Substantially Disclosing A Gift To The IRS

Take a look at this memorable prose:

         Sec 6501(c) (9) Gift tax on certain gifts not shown on return.

If any gift of property the value of which (or any increase in taxable gifts required under section 2701(d) which) is required to be shown on a return of tax imposed by chapter 12 (without regard to section 2503(b) ), and is not shown on such return, any tax imposed by chapter 12 on such gift may be assessed, or a proceeding in court for the collection of such tax may be begun without assessment, at any time. The preceding sentence shall not apply to any item which is disclosed in such return, or in a statement attached to the return, in a manner adequate to apprise the Secretary of the nature of such item.

I get it: if you never disclose the gift, the IRS can come after you until the end of time. The reverse is what concerns us today: if you disclose the gift “in a manner adequate,” then the IRS does not have until the end of time.

Gift tax cases can be … idiosyncratic, to be diplomatic. All tax is personal, but gift tax can be Addams Family idiosyncratic.

Ronald Schlapfer (RS) was a Swiss-born businessman. He had ties to both Switzerland and the United States. He owned a life insurance policy issued in 2006.The policy in turn owned all the stock in EMG, a Panamanian company previously owned by RS.

It was 2006 and RS was a nonresident of the U.S. He gifted his interest in EMG to his mother, aunt and uncle.

He obtained U.S. citizenship in 2008.

Got it: he gifted before he became subject to U.S. gift tax.

In 2013 – and after obtaining his citizenship – RS decided to play it safe and submitted an offshore voluntary disclosure filing with the IRS. It included a gift tax return for 2006, which informed the IRS of the gift to his family. The return included the following:

“A protective filing is being submitted. On July 6, 2006, taxpayer made a gift of controlled foreign company stock valued at $6,056,686 per U.S. Treasury Regulation 25.2501-1(B). The taxpayer is not subject to U.S. gift tax as he did not intend to reside permanently in the United States until citizenship was obtained in 2008.”

COMMENT: In this situation, a protective filing means that the taxpayer is unsure if a filing is even required but is submitting one, nonetheless. It is an attempt to backstop penalties and other bad things that could happen from a failure to file.

COMMENT: International practice has become increasingly paranoid for many years now. The IRS seems convinced that every UBER driver has unreported foreign accounts, and one’s failure to follow arbitrary and obscure rules are a per se admission of culpability. In this case, for example, there was technical doubt whether the gift was reportable as the transfer of a life insurance policy or as the transfer of a company owned by that policy. Why was there doubt? Well, the IRS itself created it. Rest assured, whichever way you chose the IRS would fall the other way.

The IRS disagreed that the gift occurred in 2006. There was a hitch in the transfer, and the attorney did not resolve the matter until 2007. RS in turn argued that 2007 was but a scrivener’s error. According to well-trod ground, a scrivener’s error is considered administrative, not substantive, and does not mark the actual date of the underlying transaction.

Sometime in here RS agreed to extend the limitations period.

In 2019 the IRS issued the statutory notice of deficiency (SNOD). That is also called a 90-day letter, and it meant that the next step was Tax Court - if RS wanted to further pursue the matter.

Off to Tax Court they went.

RS’ argument was simple: the statute of limitations had expired.

The IRS argued that the gift was not adequately disclosed.

The IRS argued that disclosure requires the following:

·       Description of the property gifted, and any consideration received by the donor.

·       The identity and relationship between the parties.

·       There is additional disclosure for property is transferred in trust.

·       A detailed explanation of how one arrived at the fair market value of the property gifted.

·       Whether one has taken a position contrary to any Regulations or rulings

The IRS was trying to catch RS in the first requirement above: a description of the property gifted.

Was it an insurance policy, ownership in a company, or something else?

Here is the Court:

While Schlapfer may have failed to describe the gift in the correct way, he provided enough information to identify the underlying property that was transferred.”

RS won his case. The IRS had blown the statute of limitations.

Our case this time was Schlapfer v Commissioner, T.C. Memo 2023-65.

Tax Preparer Gives Gambler A Losing Hand

 

I am looking at a bench opinion.

The tax issue is relatively straightforward, so the case is about substantiation. To say that it went off the rails is an understatement.

Let us introduce Jacob Bright. Jacob is in his mid-thirties, works in storm restoration and spends way too much time and money gambling. The court notes that he “recognizes and regrets the negative effect that gambling has had on his life.”

He has three casinos he likes to visit: two are in Minnesota and one in Iowa. He does most of his sports betting in Iowa and plays slots and table games in Minnesota.

He reliably uses a player’s card, so the casinos do much of the accounting for him.

Got it. When he provides his paperwork to his tax preparer, I expect two things:

(1)  Forms W-2G for his winnings

(2)  His player’s card annual accountings

The tax preparer adds up the W-2Gs and shows the sum as gross gambling receipts. Then he/she will cross-check that gambling losses exceed winnings, enter losses as a miscellaneous itemized deduction and move on. It is so rare to see net winnings (at least meaningful winnings) that we won’t even talk about it.

COMMENT: Whereas the tax law changed in 2018 to do away with most miscellaneous itemized deductions, gambling losses survived. One will have to itemize, of course, to claim gambling losses.   

Here starts the downward cascade:

Mr. Bright hired a return preparer who was recommended to him, but he did not get what or whom he expected. Rather than the recommended preparer, the return preparer’s daughter actually prepared his return.”

OK. How did this go south, though?

The return preparer reported that Mr. Bright was a professional gambler ….”

Nope. Mind you, there are a few who will qualify as professionals, but we are talking the unicorns. Being a professional means that you can deduct losses in excess of winnings, thereby possibly creating a net operating loss (NOL). An NOL can offset other income (up to a point), income such as one’s W-2. The IRS is very, very reluctant to allow someone to claim professional gambler status, and the case history is decades long. Jacob’s preparer should have known this. It is not a professional secret.

Jacob did not review the return before signing. For some reason the preparer showed over $240 grand of gross gambling receipts. I added up the information available in the opinion and arrived at little more than $110 grand. I have no idea what she did, and Jacob did not even realize what she did. Perhaps she did not worry about it as she intended the math to zero-out.

She should not have done this.

The IRS adjusted the initial tax filing to disallow professional gambler status.

No surprise.

Jacob then filed an amended return to show his gambling losses as miscellaneous itemized deductions. He did not, however, correct his gross gambling winnings to the $110 grand.

The IRS did not allow the gambling losses on the amended return.

Off to Tax Court they went.

There are several things happening:

(1)  The IRS was arguing that Jacob did not have adequate documentation for his losses. Mind you, there is some truth to this. Casino reports showed gambling activity for months with no W-2Gs (I would presume that he had no winnings, but that is a presumption and not a fact). Slot winnings below $1,200 do not have to be reported, and he gambled on games other than slots. Still, the casino reports do provide some documentation. I would argue that they provide substantiation of his minimum losses.

(2)  Let’s say that the IRS behaved civilly and allowed all the losses on the casino reports. That is swell, but the tax return showed gambling receipts of $240 grand. Unless the casino reports showed losses of (at least) $240 grand, Jacob still had issues.

(3)  The Court disagreed with the IRS disallowing all gambling deductions. It looked at the casino reports, noting that each was prepared differently. Still, it did not require advanced degrees in mathematics to calculate the losses embedded in each report. The Court calculated total losses of slightly over $191 grand. That relieved a lot – but not all – of the pressure on Jacob.

(4)  Jacob did the obvious: he told the Court that the $240 grand of receipts was a bogus number. He did not even know where it came from.

(5)  The IRS immediately responded that it was being whipsawed. Jacob reported the $240 grand number, not the IRS. Now he wanted to change it. Fine, said the IRS: prove the new number. And don’t come back with just numbers reported on W-2Gs. What about smaller winnings? What about winnings from sports betting? If he wanted to change the number, he was also responsible for proving it.

The IRS had a point. It was being unfair and unreasonable but also technically correct.

Bottom line: the IRS was not going to permit Jacob to reduce his gross receipts number without some documentation. Since all he had was the casino reports, the result was that Jacob could not change the number.

Where does this leave us? I see $240 – $191 = $49 grand of bogus income.

My takeaway is that we have just discussed a case of tax malpractice. That is what lawyers are for, Jacob.

Our case this time was Jacob Bright v Commissioner, Docket No. 0794-22.

Backup Withholding On A Gig Worker

I am minding my own business when an IRS notice lands in my office. Here is a snip:

Question: is this bad?

Answer: it might be.

Let’s talk about it.

The IRS requires Form 1099-NEC be provided a nonemployee service provider paid over $600 over the course of a year. This is the tax form sent to self-employeds and gig workers.

The acronym “BWH” means backup withholding.

So, we are talking about withholding on nonemployees.

How can this be? Employee withholding is easy to understand: federal income tax, FICA, state income tax and whatnot. Anyone who is a W-2 has seen it – or is seeing it – every pay date. But there is no withholding on a nonemployee. A nonemployee is responsible for his/her own taxes. How do we even get here?

There are several ways. Let’s go through two.

Let’s say that I own a business called Galactic. Galactic hires someone to take care of our IT system. That someone is named Rick, and Rick does business as REM Consulting.

OK.

Rick does work. He sends an invoice for $750. Galactic pays him $750.

Here is our first way to backup withholding.

Rick immediately exceeded the $600 hurdle. He provided covered services, i.e., he is a gig worker. Galactic will send Rick a 1099-NEC at year-end. Presently, that 1099 is at $750. It will increase every time Rick does additional work.

Galactic needs some information from Rick to prepare that 1099: a name, an address, and a taxpayer identification number (TIN). I expect the name and address to be easy, as that would be on Rick’s business card or invoice. The TIN might not be so easy. A common TIN is a social security number. I guess Rick could provide Galactic his SSN, but then again, Rick might not be keen with passing-out his SSN all day every day.

Rick instead is thinking of making REM Consulting a single member LLC. Why? The default tax rule is to disregard a single member LLC as a separate entity. To the IRS, REM Consulting is just Rick (mind you, state rules may be different). Why bother, you wonder? Because REM Consulting can get its own employer identification number (EIN). If I were Rick, I would use that EIN instead of my SSN for all business purposes.

COMMENT: If you read the instructions, REM Consulting technically does not have to apply for an EIN until it has employees. That is true but beside the point. We automatically request an EIN for all new LLC’s – single member or not.

Back to the first way into backup withholding.

Galactic asks Rick for a TIN. Rick says “No.” Why? Because we need Rick to say “No” to continue our discussion.

Galactic is required to start backup withholding immediately, as Rick has already cleared the $600 floor. The withholding rate is 24%. Galactic will withhold $180 and send Rick a check for $570. Galactic will of course have to send that $180 to the IRS (it is withholding after all). Hopefully Rick relents and provides a TIN. If so, Galactic will include his TIN and withholding on the 1099-NEC, and Rick can get his withholding back when he files his personal return.

A second way is when the payor has the wrong TIN. Let’s say that Rick gave Galactic his EIN, but Galactic wrote it down incorrectly. Galactic and Rick are a year into their relationship, and everything is going well, except that Galactic receives a letter from the IRS saying that that Rick’s 1099-NEC is incorrect. The name and TIN do not match.

There is a short period of time allowed for Galactic to review its records and get with Rick if necessary. If the matter is resolved (someone wrote the TIN down incorrectly, for example), then Galactic corrects the matter going forward. That is that, and no backup withholding is required. Galactic does not even have to contact the IRS for permission.

However, say the matter is not resolved. Rick has no interest in helping. Galactic will have to start backup withholding on its next payment to Rick. Mind you, it can later stop withholding if Rick comes to his senses.

Withholding is a pain. There is additional accounting, then one must remit the money to the government and file additional tax returns. Every step has due dates and penalties for not meeting those dates.

Let’s say you receive that IRS notice and blow it off. After all, what is the worst the IRS can do, you ask.

Well, they can hold you responsible for the withholding.

But I didn’t withhold, you answer.

They don’t care. They want their money. You were supposed to withhold from Rick and remit. You chose not to withhold. You now have substitute liability and will have to reach into your own pocket and remit. Perhaps you can ask Rick for reimbursement, but you probably should not pack luggage for that trip.

A few more things about backup withholding:

• There is a form to provide your TIN (of course): Form W-9. It is extremely likely you filled one out when you started your job.
• You might be surprised how many different types of income are subject to backup: interest, dividends, rents and so on. It is not limited to gig income.
• A famous exception to backup is retirement income. Realistically, though, you won’t be able to even open an IRA account with the major players (Vanguard, Fidelity and so on) without providing a TIN upfront.
• It can apply to nonresident foreign nationals, although the withholding rate is different.
• The way to stop backup is to correct the situation that created it in the first place: that is, provide your TIN.

A difference between the two scenarios is when responsibility for withholding begins:

In scenario one, it begins with the first payment to Rick.

In scenario two, it begins more than a year later, upon receipt of a notice from the IRS.

Both scenarios can be bad, but scenario one especially so. At least scenario two is prospective (assuming you do not blow off the multiple notices the IRS will send).

Back to the start of this post. Which scenario do I have: scenario one or scenario two?

I do not know at this moment.

Let’s hope it is not bad. 

Penalty Abatement For Preparer Errors

 

I was looking over a law review article weighing the pros and cons of different types of Tax Court decisions.

Nerd train, I admit.

But there is something here to talk about.

There are several types of Tax Court opinions. Some have precedential value, and some do not. Precedence means that a Court applies the law in the same manner to cases with the same facts.

One type is a Memorandum opinion. These tend to be heavily factual, and they involve relatively well-settled law.

Another is the Summary (or S) opinion. These involve a relatively modest amount of tax (currently $50 grand) and use a streamlined set of procedures.

The reason for different types of opinion is grounded in practicality. Memo opinions allow the Court to process more clear-cut cases without worrying about establishing unanticipated precedent. The S opinions allow taxpayers a forum without having to hire an attorney to navigate cumbersome Tax Court procedural rules.

I am looking at a case decided as a bench opinion. 

Think about the judge issuing an oral opinion right there and then and you have a bench opinion.

And these types can be combined. A judge may, for example, issue a bench opinion in a memo or S case.

I am looking at something I know all too well.

Mr. Trammer was an IT consultant.

Mrs. Trammer was a social worker.

Mr. Trammer worked primarily from home. Depending upon, he was paid as a W-2 employee or as a 1099 gig worker. He had an office-in-home and all that.

Mrs. Trammer was a W-2 employee. She drove around Michigan visiting childcare and foster care locations. She at times would purchase gifts for the kids.

She sounds like a good person.

They reported all kinds of deductions on their 2019 and 2020 returns: business deductions for the gig, employee business deductions for the social work, charitable deductions for the church.

If you recall, many itemized deductions were reduced or eliminated altogether beginning in 2018.

No surprise, the IRS disallowed a swath of deductions. Some – like employee business deductions – simply did not exist for the tax year at issue. Others – like office-in-home for the gig – had calculation errors.

Got it. They need to dig up documentation. They should immediately concede on the calculation error and employee expenses. The matter should be resolved as routine in correspondence exam.

Off to Tax Court they went.

Huh?

Upon reflection, this makes sense. The IRS and Covid did not play well together. They were not answering the phones over there. Faxing supporting documentation to the AUR Unit was often a joke. I suspect this matter went to Court by default.

Here we go:

The Trammers relied on a paid return preparer to prepare their returns for the years at issue. Although the individual return preparers identified on the 2019 and 2020 returns differed, the Trammers used the same preparation firm for both years.”

That does not sound like a CPA firm. Granted, I prepare only a fraction of returns I sign - staff accountants generally prepare - but I do review all returns before signing. 

Each year, they brought their records … who decided what items to report on the Trammers’ return and where.”

Yep.

The returns contained obvious errors such as reporting the same expense in multiple places.”

The old list-the-same-thing-over-and-over routine. Often these returns are not complex, but the preparer must be diligent when moving numbers. It consequently is common to give these returns to more experienced staff. Ideal would be to give the return to the same experienced staff every year.

The Court made short work of the returns.

Schedule C/Gig work

They failed to demonstrate the amount of expenses that they incurred or the business purposes for those expense, and they did not provide sufficient evidence from which the Court could formulate an estimate.”

Form 2106/employee business expenses

… the Trammers failed to substantiate the expenses Mrs. Trammer incurred in the conduct of her social work.”

Schedule A/Itemized Deductions

The Trammers failed to substantiate itemized deductions in excess of the standard deduction amounts that the Commissioner allowed…”

The IRS wanted penalties. They always do.

Not his time. Here is the Court:

The Trammers relied on a return preparer to whom they had been referred. They supplied the return preparer with necessary and accurate information each year, and the return preparer decided what to do with that information. The Trammers reasonably relied in good faith on their return preparer’s judgement. Accordingly, the section 6662 accuracy-related penalty does not apply for the years in issue.”

I am impressed, as I was expecting a rubber stamp.

What was different this time?

For one thing, Mr. Trammer showed up for the trial, and Mrs. Trammer participated via conference call. This gave them a chance to humanize their situation. While not conceding the errors, the Court did believe them when they said they tried. The Court, however, was not as kind to the preparer.

And remember: the next person cannot use this case (technically) as precedent in a future penalty. The Court had room to be lenient.

Our case this time was Trammer v Commissioner, TC Bench Order March 14, 2023.

Do Not Do This When Buying Disability Insurance

 

It is a tax trap. An employer thinks that they are doing a boon for their employees by providing a tax-exempt fringe benefit.

Where is the trap?

CTG: it has to do with insurance.

I don’t get it, you say. My employer pays for some/most/all my health insurance. When I see a doctor, the insurance pays some, I pay some. Granted, some health insurances are better than others, but where is the trap?

CTG: it is not health insurance.

I get life insurance at work, you continue. It is equal to a year’s salary or something like that. I have noticed that they charge me something for this on my W-2 every year.

CTG: Life insurance has a split personality. An employer can offer you up to $50 thousand of life insurance as a nontaxable fringe. Any insurance above that amount (for example, if your annual salary is more than $50 grand) is taxable to you. Mind you, the charge tends to be minimal - as the IRS uses favorable rates - but you are charged something.  

It is not life insurance.

It is disability insurance.

Let’s look at John Linford.

John sold Medicare supplement and Medicare Advantage plans. His employer decided to do a nice, and in 2011 it purchased a group disability policy from Principal Life. On the plan’s first iteration, the company paid 100% of the premiums. In 2013 the plan was amended, giving the company the option to charge an employee 25% of the premiums. The company said “nah” to the option, choosing to continue paying 100% of the premiums.

At first blush, this sounds like a beneficent employer.

John incurred a disability in 2014. He filed a worker’s compensation claim in December 2014.

John was fired a year later, in November 2015.

This may still be a beneficent employer. They might have been assisting John in getting to that disability policy.

In May 2017 Principal Life approved his disability claim.

At that speed, one could be homeless before the insurance kicks-in.

Principal Life paid him a $105 grand in retroactive benefits.

John heard that disability is generally nontaxable.

Yep.

John left the $105 grand off his tax return.

Nope.

The IRS caught it, of course.

The IRS wanted almost $22 thousand in tax, as well as a penalty chop of over $4 grand.

Off to Tax Court they went.

There is a Code section for this type of employer-provided insurance: Section 105.

           § 105 Amounts received under accident & health plans.

(a)  Amounts attributable to employer contributions.

Except as otherwise provided in this section, amounts received by an employee through accident or health insurance for personal injuries or sickness shall be included in gross income to the extent such amounts (1) are attributable to contributions by the employer which were not includible in the gross income of the employee, or (2) are paid by the employer.

Read the verbiage at (a).

Except as otherwise provided, any accident or health insurance is taxable to the extent the employer provides the insurance as a tax-free benny. Wait, you say, what about health insurance? That is not taxable. True, but health insurance is nontaxable via the “except as otherwise provided” language. There is no such exception for disability insurance.

This stuff can be confusing.

John had one more swing at the plate. Remember that the company amended the plan allowing them to charge employees 25% of the cost. John wanted to know if there was some relief there. I get it: 25% nontaxable is not as good as 100% nontaxable, but it is better than 100% taxable.

The Court said no. Potential is not actuality, and John never paid any of the premiums.

What about the penalties? Did the Court cut John some slack? One can get confused here: one rule for health insurance, another rule for different insurance.

Based on the record the Court concludes that the petitioner husband did not have reasonable cause and did not act in good faith in not reporting the disability payments.”

The Court upheld the penalties. There went another $4-plus grand.

Some companies allow one to purchase short-term disability through their cafeteria plan. Mind you, this means that the premiums are paid with pre-tax money and will result in taxable income if benefits are ever collected. I tend to back-off on short-term disability, although I prefer that one pay with after-tax dollars for either short- or long-term disability.

I, however, feel strongly about paying after-tax for long-term disability. Those benefits may continue until you reach social security age, and you do not need to be dragging taxes behind you until then. The small rush of a tax-free benny is insignificant if you are ever – in fact – disabled.

Our case this time was Cynthia L Hailstone and John Linford v Commissioner, T.C. Summary Opinion 2023-17.

Losing A Casualty Loss

 

I have stayed away from talking about casualty losses.

To be fair, one needs to distinguish business casualty losses from personal casualty losses. Business casualties are still deductible under the Code. Personal casualties are not. This change occurred with the Tax Cut and Jobs Act of 2017 and is tax law until 2025, when much of it expires.

This is the tax law that did away with office-in-home deductions, for example. Great timing given that COVID would soon have multitudes working from home.

It also did away with personal casualty losses, with an exception for presidentially - declared disaster areas.

Have someone steal your personal laptop. No casualty loss. Accident with your personal car? No casualty loss. Lost your house during the storms and tornados in western Tennessee at the end of March 2023? That would be a casualty loss because there was a presidential declaration.

I consider it terrible tax law, but Congress was primarily concerned about finding money.  

I am reading a case that involves casualty losses. Two, in fact. The Court included several humorous flourishes in its decision.

Let’s go over it.

Thomas Richey and his wife Maureen Cleary bought a second home in Stone Harbor on Cape May in the south of New Jersey. The house was on the waterfront with access to the open ocean. They also bought a 40-foot boat.

Sounds nice.

In 2017 storm Stella hit.

Richey and Cleary claimed casualty losses totaling over $820,000 on their 2017 tax return.

That will catch attention.

Here is the Court:

Such a large loss - one that caused them to reduce their adjusted gross income of more than $850,000 to a taxable income of zero – bobbed into the Commissioner’s view, and he selected their return for audit.”

The Commissioner did more than select the return; he denied the casualty loss deduction altogether.

Richey and Cleary petitioned the Tax Court.

Yep. Had to.

Whereas they lived in Maryland (remember: New Jersey was their second home), they petitioned the Court for trial in Los Angeles.

I do not get the why. Very little upside. Possible massive downside.

We added the case to one of our trial calendars for Los Angeles, but on the first day of that session neither petitioner showed up.”

Uh, Richey …?!

We postponed trial for a day to enable Richey to testify via Zoom.”

Richey explained that he learned about the trial only a week before, and even then, no one gave him specific details.

We do not find this credible ….”

This could have started better. 

The couple’s case began taking on water right at the start…”

The Court seemed amused.

Back to business, Richey. Let’s first establish that a casualty occurred.

He testified that he had taken pictures of the damage to both boat and home on his phone shortly after the storm.”

Good.

He explained, however, that a later software update to his phone deleted them.”

Seriously?

That left him to introduce only photographs of the house taken … nearly a year after the storm hit and after reconstruction had already begun.”

A year? Were you that busy?

These photographs depict no visible damage other than that which one might see at any construction site, and we could see nothing that showed damage that we could specifically attribute to the storm. “

Richey, I have a question for you.

… we did not find Richey’s testimony, standing alone, credible on this point.”

Have you seen John Wick?

As for the boat, the couple introduces a photograph of what the boat looked like before the storm, but nothing to show what it looked like afterwards. The couple also gave us no receipts for any boat repairs.”

Tell me the truth: did you do something to this judge’s dog?

Whom are we to believe?”

Richey, this is legal-speak for “we do not believe you.”

OK, we are going to have to lean double hard on the appraisals. Those involve third parties, so maybe we can get the Court to back off a bit.

Richey and Cleary did not get an appraisal of their own home valuing it before and after the storm.”

And may I ask why, Richey?

Richey instead consulted a real-estate agent who provided them with Multiple Listing Service (MLS) printouts of other people’s homes. This is a problem for many different reasons.”

You think?

The first … is that he didn’t talk to this agent until after the audit had begun.”

I have an idea, Richey, but it’s a long shot.

It is not impossible for a homeowner to conduct an appraisal himself …”

Richey, go improv. You live in Cape May. You know the prices. You know the damage the storm wrought. Make the Court believe you. Sell it.

They also produced no evidence of their awareness of market conditions in Stone Harbor. What we got were photographs of MLS printouts.”

You are a man of commitment and sheer will, Richey.

We infer from Richey’s having to reach out to an agent to give him such comparables an unspoken admission that he is not qualified to conduct an adequate appraisal on his own.”

I am familiar with the parlance, Richey.

If the absence of proof of damage causes the couple’s case to founder, the absence of proof on valuing that damage causes it to sink altogether.”

Well, that’s that. Maybe we can get something on the boat.

Richey and Cleary fare no better on the loss they claim for their boat.”

Richey, walk out of here with your pride intact.

All these attacks by the Commissioner have picked completely clean the flesh of their claimed deduction.”

Richey, just walk out of here.

Richey’s first mistake was scheduling a Tax Court hearing in Los Angeles. That led to the disastrous failure-to-show, which clearly angered the Court. The Court felt they were being lied to, and they never relented. The lack of an appraisal – while not necessarily having to be fatal – was fatal in this case. Richey was unable to persuade the Court that he had the experience or expertise to substitute for an appraisal.    

Sometimes the Court will carry water for a petitioner who is underprepared. We have reviewed a couple of these cases before, but that beneficent result presupposes the Court likes the person. That was not a factor here.

Our case this time was Richey and Cleary v Commissioner, T.C. Memo 2023-43.

Blowing Up A Charitable Remainder Trust

I was helping a friend (and fellow CPA) with a split-interest trust this busy season.

Let’s review the tax jargon in this area.

A split-interest means that there are (at least) two beneficiaries to the trust, one of which is a charity.

There are two main types of split-interest trusts:

(1)  The charity gets use of the trust assets first, after which the assets go to the noncharitable beneficiaries.

This sounds a bit odd, but it can work with the right asset(s) funding the trust. Let’s use an example. Say that you own a modest suburban strip mall. You have a solid tenant or two, providing reliable cash flow. Then you have a theater which barely survived COVID, and that only with major rent concessions.

This might be an excellent asset for a charitable lead. Why? First, you have reliable cash flow to support the annuity to the charity. Second, you have an underperforming asset (the theater) which is likely to outperform (whether as a theater or as something else) during the term of the trust.

The tax calculations for a lead use IRS-published interest rates. If you can fund the lead using assets with greater earning power than the IRS interest rate, you can leverage the math to your advantage.

How? Let’s say that the IRS expects you to earn 4 percent. You are confident you can earn 8 percent. You design the lead so that the amount “expected” to remain after the charitable term is $100. Why even bother with it for $100? Because the IRS is running the numbers at 4%, but you know the numbers are closer to 8%. You are confident there will be assets there when the charitable term is done, even though the IRS formula says there won’t be.

Your gift tax on this? Whatever tax is on $100. What if there is a million dollars there when the charitable term is done? Again, the gift is $100. It is a wonky but effective way to transfer assets to beneficiaries while keeping down estate and gift taxes.

(2) There is another split-interest trust where the noncharitable beneficiary(ies) get use of the assets first, after which the remainder goes to charity.

Once again, the math uses IRS-provided interest rates.

If you think about it, however, you want this math to break in a different direction from a lead trust. In a lead, you want the leftover going to the noncharitable beneficiary(ies) to be as close to zero as possible.

With a remainder, you want the leftover to be as large as possible. Why? Because the larger the leftover, the larger the charitable deduction. The larger the charitable deduction the smaller the gift. The smaller the gift, the smaller the estate and gift tax.

You would correctly guess that advisors would lean to a lead or remainder depending on whether interest rates were rising or falling.  

What is a common context for a remainder? Say you are charitably inclined, but you do not have Bezos-level money. You want to hold on to your money as long as possible, but you also want to donate. You might reach out to your alma mater (say the University of Kentucky) and ask about a charitable remainder trust. You receive an annuity for a defined period. UK agrees because it knows it is getting a donation (that is, the remainder) sometime down the road.

Are there twists and quirks with these trusts? Of course. It is tax law, after all.

Here is one.

Melvine Atkinson (MA) died in 1993 at the age of 97. Two years prior, she had funded a charitable remainder trust with almost $4 million. The remainder was supposed to pay MA approximately $50 grand a quarter.

I wish I had those problems.

Problem: the remainder never paid MA anything.

Let’s see: 7 quarters at $50 grand each. The remainder failed to pay MA approximately $350 grand before she passed away.

There were secondary beneficiaries stepping-in after MA’s death but before the remainder went to charity. The trust document provided that the secondary beneficiaries were to reimburse the trust for their allocable share of federal estate taxes on MA’s estate.

Of course, someone refused to agree.

It got ugly.

The estate paid that someone $667 grand to go away.

The estate now did not have enough money to pay its administrative costs plus estate tax.     

The IRS was zero amused with this outcome.

It would be necessary to invade the charitable remainder to make up the shortfall.

But how would the IRS invade?

Simple.

(1)  The remainder failed to pay MA her annuity while she was alive.

(2)  A remainder is required to pay its annuity. The annuity literally drives the math to the thing.

(3)  This failure meant that the trust lost its “split interest” status. It was now just a regular trust.

a.    This also meant that any remainder donation to charity also went away.

MA’s remainder trust was just a trust. This just-a-trust provided the estate with funds to pay administrative expenses as well as estate taxes. Further, there was no need to reduce available cash by the pending donation to charity … because there was no donation to charity.

My friend was facing an operational failure with a split-interest trust he was working with this busy season. His issue with not with failure to make distributions, but rather with another technical requirement in the Code. I remember him asking: what is the worst possible outcome?

Yep, becoming just-a-trust.

Our case this time was Estate of Melvine B Atkinson v Commissioner, 115 T.C. No. 3.