Can A Trust Carryback A Loss for A Tax Refund?

I am remembering a tax issue from 2004. The firm I was with had a sizeable business client. The business owner had two daughters and wanted them to participate in the business. One daughter did; the other daughter went on to other pursuits. The father transferred shares to his daughters using special trusts: first a QSST (Qualified Subchapter S Trust), followed by an ESBT (Electing Small Business Trust). Trusts are normally disallowed as eligible S corporation shareholders, but the tax Code makes an exception for a QSST or an ESBT. Dad settled the trusts and acted as their trustee. He was of course also the majority shareholder and CEO of the underlying company.

The company was impressively profitable, but in 2004 it had a loss. It happens.

The company had been profitable. Its shareholders, including the trusts, had previously paid taxes on that profit. Now there was a business loss. Could the shareholders – more specifically, the trusts – use that loss to any tax advantage?

And we walked right into IRS Regulation 1.469-8. As a heads up, there is no Regulation 1.469-8. The IRS reserved that slot to provide its position on material participation by a trust. However the IRS never wrote the Regulation. Practitioners were required to divine whether their client trusts would be “materially participating” in an activity or whether the trust would be “passive” in an activity.

You may remember the “passive activity” rules in the Code. These were passed in 1986 as another effort to limit tax shelters, a task which they accomplished to an admirable degree. It did so by dividing business activities into material participation and passive activities. Generally speaking, losses from passive activities could not offset income from material participation activities.  There were problems, of course, one of which was Congress’ decision to label most real estate activities as “passive.” That may be the case for many, but there are people out there who make their living in real estate. For them real estate is about as passive as my involvement with my CPA firm.

Seven years later Congress corrected this error by enacting Section 469(c)(7), which said that the passive loss rules did not apply to someone who worked at least 750 hours a year in real estate, provided that his/her real estate activities were more than one-half of his/her hours worked for the year.

Now, our client company had nothing to do with real estate but had a lot to do with plastics. Section 469(c)(7) did not apply to them. I was aware that the IRS had informally intimated that a trust could not materially participate because a trust was not a person, and only a person could materially participate. I guess their reasoning made sense if material participation was like breaking a sweat.

The law was relatively new, and no one had yet challenged the IRS. The IRS was in no hurry to publish a Regulation. Why? I thought both then and now that the IRS suspected they had a losing hand, but they were not going to back off until they were forced. The IRS could ride roughshod until someone brought suit.

And I am looking at that someone. The case is Aragona v Commissioner, and it was a Tax Court case decided March 27.

Frank Aragona settled the trust in 1979. He died in 1981, at which time the trust went irrevocable. The trust had several trustees, the majority of which were family members. The trust owned a real estate LLC, which employed several people: family, leasing agents, maintenance workers, clerks, a controller and so on. Three of the trustees worked there and received a paycheck from the LLC. It was clear the LLC was materially participating in a business activity.

During 2005 and 2006 the LLC incurred losses. The trust treated the losses as “material participation” and carried the losses back to the 2003 and 2004 tax years for tax refunds.

The IRS said these were passive losses. No passive losses were allowed, much less operating losses that the trust could carryback for tax refunds. The IRS wanted back almost $600,000 of taxes. In addition, they asserted penalties.

Here was the IRS argument before the Court: a trust is incapable of performing “personal services” because Regulations define “personal services” to mean “any work performed by an individual in connection with a trade or business.” Obviously a trust is not an individual.

The Court immediately spotted the obvious: a trust is a fiduciary vehicle whereby a trustee agrees to act in the best interest of a beneficiary. The trustee may be a “person.” If that “person” in turn performs personal services in his/her role as trustee, then why cannot those personal services be attributed back to the trust?  How else could a trust possibly do anything? The trust would have performed personal services in the only way it can: through its trustees. The same concept applies for example to a corporation. As an artificial entity, a corporation can only act through its officers. It does not have arms and legs and cannot join a softball league. Its officers can, however.

The IRS continued that a trust cannot perform personal services because of words that Congress used in committee reports and selected Code sections. Funny, said the Court. When Congress intended that a Code section disallow trusts, it used the term “natural person.” A trust, not being a natural person, cannot take advantage of that Code section. Congress did not use that term in the Code section addressing material participation. Why-oh-why would that be, asked the Court.

The IRS lost and the Aragona trust won.

Let us say a word about the penalties the IRS wanted. Obviously they became moot when the Aragona trust won, but how could the IRS possibly defend asserting penalties in the first place? It refused to publish Regulations for 28 years, and when someone had the audacity to challenge them it responded by asserting penalties?

Here is an observation from a tax pro: the IRS is all but automatically asserting penalties these days. If there is an adjustment, the IRS clicks through its quiver of available penalties and lobs a few your way. It does not care whether you had authority for your position or whether you were just being zany. The government is going broke and the IRS is chasing money under every seat cushion. However, is this good tax policy? Shouldn’t penalties be reserved for those claiming unsubstantiated deductions, masking transactions or just making up their own tax law?

Here is an idea: if the IRS asserts a penalty and loses the issue, the IRS has to pay you the penalty amount. Force them to risk a losing hand. Maybe that will prompt them to back-off a bit.

Congratulations to the Aragona trust for taking this on. 

It's Opening Day!

One does not need to be a baseball fan, just exhausted with winter.

Wish I could be there.

Be Careful If You Are An Executor For An Estate

I infrequently see estate returns. Granted, the fact that one does not need to file a federal estate return until one’s taxable estate exceeds $5,250,000 has a lot to do with it. Ohio has also helped by eliminating its estate tax, which used to apply with estates as low as $338,000. Some practitioners call this the “estate estate” return, as one is being taxed for owning property.

Then there is the estate “fiduciary” return. If you consider the estate return as a snapshot of one’s net worth at death, then the estate fiduciary is the income that net worth throws off until assets are finally transferred out of the estate and to the heirs.

One can have a sizeable estate and have no estate fiduciary return. How? Simple. One way is for the assets to transfer independent of a will, such as by joint ownership or by beneficiary designation. For example, a house owned jointly with a spouse will transfer automatically and without intervention of a probate judge. The same goes for IRAs with designated beneficiaries.

We have seen several times this year an estate with an estate fiduciary issue, although no “estate estate” return was required. What caused it? The deceased did not designate a beneficiary for his/her 401(k) at work or IRA outside work. The default is that the 401(k) or IRA goes to the estate. The attorney then holds up distributing cash because of other issues, such as bickering heirs.

Remember: the estate is filing an income tax return, the same as you are next month. An accountant has some discretion over picking the estate’s taxable year, but we cannot make its annual tax filings magically go away. If the estate gets that 401(k) and parks on it, it also gets the tax consequence of a 401(k): that is, there is tax due. There is no difference in tax because it goes to an estate rather than to you.

An estate – like a trust – however is an odd tax animal, as it can “give away” its taxable income. You and I cannot (for the most part) do that. It does so by distributing cash to the heirs, and any taxable income attaches to the cash like a bad cold.  

The estate wants to distribute cash the same year as it receives the 401(k). Why? To pull the income out of the estate fiduciary. Granted, this shifts the income to the heirs, but then again they received the cash.

We were dangerously close in a couple of cases where the attorney was delaying distributing cash and running out of days remaining in the estate tax year.

Then there is the worst-case scenario: the probate takes several years and the attorney holds up distributions until issues are resolved. The attorney finally sends the paperwork to the accountant, who is now reviewing transactions from years before. There is no planning possible. It is too late.

Let’s say that the estate received $700,000 of IRA proceeds in 2012.

The estate finally closed probate in 2014. Perhaps it was held up because of real estate. The attorney writes checks all around, holding back just enough money to pay the accountant.

And the accountant clues the attorney that the estate had tax on the IRA in 2012. So what, says the attorney; he/she made distributions to the heirs. Don’t distributions pull income with them?

Well, yes, but in the same taxable year. 2012 is not the same taxable year as 2014. The estate was supposed to pay tax for 2012. The heirs would like this result, as there would be no tax to them upon distribution in 2014.

But there is no cash left in the estate, says the attorney. What is the downside?

I am looking at U.S. v Shriner, a District Court case from Maryland. The facts are not complicated:

·       Mrs. Shriner passed away in June 2004.

·       She had failed to file income tax returns for 1997 and years 2000 through 2003.

·       The executors (Robert and Scott Shriner) hired a law firm to sort it out.

·       The law firm did and filed tax returns.

·       The IRS informed the law firm that over $230,000 was due in taxes.

·       The estate distributed over $470,000 to Robert and Scott, meaning that …

·       … the estate did not have enough cash to pay the IRS.

Robert and Scott were in trouble. They distributed assets of the estate, rendering it insolvent and unable to pay its taxes. They had better get the Court to believe that they did not know this would happen – and they could not have known this. They however failed to do so. The result? They were personally liable for the tax.

Wait a minute, you say. You mean that someone – let’s say you – could be liable because someone distributed estate assets to you, rendering the estate insolvent? How could you possibly know that?

No. What I am saying is that - if you are the executor and distribute assets in sufficient amount to leave the estate insolvent – you will be personally liable. You are the executor. You are supposed to know these things.

Combine that outcome with above-discussed tax due on a previous year IRA distribution. I have little doubt the attorney was writing distribution checks shortly after our conversation.

What Can The IRS Do To You For Ignoring That Wage Or Levy Request?

What happens if the IRS sends you a levy (say on an employee, but it could also be your account payable to a vendor) and you ignore it?

You can guess that it is not going to be good.

I am looking at U.S. v 911 Management.

Daniel Dent was the sole manager of 911 Management, a limited liability company. The company must have been successful, as it was distributing $5,700 monthly to Kathy Weathers, one of its members. In 2007, the company further entered into an agreement with Kathy to operate two hotels owned by her, from which it would pay her 3% of the monthly gross proceeds.

In 2007, the IRS served levy against the bank accounts of 911 Management. That action wound up in litigation.

In February 2008, the IRS served Notice of Levy on 911 Management. It wanted both the $5,700 and 3%, as the Weathers had fallen behind on taxes for 1996 and from 1998 through 2006. Turns out that Tom and Kathy Weathers were convicted of tax fraud. Tom was serving 60 months at Club Fed, and Kathy received two years of probation.

OBSERVATION: Tom Weathers went to prison in October 2005. Coincidentally, 911 Management was formed the same month. The Company was paying Kathy $5,700 monthly, and that amount increased when she added the management of two hotels into the mix. The IRS was fairly confident that the transaction was a sham and a way to provide monies to her while her husband was in jail.

There were technical issues with the levy notice, and the previous levy effort by the IRS was in litigation. Dent contacted his business advisor as well as an attorney, and he in turn received two separate but not conflicting responses. The business advisor informed him that a bond had been posted, satisfying all the back taxes for the Weathers. It was therefore not necessary to honor the Notice of Levy, as the matter had been resolved.

COMMENT: The Revenue Officer informed Dent otherwise and that monies were still due. This must have alerted Dent that not all the facts were in.

Dent also contacted an attorney, who had reservations about the levy procedure itself. The attorney believed that the levy did not apply, because the levy was for salaries and wages and the payments to Mrs. Weathers were neither.

OBSERVATION: Thus began a high-stakes gambit. There are tax practitioners who play a heavy-procedural game, waiting if not stoking the IRS to make a procedural mistake. For the most part, I have found this to be the arena of the tax attorneys rather than tax CPAs, and I have been on the listening end of some scathing anecdotes by IRS revenue agents over the years. The IRS catches on, of course, and will commonly assign more experienced agents when such a practitioner surfaces. Still sometimes the tactic works, and the tete a tete continues another day.

Dent informed the revenue officer that the levy did not apply. He of course did not remit the $5,700 or the 3%. The revenue officer vociferously disagreed. Dent did not remit anything, relying upon his attorney’s advice that the levy was erroneous.

Remember that I mentioned the IRS had levied in 2007, a year before? That case was decided, and both 911 Management and Dent were held personally liable for the levy request. That is what happens when one ignores a levy: one steps into the shoes of the delinquent taxpayer. It is the levy equivalent of the “responsible person” taxes, which apply when one does not remit withheld payroll taxes.

So Dent was held personally responsible. Can it get worse?

You bet.

There is another penalty: the Section 6632(d)(2) penalty, which is 50% for failure to honor the levy. The IRS wanted this penalty against Dent. Remember, the IRS believed 911 Management to be a sham, so they were going to go the extra mile against Dent for participating in the sham and resisting the levy.

There is a “reasonable cause” exception to the penalty, and the Court decided that Dent had reasonable cause. How? Apparently, there was enough smoke on the water over IRS procedure in pursuing the levy that the Court accepted Dent’s reliance on his attorney as reasonable cause.

Mind you, they accepted his reliance on an attorney as reasonable cause to not levy another 50%. Dent was already personally responsible.

Another “win” like that and Dent might bankrupt himself.

COMMENT: 911 Management came into existence when Mr. Weathers went to jail in 2005 for five years. When did 911 Management cease doing business? Five years later – 2010 – when Mr. Weathers was released from jail. Coincidence? Just saying.