Laurel and Hardy Dancing on the Fiscal Cliff

I personally would prefer Laurel and Hardy to what we have up there presently. 

Seasons Greetings

Update on Tiger Zerjav

We recently discussed Tiger Zerjav, who with his father practiced tax in St. Louis, Missouri. Tiger and his dad had attracted IRS attention, and Tiger himself was being pursed for tax fraud. Courthouse News Service (a news service for attorneys and focusing primarily on civil litigation) reported the following this morning:

ST. LOUIS (CN) - A much-sued tax adviser pleaded guilty Thursday to federal tax evasion.  Frank L. "Tiger" Zerjav Jr., 39, of Wildwood, Mo., pleaded guilty to four counts of tax evasion from 2001 to 2004, prosecutors said.

 Zerjav admitted that he funneled his income into several S-corporations and failed to include that income on his tax returns.  

Zerjav admitted that many of the expenses claimed on the S-corporations tax returns were personal and should not have been deducted. Some of the payments were for a condominium at the Lake of the Ozarks, a boat, two Sea-Doo watercrafts and a home entertainment system.

Prosecutors said Zerjav evaded $183,000 in taxes over the four years, though he and the government did not agree on the exact amount of unpaid taxes.

Zerjav faces up to 5 years in prison and a $250,000 fine for each charge. His sentencing is scheduled for March 26, 2013. Twenty-one people, companies or government entities have filed lawsuits against the Zerjavs since 2008, according to the Courthouse News database.

My Take: There is a difference between tax minimization and tax evasion. If you claim accelerated depreciation, or make a stock donation to a charity, or gift part of a business to the children using a family limited partnership, or make a like-kind exchange of real estate, you are still working within the system – albeit working to reduce your taxes. When the conversation includes “omitting income,” one may have crossed the line into fraud. 

Summerlin, Las Vegas and Not Paying Taxes Until 2039

Let me ask you a question, and then we will discuss how taxpayers and the IRS get into high-stakes battles.

Our topic today will be “home construction.” Let’s say that there is a contractor. He buys the land, grades and prepares the dirt, and sends over employees to frame, roof, wrap and finish a house.  Would we say that he is a “home construction contractor?” Yes, we would.

Let’s change this up. Say that he still buys and preps the land, but he sends over subcontractors rather than employees. Is he still a home construction contractor? Yes, we would still consider him as such.

Switch the focus to the subcontractor. Would you consider the roofer to be a home construction contractor? If one allows the terms contractor and subcontractor to be interchangeable for this purpose, then we would say yes. The overall contract is a home construction contract, so arguably any division of such contract would also be a home construction contract. Any slice of a red velvet cake is still cake.

One more. Let’s say that a third party purchases and rezones the land, clears and grades, installs water and sewer lines, builds roads and installs landscaping. He then sells individual lots to homebuilders. What we have described is commonly called a “developer.” Would we consider the developer to be a home construction contractor?

Thus begins the tax issues of Howard Hughes Corporation and its Summerlin development in Las Vegas. This thing is massive, covering almost 35 square miles on the west side of the city.  The development covers an area approximately half the size of the District of Columbia. Summerlin does not expect to sell-out its lots until 2039. Hopefully I will have been long retired and be dipping my feet in an ocean somewhere while enjoying an afternoon mojito.

There are two general tax accounting methods for contractors. One is called the percentage-of-completion method, and the second is called the completed-contract method.

·         Under the percentage-of-completion, one recognizes income as the work progresses. Say that a contract with $5 million estimated profit is 40% complete. The taxpayer reports $2 million in profit ($5 million times 40%) to the IRS. The IRS likes this method.

·         Under the completed-contract, one does not report any income to the IRS until the job is done. In the above example, the taxpayer reports -0- profit, as the job is only 40% complete. The IRS does not like this method as much.

The IRS starts by saying that every contractor must use percentage-of-completion, but it allows a few exceptions to use completed-contract. One exception for completed-contract is for a home construction contract.

Ah, you already see where we are going with this, don’t you?

Howard Hughes Corporation is arguing that it can use the completed-contract because it is a home construction contractor. They are telling the IRS “see you in 2039.” 

The IRS is having none of this. They argue that Howard Hughes Corporation is a home construction contractor the same way The Phantom Menace was a watchable Stars Wars movie. That means that Howard Hughes Corporation defaults to the percentage-of-completion method. The IRS wants its taxes – plus interest and penalties, of course.

Each side has an argument. For example, in Foothill Ranch Company Partnership the IRS conceded that a contract for the sale of land by a developer was a long-term construction contract. In a Field Service Advise dated 5/8/97, the IRS stated that contracts for the sale of land requiring the seller to provide infrastructure or common improvements are construction contracts.

Rest assured that Howard Hughes Corporation has tax advisors who know this.

The IRS in turn determined in TAM 200552012 that a land development company selling lots through related entities did not qualify for completed contract, as the company did not actually build dwelling units. The IRS parsed words in a Code section with the cutting skills of Iron Chef Morimoto, noting that the statute uses the word “and” rather than the word “or.”

            Sigh. Can you believe what I do for a living?

The real estate, especially the development, industry is closely watching the resolution of this case. This is big-bucks. That said, does it make you uncomfortable to take an accounting method – by itself non-controversial – and stretch it to Dali-like and surrealist proportions? This is how tax law too often gets made.

I anticipate that the IRS will assert an argument involving contract aggregation and division. Once the land is implicated with further construction activity, the contracts (land and construction) will be aggregated. The ultimate sale (in our case, the home) will accelerate tax recognition on any underlying contract (in this case, the land). Might be a nightmare for accountants to trace all this, but it makes more sense than Howard Hughes Corporation delaying paying taxes on the sale of Summerlin lots until 2039.

A Tiger, Tax And Magic

There is an accounting firm in St. Louis that seems determined to remain highlighted in the professional literature, and not in a good way. In 2008 the federal government sued Zerjav & Company P.C.  (Zerjav) to permanently ban it from the tax business. There are two Zerjav’s in the firm: the father “Frank” and the son “Tiger.” The father is the CPA. Tiger’s co-workers have called him “the magician” because the numbers on tax returns employees prepare are “magically” different after he reviews the return. I have known people like Tiger. One is soon headed to jail for tax fraud.

The IRS must have gotten way ahead of itself with Zerjav, however, requesting but being denied a preliminary injunction. The government then reached a settlement in 2010 rather than prosecuting the case. Each side can claim victory in a settlement, of course, and the terms of this settlement were not especially harsh. Tiger was prohibited from preparing tax returns or giving tax advice for three years. His father was barred from certain conduct, including:

• claiming business deductions for personal expenses
• improperly deducting restaurant meals, child care or education expenses
• claiming wage deductions for children, unless the children actually worked and the wages were reasonable
• changing accounting records without informing the client

That is, the father was barred from doing things that CPAs are not allowed to do in the first place! The father manufactured deductions virtually out of thin air, but it must not have risen to the level of fraud. As a consequence, the father was permitted to continue his tax practice, although with oversight for a five-year period. 

Tiger could not prepare returns for a few years – but his father could. Really? One doesn’t have to be Houdini to figure an escape from that box.

Well, Tiger is back in the news. 

Last month the government filed an indictment alleging the following:

• Tiger and his wife filed a fraudulent 2001 return showing taxable income of $43,124,whereas the correct income was $210,268
• Tiger and his wife filed a fraudulent 2002 return showing taxable income of $14,053,whereas the correct income was $225,449
• Tiger and his wife filed a fraudulent 2003 return showing taxable income of $23,627,whereas the correct income was $158,984
• Tiger and his wife filed a fraudulent 2004 return showing taxable income of $149,415,whereas the correct income was $231,804

How did Tiger accomplish this sleight of hand? In each case, the government alleges that he altered QuickBooks to conceal his correct taxable income. The IRS issued its QuickBooks summons in 2011. Zerjav resisted but a District Court determined that Zerjav had to produce its electronic QuickBooks backup file.

Folks, this is fraud, and it will get one into HUGE problems with the IRS. Fraud brings in the Criminal Investigation Division of the IRS. These are the guys/gals who have badges and carry guns, and they have little to nothing to do with regular civil tax matters. If convicted, Tiger faces up to five years imprisonment and a $250,000 fine on each count.

Seems like Tiger’s magic may have run out.

Dividing An Inherited IRA

We had a situation where a father left his IRA to his two children. The father was in his 70s, the son was in his 50s and the daughter in her 40s. The tax problem was triggered by having one IRA with two beneficiaries.

There are certain tax no-no's involving an IRA. One is to have your IRA go to your estate. An estate has no “actuarial life expectancy,” as only individuals can have life expectancies. Tax rules require an estate IRA to pay-out much sooner than may be desired or tax-advantageous. A second no-no is what the above father had done.

When there are multiple beneficiaries of an IRA, the IRS requires the IRA to calculate the minimum required distributions (MRD) based on the life of the oldest beneficiary. In our case, it wasn’t too bad, as the siblings were within 10 years of each other. Consider an alternate situation: a son/daughter and a grandchild. In that case the grandchild would be receiving MRDs based on the son/daughter’s life expectancy, which likely would not be in the grandchild’s best financial interest. 

What to do? Split the IRA into two: one for the son and another for the daughter. As long as this is done no later than the last day of the year following the year of death, the IRS will respect the division. This allows the son to use his life expectancy for his withdrawals, and the daughter to use her life expectancy.

 

The jargon for this is “subaccount,” and if you are in this situation (death in 2011), please consider dividing the inherited IRA into subaccounts by December 31.

By the way, there is a tax trap in setting up the subaccounts. These are inherited accounts, and the IRS requires inherited accounts to retain the name of the decedent. What do I mean? Say that Adam Jones passed way, so we would be looking at the “IRA FBO Adam Jones.” When the subaccounts are created, they should be named (something like) “IRA FBO Adam Jones Deceased FBO Benjamin Jones Inherited.” If one does not do this correctly, the IRS can (as has before) consider Benjamin as having withdrawn ALL the inherited IRA and put it into his own separate IRA. Since he withdrew all the inherited IRA, he has to pay tax on all of it, not just the minimum required distribution.

I consider the above tax trap to be unfair, but the IRS has brought down the hammer before. Do not be one of the unfortunate caught in this trap. We have discussed before that even an average person may need a tax pro here and there throughout life. This is one of those moments.