IRAs and Nontraditional Investments

We have received several inquiries over the last year or so about using IRAs for nontraditional investments. This frequently means real estate, perhaps commercial real estate to house a closely-held business. It might also mean using the IRA to start the business itself.

These types of transactions are not without risk. One has the risk of business failure or decline in property value, of course, but also the risk of disqualifying the IRA itself. This would be very bad, as this makes the IRA immediately taxable. To protect against this, one should roll-over the required funds from the “main” IRA into a separate IRA. Should the unfortunate occur, only the roll-over IRA will blow-up. One has contained the damage.

A nontraditional investment requires a self-directed IRA. You will need to find a custodian that will permit nontraditional investments. Most will not. Let’s say you found one. Let’s use the acronym SDIRA for a self-directed IRA in our discussion.

A SDIRA can invest in a privately-owned business. We already know that an IRA can invest in a non-private business, as these are the publicly-traded companies whose stocks are in your IRA or are in the mutual funds in your IRA. This is your Google stock or your Fidelity Contrafund.

The type of business entity is important. The SDIRA can invest in a C corporation but not in an S corporation. Why not? Because the IRS does not permit an IRA to be a shareholder in an S corporation.

The level of involvement in the business owned by the SDIRA is also critical. There are two key tax issues here:

·         The SDIRA cannot enter into a “prohibited transaction.” This is a death sentence. The SDIRA will lose its tax-exempt status and become immediately taxable. If you are under age 59 ½, there will also be penalties.

·         The SDIRA might enter into investments which themselves trigger a tax. This is not as bad as a prohibited transaction, as the overall SDIRA does not become taxable. There is tax only on the income. If the deal is good enough, paying tax may be acceptable.

Prohibited Transactions

The IRS defines a disqualified person as

·         The IRA account holder

·         A family member of the account holder.

o   This goes vertical: grandparents, parents, children and spouses

·         An entity owned 50% or more by the account holder

Think about that last one. Here at Kruse & Crawford, I could theoretically use my IRA, buy an office building and rent it to the firm, as I am not a 50%-or-more owner. Rick Kruse however could not.

Let’s go though the prohibited transactions:

(A) Sale, exchange or leasing of any property between an IRA and a disqualified person

Example 1: My SDIRA purchases property from me or my wife.  This is prohibited. It doesn’t matter if it purchases the property in a “commercially reasonable” manner – i.e. obtain an appraisal. It is not allowed. Period.

Example 2: My SDIRA pays my daughter twenty-five dollars to mow the lawn on the property.  My daughter is a family member. It is prohibited. The amount of money is irrelevant. 

(B) Lending of money or other extension of credit between an IRA and a disqualified person

Example 3: I lend you $10,000 from my IRA.

Example 4: I personally guarantee a bank loan to my IRA.

Example 5: My IRA loans money to me. 

(C) furnishing of goods, services, or facilities between an IRA and a disqualified person

Example 6: I buy a piece of property through my SDIRA and hire my wife to manage the property.

(D) transfer to, use by or for the benefit of a disqualified person of IRA income or assets

Example 7: My SDIRA purchases real estate in Ireland. The SDIRA rents out the property for most of the year. However, my wife and I use the property for one week twice a year.   Even if my wife and I pay fair-market-value rent, this is a prohibited transaction.

(E) Act by a disqualified person who is a fiduciary whereby he deals with IRA income or assets in his own interest or for his own account

Example 8: I charge my SDIRA a fee to manage its stocks, bonds, mutual funds or other investments.

(F) receipt of any consideration for his own personal account by any disqualified person who is a fiduciary from any party dealing with the IRA in connection with a transaction involving IRA income or assets.

Example 9:  My SDIRA purchase a vacation house is in Augusta. I am offered the use of a Wyoming condo in exchange for use of the Augusta property during the Master’s tournament.

IRA Taxes

(1) Active Business Income (UBTI)

Earnings within an IRA are generally tax exempt. However, certain investments can create taxable income called “unrelated business taxable income” (UBTI).  Generally, UBTI is trade or business income which is not otherwise related to the tax-exempt purpose of the IRA. The idea here is that Congress does not want a tax-exempt entity competing with the taxable business enterprise next door to it.

So if you buy a Panera’s or a Caribou Coffee, you have UBTI.

There are some exceptions to UBTI, including but not limited to:

·         dividends

·         interest

·         royalties

·         rent from real property (however see debt-financed below)

·         sales of real property, if the property is not held as inventory or held in the ordinary course of business

Dividends and interest make immediate sense, as this means stocks and bonds - the traditional investments in an IRA.

UBTI Examples:

Example 1:  The SDIRA purchases a restaurant.  The income from the restaurant will be treated as UBTI.

Example 2:  The SDIRA purchases 25% of an LLC that flips (buys, fixes and sells) real estate. Since the real estate is considered inventory, the income to the SDIRA will be UBTI. 

(2) Debt-Financed Income ( UDFI)

If there is debt involved there will likely be UDFI.

Fortunately, UDFI refers only to the percentage of income resulting from the debt-financed portion of the property,

UDFI Example:

Example 3: My SDIRA purchases a B&B in Ireland putting down 75% and borrowing 25%. 

Note that if there was no debt, the rent would be tax-free to the SDIRA.

But there is 25% debt. This means that 25% of the rent is taxable to the SDIRA. The SDIRA does get to claim rental expenses, however.

Wealth Planning

You may have read that nontraditional IRAs are being used for wealth planning. For example, Max Levchin, the chairman of the social review site Yelp, sold over 3 million shares of Yelp held in his Roth IRA. There is no tax on Roth withdrawals if one waits until age 59 ½. Levchin is in his mid-30s. He will have to wait a while, but the money will be tax-free when it comes out.

Peter Thiel did a similar transaction. He bought shares of PayPal for approximately 30 cents per share while he was CEO of the company. In 2002 eBay bought PayPal for $19 a share. 

Now how did Levchin and Thiel avoid the prohibited transaction rules? Actually, it is very simple. You have to control the company to get into a prohibited transaction. Control is usually defined as at-least-50%. When you drain your IRA to buy that Five Guys Burgers and Fries location, chances are you will own 100%. Compare that to a publicly-traded company with tens if not hundreds of millions of shares. Neither Levchin nor Thiel came close to owning 50%. 

Is this fair? I would lead off by noting that “fair” is subjective, somewhat like asking what music one likes. Levchin and Thiel played the game between the lines. You or I could do the same. It might take a new skill set and a tractor-trailer load of luck, but you or I could (theoretically) do it.

Congress has noted these transactions. There is debate about whether this type of wealth accumulation should be permitted. Discussion has sometimes involved a “ceiling” on the amount invested/deferred in the Roth, but until now nothing has developed.

The IRS and Identity Theft

One of the downsides of increased electronic tax filing is increased identity theft. We had one of our e-filings intercepted this year by the IRS for identity mismatch. The IRS did not accept the e-file and instead required a paper return with Form 14039, Identity Theft Affidavit, attached.

I was looking at (OK, I was skimming) a report from the Treasury Inspector General for Tax Administration issued May 3rd. Imagine my surprise to learn that the IRS has no special procedures for our return with Form 14039 attached.

The IRS considers the paper filing to be a duplicate return and does not immediately process it. An employee enters a transaction code into the taxpayer file to memorialize receipt. The return then goes to a separate queue to be worked on, possibly after April 15 when the filing season has ended. The IRS transfers the file to Duplicate function for initial review. If Duplicate considers it an identity theft case, the file is again transferred, quite likely to the Accounts Management function. It is there assigned an assistor, who requests copies of the original tax returns and begins the process, including correspondence, of determining who the legitimate taxpayer is.

This process is slow and the refund can be delayed until late in the year or even the following year. The average case resolution is 414 days.

The assistor very likely works in Accounts Management. The problem is that these employees also answer the toll-free telephone lines during busy season. According to TIGTA, 87% of assistors working identity fraud also answered the phones, and 60% stated that they worked the toll-free line exclusively. TIGTA considers the optimal assistor inventory (that is, caseload) to be 100 to 125 per assistor, but the average assistor had an inventory exceeding 300 cases.

The identity problem is new enough that IRS guidelines are spread out over almost 40 sections in the Internal Revenue Manual. Sometimes the guidelines are inconsistent. The IRS in addition does not have procedures to spot trends which could be useful in detecting or preventing future fraud. One problem, for example, is sending notices to the last address of record, which could just be the person perpetrating the fraud.

Training has also been an issue. TIGTA’s survey showed that almost half of the assistors believed that their training was not sufficient. In one office, 13% of assistors had received no identity theft training.

To be fair, the IRS has agreed with TIGTA’s findings and has begun implementation of many recommendations. For example, there will be specialized units in Accounts Management to work only identity fraud cases.

Then we have Congress. Three representatives this week introduced the “Fighting Fraud Act,” which would double the current penalties for tax preparers who are involved with identity theft. The intent is to give the IRS greater incentive to prosecute this type of theft, presumably because the potential payoff is greater.

Really? This is the best the mandarin class can dream up? Here is an idea: the IRS assigns a PIN to every preparer. Require every professionally-prepared return to require the preparer’s PIN. If a preparer is involved with this type of nonsense, the IRS revokes the PIN and bans the preparer from working before the IRS.

Will this stop the completely unscrupulous? Here is a question in return: in human history, has it ever been possible to stop the completely unscrupulous?

Something New In Gifting of Family Limited Partnerships

Let’s talk this time about gift taxation.

Let’s say that you have a family-owned company.  You desire to pass this on to your kids and grandkids. There are ways to do this, but the method best for you is annual gifts of $13,000, which is the amount of the gift tax annual exclusion. Both you and your spouse can give away $13,000 per beneficiary, so you are transferring $26,000 at a clip. Enough beneficiaries and this can add up.

You ask: what could go wrong?

What if the IRS challenged the value of the gift? Remember, partnership or LLC units generally do not have the same value as a direct and uninterrupted transfer of the asset(s) in the partnership or LLC.

Why is that? Well, if you are a limited member, you have to obtain the general member’s permission to asset. If you are my daughter and I am the general member, rest assured that permission is not happening for a while.  My daughter may “own” $26,000 (2 annual gifts of $13,000) in the LLC, but is it really worth $26,000?  Remember: you need my permission to get to the $26,000. Would you pay her $26,000 today on the hope and prayer that someday I will distribute $26,000 to you? 

Let’s say that IRS comes in says that the LLC units are not worth $26,000. Instead the units are worth $40,000.  What just happened? What happened is that I have to amend my gift tax return. I am now using my lifetime exemption so as not write a check to the IRS. Had I already used-up my lifetime exemption, I would be writing a check. I would not be happy.

What if I changed the terms of the gift? Instead of saying that my wife and I transferred X number of units, we say we transferred units (or fractions thereof) worth $13,000 to our daughter. If the IRS adjusts the gift value upward, then – as far as I am concerned - I “actually” gifted fewer units. Remember, I gifted $13,000 in value, NOT a set number of units. Brilliant!

Except that the IRS thought it too brilliant. This tax technique is called a “defined value clause,” and the IRS has pursued these cases on multiple grounds, including being against public policy.

One of the first cases was Proctor. There the donors gifted remainder interests using the following clause:

“In the event it should be determined … that any part of the transfer in trust hereunder is subject to gift tax, it is agreed by all parties hereto that in that event the excess property hereby transferred which is decreed by such court to be subject to gift tax, shall automatically be deemed not to be included in the conveyance in trust hereunder and shall remain the sole property of the taxpayer.”        

The Fourth Circuit of Appeals nixed the Proctor clause as being after-the-fact. It was a condition subsequent. The IRS continued its win streak with Ward and with Harwood.

Those cases are easy to understand: you cannot undo what has already been done. Let’s make it more challenging.

What if you are not trying to undo anything?  What if you have two beneficiaries: your family and any excess going to charity? Think about this for a moment. If the IRS revalues the gift, the revaluation would be “excess” and go to the charity. There is no gift tax on transfers to charity. There would be little motivation for the IRS to pursue you. The IRS still did not like this and litigated the matter in Christiansen, McCord and Petter. This time, they were not as successful.

What if you like the result in McCord but it is not your intent to include a charitable beneficiary? Congratulations. You are Dean and Joanne Wandry. The Wandry’s gifted partnership units worth $1,099,000 on January 1, 2004. The actual number of units was not fixed, pending a later valuation. The valuation was completed July 26, 2005. The IRS examined the gift tax returns and issued the tax assessment in February, 2009.

The IRS argued that

·         The descriptions on the gift tax returns sounded like a transfer of units and not dollars

·         The entry the accountant made to the books sounded like a transfer of units and not dollars

·         The attorney’s documents sounded like a transfer of units and not dollars

·         It was against public policy to transfer dollars and not units, and

·         In any event the taxpayers smelled funny.

The Wandry’s took the matter to Tax Court. They won their case this past March, and they are now famous as being the first taxpayers to win against the IRS using a formula clause that doesn’t have a charitable element. Granted, this is not the same as winning the Peyton Manning sweepstakes, but it is something.

My take: I expect to see Wandry clauses as standard boilerplate in FLP transfer documents from this point on.

A Letter To The IRS

This is an actual letter sent to the IRS approximately 15 years ago Remember to laugh at least once daily. Enjoy!

Sirs:

I am responding to your letter denying the deduction for two of the three dependents I claimed on my 1994 Federal Tax return. Thank you!

I have questioned whether or not these are my children for years. They are evil and expensive. It's only fair that, since they are minors and no longer my responsibility, the government should know something about them and what to expect over the next year. Please do not try to reassign them to me next year and reinstate the deduction. They are yours!

The oldest, Kristen, is now 17. She is brilliant. Ask her! I suggest you put her to work in your office where she can answer people's questions about their returns. While she has no formal training, it has not seemed to hamper her mastery of any subject you can name. Taxes should be a breeze. Next year she is going to college. I think it's wonderful that you will now be responsible for that little expense. While you mull that over, keep in mind that she has a truck. It doesn't run at the moment, so you have the choice of appropriating some Department of Defense funds to fix the vehicle, or getting up early to drive her to school. Kristen also has a boyfriend. Oh joy! While she possesses all of the wisdom of the universe, her alleged mother and I have felt it best to occasionally remind her of the virtues of abstinence, or in the face of overwhelming passion, safe sex. This is always uncomfortable, and I am quite relieved you will be handling this in the future. May I suggest that you reinstate Dr. Jocelyn Elders who had a rather good handle on the problem.

Patrick is 14. I've had my suspicions about this one. His eyes are a little closer together than those of normal people. He may be a tax examiner himself one day, if he is not incarcerated first. In February, I was awakened at three in the morning by a police officer who was bringing Pat home. He and his friends were TP'ing houses. In the future, would you like him delivered to the local IRS office, or to Ogden, UT? Kids at 14 will do almost anything on a dare. His hair is purple. Permanent dye, temporary dye, what's the big deal? Learn to deal with it. You'll have plenty of time, as he is sitting out a few days of school after instigating a food fight in the cafeteria. I'll take care of filing your phone number with the vice-principal. Oh yes, he and all of his friends have raging hormones. This is the house of testosterone and it will be much more peaceful when he lives in your home. DO NOT leave him or his friends unsupervised with girls, explosives, inflammables, inflatables, vehicles, or telephones. (They find telephones a source of unimaginable amusement. Be sure to lock out the 900 and 976 numbers!)

Heather is an alien. She slid through a time warp and appeared as if by magic one year. I'm sure this one is yours. She is 10 going on 21. She came from a bad trip in the sixties. She wears tie-dyed clothes, beads, sandals, and hair that looks like Tiny Tim's. Fortunately you will be raising my taxes to help offset the pinch of her remedial reading courses. "Hooked On Phonics" is expensive, so the schools dropped it. But here's the good news!

You can buy it yourself for half the amount of the deduction that you are denying me! It's quite obvious that we were terrible parents (ask the other two). She cannot speak English. Most people under twenty understand the curious patois she fashioned out of valley girls/boys in the hood/reggae/yuppie/political double speak. The school sends her to a speech pathologist who has her roll her "r's". It added a refreshing Mexican/Irish touch to her voice. She wears hats backwards, baggy pants, and wants one of her ears pierced four more times. There is a fascination with tattoos that worries me, but I am sure that you can handle it. Bring a truck when you come to get her, she sort of "nests" in her room and I think that it would be easier to move the entire thing than find out what it is really made of.

You denied two of the three exemptions, so it is only fair that you get to pick which two you will take. I prefer that you take the youngest two, I will still go bankrupt with Kristen's college, but then I am free! If you take the two oldest, then I still have time for counseling before Heather becomes a teenager. If you take the two girls, then I won't feel so bad about putting Patrick in a military academy. Please let me know of your decision as soon as possible, as I have already increased the withholding on my W-4 to cover the $395 in additional tax and made a down payment on an airplane.

Yours truly,

Bob

By the way, the IRS allowed the dependency exemptions.



The IRS, Layla, Ludwig Drums and Demutualization

Well, this is not the easiest tax reading I have ever done. I just finished Cadrecha v U.S. The case is like reading a calendar.    

You ever wonder about the difference between a tax attorney and a tax CPA? There are differences in practice. The CPA of course is much more involved with numbers and the attorney is more so with contracts and documents. A big difference is that the attorney can take a case to court. Robert and Cynthia Cadrecha (Cadrecha) could have used an attorney, because the IRS beat on them like a set of Ludwig drums.

This case has to do with a life insurance company demutualization. Demutualization means the life insurance company issues stock. The IRS took the position that any stock received would have a basis of zero; a subsequent sale would therefore be all gain. Sounds like a position the IRS would take. There was a taxpayer who took the IRS to court on this matter (Fischer v U.S.) and won. Cadrecha occurred during this period of time.

Here goes:

4/15/04           Cadrecha files 2003 tax return showing no basis in the stock.

3/20/07           He learns of the Fischer case. Cadrecha mails amended return showing basis in the stock.

3/22/07           IRS receives amended return.

5/10/07           IRS writes letter asking for more information. Cadrecha provides it.

6/26/07           IRS sends letter that it is researching.

8/6/08             Fischer wins case against IRS.

8/13/07           IRS sends letter it fell asleep and will now really start researching.

8/31/07           IRS sends letter saying “fuhgetaboutit” and disallows the amended return.

The IRS, with all its efficiency, tells Cadrecha that they filed the amended return after three years had expired. This is of course incorrect. What happened is that the IRS got the 3/20/07 filing confused with the additional information provided on 5/10/07. Generally speaking, the additional information will be attributed back to the earlier filing.

OBSERVATION: This is why we recommend using certified mail.

NOTE: Something VERY important happens here. The disallowance is on Letter 105C, which includes the following language concerning an appeals or suit:

“The law permits you to do this within 2 years from the date of this letter. If you decide to appeal our decision first, the 2-year period still begins from the date of this letter.”

I believe that Cadrecha, and Cadrecha’s accountant, got mislead by the reason given on Form 105C. Granted, the amended return was filed within 3 years, but the claim was DISALLOWED.  This has significance separate and apart from any reason given and will come back to haunt Cadrecha.

8/31/07           Cadrecha sends a letter to the IRS disagreeing with the “dates” issue.

10/1/08           Cadrecha sends a letter to the IRS asking whether anyone is still alive.

11/3/08           Cadrecha files Form 843 in order to perfect the earlier (3/20/07) claim. (An amended return is a claim).

11/5/08           IRS responds to Cadrecha’s letter of 11/3/08, saying someone is still alive.

12/30/8           IRS – in a blur of motion – responds to the claim filed 11/5/08, saying it will need more time to research and to put the children through middle school.

1/15/09           The IRS writes again, stating that it is forwarding the claim filed 11/3/08 to Austin by the slowest means possible.

6/25/09           Cadrecha’s accountant contacts the Taxpayer Advocate.

12/11/09         Cadrecha’s accountant actually speaks to an IRS employee. She (the employee) explains that the IRS is delaying because it intends to appeal Fischer. She also says that the children are doing well and have started high school.

4/19/10           Cadrecha, in a moment of insanity, writes the IRS.

8/22/10           Cadrecha writes the Taxpayer Advocate imploring it to “PLEASE help.” Johnny Depp is rumored to be in consideration for the movie lead.

4/26/11           Cadrecha receives a letter from the IRS stating that their claim was “being held in suspense” while the IRS was litigating a similar demutualization case in Arizona. The IRS also remarked how the children had grown and were soon to start college.

Anyway, Cadrecha winds up in court. What did the IRS argue? That Cadrecha’s complaint was not filed timely! Can you believe the gall?

The court decided against Cadrecha. The case was not filed timely. Look back above and reread my comment on the 8/31/07 entry. Cadrecha had 2 years to file. Not 2 years and a day or 3 years less a week. He was late.

Is it equitable? Most likely not, but it was the bright-line law.

Is there a moral? Yes. When this issue got played out like Clapton’s “Layla,” Cadrecha needed an attorney. I know, I know. One does not have unlimited money to throw around, and one has to consider whether the amount of tax at issue is worth the additional cost. But Cadrecha needed something that a CPA could not provide: a court filing before the two years ran out.

Hazard of Being a Volunteer Nonprofit Director

Can you be on the hook for unpaid payroll taxes if you are a volunteer director for a nonprofit? What if you do not have authority to write checks?

Let’s take a look at the recent (March 8, 2012) U.S. District Court decision Bunch v Commissioner.

Perceptions, Inc. was a Tennessee nonprofit formed in 2004, Perceptions provided supportive living service for developmentally disabled clients. The incorporators and initial directors were replaced by Roy Don Bunch (Bunch) and two others. Documents filed with Tennessee listed Bunch as the chairman of the board. He was also the registered agent.

Bunch was benevolent with Perceptions. He allowed it to use one of his properties rent-free. He also made start-up loans and – later – bridge loans when Perceptions did not have sufficient money to pay its bills. His generosity was not insignificant. Between February, 2005 and August, 2007, Bunch made loans of approximately $648,000.

When Perceptions had money, it would repay him. Between 2006 and 2007 Bunch was repaid approximately $558,000.

Bunch never received a paycheck. He never hired or fired employees. He never asked to see the books. He never asked if taxes were being paid. He did speak up in December, 2006 when he learned that Perceptions was thinking about employee raises. His question was reasonable: we are almost bankrupt. Why are we talking about raises? No raises were given, but Bunch’s hopes for a Congressional career were jettisoned.

In December, 2006 Bunch learned that quarter 3, 2006 employment taxes were unpaid. He loaned money to Perceptions to pay these taxes.

In June, 2007 he finally gave up and took over financial responsibility, including writing checks. He was hoping to make Perceptions a viable business. Payroll was met, providers were paid and Bunch was repaid on his loans. Perceptions however did not pay its current or back employment taxes.

The IRS finally shows up wanting to know what is going on. In March, 2008 the IRS decides that Bunch is a “responsible person” for the second and fourth quarters of 2006 and all of 2007.  You do not want to be a “responsible person,” as this means the IRS is coming after you. The IRS wanted almost $194,000 from Bunch.

Bunch was an inquisitive sort. His attorney asked the IRS for their basis in concluding that Bunch was a “responsible person.”  The IRS sent the attorney copies of an interview questionnaire but no reasoning or other basis for their determination.

Bunch filed an appeal on April 25, 2008.

Summer comes. Fall comes. Winter comes. In January, 2009 Bunch received a letter from IRS Appeals. They want affidavits and documents, which he provides. What he did not receive, however, is the basis on which the IRS concluded he was a responsible person.

Spring comes. Summer comes. In September the IRS tells him to pay the penalties. They again fail to tell him why.

In October, 2009 Bunch filed a Request for Abatement. He attaches and documents everything.

The IRS tells him his claim would open for review on January 10, 2010. Two weeks later – January 25 – Bunch receives the IRS’ denial of his claim. Bunch can almost hear the tires squealing as the IRSmobile speeds away. The IRS still failed to tell him why he was responsible.

On February 9, 2010, Bunch sends the IRS almost $194,000. He then files a court motion. He wants his money back. And to find out why he is responsible.

In court Bunch admits that he was a responsible person as of June 22, 2007, when he took over financial responsibility for Perceptions. He disagreed that he was a responsible person before that date. He had a point. One of the key indicators is whether the person in question had discretion over cash disbursements, including signature authority. A bookkeeper who pays what he/she is instructed to pay would not be a responsible person, whereas his/her boss could be.

The court disagreed with Bunch. It did not matter that he did not hire or fire, have ownership, get paid or write checks. The court reasoned that he had authority as a director and significant financial authority because he lent a lot of money to Perceptions. In fact he could have forced Perceptions out of business by simply not loaning them money. The court did not care that he did not know or did not exercise authority. The court reasoned that he could have, and “could have” was sufficient.

Bunch was a responsible person for all periods. The IRS could keep his $194,000.

Yipes!

My take: sadly, I have to agree with the court. There is a long-standing tax doctrine that one cannot intentionally stick his/her head in the sand and claim ignorance. Bunch was involved enough to lend Perceptions money on an almost-monthly basis. As a director, he had the right to ask why, where the money was going, what bills were being paid and – importantly – what bills were not being paid. He already had one fright with unpaid employment taxes, and it was not unreasonable for a director to oversee that such taxes not be overlooked in the future.

The difficult part here is separating his duty as a director from his obvious generosity with the charity. As director he had authority to inquire, berate and insist. Events came to his attention which reasonably required him, as director, to get involved. It was not reasonable for a director to turn a blind eye. He was a tremendous benefactor, but not a very good director. Had he just been a benefactor, I doubt the court would have arrived at the same decision.

On April 6 Bunch filed a motion seeking to alter or amend the court’s decision. We’ll see how it turns out, but I doubt he will be pleased.

Ohio Offers Two Tax Amnesties

As part of the 2012/2013 budget bill, Ohio has authorized a general amnesty for selected state taxes, including personal income, school district, sales and commercial activity taxes.

This is an attractive amnesty program, although it does have one significant drawback. Under the program Ohio will abate all penalties and one-half the interest. Taxes eligible for the amnesty must have been due and payable as of May 1, 2011. This means that a 2010 individual income tax will be eligible (as it was due April 15, 2011), but a May 2011 sales tax return would not (as it was due June 23, 2011). In addition, you cannot have been previously contacted by Ohio.

Ohio expects full payment when you file these tax returns. Remember – this is a revenue raiser for the state.

The significant drawback? The general amnesty window is very brief: from May 1 to June 15, 2012.

There is a separate use tax amnesty that runs from October 1, 2011 to May 1, 2013.

Note: Use tax applies to purchases of taxable products or taxable services where the seller did not collect the Ohio sales tax. The use tax applies both to individuals and businesses. The use tax is the cousin to the Ohio sales tax. It serves to prohibit one from avoiding Ohio sales tax by purchasing items from another state (free of sales tax) and then bringing them into Ohio.

If one pays all use tax due on or after January 1, 2009, Ohio will waive or abate use tax owed for prior periods. There is also a non-interest payment program available for businesses not previously registered for use tax, although this option requires an officer to personally guarantee the tax debt. On the plus side, Ohio will allow the business up to seven years to pay the back taxes. Once again, you cannot have been previously contacted by Ohio.

The IRS May Allow Videoconferencing

I am just finished reading Nina Olson’s most recent blog post. Nina Olson is the National Taxpayer Advocate with the IRS. The Advocate’s office is independent from the IRS, although it works with the IRS to resolve tax problems. I have worked with the Advocate’s office before, and in general I have been pleased. Recent contacts have concerned me, though. It sounds to me that they are being overworked, at least here in Cincinnati. I suspect they are feeling IRS budget restrictions.

Ms Olson commented on taxpayer frustrations with “corr exams.” These are correspondence exams and frequently address areas using computer matching. You may get a “corr” notice concerning missing dividends or interest income, for example, or possibly the sale of stock. The corr notices are notorious and can frequently take multiple contacts to resolve. Why? Well, a key reason is that no single examiner is assigned to work on your case. Rather, it floats in a pool, and when you send a letter it gets randomly assigned to an examiner. Say that the letter resolves many, but not all, the issues. The IRS sends out another notice. You respond, but it will not go to the same person who earlier worked on your file. There is no continuity in the corr exam process.

Ms Olson is proposing the use of videoconferencing in conjunction with corr exams. Upon receiving a notice, a taxpayer would have the option of making an appointment for an online meeting. The taxpayer gets a PIN and logs on from his home or office computer. If the taxpayer does not have a computer, he/she could alternatively go to the local IRS office or perhaps to a specially designated room at another government building. With a high-resolution camera, the examiner could even read a document that the taxpayer brought to the videoconference. The examiner would retain the case, and all future correspondence would contain his/her name, phone number and e-mail address.

Here is how Ms Olson phrased it:

As anyone who has looked at both the literacy levels of the United States population and the poor quality of IRS exam notices can attest, there is not a whole lot of communicating going on in IRS correspondence exams.”

A virtual face-to-face meeting would allow for diversity in taxpayers’ ability to read, write and express themselves verbally. The taxpayer would be able to explain himself and the examiner could better explain any necessary documentation without the back-and-forth of a correspondence exam.

What does this tax CPA think? Great idea! I am becoming quite the fan of Nina Olson.

New Jersey and the Telecommuter

We are visiting state taxation today. Our trip this time will take us to New Jersey, and it will highlight how tax law can simultaneously arrive at a technically correct but bumble-headed conclusion.

Let’s say you manufacture parts in New Jersey. Would you expect to file and pay state income tax to New Jersey?

That one is easy - of course. You are doing business there – in the meaningful sense of the phrase. You have a building, you have employees. You park your car out front. You visit Chipotle for lunch. You are there.

Let’s make this more challenging. You do not manufacture parts. You do not manufacture anything. You develop software. Your offices are in Rockville, Maryland. You do not have offices in New Jersey. You do not park your car in New Jersey or visit their Chipotle for lunch. You are not there. You have an employee who moves to New Jersey. You like her. You keep her on board.

Like a Jim Croce song, you have a name.  Your name is Telebright.

Let’s have her work from her new home. She begins her workday at 9:00 a.m. by checking with her project manager, who is based in Boston. She receives daily work assignments. When done, she uploads her work and sends it to you. She is expected to work 40 hours a week. She could live on the moon, for what location matters to her work.

She does not solicit customers. She does not have sales responsibility. She does not refresh products, or stock shelves, or install, or service. She does not supervise employees. She does not have management authority. You do not even reimburse for her office-in-home. She travels twice a year to Maryland. By the way, you do not pay for the travel – rather she pays for those trips out of her own pocket.

You – being enlightened – take New Jersey withholding taxes out of her paycheck so that she has no rude April 15^th surprise.

New Jersey surfaces, somewhat like the mutant alligator in a bad Sci-Fi network movie. New Jersey says that you are doing business in the state, and it wants you to … (wait on it) … pay corporate income taxes!

The case goes before the New Jersey Tax Court. The court cites the New Jersey statute:

Every domestic or foreign corporation which is not hereafter exempted shall pay an annual franchise tax for each tax year, as hereafter provided … for the privilege of doing business , [or] employing or owning capital or property … in this state.”

The Court then reflects philosophically:

The term ‘doing business’ is used in a comprehensive sense and includes all activities which occupy the time or labor of men for profit.”

It rolls up its sleeves and grittily reviews the law (N.J.A.C. 18:7-1.9(b)):

Whether a foreign corporation is doing business in New Jersey is determined by the factors in each case. Consideration is given to such factors as:

(4) The employment in New Jersey of agents, officers and employees.”

Oh, oh. This is going to go wrong, isn’t it? Or is it possible the court will recognize that a lone employee in the state hardly amounts to a corporate beachhead?  Here is the Court:

There is no one, single controlling factor nor is there a bright line standard that determines whether a foreign corporation’s in-state activities meet the Director’s regulatory requirements for doing business. Rather, it is only by close scrutiny of all the facts of the case, taken as a whole, that a final determination can be made. ”

It then digs in like a free agent seeking a new sports contract and drives for the bright line.

It cannot be disputed that plaintiff satisfies factor 4 … by employing Ms. … in New Jersey.”

[Telebright] agreed to permit Ms. … regularly to perform her duties at her New Jersey home.”

This consistent contact with New Jersey was not sporadic, occasional or intermittent.”

But the Court pauses. Will it realize that you are being a good sport for even keeping her employed after the move? Will it acknowledge that this is not a 19^th century economy, when a county seat could not be more than a day’s travel for any resident of the county? It hesitates:

“While it is true that [Telebright] has never maintained an office in New Jersey, nor solicited business here ….”

No! Not now Tax Court of New Jersey! You are so close!

The Court shakes it off:

 … [its] daily contact with the State through its employee is sufficient to trigger application of the CBT Act.”

The mere fact that Ms. … is the only … employee in this State does not change the court’s decision.”

Yes, the court determined that Telebright was responsible for New Jersey corporate tax because it permitted an employee to work from her home in New Jersey.

Why does this upset me?

One reason is that reasoning like this would have me filing taxes with India if I hired an on-line bookkeeper there.

Another reason is that I have read court decisions like this for more than two decades now. After a while it is like watching WWE wrestling – there really isn’t much suspense about who is going to win. There was a time when a state at least tried to develop coherent doctrines and workable principles. In recent years however state tax has become more like a hijacking on a Sopranos episode.

Another reason is this is an employee-hostile decision.

I have a friend and client, for example, who lives in Kentucky and commutes to California. Yes, you read that right. He works a week here in Kentucky and a week near San Francisco. He is situated well enough at the company that he floated the idea of having an “office” here. The company turned him down. Why? Because they do not have a footprint in Kentucky and his “office” could create one. So he commutes every other week to California. I suspect he may be their only Kentucky-resident employee.

If you were Telebright, what would you do? Would you not permit your employee to work from home, never mind the reasons? Would you even keep her as an employee?

Who gains here? Tony … er, Trenton gets a few dollars from its next mark … er, taxpayer. Who loses? For now, the company loses. In the future, the loser will be the next employee who wants to work from a New Jersey residence for an out-of-state company whose tax advisor has read Telebright.

Another Tax Chain Files for Bankruptcy

Another one of the tax resolution chains is going out of business. The newest one is TaxMasters, whose commercials featured a red-headed and -bearded fellow. That fellow was Patrick Cox, the CEO. TaxMasters had battled the attorneys general of Texas and Minnesota for fraudulent practices. I am reading that Texas had accused them of not commencing work for their clients until TaxMasters was fully-paid. So much for deadlines. Did you know that they were publicly-traded?

They follow on the heels of JK Harris, which was based out of South Carolina and filed for bankruptcy last October. JK Harris had been battling the attorneys general of Texas, West Virginia and Missouri.

Before JK Harris was Roni “Tax Lady” Deutch, who was sued by California, forfeited her law license and closed shop. She had done an “Arthur Andersen” and shredded documents. Nice.

I work tax representation, and I am not particularly surprised by the fate of these companies. They were working a specific area of representation – collections. Why? Many taxpayers first take the matter seriously only when the IRS sends them a letter indicating intent to lien or levy. 

I cannot begin to tell you how many times I have heard the refrain “What are they going to do to me? Put me in jail?” No, they will not put you in jail unless you crossed the line into criminal tax. They will take your stuff, however. We presently have a revenue officer here in Cincinnati who seems quite determined to take a client’s house, for example. At that moment those late-night commercials promising pennies-on-the-dollar sound appealing and one is willing to suspend disbelief. Don’t. If it were true I would have reduced my own taxes to pennies-on-the-dollar.

How can tax representation fit into a publicly-traded company? I am at a loss. There is no way I could do what I do being constantly worried about quarterly earnings and stock performance. Hey, sometimes it takes a client forever to assemble paperwork, or an examiner is unreasonable, or every issue goes to Appeals, or we spend time fending off an overly-aggressive revenue officer. We are not profitable on that engagement. It is part of practice. We do not rock the house every time.

My advice? If you are in a collection situation, find a local practitioner who works tax representation. Please stay away from those national tax warehouses. Ask yourself: who is paying for this airtime? You know better.

IRS To Monitor EINs

The IRS this past Wednesday issued proposed regulations requiring taxpayers with employer identification numbers (EINs) to update them periodically with the IRS.

EINs are issued to businesses, trusts and estates.

What the IRS is concerned about is listing nominees on the original EIN application as officers, partners and what not. The nominee’s authority to act and represent thereafter expires, sometimes as soon as the EIN is received, thus obscuring the true ownership of the entity.

The IRS will be revising its application form – the SS-4 – to identify when a nominee or agent is obtaining an EIN for a principal. The IRS will refer to such nominee as a “responsible party.”

The IRS also states that it will provide further rules on updating EINs – such as forms and frequency - in the future.

Senate Would Revoke Your Passport If You Owe Taxes

Harry Reid introduced an amendment to a transportation bill before the Senate. The provision allows the Secretary of State to deny or revoke a passport if you owe taxes. Here is the language:

SEC. 7345. REVOCATION OR DENIAL OF PASSPORT IN CASE OF CERTAIN TAX DELINQUENCIES.

(a) IN GENERAL.

If the Secretary receives certification by the Commissioner of Internal Revenue that any individual has a seriously delinquent tax debt in an amount in excess of $50,000, the Secretary shall transmit such certification to the Secretary of State for action with respect to denial, revocation, or limitation of a passport pursuant to section 4 of the Act entitled ‘An Act to regulate the issue and validity of passports, and for other purposes’, approved July 3, 1926 (22 U.S.C. 211a et seq.), commonly known as the ‘Passport Act of 1926’.

Would you believe this nonsense PASSED the Senate? It now goes to the House, which hopefully has more common sense. The current transportation authorization expires at the end of March, so I suppose something will pass.

Do these people scare you – even a little bit?

Taxpayer Advocate Issues Directive to IRS Commissioner

I am starting to like Nina Olson, the National Taxpayer Advocate.

I have been negative on the IRS program called the Offshore Voluntary Disclosure Program (OVDI).  This was the government reaction to the UBS and offshore bank account scandals. That however was tax fraud committed by the extraordinarily wealthy.  My background has been the Foreign Service and expat community, primarily because my wife is the daughter of a (retired) Foreign Service officer. These are rather ordinary folk who just happen to live overseas.

Tax advisors who work this area know that the IRS pulled a bait-and-switch a year ago - on March, 2011 - with taxpayers trying to comply with the freshly-resurrected foreign reporting requirements.  The FBAR has, for example, been out there since at least the early 70s, but at no time did Treasury want to confiscate 50% or more of your highest account balance for not filing a one-page form. The IRS was waist-deep with 2009 OVDI and had previously encouraged taxpayers to enter the program with lures of reduced penalties for non-willful violations.

EXAMPLE:  You have expatriated to Costa Rica. You have next-to-no ties in the United States and pay little attention to tax developments here. You have even learned to like soccer (but why?). The requirement to file an FBAR comes as quite the surprise to you. You first thought it absurd that such reporting would apply to the most ordinary of taxpayers. Surely that is for rich people only. You have to qualify as non-willful, right?

Then last March the IRS trotted-out a memo directive that it would not consider non-willfulness, reasonable cause, or the mitigation guidelines in applying the offshore penalty. Let me phrase that a different way: the IRS instructed its examiners to assume that the violation was willful unless the taxpayer could prove that it was not. Would you further believe that, at first, the memo was kept secret?

Huh? Are you kidding? O.J. Simpson received more “benefit of the doubt” than the IRS was willing to provide.

Then in August Nina Olson issued a Taxpayer Advocate Directive ordering IRS division commissioners to revoke this position and direct examiners to live up to their own promises to thousands of affected taxpayers.  The IRS division commissioners blew her off.

What?

Tax Analysts now reports that the main IRS commissioner – Douglas Shulman – has no intention of responding to Nina Olson on this matter. To aggravate the matter, there is a statutory requirement that the IRS commissioner respond to the Taxpayer Advocate within 90 days.  Do laws mean nothing to this crowd?

Is this a specialized tax area? Yes. Does it have greater import? I believe it does. It does because the tax attorney and tax CPA community – people such as me – pay attention, and this behavior diminishes confidence in the IRS and any trust in its word. The consequences are subtle, injurious and lasting. And for what purpose? To extract a penalty from someone whose only crime was not paying attention to increasingly obscure and inane U.S. tax law?

NOLs and Self-Employment Tax

Here is another one of those tax cases where you wonder how it got so far. Let’s set this up:

(1)    say that you are self-employed, and

(2)    you lost money, so you have a net operating loss carryover; and

(3)    you fail to file a later year tax return, and

(4)    the IRS prepares one for you, and

(5)    you owe a lot of tax, and

(6)    you ignore matters until you receive the statutory notice of deficiency, and

(7)    you clue the IRS that you have an NOL carryover, which reduces but does not eliminate your tax, and

(8)    the IRS still wants some tax (both income and self-employment) from you, and

(9)    you disagree because the you think the NOL reduced both your taxable income and self-employment income, and

(10) the IRS wants to know where in the tax code it says you can do that.

To understand what is happening here, think of your income tax and your self-employment tax as side-by-side railroad tracks. You use the same numbers to calculate how much is subject to income tax and to employment tax, but there comes a point where the tracks diverge. In our situation, that point is the net operating loss. There is no question you get a deduction for the NOL on your income taxes, but what is the answer for your self-employment taxes? Remember: different tracks = different trains.

Did I mention that you are an accountant?

So you are now preparing for the Tax Court. While preparing you come across this sharp rock from the tax code:

1402(a) Net Earnings from Self-Employment – The term “net earnings from self-employment” means the gross income derived by an individual from any trade or business carried on by such individual, less the deductions allowed…; except that….

                                (4) the deduction for net operating losses provided in section 172 shall not be  allowed.

Oh no. Now what do you do? Well, our taxpayer (Joseph DeCrescenzo v Commissioner T.C. Memo 2012-51) comes up with a two-pronged attack:

               

(1)    Argue that the IRS cannot raise the issue because they did not raise the issue in the notice of deficiency. The problem with this is … that they did by including the NOL in the notice.

(2)     And even if the IRS did, it was not binding on you because you suffer from acute anxiety disorder.

You can probably guess that this did not turn out well for the taxpayer. It cost him over $70,000 in penalties (late filing, late payment and etc.) alone.

It would have been much cheaper to have hired a competent tax CPA.



4th and 26

He is known for an NFL playoff game in 2004. The Eagles were playing Green Bay. It was fourth quarter. The Eagles were trailing with 1:12 remaining, 4th down and 26 yards to go for a first down.  NFL fans call this a “long shot.” He ran a slant, the Green Bay Cover 2 defense broke down, and Donovan McNabb connected with him for a 26-yard play. The play set up a David Akers field goal, which led to overtime, which led to a win for the Eagles.

The player?  Freddie Mitchell, a wide receiver.

Why are we talking about him? Because he is likely to go to jail for tax fraud.

Freddie associated himself with two people – Jamie Russ-Walls and her husband, Richard Walls. Jamie fancied herself a tax expert. For a period between 2009 and 2010, Freddie used his football contacts to lure unsuspecting athletes to Jamie, who promised them all kinds of tax refunds because she was – well, a tax expert! She and her husband prepared returns claiming refunds between $170,000 and $1.9 million. They were not deterred by things like actual W-2s. No sir. They would forge W-2s to get the refunds they promised. If not a W-2, they would manufacture a Schedule C (self-employed) to show business losses.

Freddie was the face. His job was to recruit clients.

The three had agreed to share any tax refunds they received.

These three were geniuses. What could possibly go wrong?

Freddie recruited an athlete we will call A.G. Freddie had A.G. pay $100,000 as a down payment for his 2008 tax return and 2006 and 2007 amended returns.

OBSERVATION: I have never seen a $100,000 individual income tax return. I have seen yachts with professional crews, mansions in Wyoming, airplanes, overseas residences, FLPs, rolling GRATS, skip trusts, charitable leads and a number of other high-end tax planning vehicles, but I have never seen a $100,000 individual income tax return.

Freddie and crew prepared a tax refund claim for $1,968,288.

A.G. was not the only client. The indictment cites five other tax returns claiming refunds over $2.2 million.

This will not turn out well for Freddie. There will be no “4^th and 26” this time.