A Quick Lesson In Statistics

Did you hear about the guy that drowned in a river which is, on average, 8 inches deep?

I’ve been taking a look at some taxable income statistics from the IRS.

I studied statistics at both an undergraduate and graduate level. In fact, the single hardest course I took at the University of Missouri was Nonparametric Statistics. As I was also doing my graduate tax studies at the law school, that is saying something.

Let’s go through a little exercise.

Say that you and 199 of your friends live in a splendid closed-gate community which we will call Hamiltonville. Your community is especially prosperous, and every adult makes exactly $200,000 a year. You each have a net worth of $2 million. You are - by all reckoning - successful, and you feel and act that way. Congratulations.

Now, something happens…

Steve Jobs moves into your neighborhood. You know Steve Jobs: chairman of Apple, ridiculously successful businessman, widely considered as a technology visionary and the driving force behind Apple.

And also worth approximately $6 billion.

There are now 201 people in your neighborhood. Prior to Jobs moving in, the average net worth was $2 million. Everybody was affluent.

After Jobs moved in, the numbers are different. The average net worth is now approximately $32 million. Your paltry $2 million is WAY below average.  In fact, you are approximately 93% below average. Why, you have been virtually impoverished overnight!

One could see severe wealth inequality in this picture.

Question: are you any poorer?

A Tax CPA Not Filing Taxes

My daughter goes to the University of Tennessee. Perhaps it is because she is in Knoxville that the following story about Edgar H. Gee Jr. caught my eye.

Mr. Gee is a CPA and has (had?) a small accounting firm on the west side of Knoxville off Kingston Pike. He has been at this for a while, as he is going on 40 years of professional experience.  His resume is nothing to snicker at:

·    He has published articles in the Tax Adviser (a professional publication)

·    He has testified before the U.S. House of Representatives Subcommittee on   the Oversight of IRS Activities

·    He is co-author of PPC’s Guide to Worker Classification

·    He is the winner of the Max Block Award by NYSSCPAs for Distinguished Article of the Year 2000

·    He is a past president of the Knoxville Chapter of the Tennessee Society of Certified Public Accountants

·    He was the recipient of the Discussion Leader of the Year award from the Tennessee Society of CPAs in 2001

What did he do?

Well, the IRS Office of Professional Responsibility disbarred him because he did not pay taxes for tax years 1997 through 2005. The OPR said he had engaged in disreputable conduct by willfully evading his taxes for nine years. The amount of taxes, including interest and penalties, was approximately $340,000.

I guess he can continue lecturing, but he is not practicing before the IRS again.

What argument does a tax CPA present when he hasn’t filed taxes for almost a decade? I didn’t know? That kite is just not going to fly.

It’s just sad.

BTW I do not know Mr. Gee, but maybe I’ll run into him sometime. I do hope that he is not teaching tax at UTK.

The Use Of A Dynasty Trust

President Obama’s 2012 budget included a provision to limit dynasty trusts to approximately 90 years.

What is a dynasty trust? This creature exists because of estate taxes and generation-skipping taxes. Say that you and your spouse are worth $25 million. You have a daughter, and you come to me because you want to plan your estate. You think you can live on $10 million. To make this easy, say that all your wealth is in publicly-traded stocks. We call the broker and transfer $15 million in stocks to her. At the end of the year you will have a gift tax return. The gift tax exemption this year is $5 million per person, which means that you and your spouse combine for a total exemption of $10 million. You will have a gift tax, as the net gift subject to gift tax is $5,000,000 ($15,000,000 - $10,000,000).

When your daughter passes away, that $15 million will be included in her estate again and she will pay estate tax.

Ah, you say. You now understand what the estate tax is doing. What if you gift to your grandson, that way the $15 million will escape estate tax at your daughter’s death. You “skipped” a generation. Enter the generation-skipping tax, whose purpose is – you guessed it – to tax that transfer to your grandson. No skipping allowed.

Let’s tweak this a bit. Say that you gift $10 million to your daughter and $5 million to your grandson. Now you have an interesting case study. You see, the generation-skipping tax has an exemption. That exemption amount is currently $5 million per person, or $10 million for you and your spouse. You can transfer up to $10 million to your grandson, have it escape the estate tax (at the daughter’s death) and also escape the generation-skipping tax.

Let’s tweak this again. Say that your grandson receives the gift amount (at some point in the future – it doesn’t matter when). When he passes away, the $5 million is in his estate and there will be estate tax. Is there some way to skip his estate tax?

Enter the dynasty trust. You put the $5 million in a dynasty trust. Your grandson is a beneficiary and receives distributions. He does not have enough retained power to dragnet the trust into his estate upon death. The trust escapes his estate and passes on to the next tier of beneficiaries, which are presumably your great-grandchildren.

This trust is designed to never be snared by the estate or generation-skipping tax ever again. Wow!

Enter the rule against perpetuities. There is a common law principle that allows a trust to carry-on for only so long without vesting, which is about 90 years. I studied trust law at the University of Missouri Law School and, frankly, its application in practice confused me both then and now. However, there are 23 states (including Kentucky and Ohio) that have “waived” the rule against perpetuities and allow dynasty trusts. So we can employ a dynasty in Ohio, for example, and sidestep the rule against perpetuities.

Enter Obama’s proposal to limit these trusts to 90 years or so. It would do so, not by limiting the trust, but by limiting the generation-skipping exclusion. As the trust is a creature of tax policy, the effect would be the same. Do not overly worry about this happening soon, however, as Obama’s budget was voted down without dissent in the Senate. However, the proposal does provide insight into future sources of revenue that Congress may revisit.

Because of the long-lived nature of these trusts, you are (almost by default) looking at a corporate trustee. If you haven’t reviewed trustee rates recently, you may be surprised at how expensive this can be. This in turn means that you want a certain minimum amount of money to seed the trust in order to justify the fees. This tax planning is not for the middle class. You also have to be careful in how much power is reserved to the beneficiaries, as too much may result in the trust being included in a beneficiary’s estate. You have to reserve a certain minimum, of course, such as the ability to dismiss and replace a trustee that has become unproductive or overly expensive.

I see these trusts primarily as a means of asset protection against creditor claims and divorces. It may also be a means to keep family businesses under family control, such as by placing the business(es) in a family limited partnership and then placing the partnership units into the dynasty. This would also allow one to utilize gift tax discounts, further magnifying the leverage of the dynasty trust. However, I can also see that society has an interest in not bankrolling a class of nonproductive trust-fund-uberwealthies. Perhaps the President has it right on this one: maybe 90 years is enough time for this tax vehicle.

Forget About The Airline Ticket Tax Refund

Well, that was short-lived.

I had an earlier post about obtaining refund of certain airline travel taxes.

That ended last Friday. Congress extended the FAA budget through September. Yep, next month, that September. Long-term planning specialists, this Congress. Anyway, the IRS has backtracked and said that there will be no refunds for tickets purchased before or after July 23^rd.

Refund of Airline Ticket Taxes

Some taxes have come off your airline fares and you may be entitled to a refund.

The magic date is July 23, 2011. The following have expired:

·         The 7.5% tax on the base ticket price

·         The $3.70 per person per segment (a segment is one takeoff and one landing) on domestic flights

·         The international facilities tax of $16.30 for flights that begin or end in the U.S.

·         The $8.20 premium for flights that begin or end in Alaska or Hawaii

·         The 6.25% tax on the air transport of property (this does not apply to excess baggage fees)

If you buy a ticket now, you are OK as the tax does not apply and will not be collected. However, if you bought a ticket prior to July 23, 2011 for a flight after that date, you may be entitled to a refund.

Here is the rub: the IRS wants the airlines to refund you the tax they collected. The airlines want the IRS to refund the taxes. The IRS argues that the airlines have better information to handle the refund, as they have the date of purchase and credit card information. They can have the taxes refunded to your credit card, for example.  If the IRS has to refund, all this information has to be provided with the claim, as the IRS does not have the information readily. The IRS has said they will provide additional guidance on the how-to at a later date.

I think this applies to me personally, as we recently bought an airline ticket for my mom. I can tell you in advance that, unless the taxes exceed a reasonable threshold, I will not be assembling a claim to send to the IRS. It’s not worth the hassle, even to a tax CPA.

BTW, you may have read that many airlines immediately raised ticket prices when the tax ended, thereby easily (and invisibly) adding to their profits. Nice people, those.

Rental of U.S. Real Estate by a Nonresident

I was speaking with someone from overseas about buying real estate around here and renting it out. This person is a green card holder, so their tax considerations in owing rental real estate would be the same as yours or mine.

But what if they were not a green card holder?

Different set of rules. We are talking about the U.S. taxation of a nonresident alien. A nonresident alien does not have a green card or spend enough time in the U.S. to be considered a resident.

There are two ways to handle a nonresident alien’s reporting of U.S. rental real estate.

Let’s call the first one the “default” rule. This type of income is referred to as “fixed, determinable, annual or periodic” (FDAP) and carries a 30% tax rate on the gross amount of income. Examples of FDAP are interest, dividends, annuities, royalties and rents. 

Let’s use some numbers to make this concrete:

                        Rent received                                                24,000

                        Property management                                    2,400

                        Real estate taxes                                            6,000

                        Insurance                                                        1,600

                        Depreciation                                                   9,000

                        Net profit                                                        5,000

Oh, the property manager will have to withhold the 30% upfront. The manager has to, as the tax code requires the manager to pay the 30% from his/her own funds if he/she does not withhold it from you.

Under the default rule the property manager will withhold 30% of your rental income, or $7,200, and forward it to Treasury. At the end of the year the manager will send you a Form 1042-S reporting the withholding. The good news is that you do not have to file further taxes. The bad news is that it cost you 30%.

NOTE:  The 30% is not cast in stone. It can be overridden by treaty.

The second way is to make an election, so let’s call it the “election” rule. The idea here is that you have a trade or business in the United States (you do, sort of, as a landlord), and you are going to elect to have the rental property “effectively connected” to your business. The principal tax difference is that you will owe tax using graduated tax rates on your net rental income. To phrase it another way, “effectively connected income” (ECI) of a foreign person is taxed like the income of a U.S. person.

The first thing you do is file a form (Form W-8ECI) with the property manager so the manager does not have to withhold 30% from you.

The second thing you have to do is file a tax return (Form 1040NR) at the end of the year. You have to include an election in the return alerting the IRS what you are up to. You will pay tax on $5,000, which is big improvement over paying tax on $24,000. Technically, you would be paying tax on less than $5,000, as you also get a personal exemption, but you get the idea. You also have graduated tax rates – not a flat 30% like under the default rule.

By the way, if you came into our offices using the default rule, we would likely encourage you to file a return anyway under the election rule. Why? To get back some of your 30% withholding, that’s why. The government would have gotten $7,200 from you. That was more than your profit before giving the government anything! Then we would have you fill out the paperwork to have the property manager stop withholding on your rent checks.

IRS Removes Two-Year Limit On Innocent Spouse Claims

The IRS has reversed its position on granting innocent spouse relief.

The concept of innocent spouse requires that the spouses file a joint return. The problem with a joint return is the joint liability, which means that one or both parties can be held responsible, in part or in full, for any liability.  What happens when the spouses file a joint return showing a liability and one spouse believes that the tax has been “resolved” – and believes this both in error and to his/her disadvantage? What if the spouses are later separated or divorced? What if one spouse is in jail? What if one spouse died?

The effect of joint liability can be harsh, so the IRS Code allows an escape hatch for innocent spouses.

There are three types of innocent spouse provisions in the Code. Two types require the spouse to file the claim within two years of IRS notification. The third type does not contain this provision, but the IRS has construed the provision as containing the wisp of a dim shadow of Congressional intent to include a two-year provision. With that divination, the IRS has been disallowing innocent spouse claims filed later than two years for all three types of innocent spouse claims.

Doesn’t sound like much, but think about an example.  A husband abuses his wife. He certainly is not keeping her informed about tax notices. She knows zip about the taxes other than signing the return at his behest. She finally leaves the fool. She does so however after two years of first IRS contact, not that she would know about it. Previously the IRS would have said that she was out of luck.

Well, a number of people thought this was unconscionable, including the IRS National Taxpayer Advocate, many practitioners and members of Congress. The IRS has finally relented and removed the two-year requirement from “type three” of innocent spouse. For those who follow the tax literature, the change was published in Notice 2001-70.

I have done innocent spouse claims. I am happy with this change.