The New InvestOhio State Tax Credit

The recent Ohio biennial budget bill included an income tax credit for investments in qualifying small businesses.  This was a late addition, and it was made in response to some rather depressing statistics about Ohio business over the last decade:

·         Ohio has lost more jobs than any state other than California and Michigan

·         Ohio has ranked in  the bottom 10 states for population growth

·         Ohio’s economy has ranked in the bottom 5 states

The new tax credit is referred to as “Invest Ohio.” The credit will run for two years (Ohio has biennial budgets), and the state estimates that the program will cost $100 million. The state hopes to stimulate at least 30,000 jobs, at which number the state anticipates to breakeven.

The credit is nonrefundable. You need to have an Ohio income tax to make this worthwhile.

Let’s go through the steps:

(1)    This is an income tax credit. More specifically, only taxpayers with income taxes will be able to use it. You may recall that Ohio C corporations pay a Commercial Activity Tax (or “CAT”) in lieu of income taxes, so this credit is not for C corporations. Rather it is for individuals, passthroughs, trusts and estates.

(2)    You have to be an eligible small business.

a.       Your total assets are $50 million or less OR your total sales are $10 million or less

                                                               i.      Because of the “or,” you must meet one of the two tests to qualify.

b.      You must have enough presence in Ohio to qualify. There are two alternative tests:

                                                               i.       More than half your employees are in Ohio.

1.       It doesn’t matter how many employees you have. Just one (yourself) is enough.

                                                             ii.      You have more than 50 full-time equivalent employees in Ohio.

1.       This does not need to be more than half.

NOTE: Let’s go over this, as it may not be clear. If you have 2 employees and both are in Ohio, you qualify. If you have 274 employees, of which more than 50 are in Ohio, you qualify. Technically, this second test is done by full-time equivalents rather than employees, but you get the idea.

(3)    Fresh money is going into the business as equity.

a.       This fresh money is going to acquire, increase or maintain an equity interest.

                                                               i.      You are not playing banker here. This is not a “Loan from Owner.”

                                                             ii.      You are receiving shares, units – something- that indicate ownership.

                                                            iii.      An easy example is someone who becomes a new shareholder in an S corporation by investing $25,000. This is fresh money and he/she has acquired an ownership interest.

1.       What is you already own 100%? You cannot go over 100%.

a.       Answer:  this will count.

(4)    You have to spend the money in an approved way.

a.       You have to buy tangible personal property.

                                                               i.      Desks, a copier, computer monitors or a business van will qualify.

b.      You can buy real property, as long as it is in Ohio. Ohio will not subsidize that Florida condo.

c.       You can buy intangibles, such as patents, copyrights or trademarks.

                                                               i.      The one that occurred to me was enterprise software or a website.

d.      Compensation for new or retrained employees for whom the business is required to withhold Ohio income tax.

                                                               i.      I am not sure my firm has clients that would incur employee “retraining.”

                                                             ii.      A new employee will count.

1.       There is a big EXCEPT here: the employee cannot be an owner, manager or officer.

                                                            iii.      The Ohio tax withholding becomes an issue for the border residents. For example, I live in northern Kentucky but work in Cincinnati. I do not have Ohio withholding because of the reciprocal tax agreement.  As I read this, I would not qualify.

(5)    You have to spend this new money within six months.

(6)    The credit is 10 percent.

a.       There is a maximum however.

                                                               i.      The maximum credit is $1,000,000 per taxpayer.

1.       If you are married, this becomes $2 million.

b.      My understanding is that this $1 million limit is for the first credit period, which is two years. If the credit is renewed, my understanding is that you will get a brand new $1 million limit.

(7)    Tax credit period

a.       The first period of the program runs from 7/1/2011 to 6/30/2013 (remember: biennial budget).

b.      The timing of this credit is odd.

                                                               i.      You have to wait until the period is up (6/30/13) before you can claim the credit.

1.       So an investment in 2011 gets no payoff until 2013.

2.       At least you can use it in the same year the period expires.

c.       You then get 7 years to use up the credit. More specifically, an investment in 2011 would get to use its credit in tax years 2013 to 2019.

d.      IF THE PROGRAM IS CONTINUED IN 2013 …

                                                               i.      Then the waiting period becomes five years rather than two. That is a long time to it for a credit to kick-in. An investment in 2014 would have to wait until 2019 before using the credit.

(8)    You have to keep the money invested for the credit qualifying period.

a.       That is, you cannot put money in and take it right back out.

b.      But, then again, the first period is only two years. This is not a long time.

(9)    Paperwork

a.       There is paperwork for …

                                                               i.      The application and qualification,

                                                             ii.      The certification, and

                                                            iii.      A pledge not to dispose of the investment before the end of the holding period

b.      In short, the business and its owner will have paperwork. This makes sense, as Ohio wants (at a minimum) to keep track of how many people are using the program.

c.       The program is being administered by the Ohio Department of Development. They are your contact, not the Department of Taxation.

(10) Owners of passthrough entities will claim the credit based on their distributive or proportionate share of the entity.

Rick Kruse and I agree that the key point to this credit is the fresh cash. Perhaps the cash is funded by savings, by borrowings, or perhaps by a circular transaction, but somehow new money has to enter the picture. The problem may be getting the fresh cash in the owner’s name.

Think about the following examples:

(1)               The S corporation buys a truck. There is a down payment and a term note for the balance. Even if the shareholders sign on the note, there has been no fresh cash into the business, so there would be no tax credit.

(2)               The LLC wants to buy shop equipment. There are three members. Only one of the members is willing (or able) to start the required “fresh cash” sequence.  Perhaps he/she is the only one with enough savings, enough credit or enough collateral to borrow.  Therefore, only one of the members can initiate the “fresh cash” cycle. This situation may be more about member dynamics than tax planning.

(3)               The partnership constructs a building. The construction loan is signed by the partners. Under this loan, the draws are disbursed directly by the bank to the contractors and suppliers.  Whereas one can argue “fresh cash,” there has been no increase in equity. There has been only an increase in debt.  

Here is one that intrigues me:

(4)               A key employee is awarded 50 shares under a stock bonus program. The stock vests, so the employee recognizes taxable income on his/her personal return. The business in turn purchases equipment within the requisite six month period. Do we have a "fresh cash” cycle?

BTW, the instructions and directions for this credit are virtually nonexistent as I write this. For the time being there are questions with no answers. For example, can one set up a new company in order to qualify as an “eligible small business” or will the new company being aggregated with an existing company?  This is a basic technique – and therefore a basic question - for any tax practitioner.

If your business qualifies as an Ohio eligible small business, you simply must consider this credit in your tax planning. If you will be buying equipment, or trucks, or software, or hiring ANYWAY, why not plan for the credit? If you can’t make it work then you can’t, but at least consider it.

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.

A Doctor, A Tax, An Offshore Account And A Moral

I was reading Kindred v Commissioner recently. There is not much there of technical interest, but the facts are interesting. Plus it has a moral.

Dr Kindred failed to file tax returns or make tax payments for 2001 and 2002. The IRS prepared substitutes for returns and assessed him $912,529 and $1,184,115 for 2001 and 2002 respectively. The doctor goes to court, but not to argue the amount of tax assessed.

NOTE:   Wow! This guy owes over $2 million to the IRS and is not even arguing the amount.

Dr Kindred had gotten himself involved with the Aegis Business Trust System (Aegis) out of Chicago. Aegis was a bushel of bad apples. They promoted the use of trusts – revocable, offshore - as a way to reduce taxes. The problem is that some trusts are useful and others are useless. Aegis promoted useless trusts. The IRS conducted an undercover investigation (code-named “Operation Trust Me”) which resulted in indictments and convictions for tax fraud conspiracy for the operators of Aegis.

Dr Kindred transferred money offshore to one of these Aegis trusts.

In 2003 the government indicted Aegis and froze their offshore accounts. The government seized all the accounts and kept the money, including Dr Kindred’s money.

Subsequently the doctor is contacted by the IRS, and they want $2-plus million.

The doctor’s money is gone. What is he to do?

He files a case in District Court and then Tax Court, that is what he does. His request is simple. He wants to receive “credit” for his share of the monies that were seized. After all, on the one hand he owes the government money. On the other hand the government took money that belonged to him. Seems reasonable, right?

 The district court dismisses his case. There are several issues, one of which is that the case in district court was a criminal case. No matter what, Dr Kindred was not coming out of district court with a verdict that the monies represented tax payments, mostly because the monies did not represent tax payments. Rather than make tax payments to the IRS he boxed them in an Aegis trust and shipped the monies overseas. Money yes, tax payments no.

He next goes to the Tax Court and makes the same plea. The Tax Court asked the obvious question: we are a court for taxes. We see that you owe taxes. We see that you did not pay taxes. Why are you here?

This is a worst case scenario. The doctor lost the money that he shipped offshore AND he still owes the taxes.

The moral? Wouldn’t it have been easier to just HAVE PAID THE TAXES?

New Reporting For Foreign Bank And Other Financial Accounts

I have mentioned on this blog that I have in-laws overseas (England). My wife and I have discussed buying property and retiring (some day!) overseas. She e-mailed me something recently on property in Ecuador that caught her eye. I only recall that the average temperature was not equal to the surface of the sun, which surprised me. (It’s called Ecuador because it is on the equator.)

Let’s say that my wife and I retire overseas. We would be expatriates. Nope, this is not a bad word. It means a person who lives outside his/her country of citizenship.

What tax issues should an expatriate know about? There are many, but today I want to talk about the HIRE Act, FATCA and the brand-new IRS Form 8938 Statement of Specified Foreign Financial Assets.

Congress passed the Foreign Account Tax Compliance Act ("FATCA") as part of the HIRE Act in 2010. The intent was to make it difficult for US taxpayers to evade tax by hiding assets overseas. FATCA requires US persons to file yet another form (Form 8938) to report foreign financial assets.

Form 8938 is out in draft. Interestingly, its instructions are NOT out. Form 8938 will be attached for the first time to your 2011 tax return.

Please note that this form is IN ADDITION to Form TD 90-22.1 (the "FBAR") you may already be filing with Treasury by June 30th of every year. The FBAR is required when you have more than $10,000 in foreign financial accounts.

Form 8938 is primarily geared but not necessarily limited to financial accounts.  You have to report (as I read it) foreign rental property, for example, as long as it is income-generating.  This is an issue for a couple of our clients, so I intend to go back and verify this point.

Form 8938 does have a higher reporting threshold - $50,000 – than the FBAR.

Form 8938 may require substantial time to prepare. Part I is relatively straightforward and asks you to disclose your overseas bank accounts. Part II asks you to disclose foreign financial interests (other than bank accounts) and their maximum value during the year. Depending on the financial interest, you may also have to disclose mailing addresses and other information. Part III requires the disclosure of “tax items” attributable to foreign interests previously disclosed. “Tax items” are interest, dividends, royalties and such other income, so you will (effectively) be tracing the income from the disclosed assets to a specified line on your individual income tax return.

The IRS did realize that some of this information is being disclosed on other tax filings already in their possession. Foreign corporations, for example, file Form 5471.  Foreign partnerships file Form 8865. Foreign trusts file Forms 3520 and 3520A. Part IV allows you exclude these financial interests from 8938 reporting. You do however have to provide some information on how many and what type of filings the IRS will receive on your behalf. Presumably there will be computer matching for the IRS to double-check that it has all these filings.

My take on all this? Does it seem reasonable to you that this level of reporting kicks-in at $50,000? Why not $10 or $15 million – a more reasonable threshold if in fact it is the “fat cats” that FATCA is going after?

The Value of a Family Limited Partnership

Let’s look at the Estate of Natale Giustina v Commissioner.

The Giustina family owned timberland in Oregon. As the generations passed on, some of the land came to Natale, who passed away in 2005. Natale was the trustee of the N.B. Giustina Revocable Trust.

         NOTE: Remember that a revocable trust would be included in Natale’s estate upon death.

The trust in turn owned 41.128 percent of the Giustina Land & Timber Co Limited Partnership (LP). The LP was formed in 1990 and owned 47,939 acres of timberland in the area around Eugene, Oregon. It employed between 12 and 15 people. There appeared to be no doubt what the timberland was worth – at least $143 million. A 41.128 percent share of that would be almost $59 million.

Here is today’s quizzer: what value did the estate put on its estate tax return and what did the IRS think the value should be?

If you guess $59 million, you are wrong. Here is what the two sides fought over:

                                Estate                   $12,678,117

                                IRS                         $ 35,710,000

What happened to the $59 million? This case is a good primer on valuation discounts. Let’s say that you own horseland in central Kentucky – a lot of it. Say that it is worth $20 million. You want to sell it to me. It’ worth $20 million, but I sense that time is of the essence to you. I offer $18,500,000. The faster you have to sell it, the less I am willing to offer. This is a discount, and a valuation person would refer to it is a “market” discount.

So even if you start with $59 million we could argue that the land was worth $54,750,000 to the estate.

Now let’s do something else. Let’s put the horseland in a “limited partnership.”  The limited partnership will have general partners and limited partners. The general partners make all the decisions, and the limited partners have little authority. I buy the land and put it into an limited partnership with my wife and me as general partners. Our children are the limited partners. My wife and I (the “generals”) have full control over the business of the partnership. We have the power to buy, raise, race and sell horses. We have the power to make distributions of cash or property to the partners in proportion to their respective interest in the partnership.  We have the power to buy or sell land. All decisions of the general partners must be unanimous.

The limited partners (“limiteds”) can force removal of a general by a two-thirds vote. If a general resigns or is removed, the limiteds can put in one of their own by a two-thirds vote. An additional general can be admitted if all the partners consent to the admission.

The partnership agreement does not allow my kids to transfer their interests willy-nilly. Oh no.  The partnership only allows an interest to be transferred to (1) another limited, (2) a trust for the benefit of a limited or (3) anyone else approved by the generals.  Unless you are our grandchild, it is very unlikely that the generals (my wife and I) will permit any transfer away from our kids.

How much are you willing to pay to buy the limited interest from my kid? It’s different now, isn’t it? My kid does not control her own fate with regard to the LP interest. My wife and I control. If we decide there are no distributions, then there are no distributions. If there is taxable income but no distributions with which to pay the tax … well, tough luck. I suspect you are revising your price downward the more I explain how much control my wife and I are keeping.

This is called a “control” discount.  The limited partnership allows you to introduce a control discount – if you play by the rules.

The court went through some interesting analysis of valuation methods, interest rates and discounts that is a bit inside-baseball for this blog post. At the end, however, the court found itself disagreeing with both the estate and IRS valuations and posited its own valuation of $27,454,115. This is much closer to the IRS value than to the estate.

Did the family gain anything from all this?  Let’s look at the following two values:

               
                By doing no tax planning                              $58,813,040

                The court said                                                 $27,454,115

 I would say this was good tax planning.

A Surprise for US Persons With Undeclared Canadian Retirement Plans

We have a few clients who are Canadian or lived in Canada. We have two who lived in Toronto through last year before moving to Wisconsin. Nothing like that warmer weather!

Anyway…

There is a very specific tax issue if you are Canadian and emigrating to the U.S. It has to do with Canada’s version of IRAs and 401(k)s. Canada calls them Registered Retirement Savings Plans (RSSP) or Registered Retirement Income Funds (RRIF).

In Canada these accounts are tax deferred (just like IRAs and 401(k)s in the US). In the US they are not UNLESS you make certain tax elections. The IRS otherwise considers these accounts to be just another broker’s account and will tax you annually on the interest, dividends and capital gains.

Rev Proc 2002-23 states the procedures to make an election on your US tax return. You have to make a separate election for each plan. The form you use is Form 8833 Treaty Based Return Position Disclosure. You state that you are claiming the benefit of Article XVIII(7) of the US-Canada Income Tax Convention. You’ll have to include the name of the financial institution where the account is kept, the account number of the plan, and the account balance at the beginning of the year.

If somewhere down the road you finally draw on the Canadian plan, you will owe Canadian tax. If you truly have emigrated, then Canada will consider you a nonresident and withhold – at 25%, I believe.

If you paid tax annually to the US, the US tax calculation at that moment could be hair-pulling. You would have “basis” in some of the account – to the extent you paid tax – and not have “basis” in the rest.

If this is you, please get professional advice.

Indiana Blows It But Taxpayer Has To Give Back Refund

Our ongoing search for bad state tax laws and policies takes us this time to Indiana, which is almost next door to our offices. Generally Indiana is a solid, common-sense Midwest state, but they dived into the pool of bad tax administration with Zoeller v Aisin USA Manufacturing.

Aisin filed its 2001 corporate income tax return in October, 2002. It showed the following:

                Tax due                               $1,300,367

                Payments                           $1,457,000

                Applied                               $   156,633

The Indiana Department of Revenue (“Department”) worked its voodoo and in September, 2003 issued Aisin a refund of $1,146,062.

Aisin cashed the check.

Two more years go by. In October, 2005 Aisin amends its 2001 return to show the following:

                Tax due                               $1,051,099

                Payments                           $1,457,000

                Applied                                $   156,633

                Refund                                 $   249,268

Whoa Nellie!! This is different. Normally when an accountant prepares an amended return – and there was a refund on the original return – the accountant adjusts something to show the refund. Aisin is not associating the $1,146,062 refund with its 2001 payments at all. That is aggressive.

The Department starts taking a look at Aisin’s file. Good idea. In April, 2006 the Department wanted to issue a Proposed Assessment to Aisin. It wants its money back.

                Question:            Can you see the problem a tax person would have?

I’ll give you a hint. Under Indiana Code 6-8.1-5-1(b) “… the department may not issue a proposed assessment  … more than three (3) years after the latest of the date the return is filed, or … the due date of the return.”

OK, when was the return filed? That was in October, 2002. Three years from that is … October, 2005. Can the Department even issue this Proposed Assessment? But first …

               

                Question:            Does filing an amended return affect the 3-year Indiana statute?

Here is something that will surprise you; The filing of an amended return in Indiana does not restart the limitations period (UACC Midwest, Inc n v Indiana Department State Revenue). Aisin was very slick by filing the amended within days of the statute expiring.

Back to our question. Indiana could not issue the Proposed Assessment. Indiana recognized this and pulled the assessment before it could be mailed.

Seems to me that Aisin is up by $1,146,062. It is oily, I grant you, but it is the technical reading of the law. Indiana just blew it. Or did they?

The Department next files a nontax claim against Aisin on grounds of unjust enrichment. The trial court dismisses the case and the Court of Appeals affirms. Why? Because this was a tax case, and in Indiana tax cases are heard in the Indiana Tax Court, not in Superior (that is, trial) Court.

But the Department will not be deterred. It files an appeal to the Indiana Supreme Court … which decides to hear the case! There is only one issue before the Indiana Supreme Court: is this a tax case or not?

The Court states:

“Had Aisin neither paid nor owed any income taxes but still received the check because of clerical error, the State’s action to recover would not be an action to recover any unpaid “tax” because Aisin would not have owed any tax.”

To hold that this “refund,” issued solely because of accounting or clerical errors, represents part of a tax would not serve the legislative purpose of ensuring the uniform interpretation and application of the tax laws because the tax laws are not implicated.”

Huh?

Am I to believe that Aisin left the west side of Cincinnati for a leisurely two-hour drive to Indianapolis where – like a gift from the heavens - a check in the amount of $1,146,062 floated in through an open car window? Were these the winnings from a fantasy football league? Did Aisin discover the long-lost Harry Potter manuscript at a Saturday morning yard sale? Of course this money was tax-related. The only reason that the Department even knew that Aisin existed is because Aisin was filing its taxes.

I agree with the Justices Rucker and Dickson in the dissent:

What is really at stake in this case is that the State apparently acted under the assumption that it missed a statute of limitations deadline in a tax proceeding. The State does not contest Aisin’s assertion. Instead it is reasonable to conclude that acting under the assumption that it could obtain no relief in the Tax Court by reason of a statute of limitation, the State attempted an end-run and filed this action in Superior Court. Given the lengths to which the majority was required to analyze Aisin’s various tax filings and the resultant repercussions, I agree that this a tax case and would affirm the judgment of the trial court.

It is difficult to side with Aisin, but they were right and Indiana was wrong. We all lose something when a judge or court unilaterally decides to trump the law. What we lose is predictability and the right to rely on the law.

IRS Ends Gift Tax Probes of Non-Profit Groups

On  July 7  the IRS said that it would stop its examinations of tax-exempt 501(c)(4) organizations. The IRS had quite recently been reviewing donors to these organizations for compliance with gift tax return requirements.

There is some uncertainty in the tax literature whether contributions to these organizations would be considered “gifts.” If so, and depending on the amount, there could be a gift tax return requirement. Now, when I say uncertainty, I mean that there is a classroom argument to be made. The IRS has not pursued this matter for nigh near 30 years, so it is not something that has concerned many practitioners.

The classic charity is a 501(c)(3). We are talking about (c)(4)’s, which are “social welfare” organizations. The idea is that the organization promotes the common good, although that common good can be targeted to a certain slice of the population. The AARP, for example, is a 501(c)(4), and that slice is people over age 50. A (c)(4) can even lobby, as long as it is not the primary thing the (c)(4) does. A (c)(3)  cannot go as far with lobbying as a (c)(4) can.

The big difference? Donations to a(c)(3) are deductible on your income tax return. Donations to a (c)(4) are not.

Let’s fast forward. What has changed? Well, in the last election cycle the (c)(4)s raised seven times as much money for Republican causes than for Democrat causes.

Then the IRS announced that it wanted to “look into” the (c)(4)s.

Republicans in both the House and Senate immediately questioned why the IRS was going there.

While the IRS statement is welcome, lawmakers want to find out what, if any, political muscle was used. The IRS says there was none. Republicans of course are highly skeptical.

Governor Signs Ohio Estate Tax Repeal

Governor Kasich signed the repeal of the Ohio estate tax into law on Thursday, June 30. As is common with contemporary tax bills, the law’s effective date is delayed until January 1, 2013 – approximately one and one-half years away.

There are different ways of looking at this issue. Ohio exempts the first $338,000 of the estate’s value and maxes-out at 7% on estates over a half-million. Ohio’s argument has been that it exempts the vast majority of estates in the state. In fact, over three-quarters of the tax raised is on estates over $1 million. The Ohio estate tax is peculiar because Ohio shares the estate tax with the localities in which the deceased resided. In Cincinnati, for example, this sharing amounts to almost $13 million per year. Cincinnati will, of course, face budgetary pressures.

 An alternate perspective was provided in a study from Duquesne University which estimated that state and local governments lose approximately $3 in non-estate tax revenues for every $1 increase in federal estate tax.

My perspective?

I have been in Cincinnati for over 20 years. I grew up in Florida. I can tell you that we have moved clients to Florida, but we have never moved clients to Ohio - or to Kentucky. Do taxes override all? Of course not. I would not be working in Cincinnati - where we have both state and local taxes - if that were the case.  But let's not be silly by arguing that taxes do not have an impact.

IRS Tax Liens

What Is a Tax Lien?

A lien is the IRS’ first major step in order to collect back taxes. The lien is filed county-by-county and will attach to all property you own in that county.

Why is a Tax Lien Filed?

The lien is filed to secure the IRS’ position as your creditor. A lien by itself does not mean that the IRS will be taking your money or assets, but it can ruin your credit and make it near impossible to buy a home.

The IRS has a policy of automatically issuing a lien if your debt exceeds $10,000. Mind you, the IRS still has the discretion to issue a lien below that limit.

When is a Tax Lien Filed?

The IRS first sends a letter with an assessment of your tax liability. If ignored, there will be four more letters.

You will then receive the Notice of Federal Tax Lien (NFTL). This means that a lien has already been attached to your property. Remember that liens are public record. Expect your credit card rates to go up.

Effects of a Tax Lien

In addition to ruining your credit, a lien can lead to a levy. A levy is bad. This is when the IRS seizes your assets. You probably have heard of bank levies, where the IRS takes the money in your bank account. There are also wage levies (also called garnishments), where the IRS will give you an allowance to live on and take the rest of your paycheck.

What to Do About a Tax Lien?

The first thing is: don’t stick your head in the sand! This will not go away on its own, unless you are willing to earn no money and accumulate no assets for years and years.

Second: do something! Doing nothing was not your best plan. Take the time to research and learn about IRS collections - or hire someone who practices in this area. If it is a CPA, please be aware that not all CPAs practice tax representation. Preparing a tax return is not the same as representing before the IRS. 

The IRS Is Selling a Super Bowl Ring

I am a huge NFL fan. It is, without a doubt, my favorite sport.

Did you hear about Fuzzy Thurston’s tax problems?

Who is Fuzzy? His actual name is Fred Thurston. He played with the Green Packers from 1959 to 1967. He played guard in the first two Super Bowls under Vince Lombardi.

He was considered a tough football player and part of the famed “Power Sweep.” When asked how he prepared for the bitter cold of the Ice Bowl on December 31, 1966 at Lambeau Field against the Dallas Cowboys, he replied “About 10 vodkas.”

After football he became a restaurateur. He and partners, including Max McGee, opened a restaurant named Left Guard in Menasha, Wisconsin and eventually had six locations throughout Wisconsin. Fuzzy played left guard – hence the name of the restaurant.

The trouble arose with employment taxes. Somewhere between 1978 and 1980 the Janesville restaurant failed to remit payroll taxes withheld from employees. We have spoken of withholding before. These penalties are some of the toughest in the IRS arsenal. It makes sense, if you remember that these are withheld taxes. The money belongs to the employees, and the employer is merely a conduit for remittance to the Treasury. When the employer fails to remit, it not only deprives the Treasury but it has also robbed from its employees.

So Fuzzy had a withholding problem. The tax action goes against the company and the responsible persons at the company. As a partner, Fuzzy must have had enough authority to be considered a responsible person. So were his partners. His partners paid-off their actions, but Fuzzy fought his. The initial judgment against him in 1984 was approximately $190,000.

Fuzzy continued to fight. His liability, with interest and penalties for more than 25 years, is a little more than $1.7 million. The IRS is selling off his football paraphernalia, including his 1960 Packers helmet, two 1960 footballs signed by Packers players and Vince Lombardi, his NFL championship rings from 1958, 1961, 1962 and 1965,  and Fuzzy’s Super Bowl II ring. The IRS is searching for his Super Bowl I ring also, but it hasn’t turned up.

It’s an unfortunate story, but I have to point out that Fuzzy either dug in his heels unreasonably or otherwise received horrendous tax advice. Perhaps he felt that his partners stole from him and that he wasn’t responsible. Fine, but a quick education from his accountant might have included the concept of surrogate liability, and that as a partner in the restaurant he had triggered that liability. At that point it was not a matter of right or wrong, but rather a matter of emergency room decision-making. Stop the bleed, clot the wound, stabilize the patient, live to fight another day. I have to believe he could have come up with $190,000 in 1984. He could then have sued his partners, if it made him feel better. But he was not going to win the responsible person action against him with the IRS.

Your Accountant Makes the Mistake. Do You Owe Penalties?

If your accountant omits some of your income on your personal income tax return, is it fair that you should be penalized by the IRS?

Generally speaking, reliance on a tax preparer is “reasonable cause” to request penalty mitigation from the IRS. Generally, but not always.

Enter Stephen Woodsum (SW). SW has a bachelors degree from Yale and a masters from Northwestern. He was a founding director of Summit Partners, a private equity firm.

Note: Mr. Woodsum is financially savvy.

In 1998 SW entered a transaction described as a “ten year total return limited partnership linked swap.” This transaction involved Bankers Trust Company and Deutsche Bank and included a reference to paying interest at the “LIBOR rate” upon the “notional amount” of the “reference fund.”

        Note: Financially unsavvy people do not use these words.

So, the swap was to expire in 2008 – ten years. SW was unhappy with the performance of the swap and ended it in 2006. He received at that time a Form 1099 reporting the $3.4 million Deutsche Bank paid him and another 1099 for $60,291 of interest income.

SW gave all of his tax documents to his accountant. There were over 160 such documents. SW must have had a good year, as the $3.4 million was not the largest number on his tax return. It would however had been the third largest capital gain had the $3.4 million in proceeds been reported.

The accountant prepared the return, including the interest but excluding the $3.4 million.  Some accountant. SW and his wife met with the accountant on October 15, the day the return was due. They had to go over the federal return and 27 state income tax returns. The federal return alone was 115 pages.

Mr. and Mrs. Woodsum did not notice that the accountant had left out the $3.4 million.

The IRS did notice, of course, and wanted the tax and interest, as well as penalties.

Mr. Woodsum felt he did not have to pay penalties because… well, he relied on his accountant. I agree with SW.

The court made an interesting comment. It observed that courts have previously mitigated the penalties, but it continued …

It may be (and petitioners seem to expect the Court to assume) that the omission was the result of the C.P.A.'s oversight of one Form 1099 amid 160 such forms, but no actual evidence supports that characterization. The omission is unexplained, and since petitioners have the burden to prove reasonable cause and good faith, this evidentiary gap works against their defense.”

No actual evidence supports that characterization? I would have gotten a statement from the accountant clarifying that the accountant was provided but failed to include the 1099 on my return.

The court seemed unwilling to give SW as much latitude because of his financial sophistication. The court goes on…

Mr. Woodsum, however, makes no showing of a review reasonable under the circumstances. He personally ordered the termination that gave rise to the income; he received a Form 1099-MISC reporting that income; that amount should have shown up on Schedule D as a distinct item; but it was omitted. The parties stipulated that petitioners' “review” of the defective return was of an unknown duration and that it consisted of the preparer turning the pages of the return and discussing various items. Petitioners understated their income by $3.4 million—an amount that was substantial not only in absolute terms but also in relative terms (i.e., it equaled about 10 percent of petitioners' adjusted gross income). A review undertaken to “make sure all income items are included” (in the words of Magill)—or even a review undertaken only to make sure that the major income items had been included—should, absent a reasonable explanation to the contrary, have revealed an omission so straightforward and substantial.”

I have had clients who did the same as Mr. Woodsum. It did not occur to me that they were conducting an unreasonable review. They provided all documents, answered all questions, met with me and complained about the amount I told them they owed. These are wealthy people. This is not you or I, where the absence of our salary would be immediately noticeable on our return. Mr. Woodsum reported approximately $33 million of income on his return. Note that the sale was not even the largest number on a schedule to Mr. Woodsum’s return.

The court upheld the penalties.

Perhaps this is what happens when a private equity manager gets into a complex financial transaction with names like “ten year total return limited partnership linked swap.” This court was not willing to bend much on the reporting of a “Wall Street” transaction that requires a tax seminar to understand.
The penalties were over $100 thousand.

I wonder whether Mr. Woodsum is suing his accountant for malpractice.

There Are New Deductible Mileage Rates

The IRS has revised the deductible mileage rates for the second half of 2011.

The new and old rates are as follows:

                                                          NEW                                               OLD
Business mileage                          55.5 cents/mi                                   51 cents/mi
Medical or moving                         23 cents/mi                                      19 cents/mi
Charitable mileage                        14 cents/mi                                      14 cents/mi

The charitable mileage rate did not change because that rate is set by statute and not regulation. It requires Congress to change the charitable mileage rate.

The IRS Sues Over Conservation Easements

It has been several years since I visited Washington D.C. I saw a bit of tax news recently that got me thinking about it. Several years ago I was involved in the planning of a conservation easement in D.C. As Washington has 26 historic districts, this was not that unusual. Our client was renovating residential property, and the easement was for the building façade. We normally associate an easement with access to real property, but it can also be a legally enforceable right to preserve real property. In my case, what was being preserved was the outside of the building, which was of historical interest in a neighborhood of historical consequence. You could say that they were donating the right for future generations to look at the building.

The tax advantage? Quite simple: if you follow the rules you can obtain a charitable contribution for the easement. The deduction is (theoretically) the decrease in property value attributable to the grant of the easement. Memory tells me that a reasonable range for a facade is 10 to 14 percent of the building’s value, which is not insignificant.

This area is fraught with danger. An appraisal – or appraisals – is mandatory. The easement will be transferred to a government or charitable organization, so an attorney is required. You may have to obtain the mortgage lender’s agreement to subordinate their right to that of the government or charity receiving the easement.

The IRS challenged some of these donations early on. In some cases, the IRS argued that the donation was zero, although the IRS took considerable punishment in the courts for this position (Akers and Symington, for example).

I was reading Janet Novak’s article in Forbes where she stated that the Justice Department filed a lawsuit to enjoin the Trust for Architectural Easements from certain practices the IRS considers improper. The lawsuit demands that the Trust turn over the names of approximately 800 property owners in Baltimore, New York City and Boston who have claimed this type of deduction. The IRS has already identified more than 300 taxpayers for audit.

The IRS has been concerned with these easements because of their potential for abuse. In some cases, taxpayers have claimed deductions approaching 50% of the property’s value. In others the charity buys the property, places the easement and then sells it to the taxpayer – at a reduced price. The taxpayer makes two checks out – one to purchase the property and the other as a “donation.” He/she of course deducts the second check on his/her return.

The IRS has taken fire from practitioners who argue that it is over-zealous and not regarding Congress’ intent to encourage these easements. I admit that I felt that way at first. It was easy to see a heavy-handed IRS. Consider the following quote from the court in Symington, for example:

  "We are hard pressed to imagine a prospective purchaser of a 60-plus acre parcel of land who would not   have considered the restrictions of such an open-space easement in determining his offering price. The fact that a purchaser of Friendship Farm would have been precluded from even giving away part of his land if he ever so desired, for example, to his children, or, along the same lines, precluded from ever building an additional home on his property, would certainly have affected the purchase price he would have been willing to pay."

However, I am at a loss why I would structure a transaction requiring the charity to buy the real property and for my client to subsequently write two checks. I wouldn’t. I don’t see it how it reflects normal commercial terms. It feels oily, at least to me. The IRS may have valid grounds for this action.

Possible Change in the FUTA Payroll Tax

Beginning July 1, there may be a change in your FUTA payroll tax rate.

The FUTA tax is 6.2%, although the IRS allows a credit of 5.4% if you pay your state unemployment taxes on time. This makes for a net tax rate of 0.8%. FUTA applies to the first $7,000 of wages per employee. There has been a “temporary” surcharge of 0.2% since the 1970s, and that 0.2% is set to expire June 30, 2011. If the surcharge expires, the 5.4% state credit will nonetheless remain the same, making the net cost to the employer 0.6%.

Please be aware that a proposal in the President’s 2012 budget would make the 0.2% surcharge permanent. There is an alternate budget proposal that would increase the FUTA wage base from $7,000 to $15,000 per employee.

Should the FUTA surcharge expire, it will add to an already confusing year for payroll taxes. Remember that for 2011 employers are paying Social Security taxes of 6.2% while employees are paying 4.2%.

We at Kruse and Crawford are monitoring this issue and will available to answer any questions as June 30, 2011 approaches.