness (up to the aggregate amount forgiven) because such payment is allocable to tax-exempt income. Consistent with the purpose of section 265, this treatment prevents a double tax benefit.

I admit, it is not friendly reading.

The CARES Act is a reference to the Paycheck Protection loans. These are SBA loans created in response to COVID-19 to help businesses pay salaries and rent. If the business uses the monies for their intended purpose, the government will forgive the loan.

Generally speaking, forgiveness of a loan results in taxable income, with exceptions for extreme cases such as bankruptcy. The tax reasoning is that one is “wealthier” than before, and the government can tax that accession to wealth as income.

However, the CARES Act specifically stated that forgiveness of a Paycheck Protection loan would not result in taxable income.

So we have:

(1)  A loan that should be taxable – but isn’t - when it is forgiven.

(2)  A loan whose proceeds are used to pay salaries and rent, which are routine deductible expenses.

This sets up the question:

Are the salaries, rent and other qualified expenses paid with a Paycheck Protection loan deductible?

You see how we got to this question, with Section 265, Slayton and subsequent cases that expanded on the double dip.

The IRS said No.

This answer makes sense from a tax perspective.

This answer does not make sense from a political perspective, with Senators Wyden and Grassley and Representative Neal writing to Secretary Mnuchin that this result was not the intent of Congress.

I believe them.

I have a suggestion.

Change the tax law.

Donating Eyeglasses

Some tax cases take near forever to wrap-up.

I am looking at a case involving tax year 2008; it was decided in April, 2020. It involves over $300 grand in taxes and penalties.

Let’s set it up.

A.  Take an accounting firm with offices in Cerritos, California and Kansas City, Missouri.

B.   Through them the taxpayers (Campbell) learned of a donation program involving Lions in Sight. The program was rather straightforward.

a.    A company (ZD Products) consolidates eyeglass frames (let’s say approximately 170,000).

b.   The company breaks down that number into lots (let’s say approximately 3,400 frames).

c.    It then sells the lots for approximately $50 grand each.

d.   If you buy a lot, you are advised to wait a year before doing anything. Not to fear, they will take care of your lot for you.

e.    After a year you donate the lot to Lions in Sight.

                                             i.     This is prearranged.

                                           ii.     Lions in Sight is affiliated with the Lions Club International. Its mission is to collect and provide used eyeglasses for use worldwide and to provide eye care assistance to the needy and low-income. In truth, it sounds like a fine charity.

f.     You will get a bright shiny appraisal saying that your donation was worth approximately $225 grand.

It sounds like the program ran well. In 2007 Lions in Sight had so many frames in storage that they requested ZD Products to store a sizeable new donation until 2008, when they could free up space.

Nice problem to have.

The IRS became aware and did not care for this at all. No surprise: one puts in $50 grand and – a year and a day later – gets a donation worth $225 grand.  Quick math tells me that someone with a tax rate over 23% comes out ahead.

What do we have? Someone takes a good cause (the Lions Club), stirs in a for-profit party (both the company selling the eyeglasses and the company organizing the deal), and has a sacerdote (the appraiser) bless the bona fides. Everybody wins; well, everybody but the IRS.   

We have seen something similar to this with conservation easements. Take a good cause – say preserve a wetland … or just green space. Bring in the marketers, attorneys and valuation experts. Stick the property into an LLC; sell interests in the LLC; donate the LLC interests to who-knows-who and – voila – instant big bucks tax deduction for someone who was never really that interested in wetlands or green space to begin with.

I have a question for you. Why do you think that the IRS has so many rules concerning donations? You know them: you need a receipt; past a certain dollar limit you need a letter from the charity; past another dollar limit you need an appraisal; somewhere in there you have a form attached to your tax return just for the donation.

Tripwires.

Let me give you one.

If you need an appraisal, then the appraisal has to be for what you actually donated.

Bear with me.

This story started off with approximately 170,000 eyeglass frames. They are of varying sizes, styles, quality and value. An appraisal is done on the mother lode.

Break the lode into lots of approximately 3,400.

Donate the lots.

The appraisal was done on the 170,000.

You need an appraisal on your 3,400.

You do not have this. Best you have is 34/1,700 of an appraisal.

But it is virtually impossible that each lot will be the same. There are too many combinations of styles, sizes, designers, costs and whatnot.  Just taking a percentage (34/1,700) is not good enough – not for this purpose.

You have no appraisal.

You have no deduction.

Tripwire.

The case for the home gamers is Campbell v Commissioner.