Sunday, June 27, 2010

Breaking Up is Hard to Do

There are quite a few developments in the last few months I am hoping to spout about, but I am going to skip straight to PLR 201024005. The situation is not a common one , but it is a good starting point for a discussion of the tax aspects of divorce. The taxpayer held securities that were qualified replacement property from the sale of stock to an ESOP. The requested ruling , which is favorable, holds that the transfer of the securities to the taxpayer’s spouse will not be a gain recognition event.

All well and good. The question that intrigues me is whether taxpayer’s spouse knows the implications of the settlement. In my fantasy spouse will turn the securities over to a money manager who will sell them all and end up being shocked with the resulting tax bill. There used to be a joke that there are three ways to get out of a burned out tax shelter. The first was to put the interest into a defective grantor trust and then cure the defect . It was a really neat idea. It doesn’t actually work, but it was clever. Then there was dying. Pretty drastic, but it worked (until this year anyway). Finally there is giving it to your spouse and getting a divorce. Still works.

The important thing to remember is that property received in a divorce has the same basis that it had to the couple. So if one spouse gets a pile of money and the other spouse gets a pile of low basis assets of equal gross value, there really hasn’t been an even split. If the couple has significant assets, this could be a much more important issue than who gets the dependency deduction. The dependency deduction seems to garner much more attention than it is worth. Ironically, despite all the attention it is not unusual to neglect to follow through on the requirement that non-custodial parents obtain a release form.

Filing joint returns, in my experience, seems to usually be taken as a given. In situations where you have reason to believe that your spouse has unreported income or even when they have a high exposure return, the smart thing could be to forgo some savings in the interest of peace of mind.

Finally, if alimony is involved you need to be aware that there are fairly complex rules to prevent alimony treatment for payments that are more in the nature of property settlement or child support.

Monday, June 21, 2010

The Magic of S Corporations - Tax Alchemy in Reverse

I remember a time when we had an Internal Revenue Code that was almost as old as I was. The Internal Revenue Code of 1954. Thankfully they kept the numbering scheme intact. Back then we had real tax shelters. Pure tax shelters worked on two principles. Defferal and conversion. You sheltered ordinary income with de

ductions in excess of your cash outlay. That turned around on you eventually but you recognized the turn around as a capital gain. That’s the conversion. Ordinary income taxed at 70% converted into capital gains taxed at 20%. Lead into gold.

I think it takes someone of my age to fully feel the pain of the Nathel brothers who managed to turn gold into lead with their S corporations. The arguments to salvage the situation were clever, but the tax court would have none of them and the second circuit recently confirmed the tax court. The Nathel brotheres each owned 25% of three S corporation. The same unrelated person owned the remaining 50% in each of the corporations. They entered into an agreement whereby one of the corporations was liquidated, they redeemed the third party from another and they were redeemed from the third. The third one called G&D was the source of their tax troubles.

G&D had been experiencing losses so the basis in their stock was exhausted. Additional losses had reduced their basis in loans of $649,775 that they had each made to around 112,547 each. In addition they had guaranteed about 2.5 million of G&D debt. In 2001 G&D fully repaid their debt. Then they each made a capital contribution of $537,228 to G&D which allowed them to be released from their guarantees. Then they surrendered their stock in G&;D in accordance with the restructuring.
The bottom line of their check swapping with G&D was ordinary income of $537,228 from the debt repayment and $537,228 of capital loss from the stock redemption. They tried two arguments. The first was that the capital contribution was a form of exempt income to the corporation. If the corporation had income it would go first to restore debt basis rather than stock basis. The second argument was that the capital contribution was motivated by getting out of the debt guarantee and therefore should be an treated as an ordinary loss. Neither argument went anywhere.

There are two observations to be made here. The first is that it is possible that LLC’s would have better served their purposes. The unified basis of partnership interests would likely have prevented this odd result. The other is that just a little bit of paperwork might have also saved the day. If the S corporation loans had had written evidence of indebtedness then the repayment would have been a capital gain.

All in all, it is a sad tale.

Thursday, June 17, 2010

Sometimes You Should Just Pay The Taxes

PMTA 2010-05

PMTA 2010-05 is a reasonably taxpayer friendly statement. It is, however, reasonable to infer that the affected taxpayers are not exactly jubilant. PMTA stands for Program Manager Technical Assistance. True tax junkies are not satisfied with the various rulings issued by the IRS for public consumption - Revenue Rulings, Revenue Procedures, Notices, etc. We have to use the Freedom of Information Act to eavesdrop when the IRS is talking to itself. Of course Research Institute of America does the heavy lifting. The question that the PMTA addressed was :

Whether the temporary pooling of funds on a non-pro rata basis and the appointment of a tenant-in-common owner (“TIC Owner”) as a payment and/or communications agent because of the bankruptcy of the master tenant will cause the tenants-in-common to become partners in a partnership for federal income tax purposes?

The answer was no. With typical IRS hedging the no was qualified with the assumption that the arrangements weren’t actually partnerships to begin with.

I suspect that there are many sad stories hidden behind this ruling. The TIC structure is a creature of tax law. The most general rule of tax law is that when you exchange one thing for something else, you recognize gain, if any. There are of course exceptions. Several of them are collected in Part III of Subchapter O under the heading “Common Non-Taxable Exchanges” including Section 1031 which calls for non recognition of gain or loss when the properties exchanged are of “like kind”. Of course exceptions wouldn’t be real exceptions if they didn’t have their own exceptions. Among the items that cannot be on either side of a qualified like kind exchange along with stocks, bonds, animals of different sexes and “choses in action”(whatever they are) are interests in a partnership.

The 1031 exception is particularly significant in real estate because, for the most part, all real estate in the United States is like-kind to all other real estate in the United States. So if you trade your stallion for a brood mare that is not like-kind, but if you trade your horse farm for an office building it is. You can even exchange your whole horse farm for part of an office building. Which is where the partnership thing comes in. What is the difference between a piece of real estate owned by diverse persons and a partnership of diverse persons that owns a piece of real estate? Such questions keep tax attorneys awake at night and also well fed. Revenue Procedure 2002-22 tells your the conditions your arrangement must meet to be worthy of asking the IRS to rule that it is not a partnership.

That revenue procedure was part of the birth of a veritable industry. Someone selling rental or investment property had always had the opportunity to structure the sale as an exchange by inserting a third party facilitator and is even allowed time after selling the initial property to identify to the facilitator (45 days) the replacement property and for the facilitator to acquire the property (lesser of 180 days or the extended due date of the taxpayer’s return). Someone tired of being a landlord might however view that as exchanging one headache for another. By having a TIC interest as their target there was a broader range of properties available and there would be someone else to deal with all the tenant problems and repairs . Someone else to go bankrupt and leave the TIC members holding the bag.

The saddest part in the PMTA is the reference to the fact that there will be non-prorata cash contributions. Reading between the lines one can infer that some of the owners are bit resentful at having to kick money in to straighten out the mess that they have landed in.

A couple of observations and then a moral. Even if the subsequent events converted the TICs into partnerships, this should not affect the validity of the like kind exchanges that had the TIC’s as their targets. Presumably the investors did not have the master tenant’s bankruptcy as part of their plans, They might want the ruling anyways since preparing a partnership return in these circumstances would be somewhat challenging. Since 1031 defers both losses and gains, some investors might want to argue that the arrangement really was a partnership to begin with and the partnership interest they received was worth less than their basis in their relinquished properties. That would be a real tough argument to make though,

The moral is that tax savings are money. If buying something allows you to save taxes then the thing that you buy doesn’t cost you as much. It doesn’t make it free. And it is possible that , even with the discount that the tax savings creates the thing is not worth what you are paying for it. I might go so far as to speculate that if the thing is designed with tax savings in mind that the designer feels entitled to a goodly share of your tax savings. In some cases, it might be your tax savings and then some. In which case, as the title says, it would be better to have just paid the taxes.

Oh by the way :

Any tax advice contained in this communication is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.

Tuesday, June 8, 2010

Steve Martin - Tax Advisor

Private Letter Ruling 201016097

There is a bit that Steve Martin does where he tells you how to make a million dollars and pay no income tax. It’s a very simple plan. First you make one million dollars. Then you pay no income tax. He then addresses the possibility that the IRS might contact you. Simple. You just say “I forgot”.

Any time I see something of such elegant simplicity I want there to be something to it. Some kernel of truth hidden in the nonsense. When it came to Steve Martin’s routine, though, I despaired Until now.

Private Letter Ruling 201016097 was not directed to Steve Martin. The ruling is directed to a taxpayer who is 82 and according to Wikipedia, Steve was born in 1945. Nonetheless it finally vindicates him as a tax advisor. The taxpayer withdrew all the money from a Roth IRA and failed to put it into a rollover Roth within 60 days. The head note to the ruling indicated that the failure was “due to her mental health conditions which affected her ability to handle her financial affairs”. (That “her” is another clue that it wasn’t Steve Martin, himself, applying for the ruling). More on the gender issue follows.

I thought we might be heading to a punch line involving you have to be crazy to blow a roll over deadline, but I was delighted on deeper reading to find an illustration of the Steve Martin Rule (We need to specify Steve to avoid confusion with Martin Ice Cream, a key decision on personal good will). As we read about Taxpayer A moving funds from IRA Account X to non IRA account Y at financial institution M. We find “Taxpayer A represents that he suffers from a condition which impairs his memory.” There it is. “I forgot.” Whether the memory issues having anything to do with the gender transformation between the head note and the third paragraph is a question left unanswered.

Taxpayer A was granted relief. He or she may have forgotten about the whole thing by now, but the rest of us can remember the next time we are in a jam to say “I forgot.”

Oh by the way :

Any tax advice contained in this communication is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein