Renting To Yourself And The "Cox" Strategy

My partner brought me a new client’s personal income tax return. He wanted me to “come up with tax ideas,” as though I am an Iron Chef deciding what to do with the show’s “secret” ingredient.

Something caught my eye. Let’s talk about it.

Let me set this up for you:

(1) Taxpayer is married.

(2) The wife is self-employed. More specifically, she is a proprietor and reports her business income on a Schedule C.

(3) The business owns a house used as offices. The business depreciates the house.

(4) As is true for Schedules C, all her profits are subject to self-employment taxes.

There you go. You have all the facts you need.

Got it yet?

It has to do with the house.

There is a tax case from the 1990s addressing self-rental between a business and its owner. Taxpayer (Cox) was an attorney who reported his practice as a sole proprietorship.  His offices were in a commercial building owned jointly by Cox and his wife. He paid himself rent of $18,000, which he deducted from the law practice and reported as rental income elsewhere on his return.

NOTE: Cox addressed the “passive activities” rules. He apparently had passive losses that he could release by generating passive income.  If so, his net rental income might zero-out, and he would still get an income tax deduction for paying himself rent. It would be a win-win – if only the self-rental rule did not prohibit it.

The IRS of course disallowed the $18,000 rent entirely.

Cox went to trial on a very interesting position. He and his wife owned the rental property as tenants by the entireties. He argued that the form of ownership made a tax difference.

The Tax Court was intrigued. It looked to Missouri property law, and it noticed two things. First, each spouse is entitled to the use and enjoyment of the entire property. Second, a spouse cannot unilaterally divest his spouse of his/her interest in the property.

In a tax venue, this meant that Mrs. Cox was entitled to half the rent, and that Mr. Cox could not divest her of that right.

And the Court allowed Mr. Cox a $9,000 deduction for rent on his Schedule C. It disallowed the other $9,000 (that is, his half) under the self-rental rule.

How does this apply to the new client?

Taxpayer and her husband own the house. She owns the business. I see a strategy… for her self-employment tax.

Did I trip you up?

Remember: all her Schedule C income is subject to self-employment tax, which currently is 15.3 percent. One way to reduce it is to take a tax deduction on her Schedule C and report the corresponding “income” somewhere else on her tax return - somewhere that is NOT subject to self-employment tax. Somewhere like a real estate rental.

The tax pros refer to this a “Cox” strategy. The strategy we are talking about may also cause additional taxes under the new Obamacare “net investment income” tax. A tax advisor would have to review the situation and run numbers.

Still, it is something, and it is all your money until they take it from you. If this applies to your business situation, please bring it to your tax advisor’s attention. 

The President’s myRA

The President introduced something called a “myRA” at the State of the Union speech. He explained…

… while the stock market has doubled over the last five years, that doesn’t help folks who don’t have 401(k) s. That’s why, tomorrow, I will direct the Treasury to create a new way for working Americans to start their own retirement savings: myRA. It’s a savings bond that encourages folks to build a nest egg. myRA guarantees a decent return with no risk of losing what you put in.”

The idea here is to encourage small retirement savers. The concern is that routine bank or investment fees (for example, the annual “maintenance” fee for an IRA) may discourage some (or many) from saving for retirement. Under the myRA, the government picks up that tab. The concept makes sense.

The myRA would function as a Roth-type account. Monies going in would not be deductible for income taxes.

Contributions will be automatic, voluntary and small. Initial investments could be as low as $25 and ongoing contributions as low as $5. Contributions would be made through “automatic” payroll deductions.

COMMENT: “Automatic” meaning actual employers who pay people in actual payroll department to process these transactions. Automatic seems to mean “magical” inside the Washington beltway. 

The myRA big deal will be the savers account balance “will never go down.”

COMMENT: Somewhat like a savings account or certificate of deposit. There are – by the way – no annual fees for those accounts either. They are “magical.”

The myRA will earn the same interest rate as the federal employees Thrift Savings Plan Government Securities Investment Fund.

NOTE: Which returned 1.47% in 2012. Unfortunately, inflation for 2012 was 1.8%. The G Plan pays investors the investor the average return on long-term Treasury bonds.  

It will be available to households earning up to $191,000 annually.

Participants will be able to save up to $15,000, or for a maximum of 30 years. 

            COMMENT: Remember: this is a “starter” savings plan.

There would be a provision to transfer the account to a Roth IRA.

COMMENT: That part makes sense, as these accounts can be described as “Roth-lite.”

The President created this by executive action this past Wednesday.

            COMMENT: Really? 

Reflecting the crowd currently occupying it, this White House also wants to compel employers that do not offer myRA’s to offer automatic enrollment IRAs.

OBSERVATION: Approximately half of American workers are not covered by a retirement plan at work, propelling policy mandarins to talk about “mandatory” solutions to the retirement “problem.” I acknowledge the problem - two problems, in fact. First, that many people do not save enough. It might help if they had a job, though. Second, that these hacks and their “mandatory” solutions are themselves a problem.  

Call me completely underwhelmed. 

Court Strikes Down Clergy Housing Exemption

It is a section of the tax Code that goes back to 1954, yet a judge in Wisconsin has determined that the section is unconstitutional.

Makes one wonder how we survived all these years, doesn’t it?

It is the Freedom from Religion Foundation Inc v Lew decision by District Judge Barbara Crabb in November 2013. It deals with parsonages.

Parsonages are related to a church or religious organization. The Code section addressing parsonages is Section 107, and it goes back almost to the passing of the income tax itself. The provision started life in a humble way, allowing ministers of the gospel to exclude in-kind housing (i.e., the “parsonage”) from taxable income. Fast forward a few decades, and the section expanded in 1954 to include cash allowances, wherein one is provided tax-free cash to apply to housing one selects (rather than a house owned by the church).

You have to admit, it is a sweet tax break. I would not mind if such a break existed for practicing tax CPAs.

Would my tax wish be discriminatory? Well, yes. One would have to be a CPA specializing in tax and in practice in order to get the exclusion. What if you were a CPA but did not work in tax? Too bad. You would not qualify under my tax exclusion. 

In tax talk, the Foundation went after section 107 on the Constitution’s “establishment” clause. Judge Crabb found that: 

[Section] 107(2) violates the establishment clause under the holding in Texas Monthly, Inc v Bullock 489 U.S. 1 (1989), because the exemption provides a benefit to religious persons and no one else, even though doing so is not necessary to alleviate a special burden on religious exercise.”

           

Let’s backtrack a bit. Here is Code section 107:

In the case of a minister of the gospel, gross income does not include—

107(1)   the rental value of a home furnished to him as part of his compensation; or

107(2)   the rental allowance paid to him as part of his compensation, to the extent used by him to rent or provide a home and to the extent such allowance does not exceed the fair rental value of the home, including furnishings and appurtenances such as a garage, plus the cost of utilities.

The judge is looking at Section 107(2), which is the cash allowance parsonage. What about the in-kind parsonage of 107(1)?

           

Initially the Foundation went after both 107(1) and 107(2), but the government motioned for summary judgment. The Foundation backed off, pressing only on Section 107(2).

Why?

It has to do with having “standing” to challenge a law. In brief, one is required to show injury, or the possibility of injury, traceable to the defendant and subject to remedy by the court.  As the Foundation did not have a parsonage of its own, it could not claim standing under Section 107(1). It did however change its compensation policy to pay a cash allowance to its “ministers of the gospel” (I admit, I do not understand that combination of words in reference to this Foundation), thereby bringing it into the orbit of Section 107(2). Since Foundation employees could not benefit from Section 107(2), the Foundation obtained standing.

I am not certain this lawsuit is really about taxation as opposed to hate politics, but it does have dramatic tax repercussions.

The clergy housing exemption benefits approximately 44,000 priests, ministers, rabbis and imams. It is estimated to “cost” $700 Treasury million per year. For many, it is not an insignificant piece of their compensation.  It may mean the difference between continuing in religious leadership or curtailing or abandoning their work because of financial strain.

Then there are others, such as the pastor of Elevation Church in North Carolina, who have to push the matter. The pastor is building a 16,000 square foot house, which, when completed, will be one of the largest homes in Charlotte.

My thoughts?

The tax code has long recognized that some employees are not in control of where they live, and the code has provided breaks accordingly. For example, innkeepers are usually not taxed on their accommodations, nor persons working in remote areas, nor – for that matter – the President of the United States for residency in the White House. This is the “convenience of the employer” doctrine, and it has been around as long as Section 107 itself.

Does a parsonage meet the “convenience of the employer” standard?

We don’t know, as Judge Crabb did not go there. Her decision is based on the establishment clause.

To her credit, Judge Crabb has said her ruling would not take effect until all appeals are concluded.

We can expect the politicians to step in before this story is done.

I do like the idea of a President paying taxes for living in the White House, though.

JPMorgan's Nondeductible Madoff Deal

On January 7, 2014, JPMorgan entered into a deferred prosecution agreement with the Justice Department. This is another payment in the ongoing Bernie Madoff saga, and the bank agreed to pay a $1.7 billion settlement as well as $350 million to the Office of the Comptroller of the Currency and $543 million to a court-appointed trustee.

Madoff kept significant balances with JPMorgan.  Banks are the first line of defense against fraud, but JPMorgan never filed suspicious activity reports with regulators, even though there were significant reservations as to when they became suspicious. The bank did not admit any criminal activity in the agreement, but it did allow that it missed red flags from the late 1990s to late 2000s.

What caught my eye was the following text from the following joint release by the Manhattan U.S. Attorney and FBI:
           

… JPMorgan agrees to pay a non-tax deductible penalty of $1.7 billion, in the form of a civil forfeiture, which the Government intends….”

This is unusual language.

The tax code provides a tax deduction for all of the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.

And then the tax Code starts taking back. One take back is Section 162(f):

162(f) FINES AND PENALTIES.— No deduction shall be allowed under subsection (a) for any fine or similar penalty paid to a government for the violation of any law.

Let’s drill down a little bit into the Regulations:

This prohibition applies to any fines paid by a taxpayer because the taxpayer has been convicted of a crime (felony or misdemeanor) in a full criminal proceeding in an appropriate court.   The prohibition also extends to civil fines if the fines are intended by Congress as punitive in nature.

So, if fines are paid pursuant to a criminal case, then the taxpayer is hosed. However, if fines are paid pursuant to a civil case, there is one more step: are the fines punitive in nature?

Attorneys differentiate damages between those that are remedial and those that are punitive. A remedial payment is intended to compensate the government or another party – to “make one whole,” if you will. It is intended to restore what was disturbed, upset or lost, and not intended as penalty or lashing against the payer.

Let’s complicate it bit. There is a court case (Talley Industries Inc v Commissioner) that allows damages to be deductible if they are remedial in intent, even if labeled as a fine or penalty.

EXAMPLE: The NFL fines a player for unnecessary roughness. The NFL can call this a fine, but it is not a fine per Section 162(f) and will be deductible to the player involved.

You are seeing how this is fertile hunting ground for tax lawyers. Unless the payment is pursuant to a criminal case, odds are good that it is deductible.

Now remember that this agreement is Madoff related, and that there are hard feelings about JPMorgan’s involvement with Madoff over the years, and you can see why the Justice Department included the “nondeductible” language in the agreement.

Let’s take this a step further. Under Talley, JPMorgan could deduct the $1.7 billion on its tax return. Remember, it is not a fine or penalty under Sec 162(f) just because somebody somewhere called it as such.

Would JPMorgan be likely to do this?

This is a “deferred prosecution” agreement.  If JPMorgan did deduct the settlement, they might not have an issue with the IRS, but they would likely have a very sizeable issue with the Justice Department.