An S Corporation Nightmare

Over my career the preferred entities for small and entrepreneurial businesses have been either an S corporation or a limited liability company (LLC). The C corporation has become a rarity in this space. A principal reason is the double taxation of a C corporation. The C pays its own taxes, but there is a second tax when those profits are returned to its shareholders. A common example is dividends. The corporation has already paid taxes on its profits, but when it shares its profits via dividends (with some exception if the shareholder is another corporation) there is another round of taxation for its shareholders. This might make sense if the corporation is a Fortune 500 with broad ownership and itself near immortal, but it makes less sense with a corporation founded, funded, and  grown by the efforts of a select few individuals – or perhaps just one person.

The advantage to an S corporation or LLC is one (usually - this is tax, after all) level of tax. The shareholder/owner can withdraw accumulated profits without being taxed again.

Today let’s talk about the S corporation.

Not every corporation can be an S. There are requirements, such as:

·       It cannot be a foreign corporation.

·       Only certain types of shareholders are allowed.

·       Even then, there can be no more than 100 shareholders.

·       There can be only one class of stock.

Practitioners used to be spooked about that last one.

Here is an example:

The S corporation has two 50% shareholders. One shareholder has a life event coming up and receives a distribution to help with expenses. The other shareholder is not in that situation and does not take a distribution.

Question: does this create a second class of stock?

It is not an academic question. A stock is a bundle of rights, one of which is the right to a distribution. If we own the same number of shares, do we each own the same class of stock if you receive $500 while I receive $10? If not, have we blown the S corporation election?

These situations happen repetitively in practice: maybe it is insurance premiums or a car or a personal tax. The issue was heightened when the states moved almost in concert to something called “passthrough taxes.” The states were frustrated in their tax collection efforts, so they mandated passthroughs (such as an S) to withhold state taxes on profits attributable to their state. It is common to exempt state residents from withholding, so the tax is withheld and remitted solely for nonresidents. This means that one shareholder might have passthrough withholding (because he/she is a nonresident) while another has no withholding (because he/she is a resident).

Yeah, unequal distributions by an S corporation were about to explode.

Let’s look at the Maggard case.

James Maggard was a 50% owner of a Silicon Valley company (Schricker). Schricker elected S corporation status in 2002 and maintained it up to the years in question.

Maggard bought out his 50% partner (making him 100%) and then sold 60% to two other individuals (leaving him at 40%). Maggard wanted to work primarily on the engineering side, and the other two owners would assume the executive and administrative functions.

The goodwill dissipated almost immediately.

One of the new owners started inflating his expense accounts. The two joined forces to take disproportionate distributions. Apparently emboldened and picking up momentum, the two also stopped filing S corporation tax returns with the IRS.

Maggard realized that something was up when he stopped receiving Schedules K-1 to prepare his personal taxes.

He hired a CPA. The CPA found stuff.

The two did not like this, and they froze out Maggard. They cut him off from the company’s books, left him out of meetings, and made his life miserable. To highlight their magnanimity, though, they increased their own salaries, expanded their vacation time, and authorized retroactive pay to themselves for being such swell people.

You know this went to state court.

The court noted that Maggard received no profit distributions for years, although the other two were treating the company as an ATM. The Court ordered the two to pay restitution to Maggard. The two refused. They instead offered to buy Maggard’s interest in Schricker for $1.26 million. Maggard accepted. He wanted out.

The two then filed S corporation returns for the 2011 – 2017 tax years.

They of course did not send Maggard Schedules K-1 so he could prepare his personal return.

Why would they?

Maggard’s attorney contacted the two. They verbally gave the attorney – piecemeal and over time – a single number for each year.

Which numbers had nothing to do with the return and its Schedules K-1 filed with the IRS.

The IRS took no time flagging Maggard’s personal returns.

Off to Tax Court Maggard and the IRS went.

Maggard’s argument was straightforward: Schricker had long ago ceased operating as an S corporation. The two had bent the concept of proportionate anything past the breaking point. You can forget the one class of stock matter; they had treated him as owning no class of  stock, a pariah in the company he himself had founded years before.

Let’s introduce the law of unintended consequences:

Reg 1.1361-1(l)(2):

Although a corporation is not treated as having more than one class of stock so long as the governing provisions provide for identical distribution and liquidation rights, any distributions (including actual, constructive, or deemed distributions) that differ in timing or amount are to be given appropriate tax effect in accordance with the facts and circumstances.

Here is the Tax Court:

… the regulation tells the IRS to focus on shareholder rights under a corporation’s governing documents, not what the shareholders actually do.”

That makes sense if we were talking about insurance premiums or a car, but here … really?

We recognize that thus can create a serious problem for a taxpayer who winds up on the hook for taxes owed on an S corporation’s income without actually receiving his just share of distributions.”

You think?

This especially problematic when the taxpayer relies on the S corporation distributions to pay these taxes.”

Most do, in my experience.

Worse yet is when a shareholder fails to receive information from the corporation to accurately report his income.”

The Court decided that Maggard was a shareholder in an S corporation and thereby taxable on his share of company profits.

Back to the Court:

The unauthorized distributions in this case were hidden from Maggard, but they were certainly not memorialized by … formal amendments to Schricker’s governing documents. Without that formal memorialization there was no formal change to Schricker’s having only class of stock.”

I get it, but I don’t get it. This reasoning seems soap, smoke, and sophistry to me. Is the Court saying that – if you don’t write it down – you can get away with anything?      

Our case this time was Haggard and Szu-Yi Chang v Commissioner, T.C. Memo 2024-77.

 

Section 1244 Stock: An Exception To Capital Loss

I was looking at a case involving Section 1244 stock.

I remember studying Section 1244 in school. On first impression one could have expected it a common quiver in tax practice. It has not been.

What sets up the issue is the limitation on the use of capital losses. An easy example of a capital asset is stock. Buy and sell stock and you have capital gains and losses (exempting those people who are dealers in stocks and securities). You then net capital gains against capital losses.

·      If the result is net capital gain, you pay tax.

·      If the result is net capital loss, the Code allows you to deduct up to $3,000 of net loss against your other types of income.

QUESTION: What if the net loss is sizeable – say $60 grand?

ANSWER: The Code will allow you to offset that loss dollar-for-dollar against any future capital gains.

QUESTION: What if the experience left a mark? You have no intention of buying and selling stocks ever again.

ANSWER: Then we are back to the $3,000 per year.

Mind you, that $3,000 entered the Code back in 1978. A 1978 dollar is comparable to $4.82 in 2024 dollars. Just to keep pace, the capital loss limit should have been cumulatively raised to $14,460 by now. It has not, of course, and is a classroom example of structural anti-taxpayer Code bias. 

Section 1244 is there to relieve some of the pressure. It is specialized, however, and geared toward small businesses.

What it does is allow one to deduct (up to) $50 grand ($100 grand for joint returns) as an ordinary loss rather than a capital loss.

There is a downside: to get there likely means the business failed. Still, it is something. Better $50 grand at one time than $3 grand over umpteen years.

What does it take to qualify?

(1)  First, there must be stock. Being a partner in a partnership will not get you there. This means that you organized as a corporation. Mind you, it can be either a C or an S corporation, but it must be a corporation.

(2)  The corporation must be organized in the United States.

(3)  The total amount of capital contributions to the corporation (stock, additional capital, whatever) must not exceed $1 million. If you are the unfortunate who puts the number above $1 million, then some of your stock will qualify and some will not.

(4)  The capital contribution must be in cash or other property (excluding stocks and securities). This would exclude stock issued as compensation, for example.

(5)  You must be the original owner of the stock. There are minimal exceptions (such as inheriting the stock because someone died).

(6)  You must be an individual. Corporations, trusts, estates, trustees in bankruptcy and so on do not qualify.

(7)  There used to be a prohibition on preferred stock, but that went out in 1985. I suppose there could still be instances involving 1984-or-earlier preferred stock, but it would be a dwindling crowd.

(8)  The company must meet a gross receipts test the year the stock is issued.

a.    For the preceding five years (or life of the company, if less), more than 50% of aggregate gross receipts must be from active business operations.

b.    Another way to say this is that passive income (think interest, dividends, rents, royalties, sales or exchanges of stocks and securities) had better be less than 50% of aggregate gross receipts. This Code section is not for mutual funds.

An interesting feature is that no formal election is required. Corporate records do not need to reference Section 1244.  Board minutes do not need to approve Section 1244.  Nothing needs to go with the tax return. The corporation must however retain records to prove the stock’s qualification under Section 1244.

And therein can be the rub.

Let’s look at the Ushio case.

In 2009 David Ushio acquired $50,000 of common stock in PCHG.

PCHG in turn had invested in LifeGrid Solutions LLC (LGS), which in turn was seeking to acquire rights in certain alternative energy technology.

PCHG never had revenues. It ceased business in 2012 and was administratively dissolved by South Carolina in 2013.

The IRS selected the Ushio’s joint individual return for 2012 and 2013. The audit had nothing to do with Section 1244, but the IRS saw the PCHG transaction and allowed a $3,000 capital loss in 2012.

Mind you, the Ushios had not claimed a deduction for PCHG stock on either their 2012 or 2013 return.

Mr. Ushio said “wait a minute …”

Some quick tax research and Ushio came back with a counter: he wanted a $50,000 ordinary loss deduction rather than the puny $3,000 capital loss. He insisted PCHG qualified under Section 1244.

The IRS had an easy response: prove it.

Ushio was at a disadvantage. He had invested in PCHG, but he did not have inside records, assuming those records even existed.

He presented a document listing “Cash Input” and “Deferred Pay,” noting that the deferred amount was never paid. Sure enough, the amount paid-in was less than $1 million.

The IRS looked at the document and noted there was no date. They wanted some provenance for the document - who prepared it? what records were used? could it be corroborated?

No, no and no.

In addition, PCHG never reported any gross receipts. It is hard to prove more-than-50% of something when that something is stuck at zero. Ushio pushed back: PCHG was to be an operating company via its investment in LGS.

The IRS could do this all day: prove it.

Ushio could not.

Meaning there was no Section 1244 stock.

Our case this time was Ushio v Commissioner, T.C. Summary Opinion 2021-27.

 

No Hiding Behind Preparer’s Error

 

Practitioners sometimes call it “falling on the sword.”

There is likely a phone call to the insurance company beforehand.

Something went wrong. The client now owes tax, interest, maybe penalties.

Just because that happens does not mean the practitioner was wrong. It can happen any number of ways.

·      The classic: the client does not provide all paperwork to the practitioner.

Mind you, sometimes the practitioner can tell:

… hey, you have had this account for years, but I am not seeing it this year. Do you still have the account?

And sometimes … you can’t tell. Perhaps it is a one-off. You never saw it before and you never will again, but it is there for that one year.

All the while, IRS computers are whirring and matching. They will let you know if you leave something out.

·       The tax answer is uncertain.

How can that happen?

New tax law is one way. It takes a while to get guidance out there. We saw this recently with the employee retention credit. Congress passed a law, and the IRS did its best interpreting it in real time. Its best was problematic, and the IRS subsequently paused ERC processing because of the number of fraudulent filings.    

·       The client goes to audit but does not have the documentation necessary to support a tax position. 

I think of real estate professional status, especially if one has a job outside real estate. The IRS is going to hammer on the hours worked, and you better have something other than stories to support your position. 

A variation on the above is that the IRS disagrees with your documentation. 

     Conservation easements are a current example of these. 

·       The audit from hell 

One cannot do representation work and not have stories to tell. 

     I was hired by another CPA for a research credit audit.  

The IRS agent had visited the CPA’s office, at which time he reviewed interim (think monthly or quarterly) accountings. The interims were prepared on an accrual basis, meaning that the accounting included accounts receivable and payable. 

The tax return, however, was cash basis, meaning that no receivables or payables were recorded. 

This is extremely common. Depending upon, I might consider the failure to do so to be malpractice. 

The agent considered this to be two sets of books. 

Translation: he thought indices of fraud. 

I thought that the IRS should tighten up its hiring standards. Having someone work business tax without having an adequate background in accounting is insane. 

It cost time. It cost goodwill. And it had nothing to do with the audit of a research tax credit. 

I am looking at a case that went sideways. I also see that neither the taxpayers nor the IRS appeared at the Tax Court hearing. 

The taxpayer was a teacher, and his wife was a nurse. They had a joint real estate business, and the wife had previously owned a nursing business. Although the nursing business had closed, it still showed deductions for the tax year under issue. 

The IRS had proposed adjustments, and the taxpayers had acceded. 

The taxpayers did not agree to a substantial understatement penalty, though. 

COMMENT: Think of this as a super penalty. It can flat-out hurt.

I’ve got the lay of the land now. Taxpayers wanted reasonable cause for abatement of the penalty. That reasonable cause would be reliance on a tax professional. There are requisites:         

(1)  The issue must be one of professional judgement and more than the routine processing of a tax return.

(2)  The tax preparer must be competent.

(3)  The taxpayers must have provided the preparer all relevant facts.

(4)  The taxpayers must have relied on the preparer’s judgment.

(5)  The taxpayers were injured by such reliance.

 Here is what the Court saw:         

(1)  The taxpayers did not testify.

(2)  The tax preparer did not testify.

(3)  The tax preparer deducted expenses for a business no longer in operation during the year in question.

(4)  The tax preparer reported business expenses on incorrect schedules.

(5)  The preparer did not sign the return.

The preparer had no intention of falling on the sword, it seems. The taxpayers had every intention of holding him responsible, though. They had to if they wanted penalty abatement.

It wasn’t going to happen.

Why?

The preparer did not sign the return, considered a big no-no in practice.

The Court was swift: taxpayers had not proven that the preparer was even competent.

Our case this time was Hall v Commissioner, U.S. Tax Court, docket No. 3467-23.

An Erroneous Tax Refund Check In The Mail

 

Let’s start with the Code section:

§ 6532 Periods of limitation on suits.

(b)  Suits by United States for recovery of erroneous refunds.

 

Recovery of an erroneous refund by suit under section 7405 shall be allowed only if such suit is begun within 2 years after the making of such refund, except that such suit may be brought at any time within 5 years from the making of the refund if it appears that any part of the refund was induced by fraud or misrepresentation of a material fact.

 

I have not lost sleep trying to understand that sentence.

But someone has.

Let’s introduce Jeffrey Page. He filed a 2016 tax return showing a $3,463 refund. In early May 2017, he received a refund check of $491,104. We are told that the IRS made a clerical error.

COMMENT: Stay tuned for more observations from Captain Obvious.

Page held the check for almost a year, finally cashing it on April 5, 2018.

The IRS – having seen the check cash – wanted the excess refund repaid.

Page wanted to enjoy the spoils.

Enter back and forth. Eventually Page returned $210,000 and kept the rest.

On March 31, 2020, Treasury sued Page in district court.

Page blew it off.

Treasury saw an easy victory and asked the district court for default judgement.

The court said no.

Why?

The court started with March 31, 2020. It subtracted two years to arrive at March 31, 2018. The court said that it did not know when Page received the check, but it most likely was before that date. If so, more than two years had passed, and Treasury could not pass Section 6532(b). They would not grant default. Treasury would have to prove its case.

Treasury argued that it was not the check issuance date being tested but rather the check clearance date. If one used the clearance date, the suit was timely.

The district court was having none of that. It pointed to precedence – from the Ninth Circuit Court of Appeals - and dismissed the case.

The government appealed.

To the Ninth Circuit Court of Appeals, ironically.

The Ninth wanted to know when a refund was “made.”

“within 2 years after the making of such refund …”

Is this when the refund is allowed or permitted or is it when the check clears or funds otherwise change hands?

The Ninth reasoned that merely holding the check does not rise to the threshold of “making” a refund.

Why, we ask?

Because Treasury could cancel the check.

OK. Score one for the government.

The Ninth further reasoned that the statute of limitations cannot start until the government is able to sue.

Why, we again ask?

Had Page shredded the check, could the government sue for nearly half a million dollars? Of course not. Well then, that indicates that a refund was not “made” when Page merely received a check.

Score two for the government.

The Ninth continued its reasoning, but we will fast forward to the conclusion:

… we hold that a refund is made when the check clears the Federal Reserve.”

Under that analysis, Treasury was timely in bring suit. The Ninth reversed the district court decision and remanded the case for further proceedings.

What do I think?

I see common sense, although I admit the Ninth has many times previously eluded common sense. Decide otherwise, however, and Treasury could be negatively impacted by factors as uncontrollable as poor mail delivery.

Or by Page’s curious delay in depositing the check.

Then again, maybe a non-professional was researching the matter, and it took a while to navigate to Section 6532 and its two years.

Our case this time was U.S. v Page, No 21-17083 (9th Cir. June 26, 2024).

A Charitable Deduction To An Estate

 

I had a difficult conversation with a client recently over an issue I had not seen in a while.

It involves an estate. The same issue would exist with a trust, as estates and trusts are (for the most part) taxed the same way.

Let’s set it up.

Someone passed away, hence the estate.

The estate is being probated, meaning that at least some of its assets and liabilities are under court review before payment or distribution. The estate has income while this process is going on and so files its own income tax return.

Many times, accountants will refer to this tax return as the “estate” return, but it should not be confused with the following, also called the “estate” return:

What is the difference?

Form 706 is the tax – sometimes called the death tax – on net assets when someone passes away. It is hard to trigger the death tax, as the Code presently allows a $13.6 million lifetime exclusion for combined estate and gift taxes (and twice that if one is married). Let’s be honest: $13.6 million excludes almost all of us.

Form 1041 is the income tax for the estate. Dying does not save one from income taxes.

Let’s talk about the client.

Dr W passed away unexpectedly. At death he had bank and brokerage accounts, a residence, retirement accounts, collectibles, and a farm. The estate is being probated in two states, as there is real estate in the second state. The probate has been unnecessarily troublesome. Dr W recorded a holographic will, and one of the states will not accept it.

COMMENT: Not all estate assets go through probate, by the way. Assets passing under will must be probated, but many assets do not pass under will.

What is an example of an asset that can pass outside of a will?

An IRA or 401(k).

That is the point of naming a beneficiary to your IRA or 401(k). If something happens to you, the IRA transfers automatically to the beneficiary under contract law. It does not need the permission of a probate judge.

Back to Dr W.

Our accountant prepared the Form 1041, I saw interest, dividends, capitals gains, farm income and … a whopping charitable donation.

What did the estate give away?

Books. Tons of books. I am seeing titles like these:

·       Techniques of Chinese Lacquer

·       Vergoldete Bronzen I & II

·       Pendules et Bronzes d’Ameublement

Some of these books are expensive. The donation wiped out whatever income the estate had for the year.

If the donation was deductible.

Look at the following:

§ 642 Special rules for credits and deductions.

      (c)  Deduction for amounts paid or permanently set aside for a charitable purpose.

(1)  General rule.

In the case of an estate or trust ( other than a trust meeting the specifications of subpart B), there shall be allowed as a deduction in computing its taxable income (in lieu of the deduction allowed by section 170(a) , relating to deduction for charitable, etc., contributions and gifts) any amount of the gross income, without limitation, which pursuant to the terms of the governing instrument is, during the taxable year, paid for a purpose specified in section 170(c) (determined without regard to section 170(c)(2)(A) ). If a charitable contribution is paid after the close of such taxable year and on or before the last day of the year following the close of such taxable year, then the trustee or administrator may elect to treat such contribution as paid during such taxable year. The election shall be made at such time and in such manner as the Secretary prescribes by regulations.

This not one of the well-known Code sections.

It lays out three requirements for an estate or trust to get a charitable deduction:

• Must be paid out of gross income.
• Must be paid pursuant to the terms of the governing instrument.
• Must be paid for a purpose described in IRC Sec. 170(c) without regard to Section 170(c)(2)(A). 

Let’s work backwards.

The “170(c) without …” verbiage opens up donations to foreign charities.

In general, contributions must be paid to domestic charities to be income-tax deductible. There are workarounds, of course, but that discussion is for another day. This restriction does not apply to estates, meaning they can contribute directly to foreign charities without a workaround.

This issue does not apply to Dr W.

Next, the instrument governing the estate must permit payments to charity. Without this permission, there is no income tax deduction.

I am looking at the holographic will, and there is something in there about charities. Close enough, methinks.

Finally, the donation must be from gross income. This term is usually interpreted as meaning gross taxable income, meaning sources such as municipal interest or qualified small business stock would create an issue.

The gross income test has two parts:

(1)  The donation cannot exceed the estate’s cumulative (and previously undistributed) taxable income over its existence.

(2)  The donation involves an asset acquired by that accumulated taxable income. A cash donation easily meets the test (if it does not exceed accumulated taxable income). An in-kind distribution will also qualify if the asset was acquired with cash that itself would have qualified.

The second part of that test concerns me.

Dr W gave away a ton of books.

The books were transferred to the estate as part of its initial funding. The term for these assets is “corpus,” and corpus is not gross income. Mind you, you probably could trace the books back to the doctor’s gross income, but that is not the test here.

I am not seeing a charitable deduction.

“I would not have done this had I known,” said the frustrated client.

I know.

We have talked about a repetitive issue with taxes: you do not know what you do not know.

How should this have been done?

Distribute the books to the beneficiary and let him make the donation personally. Those rules about gross income and whatnot have no equivalent when discussing donations by individuals.

What if the beneficiary does not itemize?

Understood, but you have lost nothing. The estate was not getting a deduction anyway.

An IRS Examination And A New IRS Hire

 

I have gotten dragged into a rabbit hole.

I often get involved with clients on a one-off basis: they are buying a company, selling their business, expanding into other states, looking into oddball tax credits and so forth. Several of our clients have been selling their businesses. In some cases, they have been offered crazy money by a roll-up; in others it is the call of retirement. I was looking at the sale of a liquor store last fall. As business sales go, it was not remarkable. The owner is 75 years old and has been working there since he was a teenager. It was time. The sale happened this year.

Fast forward to a few weeks ago. The CPA who works with the liquor store was taking time off, but I was in the office. The owner remembered me.

“Can I see you this afternoon,” he asked.

“Of course. Let me know what works for you.”

He brought an IRS notice of appointment with a field revenue officer. I reviewed the notice: there was a payroll issue as well as an issue with the annual deposit to retain a fiscal year.

I had an educated guess about the annual deposit. This filing is required when a passthrough (think partnership or S corporation) has a year-end other than December. We do not see many of these, as passthroughs have mostly moved to calendar year-ends since the mid-eighties. The deposit is a paper-file, and clients have become so used to electronic filing they sometimes forget that some returns must still be filed via snail mail.

The payroll tax issue was more subtle. For some reason, the IRS had not posted a deposit for quarter 4, 2022. This set a penalty cascade into motion, as the IRS will unilaterally reorder subsequent tax deposits. Let this reordering go on for a couple of quarters or more and getting the matter corrected can border on a herculean task.

I spoke with the revenue officer. She sounded very much like a new hire. Her manager was on the call with her. Yep, new hire.

Let’s start the routine:

“Your client owes a [fill in the blank] dollars. Can they pay that today?”

“I disagree they owe that money. I suspect it is much less, if they owe at all.”

“I see. Why do you say that?”

I gave my spiel.

“I see. Once again, do you want to make payment arrangements?”

I have been through this many times, but it still tests my patience.

“No, I will recap the liabilities and deposits for the two quarters under discussion to assist your review. Once you credit the suspended payroll deposit to Q4, you will see the numbers fall into place.”

“What about the 8752 (the deposit for the non-calendar year-end)?

“I have record that it was prepared and provided to the taxpayer. Was it not filed?”

“I am not seeing one filed.”

“These forms are daft, as they are filed in May following the fiscal year in question. Let’s be precise which fiscal year is at issue, and I will send you a copy. Do you want it signed?”

The manager chimes in: that is incorrect. Those forms are due in December.”

Sigh.

New hire, poorly trained manager. Got it.

I ask for time to reply. I assemble documents, draft a walkthrough narration, and fax it to the field revenue officer. I figure we have one more call. Maybe the client owes a couple of bucks because … of course, but we should be close.

Then I received the following:

 

I am not amused.

The IRS has misstepped. They escalated what did not need to escalate, costing me additional time and the client additional professional fees. Here is something not included when discussing additional IRS funding for new hires: who is going to train the new hires? The brain drain at the IRS over the last decade and a half has been brutal. It is debatable whether there remains a deep enough lineup to properly train new hires in the numbers and time frame being presented. What is realistic – half as many? Twice as long? Bring people out of retirement to help with the training?

Mind you, I am pulling for the IRS. The better they do their job the easier my job becomes. That said, there are realities. CPA firms cannot find qualified hires in adequate numbers, and the situation does not change by substituting one set of letters (fill-in whatever word-salad firm name you want) for another (IRS). Money is an issue, of course, but money is not the only issue. There are enormous societal changes at work.

What is our next procedural move?

I requested a CDP hearing.

The Collections Due Process hearing is a breather as the IRS revs its Collections engines. It allows one to present alternatives to default Collections, such as:

·      An offer in compromise

·      An installment agreement

I have no intention of presenting Collections alternatives. If we owe a few dollars, I will ask the client to write a check to the IRS. No, what I want is the right to dispute the amount of tax liability.

A liability still under examination by a field revenue officer. I have agreed to nothing. I have not even had a follow-up phone call. A word to the new hires: it is considered best practice – and courteous - to not surprise the tax practitioner. A little social skill goes a long way.

The Notice of Intent to Levy was premature.

Someone was not properly trained.

Or supervised.

I question whether this would have happened 15 or more years ago.

But then again, 15 years from now the new hires will be the institutional memory at the IRS.

It is the years in between that are problematic.

What Is Your Tax Basis When There Are No Records?

 

Since I started practice, there have been repetitive proposals to change the step-up basis rules upon death. With some exceptions, the general rule is that assets at one’s death take fair market value as their tax basis.

EXAMPLE: A decedent purchased his principal residence in 1975 for $56,000. The house is in Brentwood, Tennessee, and upon death the property is worth $1 million. The property’s tax basis is reset from $56 thousand to $1 million. Sell it for $1 million shortly after death and there is no gain or loss.

The common exception are retirement accounts: 401(k)s, 403(b)s, traditional IRAs and so on. These assets do not reset to fair market value (the tax nerds call this the “mark”), as the Code wants distributions from these accounts to be taxed as ordinary income.

There is a downside to the mark, of course. If the asset has gone down in value, then that lower value becomes the new basis.

The proposals I to which I refer would require carryover basis for the asset, meaning that tax basis will be acquisition cost plus improvements with no reference to market value at death.

I get it, I really do.

Why should income tax basis for an asset be marked just because someone died?

To continue that line of argument, why should there be a mark if one did not even have to file an estate tax return, much less pay estate taxes? The lifetime exemption in 2024 is $13.61 million. That is rarified air. So few estate tax returns are being filed that the IRS has been reassigning estate examiners to other functions.

The flip side asks how many times an asset is going to be taxed. To require carryover basis is to extend taxation on someone even beyond their death, which – I admit – seems macabre.

I prefer the mark over carryover basis for a different reason:

I am a practitioner and have been for decades. The argument for carryover basis may sound reasonable in the insulated confines of academe or expense account restaurants in corridors of power, but one should make a reality check with practitioners who have to work with these rules.

I expect that many if not most practitioners have encountered assets that are nearly impossible to cost or – if possible – possible only with extraordinary effort.

We had an example during busy season. A client and his siblings sold undeveloped land inherited from their grandfather and great aunt. The property had been owned separately, then as tenants in common, had survived two deaths and eventually found its way into a trust. The trust had terminated, and the siblings had formed a partnership in its place. One of the siblings was convinced that the basis for the land was incorrect. It was possible, as we had assumed the tax work from another accountant. We had not previously questioned the basis for the land. No one had.   

It took weeks and multiple people investigating and researching the provenance of the land. Even so, we were fortunate to research only back to the dates of the two deaths, as those would be the trigger dates for any potential mark.   

This is but one asset. One taxpayer. One practitioner. Who knows how many times the story repeats?

There is also a dark side to establishing tax basis that should be said out loud.

Let’s look at the Youngquist case.

Dean Youngquist (DY) did not file a tax return for 1996. He in fact had not filed a tax return since the late 1980s, which is a story for another day.

DY started day trading in 1996. He opened an account with Protrade. He closed that account in December 1996 and opened an account with Datek, another brokerage.

Do you remember the 1099-Bs that brokerages send you and the IRS? The Protrade and Datek 1099-Bs totaled $2,052,688 in sales proceeds.

COMMENT: I expect to see net trading losses, as net gains from day trading are uncommon.

The IRS send DY a tax assessment of $791,200, with another $796,726 in penalties and interest.

DY had been space-tripping, I guess. He did not file a tax return. He did not remember receiving notice(s) from the IRS. He had no idea that liens were filed on his property. He was shocked to learn that the IRS wanted to sell stuff to collect his taxes.

COMMENT: DY needs to tighten his game.

DY asked how the IRS got to the $791 grand in tax, much less the penalties and interest.

Easy, said the IRS. Since you did not provide records, we used zero (-0-) as your basis in the trades.

Folks, we all know there is zero chance that DY had no cost in his trades. The world does not work that way. How then did the IRS assert its position with a straight face?

Here is the Court:

The fact that basis may be difficult to establish does not relieve a taxpayer from his burden.”

DY did not even file a tax return, so it appears he put zero effort into discharging his burden.

If the taxpayer fails to satisfy the burden, the basis is deemed to be zero.”

Harsh, but that is the Coloman decision and extant tax law.

What did DY do next?

Believe it or not, he found – way, way after the fact – records for his Datek account.

The United States will abate the assessments by the portion of the assessments, penalties, and interest that were based upon the $601,612.50 in stock sales through Datek in 1996.”

Datek, BTW, was not his major trading account. Protrade was.

… there is no evidence documenting Youngquist’s actual stock transactions in the Protrade account. There are no statements from Protrade. There are no letters or emails from Protrade. Youngquist did not keep any notes about the stocks he purchased and sold, and he is unable to testify from memory about the specific stocks he bought and sold.”

DY had waited too long. Protrade was out of business.

DY had an idea:

·      He started his Protrade account with $73,000.

·      He closed his account with $67,333.

·      There was an aggregate loss of $5,677.

Seems reasonable.

Here is the Court:

First, I can find no authority to support his aggregate theory of proving basis in stock.”

This is technically correct, as each sale is its own event. Still, I would urge the Court to pull back the camera and use common sense. In legal-speak, we would call this an equity argument.

His only evidence is his own uncorroborated testimony. Youngquist’s bank account records do not reveal the November 5, 1996 withdrawal went to Protrade. There is no wire transfer record. There is no cancelled check evidencing payment to Protrade. Youngquist relies solely on his own testimony to suggest these facts.”

Personally, I believe that DY lost money overall in his Protrade account, but that is not the issue. The issue is that he needed to retain (some) records and file a return, responsibilities which he ignored. He then wanted the Court to do his work for him, and the Court was having none of that.

A taxpayer’s self-serving declaration is generally not a sufficient substitute for records.”

DY won on Datek but lost on Protrade. This was going to be expensive.

Back to the carryover basis proposal.

DY could not find records in 2013 going back to 1996. Granted, that is a long time, but that is nothing compared to requiring records from other people, possibly from other states and likely from decades earlier.  There should be a concession in tax administration that ordinary people pursuing ordinary goals are not going to maintain (and retain) records to the standards of the National Archive, at least not in overwhelming numbers. Combine that with a possible Youngquist body slam to zero, and the carryover basis proposal strikes as economically inefficient, financially brutish, possibly condescending, and an administrative nightmare. Why are we discussing a tax policy that cannot survive exposure to the real world?

Our case this time was U.S. v Youngquist, 3:11-cv-06113-PK, District Oregon.