Monday, January 31, 2011

A Sad Life Insurance Story

John M. Sanders v. Commissioner, TC Memo 2010-279

I've mentioned in a previous post that life insurance has some marvelous income tax benefits.  The build-up in value is tax deferred and becomes income tax free if it is paid by reason of the death of the insured.  Life insurance salesmen will sometimes claim it saves estate taxes.  This is a bit of a fallacy.  The estate tax savings come from having the insurance owned outside the decedent's estate.  Any appreciating asset would produce the same benefit.  Life insurance does have the merit of providing liquidity exactly when it is needed in some estate plans.  It all kind of makes me feel bad for Mr. Sanders who managed to figure out a way to manufacture taxable income for himself without the cash to pay the taxes.

Mr. Sanders had a $25,000 life insurance policy with New York Life.  He paid $31 per month on the policy from 1979 to 2006.  Between 1990 and 2004 he borrowed $7,136 on the policy.  Under the terms of the policy, interest on loans accrued at 8%. In 2006 he received a letter that the loan amount and accumulated interest was $17,203, which was $517 more than the policy's surrender value.  Unless he paid $517 the policy would be cancelled.  He didn't pay the $517 so his policy was cancelled.

He received a 1099-R from New York Life showing a distribution of $17,292.  The taxable amount was $7,175.  That is the gross distribution of $17,292 less premiums of $10,117.  Mr. Sanders found the whole thing a little confusing :

Petitioner testified that he disagrees with the taxable amount shown on the Form 1099-R because he “just did the math basically in my head” and he thinks New York Life's “mathematics are way off.”

The Tax Court didn't find much merit in his argument.

These vague contentions do not rise to the level of a “reasonable dispute” so as to impose any burden of production on respondent pursuant to section 6201(d). In any event, stipulated documentation of petitioner's premium and loan history with New York Life corroborates the information reported on the Form 1099-R.

I have a lot of sympathy for Mr. Sanders.  He paid $10,117 to an insurance company.  He drew out $7,136.  It appears coincidental that the amounts are so close, but he ended up being taxed on the entire withdrawal plus $39.  Of course he had the peace of mind that somebody would be getting $25,000 less the outstanding loan balance in the event of his death.  According to standard valuation tables that comfort would be worth less than $25 a year until Mr. Sanders was in his forties.  We can't tell from the case how old he was when he started the policy so I don't think I will go any further with that part of the analysis.

A key fact that does not receive much emphasis is:

Between 1990 and 2004 petitioner borrowed $7,136 against the policy. Insofar as he recalls, he used the proceeds for personal purposes.

So the interest that he wasn't paying was "personal interest" and not deductible.  When he constructively paid it with a deemed distribution of the cash surrender value of his policy, there was not an offsetting deduction.   He had taxable income because he didn't pay the interest he incurred for borrowing his own money.  Go figure. This was probably not the outcome that Mr. Sanders expected when he started dutifully paying his $31 per month while we were all worrying about the hostages and cursing the Ayatollah.  I hope somebody from New York Life expressed some sympathy.

Friday, January 28, 2011

S Corp Rental

Private Letter Ruling 201050002

There must have been a time when it was a good idea to have real estate in a C corporation.  It was well before my time, though and that is starting to be a while ago.  My career commenced in the waning days of the Internal Revenue Code of 1954.  Even then, before they had assassinated that indomitable old soldier General Utilities, it was not a good idea. It still happens though and they are still around here and there.  One way to deal with the problem is an S election.  Then you just have to wait ten years, although maybe it will be seven or five, if you are lucky.

The only problem is that an S corporation cannot have "passive income" greater than 25% of its gross receipts if it has accumulated earnings and profits.  If it does it is subject to an entity level tax and if the condition continues for three years it is bounced out of S status.  One solution to the problem, which I discussed in an earlier post is to purge earnings and profits.  Then there is the more risky, but also more entertaining, "DUH" approach outlined in PLR 201042010.  Purging earnings and profits can be expensive though, PLR 201050002 points to another possibility.

Included in "passive income" for purposes of the S corporation excise (Section 1375) is rent.  Rent is also considered a per se passive activity under the passive activity loss rules of  Section 469. Interest and dividends on the other hand are explicitly passive income under 1375 and explicitly not passive income under 469.  I could explain why this "makes sense", but I prefer, in this case, to stick with my "It is what it is. Deal with it." philosophy.

It turns out however that there is rent and there is rent. I have little doubt that the operation outlined in this PLR would be a rental activity for 469 purposes, but it is not considered passive income under Section 1375.  Here are the facts :

Company was incorporated under the laws of State on Date 1, and elected under § 1362(a) to be an S corporation effective Date 2. Company owns, leases, and manages commercial rental real estate. In addition, Company owns an interest in Entities all of whom own, rent, and operate commercial office and industrial buildings and apartment and multi-family residential buildings. Company is actively involved in the management of each of the Entities. None of the Entities have hired employees or other management companies to handle the day-to-day business of operating the properties owned by them.

With respect to the wholly-owned properties, Company is actively involved in performing all of the leasing and administrative functions for maintaining the properties, including repair and maintenance services. Company has A employees and multiple independent contractors involved in the day-to-day activities associated with its commercial real estate.

With respect to each of the properties owned by the Entities, Company performs varying services. For example, Company may be responsible for management, financing, tenant negotiations, cash flow decision making, remodeling decisions, lease approval and negotiations, major development approval, mortgage and sale negotiations, advertising, repairs and maintenance, capital improvements, services for snowplowing, lawn care, trash removal, overseeing construction, and bookkeeping.

For the tax year ending in Year, Company collected approximately $B in gross rents and paid or incurred approximately $C in relevant operating expenses (other than depreciation).

The ruling goes on to explain the relevant regulation.

Section 1.1362-2(c)(5)(ii)(B)(2) provides that “rents” does not include rents derived in the active trade or business of renting property. Rents received by a corporation are derived in the active trade or business of renting property only if, based on all the facts and circumstances, the corporation provides significant services or incurs substantial costs in the rental business. Generally, significant services are not rendered and substantial costs are not incurred in connection with net leases. Whether significant services are performed or substantial costs are incurred in the rental business is determined based upon all the facts and circumstances including, but not limited to, the number of persons employed to provide the services and the types and amounts of costs and expenses incurred (other than depreciation).

The problem with applying this strategy is that there is no bright line test.  If it fits your facts you may really have no alternative to getting a ruling if you want peace of mind.


Wednesday, January 26, 2011

Group Home Qualifies for 27.5 Year Life

CCA 201049026

I always thought of group homes as something that would be run on a not for profit basis.  According to the blurb for this book I was wrong:

This guide gives concise, step by step instructions for starting a group home. The demand for group homes far exceeds the supply in a lot of areas in the US. Because of the aging baby boomers, demand is likely to continue to grow as government and individuals look for cost effective alternatives to assisted living and retirement homes.

Regardless of that, this CCA caught my eye.  These are just excerpts from it, but they get the main point across pretty well.

House used to operate adult home care business that cares full-time for adults who can't live on their own qualifies as IRC Sec(s). 168(e)(2) residential rental property, and consequently owners should determine depreciation for portion of house leased as dwelling units by its customers of adult home care business, but not portion of house that is owner-occupied, using a 27.5-year recovery period or 40-year recovery period if alternative depreciation system of IRC Sec(s). 168(g) applies.

In the facts in this advice, the rental units are bedroom apartments used to provide living accommodations within a building, and are not units in an establishment more than one-half of the units in which are used on a transient basis. Therefore, the rental units are dwelling units for purposes of § 168(e)(2). All units and associated common areas in the building, including the portions occupied by the taxpayers, are dwelling units, and no portion of the building is rented or used for commercial purposes outside of the taxpayers' adult home care business. Consequently, 100 percent of the gross rental income from the building is rental income from dwelling units, even after taking into account the use of the dwelling unit by the taxpayers. In applying the 80-percent test in this case, the $2,000.00 per month allocated to the services that the taxpayers provide for their residents does not constitute gross rental income from the building because the services (24 hour supervision and care for the residents, laundry service, maid service, transportation) are other than those usually or customarily rendered in connection with the mere rental of rooms 1. Thus, in this case, the building is residential rental property. case), it is unimportant whether a particular cost for services is included in rental income or not, as 100 percent of gross rental income from the building is necessarily rental income from dwelling units.

This Chief Counsel Advice does not address whether § 280A limits the taxpayers' deductions for the use of a portion of their residence for business purposes.

In addition, the term “dwelling unit” is defined differently under § 280A(f)(1) than under § 168(e)(2)(A)(ii)(I). The conclusions in this Chief Counsel Advice concerning whether the bedroom apartments used in the taxpayers' business are dwelling units are limited to the analysis under § 168, and no inference should be drawn from this Chief Counsel Advice that these bedroom apartments are dwelling units for purposes of § 280A.

Upkeep of the house and landscaping are services customarily rendered in connection of the rental of rooms, and a portion of the monthly $2000 charge must be allocated to these services and included in both gross rental income from the building and rental income from dwelling units. The exclusion of charges for services other than those usually or customarily rendered in connection with the mere rental of rooms is relevant in the application of the 80 percent test only in the case of a building or structure containing both rental dwelling units and commercial rental space other than dwelling units. In the case of a building or structure comprised solely of dwelling units and associated areas (such as the instant

Monday, January 24, 2011

Another Scoop for PAOO - Short Sale Relocation Assistance Does Not Create Lien Equity

CCA 201103045

So here is another bonus post.  Last week I did a post on CCA 201102058.  It concerns relocation grants under the HAFA program.  As I understand the program a senior lien holder can pay an upside down property owner up to $3,000 in relocation assistance to facilitate a short sale.  The CCA indicated that the IRS cannot require that this money be turned over to them as a condition of releasing their otherwise worthless lien.

CCA 201103045, which I reproduce in full below explains that the position on relocation assistance is similar to the position that was first enunciated in PMTA 2010-058.  In that statement they discussed carve outs for transfer taxes, which also do not create equity.
Over the weekend I received an e-mail from someone whose short sale was being hung up because of this issue.  I have yet to see any other commentary on it.

ID: CCA_2010121214444350
Release Date: 1/21/2011 Office: —————
UILC: 6325.00-00

From: ———————————- Sent: Sunday, December 12, 2010 2:44:46 PM To: ———————————- Cc: ———————————- Subject: RE: opinion

It's not really the same situation although the result is the same - i.e., they should not include the payment in computing the Service's interest in the property. The October IG [interim guidance] memo deals with carve-outs to junior lienholders from money that would otherwise go to the senior lienholders. The relocation assistance is not part of the sale proceeds, it's just a payment made directly to the taxpayer and, as such, is not part of the taxpayer's interest in the real property to be discharged from the lien. A new IG memo on this will be coming out soon.

If you have a short sale that is being hung, you may have to wait for the "new IG memo" to percolate through collection, but it might be worth referring to the Chief Counsel Advice.  If this ends up being helpful, I'd appreciate you posting a comment on this blog.

So You Want to be an Exempt Organization ?

Of all the areas I look for material in I find private letter rulings the most challenging.  They tend to come in blocks on particular subjects and there will frequently be several virtually identical ones in a row.  The most typical probably concern late S elections.  I've yet to see one of those that could make a good story.  My eyes light up, however, when I see a batch that have 501 as the relevant code section.  They are frequently about organizations having their exempt status revoked, which is quite often a good story. The post I consider most amusing was a Tax Court decision on exempt status. I've still got a fairly large backlog of material to share with you, so I am going to give you a few of those rulings.  I think I could make a whole post out of a couple of them, but I'm not going to get to them and they are starting to get a little stale.

Private Letter Ruling 201050041

My tentative title for this was "Sober House".  It's great when you can mix business and pleasure, but its not so great to mix a business you own with a not for profit that you run.  That was the problem with this group.  Their mission was to provide substance abuse recovery services.  The clients, however, lived in real estate owned by the people running the not for profit.  If you are going to do something like that, which I don't recommend, you need to be scrupulous in your record keeping.  They were less than perfect.

RA-1. There appears to much overlap in the activities of the two entities. In reviewing the expenses of the organization, it appears that expenses for the for-profit entity were paid by the non-profit entity. There were a great deal of checks paid and referenced to the Intensive OutPatient Program (TOP) which is a program of the CO-1.

There were several rental properties located in City, City, City and City which were acquired and owned by RA-1, members of his family and an employee of the organization. The employee was a Counselor of ORG and it was stated that RA-1 and Counselor, Counselor acquired the real estate together. According to RA-1, these properties were bought, maintained and used for the purpose for providing housing services to the clients of ORG.

The organization was unable to substantiate amount reported on its Form 990. In particular, it reported grants to individuals, but was unable to provide records showing who received grants, how much was received by each individual or how the recipients were determined. The organization was unable to provide client records which would detail services provided. Amounts paid to workers were often paid to relatives of RA-1 and no verification of work done for the exempt organization were provided.

The organization did not establish that the rent paid by ORG for the rental properties owned by RA-1 and his relatives was a fair market value rate. Furthermore, there were no documentation which detailed out who occupied the rental properties, how much was paid for rent and the time period of occupancy.

There were other indications of a lack of internal control. Accountant had a difficult time providing documents that were clear and understandable. There were a great deal of commingling of the revenue and expenses with the for-profit entity, as well as, expenses that could not be substantiated. .

There were Board of Directors listed on the Form 990, however, during the initial interview. VP stated "there were no Board of Directors officially, however decisions regarding the organization were made by himself and RA-1. According to him, the reason for this was that people didn't want to make time to participate.

So it could have all worked out if we were just a little more civic minded.  I have to say that if you are a young CPA and somebody asks you to volunteer to be treasurer of something like this, run for the hills. 

Private Letter Ruling 201050036

I thought there must be something serendipitous in this ruling being so close to the previous one.  My tentative title for it was "Barroom Buddies".  There is a lot more to Section 501 than 501(c)(3).  You hear the most about 501(c)(3) because those are the ones that you can make deductible contributions to.  There are, however, a plethora of 501 organizations that are just themselves exempt from tax to some greater or lesser extent.  Among these are 501(c)(10) organizations which are :

Domestic fraternal societies, orders, or associations, operating under the lodge system—
(A) the net earnings of which are devoted exclusively to religious, charitable, scientific, literary, educational, and fraternal purposes, and
(B) which do not provide for the payment of life, sick, accident, or other benefits.

A real life example of a qualified 501(c)(10) organization is The Grand Lodge of Ancient Free and Accepted Mason of North Carolina.  The get the benefit of being featured here by the luck of the draw in my poking around in GuideStar.  I have little doubt that they are an example of the right way to qualify for 501(c)(10) status.

The subject of this PLR known as ORG is another matter entirely.  Here is an interesting little sidelight on exempt status.  Sometimes the motive for obtaining exempt status has little to do with the direct federal tax benefits.  In the case of ORG there was the matter of a state law that held:

"in order for a licensee to sell intoxicating liquor outside city limits, a licensee must meet certain provisions such as having obtained an exemption from the payment of federal income taxes as provided in IRC sections 501(c)(3), 501(c)(4), 501(c)(5), 501(c)(7), 501(c)(8), 501(c)(10), 501(c)(19), or 501(d) of the United States Internal Revenue Code of 19XX,

Since DIR-1 inception with the ORG she has been able to sell liquor by the drink because of his organization's exemption from Federal income tax under IRC 501(c)(10).

During our interview on July 30, 20XX I asked DIR-1 why she joined the ORG, and her response was, "it allowed us to obtain a liquor license."
"The neighborhood tavern has been owned and operated by my family since 19XX DIR-1 took over the family business in 19XX." DIR-1 never transferred ownership of the building or any other assets to the parent organization. Instead, she pays the ORG Headquarters $ per year to lease the building and its contents.

ORG consists of 32 members, and all of them were asked to join by DIR-1. There are no requirements for membership, and there's only one class of membership. To become a member, each individual pays $, then fills out a card, providing such information as their address and phone number, and in return, the parent organization sends them an identification card indicating what post the member belongs to and the name of the member. New cards are issued every year. Upon becoming a member of ORG the individual receives their first drink for free, and ct off each additional drink. In July, dues are collected and remitted to the parent, ORG #1 in City, State. Additional members are recruited by current members or word of mouth.

The ruling has a fairly extensive discussion of how much of a fraternal bond is required for the organization to qualify. Part of the discussion goes as follows:

In National Union v. Marlow, 374 F. 775, 778 (1896): the court summed up the nature of a fraternal beneficiary society as follows: ".... a fraternal-beneficial society ... would be one whose members have adopted the same, or a very similar calling, avocation, or profession or who are working in union to accomplish some worthy object, and who for that reason have banded themselves together as an association or society to aid and assist one another, and to promote the common cause. The term "fraternal" can properly be applied to such an association, for the reason that the pursuit of a common object, calling or profession usually has a tendency to create a brotherly feeling among those who are thus engaged. As a general rule, such associations have been formed for the purpose of promoting the social, moral, and intellectual welfare of the members of such associations and their families, as well as for advancing their interests in other ways and in other respects...

The IRS found that ORG was not quite up to snuff:

ORG does not meet the requirements of an organization described in IRC section 501(c) (10). Members of ORG do not have a common fraternal bond. The members do not adopt the same or very similar calling, avocation, profession, or are working in unison to accomplish any worthy objective or common cause. ORG has not been operating for religious, charitable, scientific, literary, educational and fraternal purposes, nor has ORG devoted its net earnings exclusively to religious, charitable, scientific, literary, educational, and fraternal purposes. ORG is operating in a commercial manner which is not an exempt activity described under Internal Revenue Code section 501(c) (10).

In this circumstance, Merle Haggard not withstanding, barroom buddies are not the best kind.

Private Letter Ruling 201050033

Moving on to more salubrious pursuits we come to an "org' that was formed to support gymnastic activities.  Perhaps it is consistent with the ethos of that sport (if that's what it is) to discourage slacking :

Your Bylaws state that to accomplish your purpose, "each family must fulfill their financial requirements and work their assigned number of hours at each fundraiser." Fundraising activities are held throughout the year, on almost a quarterly basis. Non-compliance results in a fee charge of $

Your Bylaws further provide that membership is open to "those persons who are parents or guardians of gymnasts who are members of the competitive teams and pre-teams at Gym" (the "members" or "member-parents"). The children of two of your directors participate in Gym and receive financial assistance from you to the extent they participate in fundraising activities.

In your application for exemption, you indicate that Gym is a for-profit organization. According to your Bylaws, the owner of Gym (the "owner") takes part in all meetings and "has a say" in your decision making. You are required to inform the owner of all pending major decisions, and the owner may be invited to submit input.

If a gymnast's family does not raise enough funds through the various fundraising activities to cover the costs of its portion of the block fees, the family must pay the difference in cash or not participate in the Gym competitive program. If payment is not received promptly, the gymnast is not allowed to compete at the following meet. You are entitled to any surplus funds on a gymnast's block fee account if the gymnast leaves the competitive program before the end of the competition season. Any surplus funds are used at your members' discretion.

In addition to the private benefit conferred to your member-parents through your fundraising activities, the equipment you own and loan to Gym for no charge results in more than incidental private benefit to the gym and its owner, because the for-profit gym gets the benefit of the use of the equipment for free. Purchasing such equipment for use by a non-exempt entity is not an exempt purpose.

Your primary purpose is raising funds to offset the costs of participation in the competitive program of Gym, a for-profit organization, for children of your member-parents. Members are credited with funds raised based upon participation in fundraising events. If members do not raise sufficient funds through fundraising activities, the parents pay the balance of the fees required for their child to participate in Gym's competitive program. You state that you do not provide financial or any other assistance to gymnasts outside of the Gym's competitive program.

Because of the direct financial benefits that your member-parents receive, your activities violate the prohibition against inurement, thereby preventing you from qualifying for exemption as an organization described in section 501(c)(3) of the Code. The requirement that each parent-member participate in your fundraising activities in direct proportion to the benefits they expect to receive causes a direct benefit to flow to these member-parents. Consequently, your earnings are being used to pay for benefits to specific individuals rather than to a charitable class, which allows your earnings to inure to the benefit of specific insiders, namely the parents of Gym's participants.

In addition, the owner of Gym sits on your board of directors and is also considered an insider. You have purchased equipment that is used for no charge by Gym, a commercial business. This transfer of your financial resources to the owners of Gym is in violation of the inurement proscription and is also sufficient to defeat exemption under section 501(c)(3) of the Code.

This bunch applying for exempt status could motivate me to launch a jeremiad about selfish narcissism but what do you expect from people who think subjectively judging kids running around and jumping constitutes a sport ?

Friday, January 21, 2011

Take A Walk on the Boardwalk - Collect a Big Historic Credit

Historic Boardwalk Hall, LLC, et al. v. Commissioner, 136 T.C. No. 1

One of the problems with tax incentives is that the people who are interested in doing the things that are being incentivized often don't have sufficient tax liability to absorb the incentive.  Some states have simplified this process with some of their credits.  If, for example, you shoot a film in Massachusetts and jump through all the proper hoops, you get what you might call a tax coupon that you can transfer to anybody who can use it.  There are people who facilitate these type of transactions like my friend Bob Dorfman of Dorfman Capital.  So if you have a large Massachusetts or Rhode Island liability that you would like to settle for less than 100 cents on the dollar, you should check him out.  Likewise if you are making a film, or renovating an historic structure or cleaning up some brownfields and would like to market your credit.  Life is not as simple when it comes to federal credits.
If a building generates a credit you need to be the owner of the building in order to benefit from the credit.  Some credits, like that for developing low income housing, would be pointless, if there wasn't a legitimate way to work around this.  The most common solution is to use a partnership.  Partnerships are sometimes used for abusive transactions, but as noted below getting the low income housing credit to investors is a proper use of partnerships
Reg §1.701-2. Anti-abuse rule(a)Intent of subchapter K. Subchapter K is intended to permit taxpayers to conduct joint business (including investment) activities through a flexible economic arrangement without incurring an entity- level tax.  .....

Example (6). Special allocations; nonrecourse financing; low-income housing credit; use of partnership consistent with the intent of subchapter K.
(i) A and B, high-bracket taxpayers, and X, a corporation with net operating loss carryforwards, form general partnership PRS to own and operate a building that qualifies for the low-income housing credit provided by section 42.

The New Jersey Sports and Exposition Authority (NJSEA) built a convention center in Atlantic City. It also operated  property known as East Hall (now known as Boardwalk Hall).  Once the convention center was built East Hall would no longer be usable without substantial renovations.  East Hall was a certified historic structure so its renovation would generate a substantial historic credit.  NJSEA could not use the credit itself.  Unlike a Massachusetts film credit, you can't just sell a federal historic credit.

So they formed Historic Boardwalk Hall LLC (HBH) and admitted Pitney Bowes (PB) as a partner.  PB was entitled to a 3% priority distribution and was allocated the entire credit.  Like many such deals it is fairly convoluted.  PB has limited upside from the economics of the deal.  There are also guarantees that the credits it gets will be sustained.  The Service didn't like the deal alleging that :

(1) Historic Boardwalk Hall was created for the express purpose of improperly passing along tax benefits to Pitney Bowes and is a sham;
(2) Pitney Bowes' stated partnership interest in Historic Boardwalk Hall was not bona fide because Pitney Bowes had no meaningful stake in the success or failure of Historic Boardwalk Hall;
(3) the East Hall was not “sold” to Historic Boardwalk Hall because the benefits and burdens of ownership did not pass to Historic Boardwalk Hall. Accordingly, any items of income or loss or separately stated items attributable to ownership of the East Hall were disallowed;
(4) respondent pursuant to his authority in the antiabuse provisions of section 1.701-2(b), Income Tax Regs., had determined that Historic Boardwalk Hall should be disregarded for Federal income tax purposes; and
(5) all or part of the underpayments of tax attributable to the adjustments in the FPAA were attributable to either negligence, a substantial understatement of income tax, or both

The essence of the case is that PB would not have committed large amounts of capital for a stinking 3% return (Remember this was back in the days when you could actually earn interest on your money).  The IRS is putting this deal in the same category with the shenanigans in Fidelity International Currency where paired options magically create basis and friendly Irishmen recognize huge currency gains so the wild geese could shelter their stock option income.  The tax court does not see it that way though.

PB taking a low economic return on a real estate deal that provides historic credits is the whole point of the historic credits.  Historic credits like low income credits are meant to encourage investments that might not otherwise be economically feasible.  Although I can't hammer a nail straight I have seen enough of the numbers produced from various real estate ventures to know that the most cost efficient way to rehabilitate a building is to start with dynamite and some big dumpsters.  Once you have a nice flat surface, the rest of the rehabilitation will go really smooth.

There is a question as to whether it is a good idea to use tax incentives to promote desired behaviors.  While I've been working on this post, Professor Annette Nellen wrote a piece on the Mass Film Credit.  BTW if you like serious discussion of how taxes should be her blog is a good choice.  Although my general rule about taxes is: "It is what it is. Deal with it.", I'll weigh in just a bit here.  The problem with unrestrained capitalism is that it does not account well for externalities.  In other words your life might be enhanced if when you go to a great metropolis many of its historic facades are preserved and the number of people living in cardboard boxes is minimized.  Then throw in the fact that people, particularly those with entrepreneurial personalities, love to chisel on their taxes.  (The fallacy that critics of the credit fall into is the belief that absent the credit there would be that much more revenue rather than creative transactions with no incidental social utility).  The credits just might direct that impulse into socially beneficial directions. 

At any rate the Tax Court supported PB.  Work was done on the building that entitled somebody to the historic credit.  PB  getting a lower economic return, is the point of having the credit.  The point of the credit is to encourage people to preserve the historic facades when the sensible thing to do is to blow the buildings up and start over.  As the Court puts it :

The legislative history of section 47 indicates that one of its purposes is to encourage taxpayers to participate in what would otherwise be an unprofitable activity. Congress enacted the rehabilitation tax credit in order to spur private investment in unprofitable historic rehabilitations. As respondent notes, the East Hall has operated at a deficit. Without the rehabilitation tax credit, Pitney Bowes would not have invested in its rehabilitation, because it could not otherwise earn a sufficient net economic benefit on its investment. The purpose of the credit is directed at just this problem: because the East Hall operates at a deficit, its operations alone would not provide an adequate economic benefit that would attract a private investor.

The Service's position in this case was a little disturbing.  It is one thing to squash deals that border on economic fictions, but here we had people reaping tax benefits for doing what Congress wanted them to do.  I hope its not that they are picking on New Jersey, because I'm from New Jersey.

Wednesday, January 19, 2011

The Saga Continues

FIDELITY INTERNATIONAL CURRENCY ADVISOR A FUND, LLC v. U.S., Cite as 106 AFTR 2d 2010-7404, 12/20/2010

The story of Richard Egan's doomed tax shelters continues.  I thought I picked up the end of it in my post in October to which I provided a sequel with some followup commentary in my post on Krause v US.  It turns out that I get to add a fourth volume to the EMC trilogy.  Not being a litigator (or any other type of lawyer), I normally wouldn't pay any attention to something like this, but I've grown attached to this case.  Also, it is noteworthy that the Egan family's legal team has finally won at least a partial victory.  Maybe that's putting it a little too strongly.

This decision is about the cost of the cases.  I guess the way it works is that the Egan team lost spectacularly enough that they have to pay some of the costs incurred by the federal government.  It seems a little petty of the feds, but there is a big deficit and every little bit helps, I guess.  The government was seeking $220,944.65, which seems like quite a handsome sum.  You have to remember, though that, there was about $80,000,000 in tax and penalties at stake in the case.

Some of the discussion is illuminating

The electronically recorded transcripts must still be “necessarily obtained” for use in the case. Plaintiffs contend that video deposition expenses are not recoverable if the witness testifies at the trial, and objects to $18,791.00 in such costs claimed by defendant. That proposition is certainly doubtful as to witnesses (such as Stephanie Denby) who resided out-of-state and who may not have been available to testify at the trial. Furthermore, and in any event, in this case—particularly given its extreme complexities and uncertainties as to how and when the case would be tried and who would be then available to testify—the videotaping of the nine identified witnesses who later testified at trial was appropriate and necessary and properly taxable as a cost.

Stephanie Denby's e-mails were some of the best material in the original decision.  I'd love to see her testimony, but I don't think they are planning on recovering some of the money in this case from releasing it on Netflix.

Plaintiffs object to the inclusion of $19,200 in printing and mounting costs for demonstrative exhibits, on the grounds that such exhibits were primarily presented electronically and were not necessary for use at trial. The government certainly was correct to make extensive use of demonstrative exhibits, given the complexity of the trial. The use of paper demonstrative exhibits was very helpful to the Court. The Court has reviewed the invoices submitted by the government, and is not prepared to reject them as unnecessary or excessive based on the evidence provided.

I wonder if there were circle and arrows and a paragraph on the back of each one explaining what it was.

Plaintiffs next object to the cost of printing the entire production of the Stephanie Denby documents during the trial. Under the circumstances, where the documents were not produced until relatively late, the cost was a necessary incident to the trial and will be allowed.

I guess the e-mails that were quoted in the decision were just the highlights.

There were a few other issues.  In the end the court disallowed:

$17,328.12, reflecting the cost of expedited transcripts;
$26,626.90, reflecting the cost of "real time" deposition transmissions;
$12,183.54, reflecting the cost of "real time" trial transmissions;
$1,200.00, reflecting the cost of the rented copier;
$2,666.07, reflecting the cost of "miscellaneous supplies";
$83.19, reflecting the cost of "general and admin[istrative] expense; and
$5,808.28, reflecting a reduction of 3/7 of the trial exhibit copying costs.

All in, I make that to be a victory of 0.08% for the Egans.

Tuesday, January 18, 2011

More On Short Sales- Relocation Grants are For Relocation

CCA 201102058

Last month I wrote a post about IRS allowing that a carve-out by a lender for transfer taxes does not create equity in their lien.  That burst of generosity is followed this month by even more beneficence.  If under the Home Affordable Foreclosure Alternative program, the senior lender provides a taxpayer with $3,000 in relocation assistance, they can actually use that money to pay relocation expenses.  The full text of the ruling is below:

In consultation with the Collection experts in Counsel, below is the answer to your question concerning whether the IRS can require a taxpayer to pay the IRS the amount of relocation expenses as a condition of discharge. Recently, the Treasury Department introduced the Home Affordable Foreclosure Alternatives (HAFA) program. The HAFA program took effect on April 5, 2010. Borrowers who participate in a HAFA transaction are eligible for $3,000 in relocation assistance. If the senior lender provides the taxpayer with the $3,000 relocation assistance required under the HAFA program, the IRS cannot require the taxpayer to turn the $3,000 over in exchange for the lien discharge. The HAFA program payment is a payment directly made to the taxpayer to assist in relocation. As such, the relocation payment has no bearing upon the taxpayer's equity in the property under a discharge analysis. Rather, this is just a payment to the taxpayer. Furthermore, under the terms of this program, since this is a required payment as a condition of participation in the program, it would likely be treated as an ordinary expense of sale to be allowed priority despite being reached by the federal tax lien. If a lender provides relocation assistance because the lender believes it makes good business sense and not because it is required under HAFA, the legal answer is the same. The IRS cannot require the taxpayer to pay the IRS the amount of the relocation expenses as a condition of discharge.

I don't know how we are ever going to solve the deficit if the Chief Counsel keeps giving away the store like this.

Monday, January 17, 2011

Interest Accrues While IRS Delays

Samir H. Abumayyaleh, et ux. v. Commissioner, TC Memo 2010-275

In dealing with the IRS, one thing that you really need is patience.  Sometimes, I think that they invented "hurry up and wait".  What is extremely frustrating is when, having dragged their feet in handling a case, they ask for an extension of the statute of limitations.  Mr. Abumaryyaleh and his spouse ultimately settled their case at appeals.  They believe though that for they should not have to pay interest for the periods during which the service was dragging its feet.  Talk about patience.  The underlying tax liabilities to the controversy are from 1993, 1994 and 1995.

Sorry to spoil the suspense, but they did not get any relief.  The Court explained:

As we discussed earlier, the Abumayyalehs allege that during each of the four periods for which they request abatement the IRS “performed no significant work”. The parties stipulated that there were instances of IRS work during each period. We conclude that these instances of work are significant. Therefore, we have fully considered, and rejected, the Abumayyalehs' factual contentions.

The Abumayyalehs argue that the alleged absence of significant IRS work during each of these four periods should be treated as equivalent to an error or delay in a ministerial act.  Because we have for each period rejected the premise that the IRS “performed no significant work”, the Abumayyalehs' legal argument is moot, and we decline to consider its merits.

So what exactly was the intense level of activity required of the IRS to keep the interest clock ticking ? The Abumayyalehs requested interest abatement for four periods in which they claim their was no significant work done on their audit. 

1.September 8, 1995, Through April 17, 1996:

For September 8 through October 24, 1995, nothing in the record shows that the IRS performed any significant work on the audit.

On October 25, 1995, Agent Crandall, or another IRS agent at her direction, generated “Currency Banking and Retrieval System” reports that related to Mr. Abumayyaleh and Cup Foods. These reports appear to be summaries of records of certain transactions involving large amounts of money. ....The due dates on the IDRs were November 7 and 8, 1995, respectively. It was about then, we infer, that Agent Crandall prepared a workpaper describing Mr. Abumayyaleh's responses to the insurance-policy IDR.

For the period from November 9, 1995, through April 17, 1996, the record is silent as to whether the IRS performed any significant work on the audit.

So roughly half way through a period of seven months a document request was sent out and the response analyzed over a period of less than three weeks.

2. , April 19, 1996, through February 13, 1997

On April 26, 1996, Agent Crandall mailed the Abumayyalehs a notice that she was expanding the audit to cover their 1993 and 1994 tax returns. This letter asked them to bring their 1995 return to an appointment which would be scheduled. (The record before us indicates that the IRS later extended the audit to the 1995 tax return. The IRS issued a 30-day letter on September 6, 1997, proposing an adjustment for 1995.) About May 1996, Agent Crandall, or another IRS agent at her direction, summoned from TCF Bank records of deposits made and checks drawn by Mr. Abumayyaleh. In order to respond to the summons, a clerk at the bank issued an internal request bearing the date May 28, 1996, for the records. (We infer from the date of the request that the IRS issued the summons about May 1996.)

From June 1996 to October 2, 1996, the record is silent as to whether the IRS performed any significant work on the audit.

On October 3, 1996, Agent Crandall conducted a bank-deposit analysis of the TCF Bank account for 1993. 4 Also on this date she issued Mr. Abumayyaleh two IDRs asking about transfers of funds among three bank accounts, and another IDR requesting documents relating to a property transaction.

On November 19, 1996, Agent Crandall asked her supervisor in writing for permission to ask the Abumayyalehs to extend the periods of limitation on assessment for tax years 1992 and 1993.
For the period December 1996 through January 1997 the stipulated facts and exhibits do not show that the IRS performed any significant work on the audit.

On February 3, 1997, the IRS received a tip from a third party suggesting that Mr. Abumayyaleh might have unreported income.

On February 12, 1997, Agent Crandall prepared a “Comparative Balance Sheet & Income Statement” for Cup Foods. This document consists of a series of tables and graphs comparing Cup Foods' financial status from year to year.

Maybe it's a prejudice of mine from being on the other side, but I don't consider asking for a statute extension working on the audit.

 3.November 12, 1997 through September 28, 1998

By January 8, 1998, the Appeals Office had received the Abumayyalehs' case file, including Agent Erickson's transmittal letter, and had assigned the Abumayyalehs' case to Appeals Officer Sandra Williams. Appeals Officer Williams conducted a “preliminary review” of the case on January 12, 1998. On or about January 21, 1998, she mailed the Abumayyalehs a letter stating that their case had been referred to Appeals as requested, that because her inventory of cases was “so large” she would not be able to consider theirs right away but would start their case and contact them “as soon as I can”, and that they could write to or call her at the address on the letter. On January 22, 1998, she conducted a “preliminary review” of a related case she had received involving Cup Foods.

The IRS Appeals Office appears not to have done any work on the Abumayyalehs' case from January 22 through September 1, 1998. On September 2, 1998, Appeals Officer Williams performed four hours of “analysis” of the case.

4.July through September 1999

On July 25, 1999, Appeals Officer Williams spent eight hours considering the letter from the Abumayyalehs' lawyer. The record does not show any other significant work on the appeal during this period. This is the last period for which the Abumayyalehs request abatement.

All in all, the taxpayers identified four periods totalling about 29 months where they didn't think the IRS did anything.  Studying the record, the Court identified sub periods within those periods that did not indicate anything being done.  Those periods totalled roughly 20 months.  Not good enough.  They did express some sympathy.

We recognize that a taxpayer could have difficulty in determining the extent, if any, to which an apparent delay is actually attributable to “behind-the-scenes” work by the IRS. See Jacobs v. Commissioner, T.C. Memo. 2000-123 [TC Memo 2000-123]. But the Abumayyalehs did not contend, in the alternative, that we should abate interest for parts of the periods of alleged delay in which the IRS has not shown continual work on their case. Consequently, the IRS has not been put on notice that it would have to show continual work (or justified delays), rather than just examples of work, in order to rebut the Abumayyalehs' allegations. Moreover, nothing in the record indicates that the IRS hindered the Abumayyalehs in obtaining meaningful judicial review of its interest-abatement determination by failing to answer questions about what it had been doing or of why it had not been doing anything for any period. The Abumayyalehs may simply not have asked.

Question -  Would it be a different decision if the taxpayers had selected the periods that the court found no activity in ?  Or would the IRS be able to document that during those periods the cleaning people moved one of the file cabinets that the case records were in ?

Friday, January 14, 2011

The Stuff You Find In Tax Court Opinions

Dean F. Pace, et ux. v. Commissioner, TC Memo 2010-273

The Sovereign Military Hospitaller Order of St. John of Jerusalem, of Rhodes, and of Malta was established in the mid- eleventh century, when merchants from Amalfi founded the Benedictine Abbey of St. Mary of the Latins in Jerusalem. By 1080 the abbey built St. John's hospital--located on the traditional site of the angel's announcement of John the Baptist's conception--which provided a place of refuge for poor and sick pilgrims visiting the Holy Land. Under the leadership of Brother Gerard, the Hospital of St. John grew to include several ancillary hospices in Palestine along the pilgrimage route. Pope Paschal II officially recognized the hospital in 1113, establishing the Order of St. John.

I thought there was something wrong with my browser, but there wasn't.  The above is actually the second paragraph of a Tax Court decision.  Dean Pace is a member of the Sovereign Military Hospitaller Order of St. John of Jerusalem.  He is also a successful trial attorney.  Naturally he represented himself in Tax Court.  I will refrain from quoting the saying as to what that indicates about the intelligence of his client.

There is a logical division of labor between attorneys and accountants in the compliance area of the tax world.  (Construe accountants very liberally to included bookkeepers and serious tax return preparers). If we want to consider a compliance matter that goes the distance the continuum would be basic record keeping, return preparation, initial audit, appellate conference, tax court, appellate court.  (That's for tax determination, we don't need to get into actual collection starting another sequence).  As you run along the continuum the matter becomes less a matter for accountants and more a matter for attorneys.  Viewed in another way as you go backwards things are less a matter for attorneys and more a matter for accountants.  Most of the work in the initial audit is accountants work.  Revenue agents are accountants and want to see a trail of numbers adding up into totals that then goes to a particular line on the return.  They don't want a story.  Although, the best case is not to be audited at all, having an audit that stops at the agent level is the next best possible result.  If the basic record keeping and return preparation have been done well, coming up with a package to present to the revenue agent is a fairly painless process.  If they have not been done well it can be a major project, but it is mainly an accountants project.

Cases like that of Dean Pace or Thomas Hale show you the result of applying the attorney sensibility from the outset.  Here are some of the highlights in Mr. Pace's case:

Pace traveled extensively in 2001, spending thousands of dollars on airfare, hotels, and incidentals. But he has failed to adequately substantiate such expenses under section 274. He provided credit-card statements and his appointment book as evidence, but the appointment book didn't include the purpose of the travel. A substantial portion of the travel expenses also appears to be related to nonbusiness travel--including a pilgrimage to Lourdes that he undertook as a Knight of Malta and wine-tasting events in Paris. We therefore uphold the Commissioner's denial of all travel expenses.

He depreciated his car using a novel method,  but the Code does not allow such creativity.

Pace attempts to substantiate $1,711 in office expenses with a list of expenses containing check numbers, dates, and descriptions. He did not, however, introduce into evidence the underlying canceled checks, and the only testimony supporting the deduction was conclusory statements by Pace and his secretary that the office expenses were “incurred in the ordinary course of business.” Therefore, we disallow in full these office expenses.

Pace deducted custom-made shirts and a tie as office expenses. He explained that he found it difficult to buy some of his clothes off the rack because of his unusual physique. Our own observation makes us suspect that Pace was being modest, but no inspection could affect our necessary conclusion: expenses in this category are not deductible because Pace failed to establish that the clothing was not suitable for everyday wear. See, e.g., Hamilton v. Commissioner, T.C. Memo. 1979-186 [¶79,186 PH Memo TC]; Rev. Rul. 70-474, 1970-2 C.B. 35. And he wore one of his bespoke shirts to trial-- showing without any doubt its suitability for everyday use.

We find Pace's evidence--both records and testimony--of the amounts of these contributions credible, and his grand tour through the Order's medieval and early modern history engaging. But his argument for treating them as business expenses, rather than charitable contributions, is another matter. Payments that qualify as charitable contributions are not deductible as ordinary and necessary business expenses under section 162 if they fail to qualify as legitimate business expenses.

I'll bet the stories about the Order drove the revenue agent crazy.
He has failed to establish that the California state taxes he deducted on his 2001 return were paid in 2001. His 2001 California return shows a $34,989 tax liability--precisely the amount of state and local taxes deducted on his 2001 federal return. But Pace couldn't possibly have paid his 2001 California state taxes during 2001, because the California return wasn't executed until 2003 (and he showed us no evidence of withholding, estimated payments, or designated use of the prior year's refund to the California Franchise Tax Board). He hasn't offered any other evidence to establish that state and local taxes were paid in 2001. We therefore uphold the disallowance of this deduction in full.
Although the Court upheld 84% of the deficiency and allowed the assessment of the accuracy related penalty, they didn't seem to have any hard feelings toward Mr. Pace.  Judges, of course, are lawyers not accountants.  They refused to sanction him for his behavior in Tax Court.
 Pace vigorously contested the Commissioner's determination, resulting in a weeklong trial, 760 pages of trial transcript, and thousands of pages of credit-card statements, canceled checks, and other documents. But Pace's aggressive advocacy doesn't rise to the level of sanctionable behavior. He may be long winded--as many lawyers and even some judges are--but delay and frivolous positions were not the crux of his case.

This is the first tax court opinion I have encountered that has a reference to a papal encyclical

In the best of all possible worlds, perhaps, Pace's pursuit of the unified life would be recognized and rewarded. See, e.g., Pope Paul VI, Pastoral Constitution on the Church in the Modern World--Gaudium et Spes sec. 43 (December 7, 1965). But the Code imposes a more exact and less merciful accounting: business expenses, charitable contributions, and the costs of everyday life must be identified, segregated, and substantiated by reliable documents and credible testimony.

The difference between the trial attorney viewpoint and that of the accountant is probably best summed up in his defense to the accuracy penalty.

Pace offers a novel defense to the accuracy-related penalty in his opening brief--that it's the IRS's fault because it didn't settle. Review of the caselaw fails to find any support for this penalties-don't-apply-when-the-IRS-won't-settle argument. And Pace never argued any of the valid defenses to the penalty. See secs. 6662(d)(2)(B), 6664(c)(1). We therefore find that he is subject to this penalty.

An accountant is thinking that a tax return is supposed to come out to a correct answer (possibly resolving any doubtful elements in favor of the client).  Of course if a return has enough moving parts she will expect that someone else might come up with a different answer, but a third accountant would be able to do a reconciliation that accounted for the difference. That is not what a return is to a trial attorney.  A return is a first offer.

If you will forgive me going into the realm of fantasy, I'd like to imagine how things would have come out if Mr. Pace had been my client.  It would, of course, vary depending on what point in the process he had hired me.  If he were a regular client I would have had him have at least a part time bookkeeper.  His actual return would probably have had a tax due greater than the return he filed (possibly not if there were some planning done).  I would have gone to the initial audit with a neat package and might have gotten a no change or possibly given up some travel and entertainment and auto expense.  I have little doubt that Mr. Pace would have done better on his 2001 return under that scenario than he actually did.  But consider, that was just one year.  What about all the years that he didn't get audited ?  I really can't say that he would be better off.

If he had hired me at the point of the initial audit, I have little doubt that he would have done better.  I would not have let him talk to the revenue agent except fairly late in the process.  The agent would have as neat a package with as many possible numbers tied out as possible.  Probably the agents proposal would have been more than Mr. Pace wanted to pay, but possibly not.  The package going up to appellate would not, however, be something from an utterly exasperated agent who disallowed everything.  Although I would never have deducted the charitable contributions on Schedule C had I prepared the return, I would have had a plausible reason if the agent brought that issue up.  Since the package was so neat, they might not have brought it up.  Depending on the exact mix of the issues, I would probably have totally unleashed Mr. Pace in dealing with appellate, although I probably would have tried to keep him off the medieval history.  Bottom line, he probably still could have had a blast representing himself in Tax Court, but there would have been a much smaller deficiency at stake. (I probably would have told him to use a tax attorney).

The most interesting scenario is if he hired me after botching the initial audit.  Appellate is the point where for the most part the accountants work is done if things have been done right from the start.  Whether the case is handed off almost totally to attorneys at that point is a fairly complex question.  But, of course, this case was probably handled wrong from the start resulting in an exasperated agent who disallowed everything.  The first thing that I would do is make up the same package I would have made for the agent tying out as many numbers as possible. It is possible that the appellate conferee, who might be an attorney, would not examine the package like an accountant would.  They might just accept it.  Then appellate and Mr. Pace could negotiate.  I would supplement Mr. Pace's persuasiveness with research on whatever technical issues there might be left.

I think I would have enjoyed working for Mr. Pace.  Of course, he might have driven at least one of my firms staff members to distraction, so I'm not sorry that he didn't think to call me.  Besides one of the most intellectually stimulating Tax Court decisions of all time would not have been written.

Wednesday, January 12, 2011

Work, Fight or Pray - Vestige of the Medieval in Our Tax Code

§ 119 Meals or lodging furnished for the convenience of the employer.
§ 134 Certain military benefits.
§ 107 Rental value of parsonages

One of the reasons I don't mind long drives is the Teaching Company.  They allow me to take courses I never got to in college, with no papers to do.  I'm a little torn about this, but I would say that Teofilio L. Ruiz is about the best that they have, which is saying a lot.  He lectures about Medieval Europe.  The thing that sticks in my mind from several of his lectures is the tripartite division of Medieval society.  Those who work, those who fight and those who pray.  The merchants and artisans in the cities were a fringe element irrelevant to the overwhelming majority who worked growing food, of which there was rarely enough.  The fighters and prayers owned just about everything and paid no taxes.

It's odd to see that division in our tax code, but the sections above lay it out pretty clearly.  When it comes to housing, it would seem that Section 119 is sufficient.  If your employer provides you with a place to live, so that you will be near at hand, the value of that place to live is excludible from your gross income.  If that place happens to be a room in a hotel for the manager, a rectory or fifteen square feet on a nuclear submarine, the principle is the same.  That's not the way it is, though.  The military and the clergy are special.  Since at least historically, housing tended to go with their jobs, monetary allowances paid in lieu of actual housing are exempt from tax.  Since the military is paid by the same entity that collects the taxes, ultimately it seems to me that it is a matter of six of one, half a dozen of the other.  Military housing allowances strike me as fairly modest.  Presumably they could be grossed up and made taxable with negligible net effect on either the deficit or military compensation.  Also there is nothing at all troubling about the federal government determining who is entitled to military housing allowances.

Parsonage is another matter entirely.  It involves the government in determining who is or is not "a minister of the gospel".  More significantly, and perhaps surprisingly to many, it is an area of abuse.  Generally speaking, ministry is not viewed as lucrative occupation.  In some cases it is, though.  There is no dollar limitation on the parsonage exclusion.  The last big flap over the parsonage exclusion was in 2002.  There were two clear requirements to the exclusion.  The first is that the entity making the payment designate the amount as a housing allowance.  The second is that the minister spend the money on housing.  The IRS inferred a third requirement namely that the exclusion be no greater than the fair rental value of the home provided.   The Warren case was supposed to be an argument about that requirement.  The Ninth Circuit, much to the chagrin of both parties, asked them to start briefing on the constitutionality of the exemption.  The Court appointed Erwin Chemerinsky as amicus or we might say, in this case, devil's advocate.

Since Reverend Warren and the IRS came to an accommodation, the Ninth Circuit decided to let the hornets nest they had stirred up calm down (WARREN v. COMM., Cite as 90 AFTR 2d 2002-6058) and freed Professor Chemerinsky to pursue other interests. ( I contacted Professor Chemerinsky and he indicated that although still interested in the issue he is no longer involved).  Congress amended 107 to include the fair rental limitation that the IRS thought was already there.

There was not a lot of activity in the parsonage area in 2010.  Just three things that I've been able to find.  The first is not of any great note, but I include it for the sake of completeness.  Rev. Proc 2010-03 was what I call the IRS "Don't even bother to ask" list.  It lists the specific items on which the IRS will not rule and includes:

(11) Section 107.—Rental Value of Parsonages.— Whether amounts distributed to a retired minister from a pension or annuity plan should be excludible from the minister's gross income as a parsonage allowance under § 107.

(12) Section 107.—Rental Value of Parsonages.—Whether an individual is a “minister of the gospel” for Federal tax purposes.

I don't think there is anything new about the IRS reticence in these areas.  Personally, I have significant resentment for item 12.  The IRS refusal to rule in this area substantially reduces the entertainment value of the corpus of private letter rulings.  Their ability to rule on whether an organization is exempt gives us a comic masterpiece like Free Fertility .  Rulings on who is and is not a "minister of the gospel"  would be immensely entertaining.

More significantly there were two court decisions on the parsonage exclusion. The first was courtesy of the Freedom From Religion Foundation.  They are challenging the constitutionality of the parsonage exclusion. I have to say that regardless of the merits of the argument, I find FRF a little disturbing.  Their distaste for religion borders on, well, the religious.  According to their website:

The history of Western civilization shows us that most social and moral progress has been brought about by persons free from religion. In modern times the first to speak out for prison reform, for humane treatment of the mentally ill, for abolition of capital punishment, for women's right to vote, for death with dignity for the terminally ill, and for the right to choose contraception, sterilization and abortion have been freethinkers, just as they were the first to call for an end to slavery.

I think they are pulling a little bit of a rhetorical fast one there in combining "free thinking" and being free from religion.  The abolition of slavery in the United States had a very strong religious impulse behind it, although many of the radical abolitionists became alienated from the denominations that they were born into.  We even have an American religion that is more or less based on free thinking in Unitarian Universalism.  I've met UU ministers who don't believe in God, but I've never known one to turn down a parsonage exclusion.

At any rate little as I am drawn to FRF, they do seem to have the stronger argument.  Personally, it doesn't bother me at all for the state to tilt the playing field a little in the favor of religion in general.  The FRF types seem to think that you have prayers at the inauguration and next thing you know it's the Spanish Inquisition.  I mean really nobody expects the Spanish Inquisition.  Apparently, though current First Amendment jurisprudence is not as easygoing as I am.  Here is part of the government's argument in its motion to dismiss:

Sections 107 and 265(a)(6)constitute constitutional accommodations of religious practice by eliminating discrimination between ministers and similarly situated taxpayers. Sections 107 and 265(a)(6) are part of a governmental policy of neutrality toward religion, and government neither advances nor inhibits religious practice through these provisions.

The government argument goes that lots of taxpayers get the convenience of the employer exclusion.  In order for clergy to get the exclusion, the IRS might have to go poking around in the rectory, which could be intrusive.  So to make all ministers equal Congress added the housing allowance.  I get the argument but I don't think it is really strong.

Then came the Driscoll case.  From everything I've read Phil Driscoll is a really nice guy.  As I write this I'm listening to him on pandora.  Nice sound.  But a parsonage exclusion of $195,000 for his second home! Ministers who are half of two income households can have 100% of, admittedly often low, compensation excluded.  Consider Terry and Robin, the couple of indeterminate gender and marital status I introduced several months ago. (Their role is to help me avoid awkward pronoun problems) In this example Terry is a UU minister and Robin is an attorney.  Terry makes $40,000 and Robin makes $200,000.  If they stretched on the house that they bought,  Terry would negotiate for the entire $40,000 to be excludible.  If I was on the congregation's ministerial compensation committee, it would be my idea. The portion of it that was interest and real estate taxes would still be deductible against Robin's income.  Thanks to Driscoll, now when Terry gets a better job they can exclude a $100,000 compensation package so they can buy a house on the Cape.  I really don't think that this type of tax gaming is good for the morale of the clergy. The tax free nature of housing allowances gives an extra twist to church financial debacles as in this story about the Crystal Cathedral.. People like me will encourage the tax gaming because that's our job.  We don't expect the tax system to be fair or make sense.  I think, though, that the cause of religion, in the broadest sense of the word, would be well served if members of the clergy would come out against their special tax status.  I'm not holding my breath.

The tax blogosphere still hasn't heated up on this issue.  I noted posts by two attorneys in a bonus post earlier this month. They focus on statutory construction, which is the key to the Driscoll case. The Driscoll case loses much of its drama if you leave out the numbers.  Robert Flach has taken note of the discussion in his What's the buzz post and has promised to weigh in on it.  That should generate some more interest.

Monday, January 10, 2011

Peace with Spain

TECH v. U.S., Cite as 106 AFTR 2d 2010-7382, 12/17/2010

Sometimes when you think back on your youth, you can shift your viewpoint and realize that many of the people you remember as being old were in reality rather young. Your camp counsellors or high school teachers for example. Not my Nana Reilly.  As far as I'm concerned she was always old.  How old was she ?  The only immigrant among my grandparents, the others being American born children of famine refugees, she recalled that when she came to this country as a young woman, not a kid, soldiers were going off to war.  Against Spain.

What she probably didn't realize was that the expenditures for that war were being paid, in part, by a new tax.  The new tax which would continue for the rest of her very long life and beyond would not have troubled her much.  You see she made sure that her children and grandchildren that didn't actually live with her were within walking distance or a very short drive so that they would all show up every Sunday.  So an excise tax on long distance phone calls was probably of no account to her.

The language of the tax indicated that it would be charged on calls that were priced based on time and distance.  The cost of long distances calls substantially declined and companies began offering a variety of flat rate plans.  The tax was levied on these charges also.  Companies began suing for refunds.  The IRS kept losing the suits, but kept on fighting them.  Finally, they threw in the towel.  For a period of time doing the refund claims was a bit of a cottage industry.  I made some efforts to get my firm interested, but the problem was you needed really big long distance bills to make it worthwhile.  In the interest of simplification the IRS indicated that it would give you a refundable credit of either $30 or $60 depending on your family size on your 2006 return.  You were entitled to the credit even if you were not otherwise required to file a return.  There were efforts made to publicize this to people.  My own efforts were limited to calling the executive director of Jeremiah's Inn to make sure the guys were filing returns to get their $30.

Something interesting happened :

The Tax Inspector General estimated that the population of non-filers eligible for the refund was between 10 million and 30 million people. As early as August 2006, the IRS estimated that approximately 21.9 million to 22 million of these people would fill out a form 1040EZ-T to obtain the refund. Given the $30 to $60 range of safe harbor amounts, which approximately 99% of taxpayers who sought the refund elected to take, these numbers show that the IRS expected to refund between $657 million and $1.3 billion of the projected 21.9 million non-filers filed the form 1040EZ-T. This estimate proved to be wide of the mark. As of the filing of the class certification motion, only about $26 million had been refunded to the approximately 700,000 tax payers that filed a form 1040EZ-T. Thus, the IRS has actually refunded only 2 to 4 percent of the money it originally expected to return to non-filers.

Given the deficit and all, it is hard to imagine anybody being really upset about this.  Apparently though, it is bothering Brian Tech.

Plaintiff essentially alleges that because the IRS failed to provide him and his potential fellow class members with reasonable notice of the availability of the excise tax refund that complies with due process, the number of non-tax return filers who actually claimed a refund was extremely low.

It might seem odd to have a fairly substantial Boston law firm AND a DC law firm representing somebody who got screwed out of $30 because he wasn't paying attention, but of course the "class" they are talking about is not Mr. Tech's high school graduating class (assuming for the sake of argument that he graduated from high school).  It's more like the coalition of the clueless.  Based on the estimates there are 20,000,000 people who didn't get the $30.  The billion or so that they left lying on the table leaves room for some pretty hefty attorneys fees.

Plaintiff asserts a single claim for a violation of due process and seeks equitable relief that will require,inter alia , the Government to provide him and similarly situated Non-Filers with reasonable notice of their entitlement to a refund of the unlawfully collected excise tax, and of the existence of the special tax form needed to promptly obtain the refunds. In effect then, what Plaintiff now seeks is certification of a massive class action suit against the United States that involves a potential class numbering in the tens of millions, seeking recompense approaching a billion dollars.

The United States's position that Tech lacks standing to pursue this action rests on its allegation that “Tech has known about, and had the ability to use, the procedure for claiming any telephone excise tax overpayment since before filing suit.” . The United States supports this allegation with the following testimony given by Tech at his deposition:

Q: How did it come about that you contacted any law firm with respect to this lawsuit?
A: A family member found some information on it, and I needed a lawyer ...
Q: So am I right that some family member informed you something about the Telephone-the availability of the Telephone Excise Tax?
A: Um-hum.
Q: So tell me what your [relative] told you with respect to the Telephone Excise Tax.
A; She said a lot of people are getting taxed unjustly, and you might fall in the category of it because you're subsidized. Everything you have is given to you by either one government or the next, and these people can help you.

The Court did not go along with the government on this and refused to knock Tech out as a plaintiff.
The case is stalled for the moment, though, because nobody can come up with a method for defining "the class". 

The United States argues that neither it, nor any other entity, has records capable of determining membership in the proposed class. While it appears facially possible for the class to be identified through the telephone carriers' records, inasmuch as the carriers remitted the tax to the I.R.S., this method, when examined carefully, is a practical impossibility. As the United States points out, there are several thousand long-distance telephone carriers operating nationwide, and during the time period at issue, there were countless mergers, acquisitions and dissolutions of carriers. If not entirely impossible, retrieving all of the necessary records from this vast amount of entities, many of which are now obsolete or have been absorbed into different umbrella companies, is an incredibly herculean task. In our view, this type of inquiry is of such a “daunting” nature that it makes the class definition insufficient.

Tech's side argues, um-hum, that the list of people who got economic stimulus payments would be good enough.  Apparently though there is no way to tell whether they had telephones or not, much less flat rate long distance plans.

Friday, January 7, 2011

Cleaning Up For the New Year - Thank You Maam

I still have a good backlog of 2010 material, that isn't blossoming into full length posts so here are a few quickies.

CCA 201048042

I'm involved in doing a lot of partnership returns and I think we do a pretty good job.  One of the trickier parts is the liabilities section on the K-1.  From our individual practice, I get to see a lot of the K-1's that are prepared elsewhere.  Often it is pretty clear that they are wrong.  Frequently it does not matter, but sometimes it does.  A large deficit capital balance with no liability allocation is an example of a likely error. This CCA provides a little bit of a warning in deal with clearly erroneous K-1's.
Section 6222 requires the partners to report the amount and allocation of liabilities consistent with the partnership return unless they file a Notice of Inconsistent Treatment on Form 8082. In the absence of such a filing we are permitted to make an assessment without issuing a FPAA. I.R.C. 6222(c). They filed no such notice here so we do not need to conduct a TEFRA proceeding to make the assessment. Since outside basis is an affected item requiring partner-level determinations, however, we would have to issue an affected item notice of deficiency in order to assess a distribution in excess of basis. In the stat notice proceeding they could arguably rely on Roberts v. Commissioner, 94 T.C. 853, 860 (1990) to allege that the partnership books and records reflect the nonrecourse debt in issue, their reporting is consistent with the actual partnership books and records, and that the Schedule K-1 issued to them was incorrect. Cf. Treas. Reg. 301.6222(b)-3 (incorrect schedule provided to partner).

Private Letter Ruling 201048025, 12/03/2010

Code Sec. 1031(f); won't make benefits of Code Sec. 1031(a); unavailable to corp. under described circumstances provided that taxpayer, related party, and any affiliate undertaking exchange hold their respective replacement property for two years following their respective acquisition of replacement property.

This was a fairly convoluted set of facts.  It involves a sequence of related party exchanges.  I think the point of it was that since there was no ultimate cash out, nobody was getting away with anything.  I'd appreciate any comments that anybody else who has studied this ruling might have.

Lori A. Malchow-Bartlett v. Commissioner, TC Memo 2010-271

Taxpayer was denied deduction for use of home for day care, because she was not properly licensed :

Under section 280A(c)(4)(A), a taxpayer may be allowed business expense deductions relating to use of a residence to conduct child day care services. However, the deductions are allowed only where the taxpayer has obtained, or has applied for and has pending, a license to conduct child daycare services under applicable State law or is exempt from obtaining a license therefor under applicable State law. Sec. 280A(c)(4)(B).

The court concluded that taxpayer acted in good faith so no penalties were assessed.

U.S. v. BEDFORD, Cite as 106 AFTR 2d 2010-7271, 12/09/2010

This case is really outside my area of interest.  It is a criminal appeal.  The thing that got him in trouble was kind of interesting though.

The genesis of this case involved a business called Tower Executive Resources that billed itself as an executive recruitment business. In fact, Tower promoted to its members the opportunity to protect assets and to enjoy tax deferral through an offshore venture. Tower marketed its asset protection services to select clients through seminars at which Defendant and others spoke.

Essentially, clients learned at these seminars how to create bogus corporate entities called “international business corporations,” referred to as IBC-1s and IBC-2s. IBC-1s were domestic corporations that would hire and pay IBC-2s, foreign corporations, to perform services for the IBC-1s. Those services did not actually occur.

Mohamed M. Magan v. Commissioner, TC Summary Opinion 2010-173

In January 2007, petitioner moved from the State of Minnesota to the State of California in order to be closer to his sister and her family. Throughout 2007 petitioner's sister was married and lived with her husband and five children in a single- family home. Petitioner's sister was a stay-at-home mom and her husband was a full-time student who only started working in late 2007.

From January to August 2007, petitioner worked nights. Although petitioner did not live with his sister and her family during this time, he would spend much of his time at their home helping with childcare and doing the family's errands. In addition to assisting with childcare and errands, petitioner also provided his sister's family with financial assistance.

In August 2007, petitioner obtained a job located far away from where his sister and her family lived. For the remainder of 2007, petitioner was unable to help his sister with child care and errands, but he continued to provide financial assistance.

Petitioner claims that he is entitled to dependency exemption deductions for his two nieces because he provided financial assistance, as well as help with child care and the family's errands. We commend petitioner for contributing to the support of his sister's family. However, he has not demonstrated that he and his nieces shared the same principal place of abode for any portion, much less for more than one-half, of the taxable year in issue.

I thought the commendation from the Tax Court was a nice touch, even thought they couldn't help the poor guy, who seems to have deserved a break.

It looks like January will have a few more post like this as I work through my backlog.  If anything really significant develops, I'll be sure to do a bonus post.

Wednesday, January 5, 2011

You Figure it Out

STAHL v. U.S., Cite as 106 AFTR 2d 2010-7154, 11/29/2010

There are certain sections of the Internal Revenue Code that have worked their way into our language.  There is even a joke where somebody says that thanks to the market collapse they now have a 201(k).  I have this inquiring mind that reasons that if there is a 501(c)(3), which everybody knows about there must also be 501(c)(1) and 501(c)(2) and who knows maybe even 501(c)(4).  Believe it or not it actually goes up to 29 (Co-op health issuers) and includes 501(c)(23) - Any veterans association organized before 1880, the principal purpose of which is to provide insurance and other benefits to veterans or their dependents.  I guess the Grand Army of the Republic was still a force to be reckoned with in 1913.  Even better it keeps going past (c).  The Stahl case is about a 501(d) organization :

(d) Religious and apostolic organizations.

The following organizations are referred to in subsection (a) : Religious or apostolic associations or corporations, if such associations or corporations have a common treasury or community treasury, even if such associations or corporations engage in business for the common benefit of the members, but only if the members thereof include (at the time of filing their returns) in their gross income their entire pro rata shares, whether distributed or not, of the taxable income of the association or corporation for such year. Any amount so included in the gross income of a member shall be treated as a dividend received.

501(d) organization file form 1065 and the members are taxed on their share of the profits.  They are not, however, considered partnerships subject to the TEFRA audit rules.  John Stahl is a member and president of the Stahl Hutterian Brethren .
SHB was organized to enable its members to live in accordance with the tenets of the Hutterite tradition. The Hutterite tradition is rooted in sixteenth century Germany. In accordance with their religious beliefs, SHB members live in a colony, and currently the SHB colony includes about 65 members. They are all part of the extended Stahl family, which includes eight brothers, two sisters, their spouses, and their children.

Hutterites disavow individual property ownership, so SHB does not pay a salary to any of its members. Moreover, the members do not contribute to or collect Social Security benefits. All of SHB's property is maintained by it and is used for the benefit of its members. SHB provides for the members' personal needs, such as food, shelter, clothing, and medical care.

According to the bylaws of SHB, any member may be expelled. Expulsion may occur for a variety of reasons, including: the member's refusing to obey SHB's rules; the member's “failing to give and devote all his or her time, labor, services, earnings and energies” to SHB; and the member's “failing to do and perform the work, labor, acts, and things required of him or her.” If a member is expelled, he forfeits all interest in SHB's property and leaves with nothing but the clothes on his back.

Stahl brought this action for the purpose of obtaining an income tax refund because, he asserts, corporate level income should have been reduced for tax purposes before it was passed through to him. He insists that the cost of meals and medical expenses of SHB's employees was an ordinary and necessary business expense. The government argued to the district court that none of the Hutterite members, including Stahl, are employees for tax purposes and that should end the inquiry. The district court agreed with the government, and this appeal followed.

After a fairly lengthy analysis, the Court concluded that the individual members are, in fact, employees even though they are not paid wages.

On balance, the individual Hutterites, who work for the SHB business, should be seen as common law employees of SHB insofar as they perform the work of that business. They are permanent workers on SHB's grounds and SHB can both insist that they perform their assigned tasks at the proper times and can direct the detail of that performance. Despite the fact that SHB and those members who work for it have a myriad of interconnected relationships, one of those relationships is operation of and working in a business. That connection is most like the relationship between an employer and employee, and should be so treated for tax purposes.

It must be nice being a judge in the appelate court.  The implications of the members being employees are far reaching but :

SHB is a Hutterian corporation, which like others of its kind, is treated as a 26 U.S.C. § 501(d) entity. By its very nature, it is not exactly like an ordinary business corporation; nor is it like the more common 26 U.S.C. § 501(c)(3) organizations. Nonetheless, we see no reason to hold that its Hutterite workers are not employed by the SHB business when, as here, they essentially meet the definition of common law employees, even if they have many other relationships among themselves and with SHB. Thus, the district court erred when it held to the contrary and granted summary judgment to the government. “Employment” is the sole issue before us, and we will not divagate into others; we leave those to the district court in the first instance.

My spell checker doesn't thing "divagate" is a word and I don't know what it means, but it seems like a cool word, so I'm leaving it there.