The New Israeli Trust Tax

Have you settled (that is, funded) a trust with an Israeli beneficiary?

I have not, but many have.

If this is you: heads up. The tax rules have changed, and they have changed from the Israeli side, not the U.S.

Until this year, Israel has not taxed a trust set up by a foreign person, even if there were Israeli beneficiaries. It also did not bother to tax the beneficiaries themselves. This was a sweet deal.

The deal changed this year. The Israel Tax Authority (ITA) now says that many trusts previously exempt will henceforth be taxable.

Israel is looking for a beneficiary trust, meaning that all settlors are foreign persons and at least one beneficiary is a resident Israeli.

EXAMPLE: The grandparents live in Cincinnati; the son moves to Israel, marries and has children; the grandparents fund a grandchildren’s trust.

A beneficiary trust can be either

·        A “relatives trust,” meaning the settlor is still alive and related (as defined) to the beneficiary

·        A “non-relatives trust,” meaning the settlor is not alive or not related (as defined) to the beneficiary 

EXAMPLE: The grandparents in the above trust pass away.

The tax will work as follows:

·        A relatives trust

o   Pay tax currently at 25% on the portion allocable to Israeli beneficiaries, or

o   Delay the tax until distributed to an Israeli beneficiary, at which time the tax will be 30%.

·        A non-relatives trust

o   Pay tax on income allocable to Israeli beneficiaries at regular tax rates (meaning up to 52%)

If one does nothing by the end of 2014, a relatives trust is presumed to have elected the “pay currently” regime.

The ITA has indicated verbally that any U.S. tax paid will be accepted as a tax credit against the Israeli tax, whether the tax was paid by the settlor (think grantor trust), the trust itself or the beneficiary.

The retroactive part of the tax goes back to 2006, and the ITA is allowing two ways for beneficiary trusts to settle up:

·        The trust can pay a portion of its regular tax liability, depending upon the influence on the trust by the Israeli beneficiary.

·        The trust can pay tax on the value of the trust as of December 31, 2013.

Again, the rules have changed, and – if this is you – please contact your attorney or other advisor immediately. 

Jurate Antioco's Nightmare On IRS Street

Ms. Jurate Antioco lived in Martha’s Vineyard, where she owned a bed and breakfast with her husband. The B&B was their home. In 2006 they divorced (after 27 years) and sold the B&B for almost $2 million. They used some of the money to pay off marital debt, but over $1 million went to her after she was unable to finish a Section 1031 exchange within the permitted time.

After approximately 1 year, she took the money and borrowed another $950,000 to buy a multifamily in San Francisco. She moved into one unit, moved her 90-something-year-old mother into another and rented the remaining three units as a source of income.

Ms. Antioco made a mistake concerning her taxes, though. She thought that – perhaps because the B&B had been her residence – that she would not owe any taxes. She fell behind in filing her 2006 taxes but did better with 2007. Her accountant informed her that she owed taxes on the sale for 2006. She was unprepared for this, as she had put almost all her money in the multifamily. She filed the tax returns, though.

The IRS of course assessed tax, interest and penalties. It is what they do.

In April, 2009 the IRS sends her a notice of intent to levy. Ms. Antioco has all her money tied up in the multifamily, so she filed for a collection due process (CDP) hearing.  She proposed paying $1,000 per month until she could work out a loan. She explained that her mom was having health issues, she was moving into caregiver mode, and anything more than $1,000 at the moment would cause economic hardship. As a show of good faith, she started paying $1,000 a month.

She contacted other lenders about a loan, but she soon learned that she had a problem. Even though she had considerable equity in the property, her current lender had included a nuclear option in the mortgage giving them the right to foreclose if another lien was put on the building

OBSERVATION: There is a very good reason to request a CDP, as the IRS will routinely file a lien to secure its debt. This could have been very bad for Ms. Antioco.

She goes back to the primary lender, and they tell her that they are not interested in loaning her any more money.

She has a problem.

The IRS sends her paperwork (Form 433-A) and schedules a hearing for September, 2009. The IRS tells her that she simply has to try to borrow before they will consider an installment plan. If she cannot, then proof of that must also be submitted.

She finds another lender and a better interest rate. The new lender will refinance but not lend any new money. Still, a lower payment frees-up cash, so Ms. Antioco decides to refinance. The new lender wants her to put her mom on the deed, which she does by granting her mother a joint tenancy in the property.

She sends her financial information (the Form 433-A), along with supporting bank documentation and a copy of her most recent tax return, to the IRS. She hears nothing.

In November, 2009 she received a notice from the IRS stating that they were sustaining the levy. The notice stated that she had requested a payment plan, but she had failed to provide additional financial information. In addition the IRS completely blew off her economic hardship argument.

Ms. Antioco appealed to the Tax Court. She pointed out that she was never asked for additional financial information, and –by the way – what happened to her economic hardship request?

And then something amazing happened: the IRS pulled the case, admitting to the Court that the Appeals officer had never requested additional financial information and had in fact abused her discretion.

The Court sent the matter back to IRS Appeals, hoping that the system would work better this time.

Uh, sure.

Enter Alan Owyang. The first thing he did was call Ms. Antioco to schedule a face-to-face meeting and review detailed questions. . Ms. Antioco explained that she would call back later that day, as she wanted to collect her documents to help her with the detailed questions. Owyang didn’t wait, and he kept calling her back that same day. At one point her accused her of being “uncooperative’ and that she “put your money where your mouth is.” He added that he had been a witness in her case.

Ms. Antioco was so rattled that she hired an attorney. Sounds like a great idea to me.

Mr. Owyang sent her a letter a few days later, saying that he thought Ms. Antioco had added her mother to the deed to defraud the government and that he also thought she could pay her taxes but “simply chose not to do so.” He asked for all kinds of additional paperwork, but not curiously no new financial information – the very reason the Tax Court sent the matter back to IRS Appeals. 

Her attorney submitted a bundle of information and requested another CDP hearing for April, 2011. He explained to Mr. Owyang that Ms. Antioco’s mother was declining and would (likely) not survive a sale and move from the apartment building. All Ms. Antioco wanted was time – to allow her mom to pass away or to finally get a new loan – after which she would able to pay the balance of the tax. She was willing to pay under a short-term installment plan until then.

Mr. Owyang told the attorney that he would not grant an installment agreement because Ms. Antioco had chosen to transfer the equity in the apartment building by adding her mother to the deed. He could not see another reason for it.

·        Even though he had a letter from the lender stating it wasn’t willing to lend any more money. And to include her mom on the deed if she wanted to refinance.

He refused to consider whether there was any “hardship.”

·        One of the reasons it went back to the IRS to begin with.

He also thought that all the talk about taking care of a 90-something-year-old mom was a “diversionary argument” that he “would not consider.”

·        I am stunned.

Mr. Owyang also contacted the IRS Compliance Division. He said that the government’s interest was in “jeopardy,” and he recommended that the IRS file a manual lien. There were problems with the filing, and Mr. Owyang went out of his way to follow up personally.

In May, 2011 Mr. Owyang filed a supplemental notice of determination, concluding that Ms. Antioco had “fraudulently” transferred the building to her mother. He went all Sherlock Holmes explaining how he had deduced that Ms. Antioco had committed fraud, concealed the transfer, became insolvent because of it and was left without any assets to pay the government. It was his judgement that she could have gotten a loan if she really wanted one, and that Ms. Antioco was a “won’t pay taxpayer” who was using her ailing mother as an “emotional diversion.”

This guy is a few clowns short of a circus.

They are back in Tax Court. The IRS this time sees nothing wrong with Mr. Owyang's behavior. They did however acknowledge that Mr. Owyang never ran the numbers to see if Ms. Antioco was insolvent, and that his determination of fraud was … “flawed.”

But Mr. Owyang had not abused his discretion. No sir!! Not a smidgeon.

The IRS wanted the Court to dismiss the case.

The Court instead heard the case.

The Court went through the steps, noting that the Commissioner can file liens to secure the collection of an assessed tax.  The IRS however must follow procedures, such as notifying the taxpayer, granting a collections appeal if the taxpayer requests one, and so on. The taxpayer had proposed a payment alternative, and the IRS never completed its analysis of her proposed payment plan. The IRS had also failed to consider her complaint of economic hardship.

The IRS did not follow procedure.

The Court then reviewed Mr. Owyang’s behaviors and assertions, refuting each in turn. The Court even pointed out that Ms. Antioco had paid down her tax debt by $88,000 by the time of trial, not exactly the conduct of someone looking to shirk and run. The Court was not even sure what Mr. Owyang’s real reason was for his determination, as his reasons were contradicted by documentation in file, not to mention changing over time.

The Court decided that Mr. Owyang had abused his discretion.

In February, 2013 the Court sent the case back to the IRS again, as the IRS never reviewed whether the $1,000 was a reasonable payment plan.

Back to the IRS. Introduce a new Appeals officer.

Ms. Antioco then filed suit against the IRS for wrongful action – that is, over the behavior of Mr. Owyang. This type of suit is very difficult to win. Ms. Antioco focused her arguments on Mr. Owyang’s abusive behavior.  The District Court determined that this behavior occurred while Mr. Owyang was “reviewing” collection action and not actually “conducting” collection, which barred liability under Section 7433.

OBSERVATION: No, he was “collecting.” What is a lien, if not a collection action?

In June 2013 the IRS finally agreed to an installment payment plan.

In July, 2014 the IRS filed suit to reduce Ms. Antioco’s liability to judgment. Reducing an assessment to judgment gives the IRS the ability to collect long after the 10-year statute of limitations.

Ms. Antioco filed a motion to dismiss.

Her reason for requesting dismissal? The tax Code itself. Code Section 6331(k)(3)(A) bars the IRS from bringing a proceeding in court while an installment agreement is in effect.

The IRS realized it got caught and last month agreed to dismiss.

And that is where we are as of this writing.

For a tax pro, the Jurate Antioco cases have been interesting, as they highlight the importance of following procedural steps when matters get testy with the IRS. From a human perspective, however, this is a study of a government agency run amok.  How often does the IRS get spanked twice by the Tax Court for abuse on the same case?

Ms. Antioco’s mom, by the way, is now 97 years old and suffering from congestive heart failure. Ms. Antioco is herself a senior citizen. May they both yet live for a very long time.

Is Suing Your Tax Advisor Taxable?

For those who know me or occasionally read my blog, you know that I am not a “high wire” type of tax practitioner. Pushing the edges of tax law is for the very wealthy and largest of taxpayers: think Apple or Donald Trump. This is – generally speaking - not an exercise for the average person. 

I understand the frustration. A number of years ago I was called upon to research the tax consequence for an ownership structure involving an S corporation with four trusts for two daughters. This structure predated me and had worked well in profitable years, but I (unfortunately) got called upon for a year when the company was unprofitable. The issue was straightforward: were the losses “active” or “passive” to the trusts and, by extension, to the daughters behind the trusts. There was some serious money here in the way of tax refunds – if the trusts/daughters could use the losses. This active/passive law change happened in 1986, and here I was researching during the aughts – approximately 20 years later. The IRS had refused to provide direction in this area, although there were off record comments by IRS officials that were against our clients’ interests. I strongly disagreed with those comments, by the way.

What do you do?

I advised the client that a decision to claim the losses would be a simultaneous decision to hire a tax attorney if the returns got audited and the losses disallowed. I believed there was a reasonable chance we would eventually win, but I also believed we would have to be committed to litigation. I thought the IRS was unlikely to roll on the matter, but our willingness to go to Tax Court might give them pause. 

I was not a popular guy.

But to say otherwise would be to invite a malpractice lawsuit should the whole thing go south.

And this was a fairly prosaic area of tax law, far and remote from any tax shelter. There was no “shelter” there. There was, rather, the unwillingness of the IRS to clarify a tax law that was old enough to go to college.

I am reading about a CPA firm that decided to advise a tax shelter. It went south. They got sued. It cost them $375,000.

Here is a question that we have not discussed before: is the $375,000 taxable to the (former) client?

Let’s discuss the case.

The Cosentinos and their controlled entities (G.A.C. Investments, LLC and Consentino Estates, LLC) had a track record of Section 1031 exchanges and real estate.

COMMENT: A Section 1031 is also known as a “like kind” exchange, whereby one trades one piece of property for another. If done correctly, there is no tax on the exchange.

The Consentinos played a conservative game, as they had an adult disabled daughter who would always need assistance. They accumulated real estate via Section 1031 transactions, with the intent that – upon their death – the daughter would inherit. They were looking out for her.

They were looking at one more exchange when their CPA firm presented an alternative tax strategy that would allow them to (a) receive cash from the deal and (b) defer taxes. The Consentinos had been down this road before, and receiving cash was not their understanding of a Section 1031. Nonetheless the advisors assured them, and the Consentinos went ahead with the strategy.

OBSERVATION: It is very difficult to walk away from a Section 1031 with cash in hand and yet avoid tax.

Wouldn’t you know that the strategy was declared a tax shelter?

The IRS bounced the whole thing. There was almost $600,000 in federal and state taxes, interest and penalties. Not to mention what they paid the CPA firm for structuring the transaction.

The Consentinos did what you or I would do: they sued the CPA firm. They won and received $375,000. They did not report or pay tax on said $375,000, reasoning that it was less than the tax they paid. The IRS sent them a love letter noting the oversight and asking for the tax.

Both parties were Tax Court bound.

The taxpayers relied upon several cases, a key one being Clark v Commissioner. The Clarks had filed a joint rather than a married-filing-separately return on the advice of their tax advisor. It was a bad decision, as filing-jointly cost them approximately $20,000 more than filing-separately. They sued their advisor and won.

The Court decided that the $20,000 was not income to the Clarks, as they were merely being reimbursed for the $20,000 they overpaid in taxes. There was no net increase in their wealth; rather they were just being made whole.

The Clark decision has been around since 1939, so it is “established” law as far as established can be.

The Court decided that the same principle applied to the Cosentinos. To the extent that they were being made whole, there was nothing to tax. This meant, for example:

·        To extent that anything was taxable, it shall be a fraction (using the $375,000 as the numerator and total losses as the denominator).

·        The amount allocable to federal tax is nontaxable, as the Cosentinos are merely being reimbursed.

·        The amount allocable to state taxes however will be taxable, to the extent that the Cosentinos had previously deducted state taxes and received a tax benefit from the deduction.

·        The same concept (as for state taxes) applied to the accounting fees. Accounting fees would have been deducted –meaning there was a tax benefit. Now that they were repaid, that tax benefit swings and becomes a tax detriment, resulting in tax.

There were some other expense categories which we won’t discuss.

By the way, the Court’s reasoning is referred to as the “origin of the claim” doctrine, and it is the foundation for the taxation of lawsuit and settlement proceeds.  

So the IRS won a bit, as the Cosentinos had excluded the whole amount, whereas the Court wanted a ratio, meaning that some of the $375,000 was taxable.

Are you curious what the CPA firm charged for this fiasco?

$45,000.

Happy Thanksgiving

When Does A Grocery Store Get To Deduct the Fuel Points You Receive?

There is a grocery store chain that my wife uses on a regular basis. They have a gasoline-discount program, whereby amounts spent on purchasing groceries go toward price discounts on the purchase of gasoline. As the gas stations are adjacent to the grocery store, it is a convenient perk.

I admit I used the discount all the time. I purchased a luxury car this year, however, and my mechanic has advised me not to use their gasoline. It sounds a bit over the top, but until I learn otherwise I am purchasing gasoline elsewhere. My wife however continues as a regular customer.

Giant Eagle is a grocery store chain headquartered out of Pittsburgh. They have locations In Pennsylvania, Ohio, West Virginia and Maryland. They have a similar fuel perk program, except that their gasoline station is called “GetGo” and their fuel points are called “fuelperks!”

Their fuelperks! operate a bit differently, though. The perks expire after three months, and they reduce the price of the fuel to the extent possible. I suppose it is possible that they could reduce the price to zero. My fuel points reduce the price of a gallon by 10-cent increments, up to a ceiling. I am not going to get to zero.

Giant Eagle found itself in Tax Court over its 2006 and 2007 tax returns. The IRS was questioning a deduction on its consolidated tax return: the accrued liability for those fuelperks! at year-end. The liabilities were formidable, amounting to $6.1 million and $1.1 million for 2006 and 2007, respectively. Multiply that by a corporate tax rate of 34% and there are real dollars at stake.

What are they arguing over?

To answer that, let’s step back for a moment and talk about methods of accounting. There are two broad overall methods: the cash method and the accrual method. The cash method is easy to understand: one has income upon receiving money and has deductions upon spending money. There are tweaks for uncashed checks, credit cards and so forth, but the concept is intuitive.

The accrual method is not based on receiving or disbursing cash at all. Rather, one has income when monies are due from sale of product or for performance of services. That is, one has income when one has a “receivable” from a customer or client. Conversely one has a deduction when one owes someone for the provision of product or services. That is, one has a “payable” to a vendor, government agency or employee.

If one has inventories, one has to use the accrual method for tax purposes. Take a grocery store – which is nothing but inventory – and Giant Eagle is filing an accrual-basis tax return. There is no choice on that one.

There are additional and restrictive tax rules that are placed on “payables” before one is allowed to deduct them on a tax return. These are the “all events” rules, are found in IRC Section 461(h), and have three parts:

·        Liability must be fixed as of year end

·        Liability must be determined with reasonable accuracy

·        Economic performance must occur

Why all this?

Congress was concerned that accrual taxpayers could “make up” deductions willy-nilly absent more stringent rules. For example, a grocery store could argue that its coolers were continuously wearing out, so a deduction for a “reserve” to replace the coolers would be appropriate. Take the concept, multiply it by endless fact patterns and – unfortunately – Congress was probably right.

All parties would agree that Giant Eagle has a liability at year-end for those fuel points. Rest assured that the financials statement auditors are not have any qualms about showing the liability. The question becomes: does that liability on the financial statements rise to the level of a deduction on the tax return?

You ever wonder what people are talking about when they refer to a company’s financial statements and tax return and say that there are “two sets of books?” Here is but a small example of how that happens, and it happens because Congress made it happen. There are almost endless examples throughout the tax Code.

The IRS is adamant that Giant Eagle has not met the first requirement: the “liability must be fixed.”

To a non-tax person, that must sound like lunacy. Giant Eagle has tens of thousands of customers throughout multiple states, racking up tons of fuel discount points for the purchase of gasoline at – how convenient – gasoline stations right next to the store. What does the IRS think that people are going to do with those points? Put them on eBay? If that isn’t a liability then the pope is not Catholic.

But consider this…

The points expire after three months. There is no guarantee that they are going to be used.

OK, you say, but that does not mean that there isn’t a liability. It just means that we are discussing how much the liability is. The existence of the liability is given.

COMMENT: Say, you have potential as a tax person, you know that?

That is not what the IRS was arguing. Instead they were arguing that the liability was not “fixed,” meaning that all the facts to establish the liability were not in.

How could all the facts not be in? The auditors are going to put a liability on the year-end audited financial statements. What more do you want?

The IRS reminds you that it refuses to be bound by financial statement generally-accepted-accounting-principles accounting. Its mission is to raise and collect money, not necessarily to measure things the way the SEC would require in a set of audited financial statements in order for you not to go to jail. In fact, if you were to release financial statements using IRS-approved accounting you would probably have serious issues with the SEC.

OK, IRS, what “fact” is missing?

The customer has to return. To the gasoline station. And buy gasoline. And enough gasoline to zero-out the fuel points. Until then all the facts are not in.

Another way of saying it is that there is a condition precedent to the redemption of the fuel points: the purchase of gasoline. Test (1) of Sec 469(h) does not allow for any conditions subsequent to the liability in order to claim the tax deduction, and unfortunately Giant Eagle has a condition subsequent. No deduction for you!

Mind you the deduction is not lost forever. It is delayed until the following year, because (surely) by the following year all the facts are in to establish the liability. The effect is to put a one-year delay on the liability: in 2008 Giant Eagle would deduct the 12/31/2007 liability; in 2009 it would deduct the 12/31/2008 liability, and so on.

And the government gets its money a year early. It is a payday-lender mentality, but there you are.

BTW test (1) is not even the difficult part of Section 469(h). That honor is reserved for test (3): the economic performance test. Some day we will talk about it, but not today. That one does get bizarre.