Wednesday, March 30, 2011

When The Wall Comes Tumbling Down

Christina A. Alphonso v. Commissioner, 136 T.C. No. 11

It's interesting that someone who struck a pedestrian with his car and someone who is assessed to repair a crumbling retaining wall end up with the same tax question - Am I entitled to a casualty loss?.  As it turns out they both got the same answer.  No.  I wrote about the car accident last week . Besides the synchronicity with the car accident case I was also drawn to this case by the location of the property.  Castle Village is just north of the New York side of the George Washington bridge.  I grew up just a couple of miles to the south on the other side of the river in Fairview NJ.  I love the views around there.

Ms. Alphonso was a tenant-stockholder in Castle Village, a housing cooperative, a form of ownership apparently more common in New York than in most places.  Although in practice, it is a lot like owning a condominium, it is not exactly the same legally.  You own stock in a corporation which owns the real estate and as a stockholder you are entitled to occupy one of the apartments.  You really don't own the apartment though, in the same sense as your would if it were a condominium.  Among other things it can make it easier for the cooperative to obtain financing for renovations and to have some control over who becomes a owner - subject to anti-discrimination laws.

Along with other residents she had the right to use common areas such as a garden and a playground.  Security guards would ask non-residents who were not in the company of residents to leave such areas.  As any homeowner knows, stuff happens when you own a home:

On May 12, 2005, the Castle Village retaining wall collapsed, causing rocks and soil to fall onto the public roads below the Castle Village complex. The collapse of that retaining wall caused significant damage.

Fixing the retaining wall must have been quite a project.  Ms. Alphonso's assessment was over $26,000 and there are over 500 housing units that are part of the complex.  Her logic in taking a casualty loss deduction seems pretty sound.  If she owned a house and there was a retaining wall on the property that collapsed and she had to spend $26,000 to repair it, that seems to qualify as a casualty loss.

Initially the IRS denied the loss on the theory that the collapse was the result of gradual deterioration of the wall.  Under that theory a homeowner would not be entitled to the loss.  They amended their theory, though, and indicated that any casualty loss would only be allowed to the housing cooperative corporation not its owners.  The Tax Court agreed with the IRS:

With respect to petitioner's assertions regarding her alleged property interest in the Castle Village grounds, petitioner is wrong in asserting that she possesses a property interest in those grounds that entitles her to a casualty loss deduction for damage to those grounds. We have carefully considered the model proprietary lease, the Castle Village board house rules, the corporate charter of Castle Village, and the bylaws of Castle Village on which petitioner relies in support of her assertion that she has such a property interest in the Castle Village grounds.  We find nothing in those documents that allows us to conclude that petitioner possessed a leasehold interest, an easement, or any other property interest in the Castle Village grounds that entitles her to a deduction under section 165(a) and (c)(3) for damage to those grounds.

Ms. Alphonso's team had another argument.  Code Section 216 allows the tenant-stockholders of a cooperative housing corporation to deduct a proportionate share of the cooperative's mortgage interest and real estate taxes.  The argument is that this proves Congress wanted the tenant-stockholders to be treated like homeowners and the principle should be extended to casualty losses.  The Tax Court didn't buy that argument either :

As the Supreme Court of the United States has held, “Where Congress explicitly enumerates certain exceptions to a general prohibition, additional exceptions are not to be implied, in the absence of evidence of a contrary legislative intent.” Andrus v. Glover Constr. Co., 446 U.S. 608, 616-617 (1980). Petitioner does not cite any legislative history establishing that Congress intended section 216(a) to permit the stockholders of a cooperative housing corporation to deduct any of such corporation's expenses that it paid or incurred except for the two deductions that Congress expressly allowed in that section.

An interesting question is how this same set of facts would play out in the context of a condominium.  I'm not a lawyer and I won't try to start playing one on this blog, but I suspect the answer might turn on subtle issues about the exact nature of a condo owners interest in the common areas.

Monday, March 28, 2011

Another SE Scheme That Didn't Work

Renkemeyer, Campbell and Weaver, LLP, et al. v. Commissioner, 136 T.C. No. 7

I often tell my daughter stories about my grandmothers, Nanna Reilly and Nanna Lyons.  When ever I start the story she has to clarify whether I'm talking about the one who liked TV wrestling or the one who smoked.  In case she is reading this, this is about the one who smoked, Nanna Lyons, whose house I grew up in.  Nanna Lyons had a great admiration for her deceased husband, for whom I am named, the New York Yankees and, possibly above all, Franklin Delano Roosevelt.  I could hear her talking to herself from time to time about the greatness of FDR.  It always started with "Social Security".  You see Peter Lyons died in 1940, having paid by my rough estimate about $20 in social security taxes which his widow had more than recovered by the time my father took charge of the air raid wardens of Fairview NJ in 1942.  She collected until her death in 1966 and I am certain that I had Franklin Delano Roosevelt to thank for all those nickels I earned going to the corner store to purchase packs of Kents.

Many of my contemporaries do not think that Social Security is quite the good deal that Nanna Lyons perceived and come up with a variety of schemes to avoid paying social security taxes (including self employment tax).  Renkemeyer, Campbell and Weaver LLP (RCW) came up with an interesting one.

For the law firm's tax year ended April 30, 2004, three of the law firm's partners were attorneys performing legal services. The fourth partner was an S corporation owned by a tax-exempt ESOP whose beneficiaries were the law firm's three attorney partners. For tax year ended April 30, 2005, the law firm's only partners were the three attorneys.

Approximately 99 percent of the law firm's net business income for its tax year ended April 30, 2004, was derived from legal services rendered by the three attorney partners.

For tax year ended April 30, 2004, the law firm allocated 87.557 percent of its net business income to the S corporation.

There was a little bit of the shoemakers children phenomenon at work as the team of tax attorneys could not find their own partnership agreement.

Petitioner asserts that the special allocation of the net business income of the law firm for its 2004 tax year was proper because the allocation was made pursuant to the provisions of the partnership agreement. But as noted supra p. 4, the partnership agreement effective for the 2004 tax year is not in the record.

In 2005, they took a different approach.  The corporation was eliminated as a partner and they divided their interest into general partnership interests and limited partnerships.  Apparently the plan was that the income attributable to the limited partnership interest would not be subject to SE tax.  That didn't work either.

The thing that was bothering me the most about this case is that there appear to have been no penalties asserted.  In a similar SE avoidance scheme, which I have a recent post about, Dr. Tony Robucci, a psychiatrist, was assessed penalties even though he was relying on an attorney CPA advisor.  The Tax Court seemed to think he should have sought a second opinion.  At least one of these fellows was himself a tax attorney, so you would think they would be held to a higher standard.

Perhaps it is because of another adjustment:

Further, respondent reduced the law firm's gross business revenues by $905,000 (and consequently reduced the law firm's net business income) after determining that a legal fee in a like amount had not been received during the 2004 tax year.

Sometimes we lose track of the basics.  Cash basis taxpayers who only report the income that they actually receive don't have to pay as much as those who report more than that.  You would think that the Tax Matters Partner Troy Renkenmeyer would be sensitive to that given his background with Arthur Andersen, where they got into all those difficulties about revenue recognition.

Friday, March 25, 2011

Who's the Casualty Here ?

Robert K.K. Pang, et ux. v. Commissioner, TC Memo 2011-55

Not everything that happens happens to you.

We recently lost someone to an auto accident, so I'm not inclined to take my usual irreverent approach to this case.  It was an interesting one, though, so I didn't want to let it go by.

Here is the story:

On December 5, 2002, Mr. Pang was involved in an automobile accident in which he hit a pedestrian with his vehicle. The pedestrian later died as a result of this accident. The pedestrian's estate filed a claim against Mr. Pang for wrongful death.

Mr. Pang had a personal automobile insurance policy with Tradewind Insurance Co., Ltd. The policy had a liability limit of $100,000 per person for bodily injury, death benefit endorsements of $50,000, and personal injury protection (PIP) of $10,000. 2 Mr. Pang's insurance company concluded that the proximate cause of the accident rested with Mr. Pang, and they tendered to the estate payments that exhausted the policy's limits—i.e., $100,000 for bodily injury, plus a death benefit of $50,000, plus a PIP payment of $10,000.

In order to fully settle its claim against Mr. Pang, the estate insisted on a large contribution of funds from Mr. Pang in addition to the insurance funds it had already received. Following arbitration, Mr. Pang agreed to pay $250,000 to the estate.

I'm feeling particularly unkindly toward motorists who hit pedestrians this month, but if you think about it, all it takes is a bit of inattention.  I've had some close calls myself both as a pedestrian and a driver.  So if I was Mr. Pang's tax advisor, I'd be thinking the same thing  his advisor or he himself must have been thinking.  Is there anyway that the $250,000 might be deductible ?  They came up with a theory:

The Pangs maintain, however, that their $250,000 settlement payment is deductible under section 165(c)(3) as a casualty loss because Webster's Dictionary defines “casualty” as "[l]osses caused by death, wounds” and the accident victim's death in December 2002 was certainly a casualty.

The Tax Court wasn't buying it.

This issue is resolved not by Webster's definition of “casualty” but by the Code's provisions for “casualty loss”............... Moreover, the Pangs' position conflates two distinct things—the victim's casualty (which occurred when he died in 2002) and the Pangs' financial loss (which occurred when they made their payment in 2004)  —and does not explain how the “casualty” of the victim results in a deductible “casualty loss” for the Pangs under section 165.

The Pangs' claimed loss is attributable not to property damage but to the monetary settlement of a wrongful death claim. To the extent the Pangs are arguing that the payment constitutes a loss of their property, we find that to be beyond the scope of section 165(c)(3). The term “losses of property” in section 165(c)(3) does not include a taxpayer's monetary payment to a third party or a decrease in the taxpayer's net worth.

I generally root for the taxpayer, when their arguments aren't totally lame.  I don't think Mr. Pang's argument was all that lame, but I'm still glad that he lost.  Think about driving a little slower and pay attention to your driving and don't be such a cheapskate on your liability limits in case, God forbid, something happens anyway.

Wednesday, March 23, 2011

Some More Randomness

Here are a few developments that don't seem to merit a full treatement and are starting to get a little stale.

Richard H. Franke v. Commissioner, TC Memo 2011-10

I really thought I could make something of this.  It was about whether somebody who had fallen for a tax protester type package was liable for fraud penalties.  He was only arguing about money.  The people who created the package are doing time. The scheme was based on creating a "Corporation Sole", which is a legal form used generally by religious groups to associate title to property with whoever holds a particular office.

What was really interesting was that Mr. Franke was an enrolled agent and he was using the scheme to shelter his tax preparation income.  He was continuing to insist to the Tax Court that he believed the scheme worked as they found him liable for the penalty.  I generally think that enrolled agents don't get enough respect so I was kind of disappointed.

TRC, INC. v. U.S., Cite as 107 AFTR 2d 2011-XXXX

The company was trying for a refund of penalties for failure to timely pay over payroll withholdings.  They were not successful.  The decision emphasized that withholings are special in that the money was never yours in the first place :

In determining if the taxpayer exercised ordinary business care and prudence in providing for the payment of his tax liability, consideration will be given to the nature of the tax which the taxpayer has failed to pay. Thus, for example, facts and circumstances which, because of the taxpayer's efforts to conserve assets in marketable form, may constitute reasonable cause for nonpayment of income taxes may not constitute reasonable cause for failure to pay over taxes described in section 7501 that are collected or withheld from any other person.

Although it is the duty of the court to weigh all of the factors identified in the regulations, “it will be the rare case where the government is made “the unwilling partner in a floundering business” without the employer incurring the duty to pay a penalty for having made such a choice” to fail to pay trust fund taxes over to the government on a timely basis.

The best thing for small businesses is to use a service like Paychex.  If you don't have the money to pay over the withholdings, it really means that you don't have the money to make payroll.

Private Letter Ruling 201101028, 01/07/2011

This was a withdrawal of exempt status,  The organization was supposed to be raising funds for charities.  It's only activity was gambling, apparently Bingo, and contributions from other organizations controlled by the same person.  It may be that they applied for exempt status in the first place in order to be able to get licensed for the gambling.  It seems like many organizations apply for exempt status more to get some sort of state law privilege or creditability with actual exempt organizations or local and state governments.  The IRS probably has enough to do collecting federal revenue without being used as vehicle for liquor licenses and gambling permits.  But as I often say "It is what it is.  Deal with it."

Private Letter Ruling 201101027, 01/07/2011

This one is another revocation of exempt status, this time for "inurement".  It was pretty convoluted.  I'll just give you a taste of what ORG (The not really not for profit) was up to:

Given the facts, it appears that CO-2, DIR-6 as president, purchased the land in January 19XX from LAND order to build a golf course; which was also on or around the time the land was discovered to contain toxins, which would have certainly devalued the land at that point in time Not able to build a golf course due the toxins, CO-2 then only held the land for an 8-month period who would then sell the land to CO-1 who would also only hold it for an 8-month period before selling it to ORG at a value that may or may not have been the fair market value given the discovery of the toxins in the land. Without contemporaneous certified appraisals the value of the land during each sale remains unknown. To state that no appraisals were ever conducted for any of these transactions is unlikely since most land and property sales are accompanied by a certified appraisal.

ORG has not demonstrated that the transaction with DIR-6 was in fact at arms-length. Without a certified appraisal at the time the land was sold to ORG and in light of value of land recorded by the county, the facts indicate that ORG purchased land that was grossly overvalued. This transaction allowed the FAMILY to divest ORG of several hundred thousand dollars as illustrated below:

Few things trouble me more than people using exempt organizations to enrich themselves.

Valarie N. Stephenson v. Commissioner, TC Memo 2011-16

This was an innocent spouse case.  It is one where the taxpayer won for a change.  That she had to go to Tax Court is indicative of how hard it is for people to win these cases.  There are 8 factors that are considered, one of which is abuse by non-requesting spouse.  Here is what she had on that one:

Mr. Stephenson abused petitioner throughout their marriage. During trial petitioner provided specific examples of abuse, including a time when Mr. Stephenson threatened to kill her or himself if she left him and times when Mr. Stephenson threw items at her. Mr. Stephenson regularly humiliated petitioner in front of his family and their friends and demeaned her when she asked questions. Mr. Thomas corroborated some of petitioner's testimony by credibly testifying that petitioner had bruises on her body and told him that she was in an abusive relationship.

I know it is more a matter of principle, but the denial of joint filing to same sex couples is probably not quite the hardship they think it is.  Joint and several liability is the dark side of joint return filing that most planners, even divorce attorneys, who should know better, ignore.

Unless something really huge happens, there will be quite a few posts like this in the next couple of weeks as I have a pretty big backlog and not much time to give things the full treatment.

Monday, March 21, 2011

Thanksgiving Without Mom Almost Costs $3,000,000

Estate of Sylvia Riese, et al. v. Commissioner, TC Memo 2011-60

One of the things I often say about sophisticated estate planning techniques is that when they fail, it is often a failure of execution rather than conception.  Someone comes up with a sound plan, the documents that will execute the plan are drafted and then somewhere along the line things are not executed in accordance with the plan.  In this case the taxpayers came out OK anyway, but it still represents a cautionary tale.

The case concerns a QPRT - (Qualified Personal Residence Trust).  The technique allows a taxpayer to make a gift of a future interest in their residence.  During the term of the trust they continue to live in it and are treated for income tax purposes as if they own it.  At the end of the term it is treated as being owned by the benerficiaries or a trust for their benefit.  The advantage of the arrangement is that the donor gets to use todays value of the residence (and we all know real esate only goes up).  In addition since it is ownership of the house in the future that is being gifted the value is discounted to take into account the time value of money. (Remember when money used to earn interest).  The disadvantage is that at the end of the term the donor has to start paying rent, if she wants to keep living in the house.  The purpose of the preceeding discussion is to give context for this cautionary tale.  It is not a comprehensive discussion of the QPRT technique.

Mrs. Riese appears to have had some good estate planning done for her:

Mr. Tucker represented decedent with regard to estate planning and other matters.  In 1999 Mrs. Grimes mentioned to him that decedent was agreeable to some additional estate planning with respect to the residence. In response, Mr. Tucker and Mrs. Grimes began considering the establishment of a QPRT for decedent. Mr. Tucker sent a letter dated September 17, 1999, to Mrs. Grimes explaining the Federal gift tax costs and some of the benefits of establishing a QPRT for decedent. Mrs. Grimes then visited decedent and explained the contents of the letter to her. Decedent asked Mrs. Grimes whether she would directly benefit from the establishment of a QPRT. Mrs. Grimes explained that establishing a QPRT would result in a lower estate tax liability but also that decedent would have to pay gift tax on the transfer and pay rent to live in the residence after the QPRT expired. Decedent agreed that a QPRT would be acceptable and gave Mrs. Grimes permission to proceed.

There was good execution on the front end:

On April 19, 2000, decedent established the Sylvia Riese QPRT (the QPRT) under section 25.2702-5, Gift Tax Regs., and executed a deed transferring the residence thereto. Decedent reported the transfer of the residence to the QPRT on Form 709, United States Gift (and Generation-Skipping Transfer) Tax Return, for tax year 2000.

Things went awry when the trust reached its termination date.  At that point the trust should have deeded the property to the remainder beneficiaries (new trusts in this case).  The new owner or owners then should have taken responsbibility for paying all expenses related to the property.  Since Mrs. Riese was still living in the property she should have signed a lease and started paying rent.  That's not exactly what happened.

The QPRT agreement states, in pertinent part, that if the settlor (i.e., decedent) survives the termination date of the QPRT, the QPRT shall terminate and the balance of the trust fund (i.e., the residence) shall be distributed 50 percent each to two trusts, known as the 1997 Property Trusts (the Property Trusts), which decedent established in 1996 for the benefit of Mrs. Grimes and Ms. Zipp. The QPRT terminated by its terms on April 19, 2003. Decedent (or the QPRT) did not execute a deed transferring the residence to the Property Trusts.

Mrs. Grimes never discussed rent directly with decedent after the QPRT terminated. However, around the termination date Mrs. Grimes called Mr. Tucker inquiring about how to determine the proper amount of rent to charge decedent. She testified: “I knew she'd agreed to it and, you know, I didn't—I didn't want to feel like I was badgering her. And so I called *** [Mr. Tucker].” Mr. Tucker explained to her that fair market rent could be determined by contacting local real estate brokers and that this could be done by the end of the year (i.e., December 31, 2003). Mr. Tucker entered a “tickler” in his pocket calendar to remind himself to call Mrs. Grimes by Thanksgiving to make sure everything was taken care of.

The significance of Thnaksgiving is unclear.  Perhaps the plan was to get Mom to sign a rent check before the turkey was carved.  Sadly, Mrs Reis did not even make it to Haloween as she suffered a stroke and died on October 26, 2003.  She would not be able to sign a rent check covering the period that she was a tenant rather than an owner as the ball descended in Times Square as Mr. Tucker apparently had planned.

It is unusual for landlords to let people live in a house for 6 months without paying any rent.  The IRS contended that Mrs. Reis had not really given the house away.  People realize that they can't take it with them, but their preference is to control it till slightly before their last breath and then have it go to their heirs without being included in their taxable estate.  There are laws in place to frustrate this natural desire and the laws will take note of implicit understandings.

The Tax Court ended up cutting the family quite a bit of slack:

We find as a matter of fact that there was an agreement among the parties for decedent to pay fair market rent, the amount of which was to be determined and payments to begin by the See Diaz v. Commissioner, 58 T.C. 560, 565 (1972) end of 2003. (basing analysis upon evaluation of the entire record and credibility of witnesses). The Secretary had not issued any regulations or guidance as to how and when rent should be paid upon the termination of a QPRT. We believe that doing so by the end of the calendar year in which the QPRT expired would have been reasonable under the circumstances.

Unlike many cases involving the transfer of a personal residence where the decedent continued to live in the residence until death, see, e.g., Estate of Van v. Commissioner, T.C. Memo. 2011-22 [TC Memo 2011-22], the existence of an implied agreement in this case is negated by the express agreement among the parties for the payment of rent. Many factors, e.g., the creation of the QPRT, the payment of gift tax upon the transfer of the residence to the QPRT, the several instances in which decedent agreed to pay rent, the fact that Mrs. Grimes called Mr. Tucker upon the QPRT's termination to find out how to determine the amount of rent to charge, and Mr. Tucker's corroborating testimony, all lead us to find that there was no agreement or understanding that decedent would retain an interest in the residence for life without paying rent.

We believe that Mrs. Grimes, on the advice of counsel, intended to and would have determined fair market rent by the end of 2003 and decedent would have paid rent. We believe further that Mr. Tucker would have made sure a lease was executed, rent was determined, and all appropriate changes were made to effect the change of ownership. Unfortunately, decedent died unexpectedly in October before any of this occurred.

There was a deficiency of over $3,000,000 involved in this case so I'm willing to wager that the litigation cost was substantial.  Although the taxpayer prevailed (They lost on some other small issues) it must have been kind of nerve racking.  It could have been avoided if when the gift was made in April of 2000, a plan had been made to sit down with Mrs. Reis in say February of 2003 to go over what would be happening in the next couple of months.  The rent determination, the transfer, the lease and the initial rent payment should have all been done in April 2003.

Other practitioners might read this case and come to the opposite conclusion saying that it proves that waiting till the end of the year to clean everything up is just fine based on:

The Secretary had not issued any regulations or guidance as to how and when rent should be paid upon the termination of a QPRT. We believe that doing so by the end of the calendar year in which the QPRT expired would have been reasonable under the circumstances.

I would disagree with that analysis.  There is no reason to take chances like that with so many dollars at stake.

Saturday, March 19, 2011

The Hazards of A Common Name

This is an off-topic bonus post.  I noted in a recent post that I am self absorbed enough to blog about my own blog, so it should hardly be surprising that I google myself from time to time.  This time I was hoping that my achievement of being published in Bay Windows would drown out references to the persons, that I, quite unfairly, characterize as impostors. 

Instead I find that even when limiting myself to a search of blogs that the dominant Peter Reilly story concerns testimony in favor of a law requiring that confessions be taped.  The testimony comes from a different Peter Reilly who was accused of murdering his mother.  My own mother, God rest her soul, passed away in 1993 after a long illness.

It seems like he is promoting a worthy cause so I really hold no resentment for the fact that you have to go to page 2 of a google search on our very common name before you get to the person I think of as the real Peter Reilly.  I do make page 1 of an image search and I must say that I think I am above average good looking as far as Peter Reilly's go.

Friday, March 18, 2011

Miss Is As Good As a MIle

Todd D. Bailey, Jr., et ux. v. Commissioner, TC Summary Opinion 2011-22

Quite a few cases about the passive activity loss rules show up in tax court.  Frequently, the taxpayers seem a bit lame.  There was the fellow who wanted to count the time that he was "on call" for his tenants.  Also, the have to put up with their time estimates being considered "ballpark guesstimates", a robust term who's use in tax law seems to be limited to passive activity cases.  The case of Pamela Bailey (she is the ux.) has none of that.  Although I see the inexorable logic of the tax court, I think she got rather a raw deal.

The passive activity loss rules (Section 469) was the Tax Reform Act of 1986's knock-out blow to tax shelters as we used to know them.  The rules require us to put our trade or business activities into various buckets.  Losses within the "passive activity" bucket can only be used to the the extent there is gain in the passive bucket (Note.  Some people say "offset", which can lead to error.  A capital gain in the passive bucket is still a capital gain).  There is a significant amount of complexity to the rules, which I will run roughshod over in discussing this case.  A passive activity under these rules (The term is used in other areas, like S Corporations, and has different meanings.) is a trade or business in which the taxpayer does not materially participate.  There are a variety of ways to meet that standard, but the one that is relevant here is 500 hours in a year.  Then there are rental activities.  Rental activities are per se passive.  If you own rental property, please don't yell at me.  I know it can be a lot of work.  This is the tax law.  It is what it is. Deal with it.

There is an exception to the per se passive rule for rental activities.  People in real estate trades or businesses can treat rental activities like other businesses.  There are a number of requirements, but the critical one for this case is 750 hours engaged in real estate activities. 

Todd Bailey was an emergency room physician.  He is one of the types of people I think about whenever I think I have stress.  At any rate Dr. Bailey doesn't really enter into the case other than producing wages of $212,200 that might have been sheltered by real estate losses.

It was Mrs. Bailey who was handling the real estate.  She had qualifications:

Petitioner's father was a builder. Her mother worked with her father as a bookkeeper and an interior decorator. This upbringing gave petitioner an “eye” for the housing market, and experience with building codes, architectural plans, and subcontractors. Beginning around 1980 and using mortgage financing and joint funds with petitioner husband, petitioner continuously was in the market to purchase property with potential for either resale or conversion into income- producing property.

She had four properties :

1. The Inn on Alisal Road

One of petitioners' rental properties was on Alisal Road, about 6 or 7 miles from the couple's home. They purchased the property in 2000. The structures consisted of a 1,200-square- foot, two-bedroom, 3/4-bath (no tub) front house, built in 1949 or 1950, and a smaller back unit that had been converted from a one-car garage into a separate residential dwelling.

Petitioner named this combined property “The Inn on Alisal Road” (Inn). As the name indicates, petitioner furnished the two units and offered them together or separately for short-term rent to overnight lodgers, usually for about 3 days at a time.

2. The Second Street Property

....... second of petitioners' rental properties was on Second Street (Second Street property), about two blocks from the Inn. Petitioners purchased the property in 2000 for $292,000. Similar to the Inn, the property included two structures. The front unit was a 1,149-square-foot, three-bedroom home, with 1-3/4 baths. The back unit was a one-car garage that petitioner converted in 2002 into a small residence with a three-quarter bath and a kitchenette.

This one turned out to be a classic property from hell.  It could stand as a warning to those who see late night commercials promising that by adopting certain secret methods you can make a small fortune in real estate with no capital and little work :

By late 2000 petitioner's tenants in the front house noticed a mildew problem. The tenants moved out. They turned out to be petitioner's last tenants in the front unit. As petitioner began stripping away layers of linoleum to determine the extent of the mildew problem, she discovered that black mold was present throughout the entire underpinning of the home. By the end of 2001 petitioner was “at wits' end”. She eventually discovered that an earlier inspector had determined that the home has insufficient subvents. In addition, a prior owner built an addition that blocked some of the existing subvents. Further, the El Nino storm of 1997-98 soaked the carpets, flooring, and walls, compounding the problem. The toxic mold infestation was so bad that petitioner was unable to provide a warranty of habitability to any prospective tenant.

The type of real estate endeavors that Mrs. Bailey engaged in are probably one of the best ways that someone with little to start with can become fairly prosperous.  It is by no means a sure thing, though.  The requirement to be absolutely certain that you will make a small fortune in real estate is the same as in any other endeavor.  Start with a large fortune.

3. Boise Property

The third of petitioners' rental properties was on Rose Hill Street, Boise, Idaho (existing Boise property). Petitioner became interested in Boise because she found that she liked the area from visiting a brother living there and a great uncle who lived nearby. The record is sparse about this property, other than that it was a single-family home that petitioner purchased in an earlier year and which one tenant or family rented for all of 2004.

4. New Acquisition in Boise

On August 25, 2004, petitioner paid $185,000 to acquire another one-story single-family home in Boise, on a 3/4-acre lot, also located on Rose Hill Drive (new acquisition in Boise). She financed the purchase with a $166,315 mortgage and joint funds. The house, built in 1941, is a “darling” home with a wood burning fireplace, crown molding, and a brick exterior made with “clinker bricks”. The main floor contains two bedrooms, one bathroom, and a small kitchen. Prior owners had converted the basement into an apartment for a person who took care of the owner. Petitioner did not begin renting the home to tenants in 2004.

Mrs. Bailey kept good track of her time and the IRS found her to be credible - no "ballpark guestimator".  Time spent on real estate was as follows :
The Inn on Alisal Road                324
The Second Street property         358
The existing Boise property           24
The new acquisition in Boise        105
Researching potential acquisitions 192
Grand total for all properties      1,003

There was no issue raised about her not electing to aggregate.  So she should be fine.  Not so fast.  The Inn on Alisal Road had rentals for, on average, three day periods.  So it was not a "per se" passive rental activity.  It was a non real estate trade or business reported on Schedule C.  When those hours are kicked out she ends up with a total of 679 hours in real estate activities.  Close to 750 hours, but the 750 is a "bright line" test.  There are areas besides horseshoes and hand grenades where almost can count, but this is not one of them.

Mrs. Bailey did not get hosed quite as badly as she might have.  Note that the 324 hours on the Inn is less than 500, which could make it a trade or business in which she did not materially participate.  Fortunately she met an alternative test, probably that she put in more time than anybody else did on the activity.  Of course if the Inn had been profitable, that would have hurt her.

All in all, this case covers a good bid of ground that would be of interest to landlords and their advisors. 

Thursday, March 17, 2011

Danger Danger Will Robinson - Housing Stock to Be Devastated

So one rule that I have for the blog is to not comment on tax policy.  The PAOO Prime Directive is "It is what it is. Deal with it."  I violate the rule about as often as Captain Kirk used to violate the Federation's Prime Directive, roughly every other week or so.  Here is a new rule.  If somebody asks me nicely to write about something in my blog, I will, particularly if they ask me nicely twice.  I've decided that this rule overrides the Prime Directive.  Let's call it the Super Prime Directive.

So here is the very nice email I just received:

Hello Peter

I sent you an email last week and didn't hear back so I wanted to follow up. Congress and the Administration are looking into scaling back or eliminating the Mortgage Interest Deduction. The consequences would be devastating to the recovering housing market and the tens of millions of home owners who benefit from the deduction.
The House recently introduced a resolution to retain the mortgage interest deduction and I hope that you’ll help spread awareness about it on Passive Activities and Other Oxymorons. We created to support this initiative and I've also created a useful site for bloggers and journalists to borrow resources from:

Please let me know if you have any questions or need more information. If you are able to post about this, I'd love to get the link and share it with my team.

Thank you,

Ruth Potter

You should check out the website.  It has some really nice pictures and is very well done.  The gist of the site is in the text over a picture of a lovely home with an American flag on it:

The mortgage interest deduction is at risk of being terminated.  The consequences would be devastating to home owners, the housing market and the nation's economy.

Being self absorbed and also because it was easy, I recomputed my 2009 tax return without the home mortgage deduction.  It would have cost me $2,075.  I'll call it forty bucks a week to be accurate, but not precise.  I suppose I could stop buying Mountain Dew and a chocolate frosted donut every morning.  Most likely though, it would mean my kids will inherit a little less or that I will run out of money when I am 94 instead of 96.  Then I tried to think how bad could it possibly be for somebody else.  Because of the limitation on the balance of a mortgage that can create a deduction you are not going to see many mortgage interest deductions north of $50,000.  To keep the math simple I'm going to say losing that deduction might cost somebody $20,000.  Now that's a lot of money.  Of course I have a hard time with the idea of spending more than $1,000,000 on a house.  If the deduction is going to make the difference maybe you should be shopping for a starter home in the $500,000 range.  I know.  It's easy for me to say not living in Silicon Valley.

I'm sorry that given that someone has nicely asked me to write about something that I can't quite share their passion.  Check out their website and see what you think though.  And if you want me to write about something all you have to do is ask.  Agreeing with you will cost extra.

Wednesday, March 16, 2011

Tax Court Finds Psychiatrists Entity Structure Slightly Crazy

Tony L Robucci, et al. v. Commissioner, TC Memo 2011-19

It's funny how a tax court decision can cause me to reflect on my misspent youth.  David Rothman's book, which was relatively new when I read it in 1974 inspired me to take on as my masters project at the famous University of Chicago a multiple career line biography of the Association of Medical Superintendents of Institutions for the Insane.  The organization is now known as the American Psychiatric Association.  My time spent in a basement pouring through their journals and in the computer center creating 80 column cards that summarized biographical data and then were fed into a massive computer to be analyzed by SPSS helped me develop a fondness for the psychiatric profession.  That generation, which did not yet call themselves psychiatrists, seemed to think that if they could just get the building design right they could cure people, perhaps another instance of the phenomenon known as edifice complex.  The other outcome of my foray into historical research was my realization that I was ill suited to it. So I took up public accounting, which, at least at the start of your career, is much less competitive than the academic life.

My sympathy for the psychiatric profession makes me feel bad for Dr. Robucci, who appears to have been ill served by my profession.  His advisor was both an attorney and a CPA which softens my pain a bit, although I'm sure it is of little comfort to Dr. Robucci. Dr. Robucci met with the firm of Mark H. Carson to come up with ways and means of minimizing his tax liabilities.  I must say their plan was something of a doozy.

Mr. Carson recommended, and persuaded Dr. Robucci to adopt, the organizational structure, involving an LLC and two corporations, that is at issue herein. That initial discussion also covered the possibility of structuring Dr. Robucci's practice in such a way as to reduce the amount of self-employment tax that he was paying while also minimizing any other tax liabilities that he might incur. ............On November 2, 2001, Mr. Carson incorporated Westsphere, and on December 20, 2001, he organized Robucci LLC and incorporated Robucci P.C.

The basic idea is that Dr. Robucci's return from his psychiatric practice consisted of two elements.  One was from the value of the goodwill of his practice and the other was from the work that he did.  The structure segregated the two elements  There were some problems with execution:

Mr. Carson determined the ownership percentages, and he also determined the 85-percent-10- percent split in Dr. Robucci's ownership interest between that of limited and general partner. Mr. Carson, who has testified as an expert in valuation matters since 1976, based his determination of an 85-percent limited partner ownership interest for Dr. Robucci on what he determined to be the value of Dr. Robucci's goodwill and what would be a reasonable rate of return on that goodwill at the time he formed Robucci LLC. Mr. Carson never discussed with Dr. Robucci the basis for the 85-percent-10 percent allocation between his limited and general partner interests in Robucci LLC (although Dr. Robucci did understand that his 10-percent general partnership interest represented his interest as a provider of medical services and his 85-percent limited partnership interest represented his interest attributable to his capital contribution of intangibles), nor did Mr. Carson prepare a written valuation in support of his (which describes Robucci LLC) is treated, for Federal tax purposes, as a partnership. Thus, Robucci LLC's members would constitute partners for Federal tax purposes if it were respected as a two-member entity. attribution of an 85-percent limited partner interest to transferred intangibles. Dr. Robucci did not make any written assignment of the tangible or intangible assets of his practice to Robucci LLC.

During the years in issue Robucci LLC and Westsphere had bank accounts; Robucci P.C. did not. Dr. Robucci did not have an employment agreement with any of those three entities, nor did any of them have employees during the years in issue. Neither Robucci P.C. nor Westsphere paid a salary to Dr. Robucci or to anyone else during those years. Dr. Robucci did not keep records of any time he might have spent working for Westsphere. Although Robucci LLC deducted “management fees” for each of the years in issue ($31,475, $25,500, and $38,385 for 2002, 2003, and 2004, respectively), its returns do not specify to whom they were paid or for what services.

Beginning with their dates of organization and throughout the years in issue, Robucci LLC and the corporations used the same business address, although there was no written lease agreement between Robucci LLC and either of the corporations.

The corporations did not (1) have separate Web sites or telephone listings, (2) pay rent to Dr. Robucci or Robucci LLC, (3) have customers other than Robucci LLC or contracts with any other third parties, or (4) advertise. Westsphere did not have separate dedicated space in Dr. Robucci's office

Although Mr. Carson, who, inter alia, was a valuation expert did not prepare a valuation of the intangibles nor any sort of document assigning the intangibles to any of the entities he did whip up a few other documents including a loan agreement, an employee reimbursement agreement (with a formal grievance procedure), a medical reimbursement plan  and an operating agreement for the LLC.  It was probably a pretty impressive binder.  So at least the attorney side of Mr. Carson produced a bulky, if incomplete, package.  The CPA side seems to have fallen down on the job, although we really can't tell this for sure.  It may be that he gave advice on execution that the doctor did not follow.

Regardless of the execution issues, I think the plan was fundamentally flawed.  It is based on the premise that 85% of the net income of a single doctor psychiatric practice is attributable to the goodwill.  We had an acronym we used to use for notions such as this.  It was RFD which stood for "Reeee - diculous". (Many of our acronyms contained a silent F). As my own admittedly fairly limited exposure doing tax consulting for mental health professionals and this story in the New York Times indicates psychiatry is fairly labor intensive and given the educational qualifications not all that lucrative.  There is very little opportunity for leveraging the work of others, which is critical for a return on the goodwill of a professional practice.  It might be that Mr. Carson could have plausibly made the argument about his own firm, which had 3,500 clients, but I doubt that there is a single physician medical practice of any type, where it would be reasonable.  Unlike CPA's psychiatrists cannot subdivide their deliverables into pieces some of which can be provided by other psychiatrists or para-professionals who are paid somewhere between 30 to 40 per cent of what they are billed out for. Outsourcing portions of the work to India would probably be impossible as opposed to just a bad idea.

I can't find any fault with the Tax Court's decision on Dr. Robucci's tax liability:

The result is that Dr. Robucci is treated as a sole proprietor for Federal tax purposes, which was his status before the formation of Robucci LLC and the corporations. It follows, and we hold, that the net income arising from his psychiatric practice during the years in issue, including any amounts paid to Robucci P.C. and Westsphere, was self-employment income of Dr. Robucci subject to self-employment tax under section 1401.

I do take exception to the Tax Court subjecting Dr. Robucci to penalties.  Here is part of their rationale:

It is not that Mr. Carson's goal of directing some of Dr. Robucci's income to a third-party corporate management service provider and bifurcating Dr. Robucci's interest in Robucci LLC so that he would be separately compensated for the use of his intangibles was obviously unreasonable. On the contrary, had it been more carefully implemented, it well might have been realized, at least in part.  The problem for Dr. Robucci is that Mr. Carson's strategy for implementing his tax minimization goal was patently inadequate to the task, a fact that should have been obvious to Dr. Robucci and have prompted him to either question Mr. Carson or seek a second opinion.

Unless there is another Colorado CPA with the same name Mark H. Carson is still operating.  Given the extent to which public accounting and the legal profession are regulated Dr. Robucci's reliance on him was reasonable.  I'm wondering if it is possible that the penalties have been misdirected.

Monday, March 14, 2011

Congress Provides Subsidy to Gay Marriage

The official position of this blog on all matter of what the tax law should be is "It is was it is. Deal with it."  I observe and seek practical pointers, humor and matter for reflection.  I break my rule of indifference to what "should be" from time to time. The tax ramifications of the Defense of Marriage Act provide enough interesting items, that there is no need for my opinion.

Just to bring you up to speed, Section 3 of the Defense of Marriage Act provides, that, for all purposes of federal law, marriage is only between persons of opposite gender and the word spouse means someone of the opposite gender.  Several states, including Massachusetts, allow persons of the same gender to marry.  Such persons are considered either single or head of household (depending on their circumstances) for federal income tax purposes.  Accordingly they are not eligible to file joint returns.  I have a mythical couple called Robin and Terry, whom I invented to avoid awkward pronoun problems.  Robin and Terry are of indeterminate gender and marital status.  For purposes of this post, they are of the same gender and were married in Massachusetts in 2007.

Section 3 of DOMA has been the subject of litigation.  The Federal District Court of Massachusetts in Gill v OPM has ruled that it is unconstitutional, because it has no rational basis.  The Justice Department had indicated that it would appeal the ruling.  Generally the Justice Department defends the constitutionality of laws passed by Congress regardless of what the current administration thinks of them.  The view is that "unconstitutional" and "bad idea" are not synonymous.  The Justice Department has recently, however, concluded that Section 3 of DOMA is indefensible.  So the Administration will not fight it in court any more.  They will continue to enforce it.  So as far as the IRS is concerned Robin and Terry are still not married.

If I were in charge of the vast right wing conspiracy what I would do is have Congress now repeal Section 3 of DOMA.  What they would say is that they were repealing it not on an equal protection theory, but because it violates the 10th Amendments.  It's up to the states to decided who is or is not married and if a couple of states are infected by crazy liberal ideas, the rest of just have to live with it.  Besides, there is some evidence that on net the overall collection of federal tax would be higher if same sex marriages were recognized for federal purposes.

Instead conservative congressman are going to have Congress take up the defense of DOMA in the courts.  By doing this they are, in effect, subsidizing same sex marriages.  Here is why.  People whose marriages are recognized for federal taxes can file either jointly or married filing separately.  People whose marriages are not recognized for federal purposes file as single or head of household depending on their circumstances.  Of the four rate tables married filing separate is the worst.  I just ran the numbers on someone who was single as if he were married filing separately.  It cost him about $4,000.  Taking two married filing separate returns and turning them into joint will almost always save money (An exception might be if one of them had large medical expenses).  Taking two single returns or a single return and a head of household return and turning them into a joint return is much more unpredictable.  It could go either way. ( I should also point out that there is a benefit to the government from joint returns that taxpayers and planners often ignore. By filing a joint return the taxpayers assume joint and several liability. That means the government can collect the whole tax from either one of them.) So the ideal situation would be for you to be able to choose on a year to year basis whether you are single or married for federal income tax purposes.  The unwillingness of Congress to throw in the towel on Section 3 of DOMA, in effect, puts Robin and Terry in that situation.

Under the law in effect now Robin and Terry are single for federal income tax purposes.  If that gives them the most favorable tax, they can just file that way and not worry.  I don't think there is any likelihood that if Section 3 of DOMA is declared unconstitutional there will be examinations of returns of people who have been filing as single.  If I was in charge of the vast right wing conspiracy, I would certainly be threatening that.  "You want marriage equality.  Fine you have it.  Send in four grand."  When the IRS recently ruled that registered domestic partners in community property states have to split their income, they made filing amended returns for open years optional.  Presumably if Gill v OPM is upheld, there will be a similar outcome.

Because of Gill v OPM, however, Robin and Terry have a reasonable basis for filing a joint return if that saves them money.  The conservative thing to do is to file as single and then put in a claim for refund, but if they are feeling wild and crazy they can just file the money saving joint return and their only exposure should be the interest.  Now I am precluded from giving advice based on the audit lottery, but an observation I would make as a policy matter, is that there is nowhere on the return, where they ask you what your gender is.  It is conceivable that I could prepare Robin and Terry's return and engage to represent them in an audit without knowing what the gender of either of them was.  If they told me they were of the same gender, I'd tell them all about DOMA and Gill v OPM, etc, but frankly if Robin came in with all the information or we handled everything through the mail or our portal, it would not occur to me to ask.  It's a little antediluvian, but you have to be careful about asking guys my age whether they are married to a guy.

So, there is a very respectable conservative argument for repealing Section 3 of DOMA (States rights) and continuing the court fight means that same sex married couples, in the aggregate will be paying less federal tax.  Is this the working of the vast left wing conspiracy ? Is the vast right wing conspiracy shooting itself in the foot ? Or is much of the world run by random knee jerk reactions without much long term thought ?  To me when it comes to tax law my motto is "It is what it is. Deal with it." How it gets that way is a little mysterious and of little practical importance.

I think I'm going to give Robin and Terry a break for a while.  There are some other developments that I will focus on in the next few posts.

Friday, March 11, 2011

PAOO Make Bay Windows - Next Stop Ellen

If moral disapprobation of homosexual conduct is "no legitimate state interest" for purposes of proscribing that conduct...what justification could there possibly be for denying the benefits of marriage to homosexual couples exercising "the liberty protected by the Constitution"? Surely not the encouragement of procreation, since the sterile and the elderly are allowed to marry.

When I started this blog, I didn't think I would be focusing on GLBT issues and actually I'm not.  There is a tax blog that does.  It is called Santa Clara Law Same Sex Tax Law Blog.  I'm largely driven by my raw material.  It does work out however that of my top ten posts in terms of traffic, three are of GLBT interest.

My top ranked post concerns the deductibility of gender reassignment surgery.  It owes its popularity to endorsements by two friends, noted science fiction author John Sundman and activist Cecilia Chung.  John and I attended the same high school a million years ago.  An even more famous alumnus of the same high school wrote the passage that is quoted above. Cecilia and I are on the board of Just Detenion International, which is dedicated to ending sexual abuse in all forms of detention.

My sixth ranked post is about an IRS ruling (CCA 201021050) that holds that registered domestic partners in community property states should be splitting their income.  The ruling made filing amended returns for prior years optional.  I introduced Robin and Terry, the couple of indeterminate gender, who help me get around awkward pronoun problems.  The question I ask is what happens if Robin files for a refund and Terry doesn't file a balance due return.  The Santa Clara Law people are not as evil minded as I am.  At any rate, I was one of the first bloggers to notice that ruling and it inspired in me the fantasy that is the subject of this post.

My ninth ranked post (and climbing) is on Gill v OPM, in which the Federal District Court of Massachusetts ruled that Section 3 of DOMA (Defense of Marriage Act) is unconstitutional. Section 3 of DOMA holds that regardles of state law marriage for all federal purposes is between a man and a woman and spouse means someone of the opposite sex.  Among the plaintiffs in Gill were some people who would have saved money if they had been able to file joint returns. I make the point that people who might benefit from this ruling need to file refund claims before the statute of limitations expires.  2007 is looming.

So the grand announcement is that the post on amended returns has been republished by Bay Windows, New England's premier gay newpaper.  So that brings the fantasy I had when I first put up the comment on the then very obscure CCA 201021050 - an interview on the Ellen Degeneres show - one step closer to reality.  Also by comparing the Bay Window version to my original you can see how good this blog would be with some professional editing.

Just to show you that there are depths of self absorption beyond blogging about your owns blog, I'm going to explain the quotation above that has been used to support gay marriage with a pointless anecdote from my high school.  The faculty of Xavier High School consisted of Jesuit priests, scholastics (who were on the way to becoming Jesuit priests), lay teachers, who were like regular guys and  the Military Science faculty.  Xavier, at that time, required all students to be in Junior ROTC.  The Military Science faculty consisted of an active duty Army officer and a couple of active duty senior NCO's and a few more retired NCO's.  With the exception of Father Hareiss, who had been drafted into the Wehrmacht while a young Jesuit and regaled us with stories of the street fighting in Munich "Venn, he vas a young boy in Chermany", the most colorful faculty members were the retired sergeants.

  Among them was Sergeant Daley, from whom we learned in the basement rifle range, that a certain unmentionable type of hair is actually a unit of measure.  Sergeant Daley told us many things that we would need to know as rookie Army officers (which almost none of us became).  One of those things was the unfortunate chronic shortage of blank ammunition to create realistic training exercises.  The other was an anecdote about the dangers of blank ammunition.  In lieu of a bullet a blank round had a small wad of material that is dangerous at very close range.  He illustrated this point with a story about someone firing a blank with his rifle pointing down in a crowded room.  At that range the wadding material could penetrate the top and bottom of a combat boot and the intervening biological material.

So what does that have to do with the above quote about gay marriage.  Justice Antonin Scalia wrote that passage in his dissent in Lawrence v Texas which ruled anti-sodomy laws were unconstitutional.  The passage has since been used to defend gay marriage.  You see Justice Scalia attended Xavier even longer ago than John and I did.  When he attended Xavier, Sergeant Daley was still on active duty and unavailable to warn young high school lads about shooting themselves in the foot.

Wednesday, March 9, 2011

Neither Mentionable Nor Deductible

Anietra Y. Hamper v Commissioner, TC Summary Opinion 2011-17

                                           I see London
                                           I see France
                                           I see Sally's ********

Anietra Y. Hamper was a news anchorwoman.  I should mention that she appears to be a serious journalist and is writing a blog on her trip to Vietnam.  She was not an anchor on Naked News, so she had to spend quite a bit of money to purchase the proper attire for a news anchorwoman.  Her clothes shopping was governed by something called the Women's Wardrobe Guidelines. Apparently, and unfortunately for Ms. Hampers case, TV anchorwomen are required to dress like, well, CPA's :

The guidelines provide that the “ideal in selecting an outfit for on-air use should be the selection of `standard business wear', typical of that which one might wear on any business day in a normal office setting anywhere in the USA.” The guidelines point out that there is no correlation between the cost of an outfit and its appropriateness for use, and generally a conservative outfit purchased “off the rack” at a local department store is more acceptable than excessively stylish items purchased at a designer boutique.

The guidelines also recommend avoiding certain clothing such as those with flamboyant or loud patterns which may be distracting on camera, heavy tweed suits, and outfits with buttons or accessories that are overly large, as television tends to make them look even larger.

Apparently Ms. Hamper has taste in clothing that is either more flamboyant or more casual than that required to be worn on air and in her public appearances as an "ambassador" of the station.

During the years at issue petitioner purchased clothing for her position as a news anchor. She wears her business clothing only at work and maintains her business clothing separately from her personal clothing. She explained that the requirement to wear conservative clothing makes her business clothing unsuitable for everyday wear.

There actually is a case in which the Tax Court allowed a deduction for clothing suitable for ordinary wear :

Some of the clothing purchased by the petitioners for use during production of their television series was suitable for their personal wear, and was in fashion at the time it was purchased.

There were, however, some special circumstances :

The clothing purchased by petitioners for use in the production of their television show was, until disposed of, kept at the studios. At the end of a "shooting" season, the wardrobe remained in the studio and was placed in mothballs and zipper bags and was not taken home.

Some of the wardrobe clothing was not suitable for personal use in the area where petitioners resided. The show depicted the average family, and did not specify its locale as being in southern California. During most of the months when the show was being shown the clothing used on the show was much heavier than clothes normally suitable for wear in southern California.

During the production of the television series, retention at the studio of clothing worn by the principal actors was required. Upon occasion petitioners had to reenact certain scenes, so that the same clothing must be available and worn during such reenactments.

The case was Oswald "Ozzie" G. Nelson, TC Memo 1966-224 and the IRS acquiesced in the decision (Action on Decision 1972 WL 33220, 11/08/1972).  Those of you who fondly remember Ozzie and Harriet will be glad to know that Ozzie's occasional wearing of a heavy sweater to a football game did not impact its deductibility.  Sadly, there was inadequate substantiation with respect to Ricky and David's personal use of the clothing, so much of their apparel was disallowed.

I wish to express my sympathy for Ms. Hamper not so much for her losing the case although I can understand her logic in thinking her clothing was deductible :

Petitioner used a self-described criterion for determining whether a clothing expense was deductible. She would ask herself “would I be buying this if I didn't have to wear this” to work, “and if the answer is no, then I know that I am buying it specifically” for work, and therefore, it is a deductible business expense.

Sadly, many of us could make that same argument even though we don't appear on television.  In the occasional evaluations that are made of partners in my firm, my high marks for thinking outside the box are substantially offset by failure in the "executive presence" category, which includes less than perfect wardrobe choices on my part.

My sympathy for Ms. Hamper relates to the publicity that this decision has generated.  Here is an example, which I do not recommend you view, but present by way of example.  In compiling the items of apparel that she attempted to deduct Ms. Hamper may not have reflected that tax court decisions are published.  Although, not that widely read, elements of them have the potential to go viral.  Here is a slightly bowdlerized version of a section of the decision:

Petitioner's clothing purchases for work consisted of such items as traditional business suits, lounge wear, a robe, sportswear, active wear, ********************* and evening wear. She also deducted expenses for an Ohio State jersey, jewelry, bedding, running and walking shoes, and dry cleaning costs.

Yes Ms. Hamper was trying to deduct items of clothing that her viewers are not meant to view on conventional news programs.  She probably did not realize that among some of those who peruse tax court decisions, there is some level of adolescent male sensibility.  I may be expressing a Victorian attitude in the age of Victoria's Secret, but I hope that Ms. Hamper will accept my apologies for the ungentlemanly behavior of the tax blogosphere in this matter.  I doubt that lady tax bloggers were responsible for this matter being exposed to the general media.  I need to get back to my day job, so I cannot spend time researching who was the first to break this story.  I picked it up in my regular review of tax court decisions.  Since the taxpayer was something of a celebrity, I did a little further research and found that it had already been covered quite a bit.  I would have dropped it, until I realized I had a different perspective to offer.  Again, I'm sorry Ms. Hamper that your aggressive tax position has caused your undergarment decisions to be so widely exposed.

Monday, March 7, 2011

Sometimes You Need to Burn First

LINTON v. U.S., Cite as 107 AFTR 2d 2011-565, 01/21/2011

One of my earliest blog posts, mentioned the Lintons.  I was toting up the score on family limited partnerships for 2009 declaring the year to be a tie with two wins for the IRS and two for the taxpayers.  So early in the blogs existence I hadn't thought through all the implications of the scoring system.  So I will leave it to the readers to determine whether we need to reopen the score book for 2009.  The Lintons have appealed and appear to have won.  Perhaps it would be more accurate to say they have gotten the game into overtime.  In the first decision, the IRS won on "summary judgement".  The appeals court is sending the case back for reconsideration.

 You may have seen the cartoon on which the bumper sticker is based.  Ferocious barbarians are running around the village with torches while the chieftain reflects that it is better to pillage first.  That would seem to be a universal principle, but there are exceptions.

As I mentioned in a previous post, there are some excellent business and family reasons for establishing family limited partnerships.  The excitement though is about the discounts.  You put the assets in the family limited partnerships.  The resulting value of the partnership interests is less than a proportional amount of the underlying assets.  You need to form the partnership and put the assets in it before you make any gifts.  If you give away an undivided interest in the assets and the donees contribute those undivided interests, it doesn't work.  You need to do the thing that reduces the value, then make the gift - Burn, then pillage.

The parties have assumed that in determining the character of the Lintons' gifts, the sequencing of two transactions is “critical,” Senda v. Comm'r, 433 F.3d 1044, 1046 [97 AFTR 2d 2006-419] (8th Cir. 2006), and we do so too, without deciding whether that is always so in cases of this ilk. The transactions at issue are: (1) the contribution of cash, securities, and real property to the limited liability company, and (2) the transfer of LLC interests to the Lintons' children's trusts. If done in that order (and with some lapse of time between the transactions), as the Lintons contend occurred here, the gifts would ordinarily be characterized as gifts of LLC interests, and the value of those LLC interests might be discountable for tax purposes. If, however, the contributions to the LLC occurred after the transfer of LLC interests to the children's trusts, the gifts would ordinarily be characterized as indirect gifts of the particular contributed assets and would not be discountable.

In the first go round the court had concluded that things were done in the wrong order.  The Lintons, however, insisted that they had done their burning before they pillaged.  The problem is that this stuff is all just paperwork.  The way you tell what order things were done in is by the dates on the paper.  Here were the relevant documents :
Quit Claim Deed: signed by William and conveying a parcel of his separate property real estate to WLFB. The parties agree the quit claim deed was effective on January 22.

Assignment of Assets: signed by William as assignor and by both William and Stacy as assignees on behalf of the LLC.

Letters: signed by William and authorizing the transfer of securities and cash to WLFB. The parties disagree as to when the transfers of securities and cash were effected.

At the same meeting with attorney Hack, William, Stacy, and William's brother James Linton, signed, but left undated, several other documents:

Trust Agreements (four total—one for each child): signed by William and Stacy as grantors and by James as trustee; forming and apparently funding irrevocable trusts for the children.

Gift Documents (eight total—one each from William or Stacy to each trust): signed by William or Stacy as assignor and by James as trustee, gifting 11.25 percentage interests in WLFB to each respective trust.

Even though the burning documents were signed at the same meeting as the pillaging documents, the pillaging documents were not meant to be immediately effective.  Then came the oops moment :

Two or three months later, attorney Hack assembled these key documents. For all undated documents, he filled in the missing date as January 22, 2003. In his deposition, Hack stated this insertion was erroneous, and that these documents should have been dated January 31, 2003. William agrees that January 31 was the correct date. This testimony is consistent with that of Caryl Thorp, an accountant with Moss Adams, LLP, who advised the Lintons on the ordering of the transactions.

Really what good is a lawyer's story with out a CPA to back him up ?

The case goes into a fairly interminable discussion of what constitutes a completed gift under the laws of the State of Washington.  Here is the introduction to that discussion:

Under Washington law, “the elements of a completed gift are (1) an intention of the donor to give; (2) a subject matter capable of delivery; (3) a delivery; and (4) acceptance by the donee.” In re Marriage of Zier, 147 P.3d 624, 628 (Wash. Ct. App. 2006). The transfer of the LLC interests occurred when all four elements of a completed gift first existed simultaneously. We must determine when that was. We discuss each element individually, but we defer discussion of the first element, intention to give, until the end, as here it is both the decisive element and the most difficult to determine.

You probably don't want more of that, trust me.

They also discussed an entertaining theory advanced by the Lintons.  The argument is that if the gift of the LLC interests happened before the transfer of the property, then the Lintons should have gotten credit for the property fair market value in their capital accounts.  Hence if the IRS is right instead of a 47% discount, there is no gift all.  The Court wasn't buying it.

The Lintons' “failed-gift” theory is clever; unfortunately for them, it is too clever. The membership ledger of the LLC shows that the capital accounts of the children's trusts were, in fact, increased, as does the LLC's informational return that its accountants prepared and filed with the IRS in March 2004. The Lintons contend that if we conclude the government is right about the timing of the transactions, these documents were prepared on a mistaken assumption (i.e., that the LLC interests were transferred after the assets, and, therefore, by virtue of the IRC § 704 capital account rules, included a pro rata transfer of the assets from the donors' capital accounts to the donees') and should be ignored. On their theory, the informational return and the ledger would only reflect what everyone believed to be the state of the capital accounts, not the actual state of the capital accounts.

 But tax law is concerned “with the realities of a situation and not with the formalities of title.”...... The membership ledger and the LLC's informational return together reflect the substantive reality of the situation: All parties involved regarded the trusts' capital accounts as having been enhanced. In other words, all concerned parties acted as if William and Stacy Linton had “so parted with dominion and control [over the assets] as to leave in [them] no power to change [their] disposition.”

In the end.  This is not the end.  We will be hearing more about this case.

Genuine issues of material fact exist as to the sequence of transactions by which the gifts were made. We remand this question for the district court to determine, following further proceedings, when the four elements of a gift under Washington state law were simultaneously present, and, in particular, to determine when the Lintons first objectively manifested their intent to make the gifts effective. We also reverse the district court's grant of summary judgment in favor of the government as to the application of the step transaction doctrine. Finally, we affirm the district court's order denying summary judgment to the Lintons, holding that they are not entitled to summary judgment on their failed-gift theory.

I think the moral to the story is that forming a family limited partnership, funding it and making a gift of the partnership interests is probably worth more than one trip to the lawyer's office.  Let the village burn for a month and then go back and pillage it.

Friday, March 4, 2011

It's OK To Tell Them Why You Want Them to Hold Your Money

Ralph E. Crandall, Jr., et al. v. Commissioner, TC Summary Opinion 2011-14

This case really mystifies me.  It is about a failed tax-free exchange.  So here's the deal.  One of the most general rules of income tax is that if you trade one thing for another thing and the thing you get is worth more than the basis of the thing you gave up, you have taxable income.  When the thing you get is money, most people understand that, but it is true regardless of what you get.  Like any good general rule, there are many exceptions.  Part III of Subchapter O contains a host of them including Section 1031.  Section 1031, like 401(k) and 501(c)(3), has worked its way into common conscious enough to rate a Wikipedia entry.  It's basic holiding is:

No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment.

Although it has very broad applicability the biggest action in 1031 is in the area of real estate.  This is because all real estate in the United States is considered to be of like-kind with all other real estate in the United States.  So you can't swap your cow for a bull and have it qualify as a like kind exchange, but you can swap your farm land for an office builing.  I swear I don't make this stuff up.  I don't have enough imagination.

Since it is unlikely that somebody who wants your property is going to have property you want, taxpayers began devising schemes to do three way swaps.  Eventually this was regularized.  You can arrange to sell your property and have a "qualified intermediary" receive the proceeds.  You then have up to 45 days to designate a target property and 180 days (You may have to extend your return to have the full 180 days) to close on the target property.  Exchange facilitation is a minor industry.  I gave a cautionary tale about exchange facilitators a few months ago.  Basically you want to use one that keeps your money in a segregated account.  You won't go too far wrong using the likes of Wells Fargo, but you can shop around. 

What happened to Ralph Crandall is a classic case of somebody getting half the story and going ahead and acting on it.  Maybe he heard about 1031 from his barber.  He didn't hear about it from my barber, certainly, because then he would have called me.  Actually, my barber cuts most of the CPA hair in central Massachusetts, so maybe he would have called somebody else, but he would not have flown blind.

Here's how it went:

Petitioners owned an undeveloped parcel of property in Lake Havasu City, Arizona (Arizona property). Petitioners held the Arizona property for investment. Petitioners desired to own investment property closer to their California residence. After receiving some limited advice concerning a tax-free exchange of properties, petitioners took steps to sell the Arizona property and purchase new property with the intention of executing a tax- free exchange. On March 4, 2005, petitioners sold the Arizona property for $76,000. The buyers of the property paid petitioners $10,000, and the remaining $66,000 was placed in an escrow account with Capital Title Agency, Inc. (Capital Title). At petitioners' direction $61,743.25 was held in the escrow account. Capital Title initially released $4,256.75 to petitioners. Petitioners' basis in the Arizona property was $8,500.

In furtherance of the purchase petitioners made payments to Chicago Title Co. (Chicago Title) and placed in an escrow account as follows:
Jan. 4, 2005 10,000.00
Mar. 14, 2005 (three separate payments)24,700.00, 4,256.75, 294.00
Mar. 18, 2005 61,550.00

The Capital Title and Chicago Title escrow agreements did not reference a like-kind exchange under section 1031, nor did they expressly limit petitioners' right to receive, pledge, borrow, or otherwise obtain the benefits of the funds

This is the part that mystifies me.  Capital Title is a name used by several companies so I can't be sure about it. Chicago Title , though,has a division that does 1031 exchanges.  Didn't Mr. Randall think to tell the company that he was trusting his money with that he was doing a 1031 exchange ?  Didn't they think to ask him why he was escrowing money?

I could go on at length about what is and is not allowed in handling 1031 exchanges but I generally don't.  The reason is that if you have a plain vanilla deal you should contact a company that does a lot of exchanges and do what they tell you.  It really doesn't matter what I think.  If you have a complicated transaction then give me a call. 

The Tax Court felt sorry for Mr. Randall, but they couldn't help him:

Neither escrow agreement expressly limited petitioners' right to receive, pledge, borrow, or otherwise obtain the benefit of the funds nor made any mention of a like-kind exchange. Because of the lack of limitations, neither escrow account was a qualified escrow account. See Hillyer v. Commissioner, T.C. Memo. 1996-214 [1996 RIA TC Memo ¶96,214]; Lee v. Commissioner, supra. Although petitioners used the funds in the Capital Title escrow account to purchase the California property, the lack of express limitations in the escrow agreement results in petitioners' being treated as having constructively received the proceeds.

We conclude that the disposition of the Arizona property was a sale and the funds deposited in the Capital Title escrow account represent the receipt of the proceeds. See sec. 1001(c). Consequently, this transaction does not qualify for section 1031 nonrecognition, and petitioners must recognize gain for 2005. See sec. 1001(c). The Court notes that the tax consequences are not what petitioners intended and the result may seem somewhat harsh. However, Congress enacted strict provisions under section 1031 with which taxpayers must comply. We also note that respondent has conceded the accuracy-related penalty.

How could he have avoided this problem ?  He could have told the people escrowing the money that he was doing a 1031 exchange.  If they didn't know what he was talking about, he could have found somebody else.

Wednesday, March 2, 2011

Even the 2011 Stuff is Getting Stale

As I finished my clean up of 2010 and posted items that I found more timely, 2011 material was accumulating. I will rarely post something that is more than two months old and I hate to cast away the rough diamonds that I don't have time to polish, so here are some more fairly random items of interest.

Two of them about mail, so I thought I'd recommend the novel Mail.  Ms. Medwed is married to a distinguished tax attorney and some tax humor creeps into her work from time to time.  I think its terrible that it appears that you can have the book for the price of the shipping and handling, but you would be foolish not to buy it.  It's really great.  I, myself, have a copy autographed by the author. 

Jeffrey L. Rayden, et ux. v. Commissioner, TC Memo 2011-1

This was a about business use of a home. Taxpayer was claiming 70% and IRS was willing to allow 43%. Tax Court went with the IRS. They had a pretty big house :

Petitioners' two-story residence consists of 12 rooms. There is additional space in the area of the vestibule, hall, and staircase. There is also an attached three-car garage. Petitioner's family put the master bedroom and master bathroom to personal use. Petitioners' daughter used the room designated on Exhibit 15-P as bedroom 2, including the sitting area, bathroom, and closet, for personal purposes. Petitioners asserted at the trial that 10 percent of the use of bedroom 2 was for business. The room designated as the guest room consists of 283 square feet and was used by petitioner wife in connection with her travel agency business.

The problem the taxpayer has is that a portion of a house must be used exclusively for business in order to qualify:

Exclusive use of a portion of a taxpayer's dwelling unit means that the taxpayer must use a specific part of a dwelling unit solely for the purpose of carrying on his trade or business. The use of a portion of a dwelling unit for both personal purposes and for the carrying on of a trade or business does not meet the exclusive use test.

Respondent conceded that petitioner used the library and the garage exclusively for business. We also find that petitioner used the living room exclusively for business. Although petitioner's own exhibit claimed that the business used the living room only 95 percent of the time, at trial he credibly explained that “The only reason I put down 95 percent is that somebody who would be visiting could have possibly walked in [or through] that area and walked out.”

This Court has previously held that the mere nonbusiness passage from one room to the next can be classified as a de minimis personal use of the room and will not disqualify the room from the exclusivity requirement of section 280A(c)(1).

Although petitioner first explained that he did not eat in the breakfast room, in response to a question by the Court he conceded that on occasion he or his family may have eaten in the breakfast area. Petitioner also did not use the den, vestibule, and adjoining bar exclusively for business. Petitioner explained that “maybe one or two times a year, [the area] was used sometimes by family that were visiting”. We do not regard as de minimis this personal use of the room by visiting family.
Petitioner also did not use the dining room exclusively for business when his family was visiting. Petitioner testified that “one or two nights a year” when his sons were in town they would have a family dinner in the dining room. Petitioner is not entitled to a deduction for items of expense apportionable to these rooms.

I once read that the most expensive meal that a family has is when they eat in their dining room. In order to get to that result you have to apportion the extra cost that the dining room creates over the number of meals that the family eats there. I wonder if Mr. Rayden will be taking his sons out to restaurants in the future.

CCA 201052003

This was about an amended return that was mailed on the day the statute of limitations expired for the relevant tax year. The ruling, which has some other twists and turns to it, holds that the "timely mailed, timely filed rule" does not apply to an amended return. The reason is that an amended return is not a return "required to be filed". So if you have been waiting to file an amended return that might yield a refund, don't let yourself get too close to the due date. I noted this ruling in my recent post on DOMA.  Couples who might benefit from DOMA being declared unconstitutional should be getting their 2007 refund claims in shortly not rushing to the post office with them the Monday after Emancipation Day.

John A. Boultbee v. Commissioner, TC Memo 2011-11

This is the other mail ruling.  It is also about the "timely mailed, timely filed rule".  Mr. Boultbee mailed a Tax Court petition five days before it was due.  It arrived three days after the due date.  The twist was that he had mailed it from a foreign country.  Now being in a foreign country gave him 150 days instead of 90 days to file the petition, so maybe he doesn't really have a beef.  The "timely mailed, timely filed rule" applies to the US mail.  Mr. Boultbee was able to prevail, though.  He used a registered mail service that is available in the obscure foreign country where he was located.  Because of their tracking and that of the US Post Office Service he was able to demonstrate that the petition hit the US mails in time to be "timely mailed".

Petitioner mailed his petition from Victoria, British Columbia, Canada, using the registered mail service of Canada Post on June 9, 2010, the 145th day after the notice of deficiency was sent to petitioner in Victoria. A Canada Post postmark of June 9, 2010, is stamped on the front of the envelope. The Canada Post system, which allows for tracking of documents using a unique identifier on the sticker affixed to the envelope, indicates that the envelope in which the petition was mailed left Canada at 1:51 p.m. on June 10, 2010.

Although no U.S. Postal Service postmark is stamped on the envelope, the U.S. Postal Service Track and Confirm service allows for tracking of inbound registered mail using the same unique identifier used for the Canada Post registered mail.  The U.S. Postal Service Track and Confirm service indicates that the envelope in which the petition was mailed was received by the U.S. Postal Service International Service Center in Los Angeles, California, at 10:21 a.m. on June 11, 2010. The envelope was then dispatched to Washington, D.C., where it was received on June 17, 2010, at 10:24 a.m., and then delivered to the Court that same day at 11:34 a.m.

I was going to throw in something about Sergeant Preston and King, his sled dog, but that's the Yukon, which is north of British Columbia.

Beverly B. Bang v. Commissioner, TC Summary Opinion 2011-1 

It's really not nice to make fun of somebody's name so it is a good thing that I never will do a full length post on this case with the title "Botta Boom Botta". Besides the title I had even come up with an introductory quote. Further research indicated that maybe Albert Einstein didn't really say that compound interest is the most powerful force in the universe. Nonetheless, Ms. Bang may feel that way.

Ms. Bang was involved in a tax shelter back in the good old days of the Internal Revenue Code of 1954. It wasn't really that big a deal:
The Contra Costa Partnership Bang was a partner in a partnership called Contra Costa Jojoba Research Partners. This partnership, which we shall refer to as the Contra Costa partnership, filed a partnership tax return for its 1983 tax year on which it deducted $437,500 in research and experimental expenditures under section 174. On her own 1983 tax return, Bang reported a deduction of $12,500 for her share of the $437,500 deduction that the partnership had claimed. The 1983 tax return was due on April 15, 1984.

The IRS didn't like the partnership's deductions which led to some litigation. It took a while. Finally Ms. Bang got a notice that she owed an additional $2,636 in tax for the year 1983. She paid it. She also paid a negligence penalty of $131.80 So what's the big deal ? The big deal is that she didn't think she should have to pay $21,553.52 in interest (That was figured at 120% of the regular rate) and a 50% of interest penalty bringing the total tab to $32,343.46. She didn't think it was her fault that the IRS had taken over 20 years to settle this case and finally bill her.

This was an appeal from a collection due process hearing so there were a lot of procedural issues. Ultimately, though she didn't get any relief.

Martin Barajas, et ux. v. Commissioner, TC Summary Opinion 2011-2

This was a pretty ordinary substantiation case.  It is interesting in that the Tax Court held to a significant extent for the the taxpayer.

Respondent's continuing disallowance of car and truck expenses relating to petitioner's business mileage to and from Los Angeles stems from petitioner's ability to provide supporting documentation for only 37 (or 77 percent) of his 48 trips. Respondent's insistence on 100 percent corroboration of the mileage log, however, contradicts the Secretary's own regulation. A taxpayer may substantiate his consistent pattern of business use of listed property for the entire year if he can establish by corroborative evidence that the periods for which he has adequate records are representative of the whole year. Sec. 1.274-5T(c)(3)(ii)(A), Temporary Income Tax Regs., 50 Fed. Reg. 46021 (Nov. 6, 1985) .

The taxpayer lost out on some overnight expenses because of failure to keep receipts, but because the amounts were reasonable and the taxpayer had used a competent preparer the Court did not allow the IRS to assess negligence penalties.

Private Letter Ruling 201101029

This was a denial of exempt classification.  They were seeking exemption under 501(c)(15) (small insurance company.)  The mutual insurance company was composed of 6 taxicab companies. Although each was operated independently there were familial relationships amond the shareholders of the various companies.  The IRS wasn't buying it.

There is an insufficient number of insureds to provide for an adequate premium-pooling base. In addition, your risk is too heavily concentrated in two insureds. As a result, your business lacks one of the principal elements of insurance, risk distribution. Thus, because you do not qualify as an insurance company, you do not meet the statutory requirement for exemption under section 501(c)(15) of the Code.

Well that will do for one post.  There's plenty more where that came from.