Tuesday, May 31, 2011

From The Boston Tax Institute

Boston Tax Alert 2011-24,2011-25, 2011-26

Lu Gauthier of The Boston Tax Institute has given me permission to republish his newsletter. The BTI newsletter is a regular feature of this blog now going up every Tuesday. Be sure to check out the BTI catalog for great CPE value.  These are going up a little late because of the holiday. 

Our thanks to Steven Cohen, Esq. for the following email!

The Massachusetts Legislature has enacted a new law that will increase homestead protection for homeowners in Massachusetts. Homestead protects a person's residence from most creditors. If a homeowner is sued by a creditor or files for bankruptcy, a portion of their equity in their home - the "homestead estate" - is deemed unavailable to their creditors. The new law was passed on December 16, 2010, and became effective on March 16, 2011.

The new law provides that Massachusetts homeowners' property will automatically be protected from debt collectors up to $125,000, provided they occupy or intend to occupy their home as their principal residence and that they hold that much equity in their properties. Prior to this statute, homeowners only received this protection if they filed a declaration of homestead with the Registry of Deeds. The new law makes this protection automatic for up to $125,000. Homeowners may still file a separate declaration of homestead with the Registry of Deeds, which will provide additional protection of up to $500,000.

If the homeowners are over age 62 or disabled, each owner is entitled to the full exemption amount of $500,000 resulting in protection of up to one million dollars for an older couple. If they are under 62 years old or not disabled, the total exempt amount allowed for a couple will be $500,000.

The new Homestead law as it applies to elders will be discussed by Steve in Medicaid Planning on 6/20 in Waltham. The entire new Homestead law will be discussed in detail by Lisa Delaney, Esq. in our 1/2 day seminar entitled New MA Homestead Exemption on 6/21 in Randolph.
An issue that has arisen in a number of recent IRS examinations is whether the taxpayer should extend the statute of limitations. My position continues to be that in most cases the statute of limitations should NOT be extended. An extension just gives the examining agent more time to develop his issues and to examine other tax years. If an extension were to be given, it should only be for a very short duration such as a few months in order to allow the agent to finalize the case and write up his report. In hindsight, in most cases, it appears to have been a major error of judgment to have extended the statute of limitations! This and other scintillating issues will be discussed in detail in our seminar entitled How to Handle an IRS Audit / Appeals Conference on 6/1 in Waltham.

PAOO Comment: The above is from Lu Gauthier himself.  BTW his instructors are all quite good (well except maybe for the time I did a course), but I don't think I am doing them injustice when I say that Lu, himself, is probably about the best.


Herb Daroff provided the following questions to ask CPAs to spark interest in his seminar on Business Succession Planning on June 7:

Who's going to own your client's business after you?

What is your client's business succession plan?

Closely-held family-owned private businesses come in four varieties:

1. ONE OWNER -- with NONE of his or her children active in the business to succeed him or her in ownership or management.

Most SELLERS want far more than a BUYER will pay.

SELLERS want enough so that they can afford to retire.

The SELLING stockholder also is frequently a RETIRING key employee.

Learn how to take advantage of EMPLOYEE benefits which are far more tax efficient than EMPLOYER benefits.

2. ONE OWNER -- WITH one or more of his or her children active in the business to succeed him or her in ownership or management.

The most common plan is for the child(ren) to BUY the business from their parent.

This is the LEAST tax effective way to accomplish this!

Learn the right way to transfer a business from generation to generation.

3. MULTIPLE OWNERS -- with NONE of their children active in the business to succeed them in ownership or management.

Cross-Purchase Agreements are far more tax efficient than Redemptions.

However, both result in paying estate taxes on far more than the business is worth

150% if 2 equal owners,

183.33% with three equal owners, etc

Learn how to create Estate Enhanced Cross-Purchase Arrangements.

4. MULTIPLE OWNERS -- WITH one or more of their children active in the business to succeed them in ownership or management.

These are typically the largest and most complicated cases.

Learn how to separate VOTE, from EQUITY, and from INCOME in order to develop the most effective plan from a tax, legal, financial, and people point of view

Monday, May 30, 2011

Having Your Cake and Eating it Too

Larry E. Tucker v. Commissioner, TC Memo 2011-67 

I could probably make a full length post out of this one, but I told a similar story not long ago and that one had much more dramatic numbers.  Unlike the attorney who managed to lose over $20,000,000 he had earned before he bothered to pay the taxes on it, Mr. Tucker was dealing with more modest sums:

 In January 2003, Mr. Tucker received payment in advance for some independent contractor web design project to be performed by him later in the year. He knew he would need this money to live on during the year, but he also knew he owed taxes and other creditors. In retrospect unwisely, he decided to try to leverage currently-unneeded funds  into profits by which he could pay off his back tax debts and other creditors. So, he wire transferred some of the funds from his checking account to a newly-opened E-Trade account between January 10, 2003 and April 3, 2003. During January, he put $23,700 into the E-Trade account. Then, he began day trading. By the end of January, he showed a small profit, since the account was valued at $25,873.16 on January 31, 2003. From there, however, everything went south.

We don't learn from the case what happened to the "web design project".  The case is about the IRS "abusing its discretion" in not allowing Mr. Tucker a work-out on his tax debts.  The Court went with the IRS on this one:

The losses that Mr. Tucker sustained were not due to an unforeseeable event but rather were commonplace (especially for a neophyte) in such a highly volatile activity. Mr. Tucker knew he owed outstanding taxes; and he had the cash in hand that would have paid in full the taxes and accruals he owed as of early 2003 (i.e., for tax years 1999, 2000 and 2001); and yet he chose instead to devote that money to a risky investment. Mr. Tucker's foray into day trading was purely speculative, and his already slim chances of success were undermined by his inexperience. In short, Mr. Tucker's circumstances were of his own making. Therefore, we cannot criticize the Office of Appeals' conclusion that Mr. Tucker's losses associated with his day trading were a dissipation of assets that should be considered for inclusion in RCP as contemplated by IRM pt.

John L. Parsley, et ux. v. Commissioner, TC Summary Opinion 2011-35

The decision was about penalties.  There was a slightly convoluted fact pattern:

Myrna L. Parsley (petitioner) has been a real estate agent for more that 30 years. Petitioner in 1999 or 2000 took classes to learn about section 1031, involving so-called like-kind exchanges. She takes continuing education courses to maintain her real estate license and is a member of various real estate professional associations. Petitioner married her current husband, petitioner John Parsley, in 2000. He is also in the real estate business.

Petitioner's ex-husband, Joseph Benedict (Benedict), was a real estate broker. While married to petitioner Benedict purchased commercial property on Agler Road (the property) in his name only in June 1990. Petitioner learned of the purchase in 1992. After petitioner confronted Benedict with her discovery, he deeded to her an undivided interest in the property as a tenant in common. At that time petitioner was not engaged in the sale of commercial property. In January 1998 petitioner and Benedict divorced.

As part of the 1998 divorce settlement, Benedict was ordered to deed to petitioner his remaining ownership interest in the property, making her sole owner of the property. In September 2000 the State court caused Benedict to issue a quitclaim deed to petitioner for the property. Petitioners sold the property in February 2006 for $700,000. Petitioners reported a capital gain of $256,272 from the sale on their 2006 Federal income tax return. Petitioners calculated their gain using a basis of $502,205. Benedict purchased the property for $320,000. Respondent computed a capital gain on the sale of $488,071. The record does not reflect the extent to which depreciation affects the parties' calculations of basis and gain.

The taxpayers had told their preparer that their basis in the property was around $500,000.  Because of the sparseness of the record the tax court gave them credit for basis of $320,000 (Nobody seems to have given them information on depreciation).  Part of the reason for upholding the penalties was that the taxpayers had the professional knowledge to find out what Mrs. Parsley's ex-husband had paid for the property.

Todd A. Dagres, et ux. v. Commissioner, 136 T.C. No. 12

This one had a fairly interesting return presentation problem.  Mr. Dagres was a venture capitalist.  He loaned $5,000,000 to a business associate, who in addition to paying AFR would provide him leads on profitable investments. Apparently the business associate was not himself such a great investor as he was unable to pay the interest on the loan.  Ultimately it was settled with Mr. Dagres taking a loss of $3,635,218 on the transaction.  His position was that it was a business bad debt. The IRS said it was a non business bad debt, which would give rise to a capital loss.  Alternatively they argued that if it was a business bad debt it was related to his business of being an employee of a venture capital firm, which would subject it to the 2% floor and make it non deductible. 

Mr. Dagres, being a venture capitalist, had a pretty good salary $2,640,198. That is, of course, chump change compared to his capital gains of $40,579,41.  The capital gain was not mainly from his own investing.  It was the "profits interest" or "carry" from being a managing member of a venture capital partnership.

I would have been scratching my head about the return presentation problem.  His advisers solved it by creating a Schedule C for his venture capital business and putting the bad debt deduction there.  Not elegant, but it worked. 

In exchange for this service, the fund manager receives both service fees and a profits interest, but neither the contingent nature of that profits interest nor its treatment as capital gain makes it any less compensation for services.

It looks to me like the Tax Court is letting the venture capitalists have their cake and eat it too.  The partnership gets investor treatment which is attributed to the manager, but the manager is allowed trade or business treatment for purposes of taking a deduction.

Friday, May 27, 2011

LGBT Advocacy Organization Denied Exempt Status

Private Letter Ruling 201120036

Nothing like a slightly sensational headline to grab their interest.  This is probably not the work of the vast right wing conspiracy.  I've made a desultory attempt to figure out the organization involved but haven't had any luck yet.  I've included a link to the full text so maybe you can figure it out.  The most frustrating part about private letter rulings is their anonymity.  Of course that is the fun part because you can try to figure out who it is or just make something up.  So here is the story.

Org X has been denied its application for exempt status.  X's members are for the most part employees of Y.  They are a little confused as to when they started :

Page 1 of the Form 1023 application states your organization, X, was formed as an unincorporated association on December 1, 1992, as this is when the Y Company formally recognized you as an employee caucus group. However, the document entitled "X Original Charter" indicates you were formed on July 20, 1995. visibility within the Y Company and beyond to its members, and to provide an official point of contact between its membership and Y, as well as with other gay, lesbian, bisexual, and transgender organizations external to the Y Company." You also indicate having the Y Company become the employer of choice for individuals of the lesbian, gay, bisexual, and transgender community where these individuals can work in a culture of equality and enjoy successful employment.

That type of institutional memory problem is common to membership organizations that evolve with different viewpoints on where it all began.  It's probably better if you can keep it consistent within the Form 1023, but I don't think that was there major problem.

The organization has some significant achievements:

Past achievements made by you and additionally listed in the activity narrative and in documentation included with the application include working with the Y Company to implement Extended Household Healthcare Benefits in 1995, assisting in adding "sexual orientation" into the company's anti- discrimination policy in 2004, the granting of Domestic Partner benefits to lesbian, gay, bisexual, and transgender and straight employees (in Canada in 1994 and the United States in 1997), creating and deploying workplace guidelines to aid employees and their managers and becoming an advocate for lesbian, gay, bisexual, and transgender employees who have experienced harassment in the workplace. And in 2006 you joined the Business Coalition for Domestic Partner Benefits Tax Equity. Your organizing document also lists documentation to support similar activities in your "Goals" section.

As a result of your efforts within the Y Company, you, as well as the Y Company, have received several forms of external recognition. These include the Y Company being placed on several best places to work list for lesbian, gay, bisexual, and transgender employees and have received several corporate leadership awards from your efforts, specifically in 1996, 2003, 2005 and 2007.

There are probably enough clues in there to figure out who the Y Company is, but I haven't been able to.

So what is the problem with X's application for exempt status ?

....you have stated in a "Performance Excellence Plan" submitted with your application, that your goals and objectives include increasing public awareness of the Y Company's commitment to member employees, grow awareness of the Y Company brand in the members community and assist the Y

Company in regaining a "leadership position" in the members market. You also stated that you took part in a job fair as representatives of the Y Company to enable the Y Company to demonstrate its diverse workforce. As this court case indicated, promotion of a for-profit industry and/or business is a substantial nonexempt purpose and, even as a secondary activity, precludes exemption under section 501(c)(3) of the Code. Furthermore, as with the case involving the Better Business Bureau of Washington, D.C., regardless of the number of truly exempt activities, the non-exempt purpose of your organization is too substantial to ignore, especially when considering you are primarily funded by the Y Company.

It would be a little tedious for me to list them all but in its denial of exemption under 501(c)(3), the IRS suggests numerous times that X consider 501(c)(5) "Labor, agricultural, or horticultural organizations". Besides continuing to maintain that they qualify under (c)(3) they refuse to do that because:

In your response you have stated that applying for exemption under section 501(c)(5) is not an option, as this would result in you and your members violating the policies of the Y Company, as the Y Company does not allow its employees to establish labor organizations.

So enlightened as the Y Company may be on LGBT issues, they don't want no union organizers hanging around the shop.

I still want to figure out who the Y Company is.  One other clue is that X indicated that it had joined the Business Coalition for Domestic Partners Benefits Tax Equity in 2006.  The membership list is pretty impressive.
I'm going to ask some of my leftist friends what they would think about the X organization that celebrates the LGBT friendly policies of the union busting Y company.

To Keep Your Story Straight You Need to Know What it Needs to Be

Yusufu Y. Anyika, et ux. v. Commissioner, TC Memo 2011-69

After the introduction of the at-risk rules, real estate was the last real tax shelter.  Then came the passive activity loss rules.  The passive activity loss rules (Code Section 469) require us to put our trade our business activities (including interest in flow through entities) into buckets.  Losses in the passive bucket can only be used to the extent of gains in the passive bucket (It is not an "offset".  Passive capital gains release passive ordinary losses.  So sometimes a gain can reduce your liability.)  Losses that are not used are carried forward and are attached to the activity that generated them.  They are released when the activity is fully disposed of even if there is no passive income in that year. 

Activities are classed as passive based on how much you participate in them.  Their are a number of ways to meet the "material participation" standard.  The simplest is 500 hours per year.  "Rental activities" are special.  They are deemed to be passive regardless of how much time you spend on them.  There is an exception to that rule.  Rental losses are not "per se" passive to people engaged in real estate trade or businesses.  The magic number here is 750 hours:

such taxpayer performs more than 750 hours of services during the taxable year in real property trades or businesses in which the taxpayer materially participates.

Sometimes people miss that "materially participates" part of the requirement.  In order for the exception to work for many people, they need to make an election to aggregate all their real estate activities for purposes of measuring material participation. Otherwise somebody with five properties might not be considered to be materially participating in any of them.

Now the 750 hours is not the whole story as Mr. Anyika discovered a bit late in the game.  Here is his situation:

Petitioners, Yusufu Yerodin Anyika (Mr. Anyika) and Cecelia Francis-Anyika (Mrs. Francis-Anyika), are married and filed joint returns for tax years 2005 and 2006. Mr. Anyika is employed as an engineer, and he works 37.5 hours per week, 48 weeks per year. Mrs. Francis-Anyika is employed as a nurse, and she works 24 hours per week.

Mr. Anyika has been purchasing, renovating, managing, and selling rental properties since the 1990s. He views his rental real estate activity as a second job and as an investment. During 2005 and 2006, Mr. Anyika owned two rental properties.

Mr. Anyika spent a good bit of time on the properties and thought he should qualify for the real estate trade or business exception.  He explained this in his petition and at trial:

 In their petition and at trial, petitioners contended that Mr. Anyika qualified as a real estate professional because he had spent at least 750 hours actively managing the rental properties. On Form 4564, Information Document Request, submitted by petitioners during their audit, petitioners declared, under penalty of perjury, that Mr. Anyika devoted 800 hours per year to working on the rental properties during 2005 and 2006.

With that nice fifty hour cushion he thought he was all set. Unfortunately 750 hours is not the only requirement.  Here is the other requirement:

more than one-half of the personal services performed in trades or businesses by the taxpayer during such taxable year are performed in real property trades or businesses in which the taxpayer materially participates

Mr. Anyika also worked full time as an engineer which took up substantially more than 800 hours per year.  He tried to salvage the situation:

It was only after the Court had explained the law that Mr. Anyika understood, for the first time, that he would have to have spent at least 1,800 hours engaged in the real estate business in order to qualify as a real estate professional under section 469(c)(7)(B). After understanding that, to qualify, he had to spend more hours engaged in managing the rental properties than he did working as an engineer, Mr. Anyika began to contend that he had spent the equivalent of 8 hours per day, 5 days per week, 48 weeks per year (1,920 hours per year) working on the rental properties. After being confronted during trial by the evidence of his prior signed statement that he worked 800 hours per year on the rental properties, Mr. Anyika stated that he was “speaking from memory with the exact numbers”, and that to be sure, he would need to look over the numbers more closely.

The Court did not find him credible:

We do not find Mr. Anyika's testimony that he worked approximately 1,920 hours per year on the rental properties credible. Not only does it contradict his earlier signed statement, but it also changed during trial once Mr. Anyika realized that he would need to have devoted more hours to his real estate properties than to his job as an engineer (i.e., he would need to have spent more than 1,800 hours working on the rental properties), instead of the 750 hours he had originally believed would be sufficient for him to qualify as a real estate professional under section 469(c)(7).

When it came to the penalties taxpayers tried the classic "Turbo Tax made me do it" defense.  The Court, using more measured if less colorful language, gave the old data processing answer to the Turbo Tax defense - Garbage in, Garbage Out.  Their has been much talk, of late, of what the qualifications of people who prepare tax returns should be.  Their will be special exams with members of some professions such as CPA's exempt from taking then.  Based mainly on reading tax court decisions, I think members of some professions should be required to take a special exam before they are allowed to prepare their own returns specifically engineers and attorneys.  Nobody ever listens to me, though.

Thursday, May 26, 2011

How to Screw Up an Easement Deduction

Randall A. Schrimsher, et ux. v. Commissioner, TC Memo 2011-071
Boltar, L.L.C., et al. v. Commissioner, 136 T.C. No. 14
Gordon Kaufman, et ux. v. Commissioner, 136 T.C. No. 13
1982 East, LLC, et al. v. Commissioner, TC Memo 2011-84

Several years ago I remember hearing ads on the radio encouraging me to donate my used car to charity rather than sell or trade it.  The reasoning was that it might be worth many thousands of dollars more as a tax deduction.  Being a seasoned tax professional I thought there was a flaw in there somewhere.  The practice was pervasive enough that the Code was actually amended to the effect that a charitable contribution of a motor vehicle was limited to the amount that the charity received for selling it.  People who own historic buildings or open land have been presented with a similar prospect.  Why take all the risk of trying to develop your property when the donation of a conservation easement that will be valued based on a hypothetical development can yield you so much more ? I recently did a post on an organization, established to accept conservations easements, that lost its exempt status.  In the last few months there have been several conservation easement cases (including historical facades).  They did not go well for the taxpayers.

Randall A. Schrimsher, et ux. v. Commissioner, TC Memo 2011-071

This was a case of poor execution.

On December 30, 2004, Randall A. Schrimsher (petitioner) executed a document entitled "Preservation and Conservation Easement Agreement" (the agreement) granting a facade easement to the Alabama Historical Commission (the commission). The facade easement is with respect to property in Huntsville, Alabama, commonly known as the "Times Building". The agreement states in relevant part: for and in consideration of the sum of TEN DOLLARS, plus other good and valuable consideration, the receipt and sufficiency of which are hereby acknowledged, the Grantor [petitioner] does hereby irrevocably GRANT, BARGAIN, SELL, AND CONVEY unto the Grantee [the commission], its successors and assigns, a preservation and conservation easement to have and hold in perpetuity *** .

On Form 8283, Noncash Charitable Contributions, attached to their 2004 joint Federal income tax return, petitioners listed the appraised fair market value of the facade easement as $705,000. Petitioners' "Appraisal Summary" on the Form 8283 omitted various required items of information; in addition, it was not signed or dated by the donor, the appraiser, or any representative of the donee.Petitioners did not attach to their tax return any written appraisal of the facade easement

Without expressly alluding to the language that respondent has termed boilerplate, petitioners argue that the "clear and unambiguous" merger clause signifies that the agreement was the "entire agreement", and consequently "it is apparent" that no cash or compensation was exchanged between petitioners and the commission. Thus, petitioners seem to suggest that the consideration recited in the deed ($10 plus other good and valuable consideration) was fictitious. And indeed it might have been.

The only statement in the agreement concerning consideration is the statement that the commission provided consideration of $10 plus other good and valuable consideration. Whether or not it be considered boilerplate and whether or not it be considered in conjunction with the merger clause, this statement does not indicate that the commission provided no goods or services.

Conclusion For the reasons explained above, we conclude and hold that there is no genuine issue as to any material fact and that a decision may be rendered as a matter of law disallowing the disputed deductions for petitioners' failure to obtain a contemporaneous written acknowledgment of the facade easement. In the light of this conclusion, it is unnecessary to address respondent's alternative contention that petitioners failed to satisfy the requirements of section 170(f)(11).

That's a nice looking facade and I'm glad it is being preserved.  It is a shame that the deduction was lost due to seemingly elementary errors.  The donation is supposed to be for no consideration and the charity is supposed to explicitly state that in its acknowledgement.  The instructions for Form 8283 are fairly explicit.  For a deduction of $705,000 a little effort would seem to be reasonable.

Boltar, L.L.C., et al. v. Commissioner, 136 T.C. No. 14

The essence of an easement donation is that the property is not worth as much with the easement as without it.  The cases can become dueling expert cases.  In this one the Tax Court determined that the taxpayer's experts had gone so far into being advocates that their evidence deserved no consideration.

Held, further, P's experts failed to apply the correct legal standard by failing to determine the value of the donated easement by the before and after valuation method, failed to value contiguous parcels owned by a partnership, and assumed development that was not feasible on the subject property. R's motion to exclude P's report and expert testimony is granted.

In the reply brief, respondent aptly summarizes the deficiencies of the Integra experts' analysis as: failure: to properly apply the before and after methodology, to value all of petitioner's contiguous landholdings, to take into consideration zoning restraints and density limitations and to take into consideration the pre-existing conservation easements. As a result, the Integra Experts saw nothing wrong with a hypothetical development project that could not fit on the land they purportedly valued, was not economically feasible to construct and would not be legally permissible to be built in the foreseeable future. Respondent asserts that petitioner has departed from the legal standard to be applied in determining the highest and best use of property and instead determined a value “based on whatever use generates the largest profit, apparently without regard to whether such use is needed or likely to be needed in the reasonably foreseeable future.”

In most cases, as in this one, there is no dispute about the qualifications of the appraisers. The problem is created by their willingness to use their resumes and their skills to advocate the position of the party who employs them without regard to objective and relevant facts, contrary to their professional obligations.

As the above cases illustrate, the same rules apply regardless of which party offers the unreliable evidence. Justice is frequently portrayed as blindfolded to symbolize impartiality, but we need not blindly admit absurd expert opinions. For these reasons, excluding unreliable and irrelevant evidence, rather than receiving it “for what it is worth” and then rejecting it or giving it no weight, serves several purposes.

In this case, in the view of the trial Judge, the expert report is so far beyond the realm of usefulness that admission is inappropriate and exclusion serves salutary purposes.

In support of the argument that the 174-unit condominium project assumed by the Integra report could not be physically placed on the subject property, respondent points out that the site plan for the proposal assumes 10 acres, whereas the subject property was only 8 acres, and the Integra experts ignored the effect of a preexisting 50-foot-wide utility easement for a gas pipeline across the property. As a result, respondent argues, at least 4 of the 29 hypothetical buildings, each containing 6 units, could not be constructed. Petitioner's only response is a bald and unpersuasive assertion that the project “will fit, it just won't fit as drawn” on the site plan.

Although the Integra experts determined that sales of comparable land nearby were occurring at approximately $12,000 an acre, their conclusion would assign a value of approximately $400,000 per acre to the subject property. Additional factual errors made by the Integra report authors undermine the reliability of their conclusions and demonstrate the lack of sanity in their result. If the report and their testimony were admitted into evidence, we would decide that their opinions were not credible. The assertion that the Eased Parcel had a fair market value exceeding $3.3 million on December 29, 2003, before donation of the easement, i.e., that it would attract a hypothetical purchaser and exchange hands at that price, defies reason and common sense. That conclusion is certainly inconsistent with the objective evidence in this case.

People expect to make money when they buy land to develop it.  A lot of that profit is not inherent in the land, but rather a return on the risk and the skill of the developer.  The valuation of a conservation easement needs to account for that reality.

Gordon Kaufman, et ux. v. Commissioner, 136 T.C. No. 13

This was a follow-up on a previous decision and had a lot going on.  The main thing I noted was that even though they were denied a deduction for the easement, they were still entitled to deduct some of their out of pocket cash contributions that were related to the easement.

While the parties have wrestled over the value of the facade easement, given our disposition of the facade easement contribution issue on legal grounds, that is not a question of fact we must decide. Moreover, respondent does not claim that the cash payments were in consideration for NAT's facilitation of a sham transfer. Seeing no benefit to Lorna Kaufman other than facilitation of her contribution of the facade easement (which we discuss in the next paragraph) and an increased charitable contribution deduction, we shall not deny petitioners' deduction of the cash payments on the ground that the application required a “donor endowment” to accompany the contribution of facade easement.

1982 East, LLC, et al. v. Commissioner, TC Memo 2011-84

This case concerns a facade easement donated to the National Architectural Trust.  I wanted to give you a link, but I am not sure that what appears to be the succesor organization really is so you will have to do your own research.  The deduction failed on two grounds.  The first is highly technical.  Basically if the building burns down then the charity that had the easement should get a proporionate part of the insurance proceeds:

 it was clear under operative lender agreement that bank would retain “prior claim” to all condemnation and ins. proceeds “in preference” to donee org. until mortgage was satisfied and thus, at any time preceding mortgage's repayment, there existed possibility that bank could deprive donee org. of value that should have otherwise been dedicated to conservation purposes.

The other is more of, I hate to say it, common sense one.  The building is in the Metropolitan Museum of Art historic district.  If you tried to make any changes to it, regardless of any easements, there are lots of people who would make your life miserable.  So the partnership granting a facade easement is a little like me renouncing my super powers.

The taxpayer does get some points for good execution though:

We agree with petitioner that Mr. Asser made a reasonable attempt to comply with the Internal Revenue Code and that he acted in good faith. We understand that Kaufman I is the first time that a court has considered the effect of a mortgage on a contribution of an easement claimed to be a qualified conservation contribution. That interpretation of the relevant regulation was not published until more than 4 years after Mr. Asser filed the 2004 return. We do not believe that the regulations interpreting the perpetuity requirement of section 170(h)(5) are so crystal clear and unambiguous as to make the imposition of the accuracy-related penalty appropriate. We also find that Mr. Asser acted in good faith by securing three separate appraisals of the donated property and disclosing the contribution of that property on LLC's 2004 return. See Rolfs v. Commissioner, 135 T.C. 471 (2010). Accordingly, in the light of all of the facts and circumstances, we find that Mr. Asser acted reasonably and in good faith and hold that LLC is not liable for an accuracy-related penalty under section 6662(a).

Conservation easements including facade easements are a good tool.  The lessons here are to not stint on execution and be reasonable on the appraisal.

Wednesday, May 25, 2011

Faster Basis Recovery Allowed When Earn-out Payments Unlikely

Private Letter Ruling 201111002

There are some deal concepts that drive me crazy.  One of them is "earn-out".  It seems like if you are still participating in the profits of a business then you really haven't sold it.  I remember a conference I was at where one of the speakers said that sometimes they'll tell somebody "OK we'll buy 80% instead of 100% that's how you will have your earn-out".  One of the problems with an"earn-out" is how you are supposed to recover your basis in an installment sale.  This ruling allowed a taxpayer to more quickly recover  basis when it became apparent that receipt of the contingent portion of the sales proceeds was unlikely.

LLC's proposed alternative method of basis recovery to report payments from contingent payment sale, which would result in basis recovery at rate at least twice as fast rate at which basis would be recovered under normal basis recovery rule of Reg § 15a.453-1(c)(3) , represented reasonable basis of method recovery and therefore taxpayer was permitted to use method for sale of assets under asset purchase agreement, which are subject to Code Sec. 453; installment treatment, but only if taxpayer doesn't receive any contingent payments in either of stated years.

The contingent payments are based on EBITDA, which stands for "earnings before interest, taxes, depreciation and amortization".  Interest, taxes, depreciation and amortization are financial matters independent of the operation of the business.  Also in the short run depreciation and amortization are predictable as they are mainly based on the acquisition.

Under the Asset Purchase Agreement, the contingent payments are paid only if Buyer achieves certain consolidated target Earnings Before Interest, Taxes, Deprecation and Amortization (EBITDA) goals. The targets for each earn-out payment are based on EBITDA levels of $p for Year 1, $q for Year 2, and $r for Year 3 (EBITDA target). In any year that the EBITDA target is met, the consideration due to Taxpayer in the following year is $s, plus a% of excess earnings. Excess earnings are defined as the amount of EBITDA achieved by Buyer in an applicable earn-out period in excess of the consolidated EBITDA target. If for any earn-out period, Buyer does not achieve the EBITDA target, then Buyer does not pay any contingent payment the following year.

The deal has not gone as well as expected, or at least hoped due the Event.  One of the things that I both hate and love about private letter rulings is the anonymity.  I hate it because I always like to know the story behind the story.  I love it because I can make guesses about the facts and maybe even make up a story.  So here is why they are not making as much money as they hoped:

Taxpayer's business operations through the date of the asset sale were primarily in the oil and gas services industry. Taxpayer provided pipe coating, fabrication and bending services to the oilfield industry. Since the time of the sale, there was an Event on Date.

 Governmental actions related to the Event have affected the principal market of the business that Buyer purchased, and thus, decreased demand for that business' products. The Event has also resulted in many of Buyer's customers delaying contracts, as well as Buyer reducing the workforce at the plants it purchased from Taxpayer by b% in Year 2. In addition, demand for products of Taxpayer's former business has decreased due to increased competition, as well as the decline in the price of crude oil.

So I'm guessing that Event was the Gulf Oil Spill.  Don't you feel bad.  You were probably thinking about the birds and the fishies, while "Taxpayer" was suffering a hit on EBITDA.  It reminds me of a conference I was at once.  There was a drought going on and someone's comment was that they were worrying about it lousing up the grass on the golf courses.

Taxpayer requests a ruling allowing it to use an alternative method of basis recovery, as provided under § 15a.453-1(c)(7)(ii). Under its alternative method of basis recovery, Taxpayer proposes to allocate the same ratio of basis to each installment payment as that installment payment bears to the estimated amount of aggregate payments to be received by Taxpayer during the four years in which payments could be received. Because Taxpayer does not anticipate receiving any contingent payments, Taxpayer would allocate e% of basis to Year 1 and f% of basis to Year 2.

The ruling was favorable so Taxpayer will recover basis in the same manner as if there were no provision for contingent payments.

Tuesday, May 24, 2011

From The Boston Tax Institute

Boston Tax Alert 2011-19, 2011-20, 2011-21

Lu Gauthier of The Boston Tax Institute has given me permission to republish his newsletter. The BTI newsletter is a regular feature of this blog now going up every Tuesday. Be sure to check out the BTI catalog for great CPE value.

Our thanks to Natalie Choate, Esq. for the following email!

The Massachusetts Department of Revenue should take out a billboard reminding taxpayers that they did NOT receive any Massachusetts income tax deduction for their retirement plan contributions while self-employed (including, in most years, partnership 401(k) elective deferral contributions), or for their personal IRA contributions (even if they were deductible federally). Those Mass.-nondeductible contributions could add up to a substantially higher "Mass. basis" worth thousands of dollars in reduced Mass. taxes upon ultimate distribution of the plan.

Then the DOR should follow up with some television ads explaining how the Massachusetts system for recovering so-called "basis" in a plan or IRA is totally different from the system you follow on your federal return: The Internal Revenue Code uses the "cream in the coffee rule" (distributions carry out pretax and after-tax money proportionately). Massachusetts uses the "your own contributions come out first" approach. Even when the client's basis is initially the same for both federal and Mass. purposes this difference will quickly make them different, as the Mass. basis will get used up (distributed) long before the federal.

If you are not aware of these vital differences, your client could be leaving a substantial amount of money "on the table" by not claiming income tax exclusions on his Massachusetts return that he's entitled to. The issue is particularly important this year, due to many large Roth conversions done in 2010 that are being reported in the 2011 filing season. Natalie Choate's seminar on June 3, 2011, at the Hyatt Summerfield Suites in Waltham will explain the differences between the federal and Massachusetts rules for determining (and recovering) "basis" in a retirement plan or IRA-including the effect of rollovers, the DOR flip flop on partnership 401(k)'s, and how to advise beneficiaries.
Our thanks to Philip R. Dardeno, CPA, MST for the following email!
For anyone that represents Cellular Telephone Franchises

I was asked by a group of cellular industry franchises to represent them in trying to get DOR to change its policy with regard to sales tax on the sale of cellular phones as part of a bundled transaction. After many meetings and much discussion, we just received a favorable answer in DD 11-2 which allows the franchise to charge sales tax to the customer on the higher of the cost or the sales price (remember: cell phones are heavily discounted in these transactions).

The previous DOR policy was that the sales tax fell on the "fair market value of the phone" which they said was the amount listed as "retail price", obviously a number much greater than the amount charged.
In other matters:

Income Tax: The DOR is still vigorously pursuing domicile cases and has a project auditing "Excess Trade or Business" deductions.

Sales tax: The latest industry wide audits appear to be "Boat Clubs" and medical equipment sales.

Corporate: There are a number of cases reviewing the Film Credit which always are controversial. These and other issues will be discussed by Phil in his seminars entitled MA Taxes in Review on 06/16 in Randolph and 06/24 in Waltham.
PAOO Comment - I have worked with Phil over the years on some difficult Mass cases.  He is great.
Our thanks to Kurt Czarnowski, formerly with the SSA as Regional Communications Director in N.E., for the following email!
Unfortunately, many people do not completely understand how work and earnings impact a person's ability to collect Social Security retirement benefits. As a result, they may be losing out on monthly payments which are rightfully theirs.

The good news is that the Senior Citizens' Freedom To Work Act of 2000 eliminated the Social Security annual earnings limitation beginning with the month a person reaches Full Retirement Age (FRA). (From 2000 through 2002, FRA was age 65. However, in 2003, it began increasing, so that FRA is now age 66 for people born between 1943 and 1954.) This means that if you are at Full Retirement Age or older, and you work, you can receive a full monthly Social Security benefit, no matter how much you earn. In addition, any earnings you may have had prior to the month you reach your FRA do not impact your ability to collect benefits from FRA going forward.

But, if you are under FRA, there is still a limit on how much you can earn and still receive full Social Security benefits. In 2011, the annual limit is $14,160, and if you are younger than full retirement age during all of 2011, you lose $1 in benefits for each $2 you earn above that amount.

If you retire in mid-year, you already may have earned more than the yearly earnings limit, but that doesn't mean you can't collect benefits for the remainder of the year. There is a special rule that applies to earnings for one year, usually in the first year of retirement. In 2011, this rule lets you collect a full Social security check for any month your earnings are $1,180 or less, regardless of the yearly earnings total.

It is important to note that if some of your retirement benefits are withheld because of your earnings, these payments are not completely lost. Starting at your full retirement age, your benefit amount will be recalculated, and it will be increased to take into account those months in which payments were withheld.

More about the impact of work on the receipt of Social Security benefits, as well as many other issues, will be covered during Kurt Czarnowski's upcoming seminars on Social Security, which will be offered five times during the week of June 12 and also on 08/12.

PAOO Comment - As I explained in a recent post nobody will ever get as good a deal from Social Security as my Nanna Lyons did (She wanted FDR to be canonized).  Nonetheless careful planning in this area can lead to good results.

Monday, May 23, 2011

How Forgiven Debt Begets Tax Issues

Angela Sanders

I've been searching for guest bloggers, but this one found me. Angela Sanders is affiliated with the Oak View Law Group and has guested on several blogs.

When you settle your debt in less than you owe, a sense of complacency may overpower you. But let me caution you that your forgiven debt is soon to get exposure to the IRS. The amount you are forgiven by your lender is deemed to be your income and so the IRS will levy taxes on it. However, if you consolidate debt, it will restructure your lending term whereby you will pay your debt in an elongated time frame. In that case, no tax may be imposed on you as you are paying principal balance to your lenders. But, apart from some specific cases, a borrower must pay the taxes for his ‘charged off’ debt. It may be your forgiven debt after mortgage foreclosure or forgiven credit card debt.

Even when your home is foreclosed, you may not be exempt from the liabilities of your unpaid mortgage balance. After the foreclosure process is done, the lender will take possession of your house and then he will try to recoup his losses by selling it through an auction. The lender will sell your house for that much money what you owed to your mortgage lender. If the house gets proper valuation, then the bank will accommodate the selling proceeds with the unpaid mortgage balance. Then the borrower will no longer be tied to any kind of mortgage related debt.

However, if the house does not sell well, the bank will try to sell it through a real estate agent. In that scenario, the bank will usually try to sell it as soon as possible. Because, this time the bank will be responsible for the upkeep of the house and even during that time it has to reckon for the taxes. So, chances are  that the property may be sold for less than the mortgage balance. The lender has to face mortgage deficiency for not getting the proper value against his mortgage loan. Now, either he has to sue against the borrower or discharge his debt completely. If the lender discharges the debt, the borrower will receive a Form 1099 which he has to fill up along with his yearly tax return. Forgiven debt accrues significant tax consequences for the debtor which he has to show in his tax return.

Now, in some cases a forgiven debt may also get tax forgiveness.

1. If the foreclosed house is not the primary residence of the former home owner.

2. If it is not a guest house or commercial property of the debtor.

3. If the mortgage balance is less than $ 1 million of a bachelor.

4. If the mortgage balance is less than $ 2 million for married people.

5. A borrower can obtain tax forgiveness by filling a Form 982 along with their tax return.

What is very significant is that debt forgiveness can also leverage a lender by offering him some tax benefit. He can compensate some of his loss by having some tax deduction.

PAOO Comment - I have done a few posts about people getting caught by surprise by debt discharge income.  Here is an example.  Probably the most common exception that will apply is that debt discharge income is not taxable to the extent of the taxpayers insolvency.  As the case I just highlighted illustrates though you have to be able to document your insolvency.

Assignment of Refund

CCA 201111005

This CCA provides a bit of a cautionary note for contracts involving the sale of most of the assets of a corporation.  A corporation sold most of its assets to another corporation.  Included in those assets was a refund of excise taxes.  The request was made to the IRS to pay the refund to the buyer when it was allowed, but they are not going to do it.  It's worth reading the whole ruling.  I've left the blank spaces that have been scrubbed to preserve the air of mystery:

Release Date: 3/18/2011 Office: ——————-

From: ——————————— Sent: Friday, October 08, 2010 11:33:43 AM To: ————————- Cc: ——————————- Subject: POA inquiry —————

You forwarded an inquiry from an Appeals Officer who is considering a claim for refund of excise taxes for the fourth quarter of ——— and the third quarter of ——— made by —————————-—————————————————submitted the refund claim, but then sold most of its assets to ———— ———————————————— The sales agreement between ———————-and —————————— specifically includes “tax refunds” among the assets being sold. The Appeals Officer has been contacted by an attorney who purports to be the authorized representative of both ————————— and ———————-for the taxes in question. The attorney has requested that the refund be issued in the name of ———————, and forwarded to him. The Appeals officer plans to allow the refund, but is unsure of what name it should be issued in, and who it should be mailed to. According to the representative, ———————-has not been dissolved, because the state in which it was incorporated does not allow for dissolutions when the corporation has outstanding debts. There are Form 2848s, Power of Attorney and Declaration of Representative, from both ————————— ————————————————————————————————————————————————————————and ———————to the same individual. The 2848 from ———————-specifies that it covers several different excise tax periods, including the third quarter of ———, but not the fourth quarter of ——-———. The 2848 from ———————-states that it covers excise taxes from —————————.

Generally, the Service issues refunds to the person who made the overpayment, I.R.C. § 6402, and the claimant of the refund, Treas. Reg. § 301.6402-2(f)(1). In this case, ———————-was both the person who made the overpayment and the claimant of the refund. Although ——————-——- sold most of its assets after filing its refund claim, the sale was not sufficient to make the purchaser, ———————, the owner of the refund. The Anti-Assignment Act provides that an assignment of any claim, or an interest in any claim, against the United States Government “may be made only after a claim is allowed, the amount of the claim is decided, and a warrant for payment of the claim has been issued.” 31 U.S.C. § 3727(b). In this case, the purported sale of the refund took place on ——————————-, well before the claim was allowed, the amount of the claim was decided, or payment was authorized.
 Although the prohibitions of the Anti-Assignment Act are waivable by the Government, see, e.g., Schwartz v. United States, 16 Cl. Ct. 182 (1989), there are two reasons why the Government should not waive the Act in this case. First, the Service should be careful to prevent ———————-——————————————————————————————————————————————————————————, which we know has not been dissolved, from having any cause of action against the Service. Second, there may be other liabilities of ———————that could be satisfied by the overpayment at issue here. This would include other federal tax debts owed by ———————-that could be offset under I.R.C. § 6402(a), as well as other debts that could be offset under I.R.C. § 6402(c) through (f) by the Financial Management Service (FMS) and the Treasury Offset Program (TOP). See also United States v. Shannon, 342 U.S. 288, 291-92 (1952) (“Other courts have found yet another purpose of the statute, namely, to save to the United States `defenses which it has to claims by an assignor by way of set-off, counter claim, etc., which might not be applicable to an assignee.'”) (quoting Grace v. United States, 76 F.Supp. 174, 175 (D. Md. 1948)). The Appeals Officer reports that ———————-may have an outstanding liability for excise taxes for the second quarter of ———. Any other debts that could be offset under I.R.C. § 6402(c) through (f) will be captured by TOP once the refund has been certified to FMS in ———————'s name and EIN.

Given our conclusion that the check should be written out to ———————after any available offsets are made, we also conclude that this check should be delivered to ———————. The Power of Attorney for ———————-appears to be a properly completed 2848 fulfilling the requirements of Treas. Reg. § 601.503. It authorizes the representative to receive, but not endorse or cash, refund checks issued to ———————. See Treas. Reg. § 601.506(c). The regulations require that a power of attorney contain the type of tax involved, the Federal Tax form number, and the specific years or periods involved. While the 2848 from ————————— contains all these items, its list of tax periods involved includes only one of the tax periods at issue, namely the third quarter of ———. The refund attributed to this period may be sent directly to the representative. The other tax period at issue, the fourth quarter of ———, is not included on the 2848. The general rule is that powers of attorney are to be strictly construed such that the agent is granted only those powers which are specified by the instrument. See 3 Am. Jur.2d Agency § 28. Because of this rule of strict construction, as well as the specific regulatory requirement that has not been met, the existing 2848 is not sufficient for the fourth quarter of —— ———.

At this time, the only information we have on the continuing existence of ———————-has come from the representative. Therefore, we recommend ——————————————————————————— ——————————————————————————————————————————————————————————-—————————————— ————————————————————————————————————————————-———————————————————————————— ——————————————————————————————-—————————————————————————————————————————— ————————————————-———————————————————————————————————————————————————————— ——-——————————

If you have any further questions, please contact me.


Friday, May 20, 2011

Dealership With Multiple Franchises Cannot Separate Goodwill

LAFA 20111101F

This is one of those things that is interesting to tax nerds and a fairly small number of actual business people.  You buy an automobile dealership with multiples lines.  Most of what you are paying is attributable to the franchises.  That's a Section 197 intangible amortizable over 15 years.  But wait a second.  Isn't it a number of Section 197 intangibles amortizable over 15 years.  What difference does it make ?

Well if everything goes fine, it doesn't make any difference.  Everything did not go fine for the Dealer that is the subject of this LAFA (Legal Advice by Field Attorney).  Manufacturer terminated some but not all of the franchises that Dealer owned.  Dealer wants to write off a proportionate part of its basis in the franchises.  The IRS is not allowing it:

Even if the goodwill associated with the W and Y2 franchises became worthless when Manufacturer terminated the franchise agreements, section 197(f)(1) of the Internal Revenue Code 1 prohibits a deduction for worthless amortizable section 197 intangibles, including goodwill, where other amortizable section 197 intangibles purchased as part of the same transaction or series of transactions remain. The amount of any worthless amortizable section 197 intangibles instead is included in the basis of the remaining amortizable section 197 intangibles.

The interesting question is whether better work on the font end of this deal would have allowed a different result:

Dealer makes two principal arguments in support of deducting the goodwill associated with the W and Y2 franchises. First, Dealer claims that the asset purchase agreement separately stated a goodwill value for the W franchise. Dealer reasons that the remainder of the goodwill was, therefore, allocable to the X, Y1, Y2, and Z franchises. We have reviewed the purchase agreement and find no such allocation. The allocation that Dealer provided to you was on a summary sheet that is undated and unsigned. There is no evidence that this summary was ever included in the original agreement.

Charles V. Dumas, who wrote the LAFA, does not think so:

And even if the goodwill was separately stated for each franchise, we believe section 197(f)(1) still applies, as all of the goodwill was acquired in a single transaction or series of related transactions. Dealer even admits that Manufacturer required alignment of certain franchises and considered multiple franchises as one “unit” for franchising purposes.

In the relative ranking of authority a LAFA is not way up there, but dealers in this situation (and I believe there are quite a few) should be cognizant that there may be a challenge to write-off of some franchises when some remain.

Thursday, May 19, 2011

Personal Service Corporation and C Corp - Recipe for Disaster

Mulcahy, Pauritsch, Salvador and Co., LTD. v. Commissioner
 TC Memo 2011-74

I've wavered on whether to give this one the full treatment.  It is getting a little stale and it was generating a good bit of schadenfreude on my part, which I find unseemly. The more I look at it, though, the more important it seems. It is about an accounting firm and it brings back ancient memories:

The firm is an accounting and consulting firm with its principal place of business in Orland Park, Illinois. The firm was founded in 1979 by Edward W. Mulcahy, Michael F. Pauritsch, and Philip A. Salvador. We refer to the three men collectively as the founders. Throughout the years in issue—2001, 2002, and 2003—the founders served as the firm's board of directors and sole officers. The founders also served as the only members of the firm's compensation committee, which determined what the firm paid its employees, officers, and board members. The firm was a C corporation and a cash-basis taxpayer; it used a calendar year for its taxable year.

The founders (or in my terms - the big guys) owned 78% of the firm (MPS) and the other three partners (little guys) owned 22%.  The big guys weren't content to just set their own salaries and decide how the remaining crumbs would be allocated among the little guys. For some reason not entirely clear from the record they paid some of what would have been their comp to various entities:

At issue is the deductibility of payments the firm made to three related entities: Financial Alternatives, Inc. (Financial Alternatives), PEM and Associates (PEM), and MPS Limited (MPS Ltd.).

The sole shareholders of Financial Alternatives were the founders (Mulcahy, Pauritsch, and Salvador). The founders owned Financial Alternatives in equal shares. Financial Alternatives was a C corporation that used a taxable year ending June 30. It filed Forms 1120, U.S. Corporation Income Tax Return, for taxable years ending June 30, 2002, 2003, and 2004.

The year end difference hints that there was some sort of deferral game going on, MPS was a calendar year C corporation. In order to not have corporate tax they would have had to have paid out salaries in December. By instead paying another corp with a June year end which they zero out in June, they defer income for a year. Conceivably they could have classified "Financial Alternatives" as other than a personal service corporation which would allow them to take advantage of graduated corporate rates. That seems a little unlikely.  It is interesting to note, however, that the big guys owned 78% of MPS.  Had they owned more than 80%, the two corporations, MPS and "Financial Alternatives", would have been part of a controlled group. When you count the little guys five or fewer individual do own 80% of each corporation and taking everybody's lowest percentage in each corporation you get more than 50%.  However thanks to Vogel Fertilizer, the little guys, who own 0% of Financial Alternatives don't count toward the 80% test on MPS. 

The founders also owned PEM in equal shares. PEM was a general partnership. It filed Forms 1065, U.S. Return of Partnership Income, for taxable years 2001, 2002, and 2003.

Mulcahy and Salvador owned MPS Ltd. in equal shares, but Pauritsch was not an owner. MPS Ltd. was a limited liability company filing as a C corporation. It filed Forms 1120 for taxable years 2002 and 2003.

MPS Ltd would not have been part of a controlled group with either of the other two C corporations, once again thanks to Vogel Fertilizer.  I've always thought that having an LLC elect to be treated as a C corporation is like hitting your head against the wall because it feels so good when you stop, but I imagine they were up to something when they made the election.

The case doesn't tell us what the big guys were up to.  The deferral is pretty apparent and maybe multiple use of corporate graduated rates.   Of course it is not inconceivable that they were doing it all just for the hell of it. Whatever, they were trying to accomplish, though, I think it turned out not to be worth it.  The IRS disallowed the deductions for fees paid to the three other entities.  It made for some impressive numbers:

The IRS determined the following deficiencies in tax: $317,729 for 2001, $284,505 for 2002, and $377,247 for 2003. The IRS also determined that the firm was liable for accuracy-related penalties under section 6662 in the following amounts: $63,546 for 2001, $56,901 for 2002, and $73,238 for 2003.

The IRS argument was that the entities didn't really do anything for MPS.  The defense to that is that MPS was really paying for the work that the big guys did.  I find the Court's commentary a little confusing:

Therefore, the IRS argues, the “consulting fee” payments should be tested for deductibility as payments for the related entities' services—as opposed to payments for the founders' services. We need not reach this issue because, even if the payments are tested for deductibility as payments for the founders' services, the firm failed to show that the payments are deductible.

Section 1.162-7(a), Income Tax Regs., provides that “There may be included among the ordinary and necessary expenses paid or incurred in carrying on any trade or business a reasonable allowance for salaries or other compensation for personal (Emphasis added.) The firm services actually rendered.” concedes that no services were rendered by the related entities. Therefore the firm is not entitled to deduct the “consulting fee” payments as payments for services rendered by the related entities. “consulting fee” payments, as it would have been required to do with respect to employee compensation payments to the founders. It did not include the “consulting fee” payments on the founders' Forms W-2, Wage and Tax Statement, as it would have been required to do with respect to employee-compensation payments to the founders. It did not issue the founders Forms 1099-MISC, Miscellaneous Income, as it would have been required to do with respect to payments of nonemployee compensation to the founders. Finally, it did not report the “consulting fee” payments on its income tax returns as officers' compensation.

Evaluating the payments as if they were payments for the founders' services, we find that the firm has failed to show that it is entitled to the deductions.

The IRS argument is very simple. The entities didn't perform any services.  Only the IRS can argue "substance over form".  The taxpayer got to choose the form and is stuck with it.  You can't now say that the payments were really to the big guys, themselves, rather than the entities.  It seems like the Court is neither agreeing or disagreeing with that position. Instead it is saying that it doesn't matter because the payments have not been established to be reasonable compensation to the big guys.  So much of the discussion is what you would find in a reasonable compensation case.

One of the tests for reasonable comp is whether an "independent investor" would be satisfied with the return they received after the comp.  MPS made an argument on that basis:

The parties disagree on how to calculate the rate of return on investment, which is also known as the rate of return on equity. The firm contends that the rate of return on equity is equal to its gross revenue for one year minus its gross revenue for the prior year, divided by the gross revenue for the prior year. This definition is based on the theory that the value of the firm's equity is equal to the firm's gross revenue for one year. The firm claims that annual gross revenue is an appropriate measure of the firm's equity because someone once offered to buy the firm for a purchase price equal to one year's gross revenue. Gross revenues were $5,496,028 for 2001, $5,742,420 for 2002, and $6,338,482 for 2003, and the firm claims that gross revenues for 2000 were $5,405,102. 12 So the firm calculates that from 2000 to 2003 the cumulative rate of return for the shareholders was 17.27 percent.

Yeah right. I'm sure that if they ever did an asset deal they would recognize more than 6,000,000 of corporate gain and then liquidate.  The never heard of personal good will or consulting fees and deferred compensation or who knows what else.

Regardless, I think that the Court misunderstood the taxpayers argument:

We agree with the IRS that the rate of return on the firm's equity should be calculated by reference to annual net income, not the year-to-year change in gross revenue. It is inappropriate to look to gross revenue (or to changes in gross revenue) to determine if equity investors are receiving good returns on their investment. A corporation's shareholders do not seek to maximize gross revenue. They seek to maximize profit. See Boyer v. Crown Stock Distribution, Inc., 587 F.3d 787, 793

Gross revenue was being used as a short-cut valuation method.  If you had an entity that held assets that were increasing in value without income recognition you might consider that was a good deal.  They were maintaining that the value of the accounting firm was going up because the valuation would be based on gross revenue. The Court then indicates that an investor would evaluate return based on taxable income:

Both rates of return were high enough to create a presumption that the compensation received by the respective shareholders for their services was reasonable. But in this case, the firm reported taxable income of $11,249 for 2001, a tax loss of $53,271 for 2002, and taxable income of zero for 2003. This makes the rate of return on equity either near zero, below zero, or zero, in each respective year. Thus the independent investor test does not create a presumption that the amounts were reasonable.

Remember MPS is a cash basis taxpayer.  One might argue that accrual basis income would be the correct measure.  Frankly, though a professional firm that consistently has accrual income in excess of cash income may be heading for a trouble.  I had a managing partner early in my career who I determined, counting himself, his brother and his father, had boiled over 100 years of public accounting experience down to two fundamental principles "Money coming in is good."  "Money going out is bad." Whevever someone was packing up to do field work, he would ask him where he (and it was more than likely a he) was going.  The managing partner always had the same direction, regardless of the client, "Bring back a check".  Whevever one of the whippersnapper partners mentioned the concept of accrual basis income for the firm his response was "You're kidding yourself".

So much for the "independent investor" test, which brings us to the next stage of the analysis:

Without the aid of the presumption of reasonability, the firm has not otherwise shown that the amounts it seeks to deduct as compensation were reasonable. Generally, “reasonable and true compensation is only such amount as would ordinarily be paid for like services by like enterprises under like circumstances.”

Things did not start off well for MPS:

Marc Rosenberg, opined on the reasonableness of amounts paid to each founder, which included (i) amounts designated as compensation and (ii) amounts designated as “consulting fees”. The first problem with his analysis is that the statistics he gathered from other firms were irrelevant. He appears to have relied on the following statistic he gathered from each firm: (i) the sum of (a) the salaries the other firm ostensibly paid its owners for its owners' services and (b) the other firm's net income, divided by (ii) the other firm's total number of owners. This statistic does not necessarily correspond to what owners of other firms received for their services. For example, suppose that another company paid its sole owner $300,000 per year in “salary” payments that were ostensibly for services. This does not mean that the owner's services to the company were worth $300,000. Even though the $300,000 in payments were nominally labeled by the company as “salary”, the payments could in reality be a return on the owner's investment in the company (or a repayment of the investment).

They then wheeled out their most powerful argument.  The actual salaries that the big guys took were not that much more, possibly even less, than what the little guys and even some of the non-shareholders were making.  It is a fundamental law of nature that the big guys are supposed to be making a lot more, because, well, they are the big guys.  Apparently the judge wasn't aware of that fundamental principle:

The firm—which has the burden of proof—simply has not offered enough evidence to allow us to compare the relative value of the founders' services and the services of the nonshareholder employees.
 The final piece of the reasonable compensation argument concerns "intent to compensate".  Taxpayer did not do well in that one either:

We find that the firm intended for the payments to the related entities to distribute profits, not to compensate for services. As discussed above, Salvador chose the amount to pay each year so that the payments distributed all (or nearly all) accumulated profit for the year. He did this for tax planning purposes. Each founder's percentage of the payments to the related entities was tied to hours worked, but the firm's intent in making the payments was to eliminate all taxable income. The firm did not intend to compensate for services.

MPS was founded in 1979.  It could be a good idea for a professional service firm to be a C corporation then - mainly because of the pension rules. Being a C corporation is like being married.  It's easy to get into, but can be expensive to get out.  I can't ever recall seeing a C corporation service firm that either accumulated taxable income or paid dividends.  I think the owners of MPS find themselves in this world of hurt, because they were too cute with the other entities.  If they had just paid themselves "big guy" salaries there is a good chance that they would have had a no change audit. What would be supremely ironic is if the side entities were created for purely cosmetic purposes to avoid reasonable comp exposure.  If they weren't using graduated corporate rates, it may be that the purpose of the careful Vogel Fertilizer ownership structuring was to avoid disclosing that there was a controlled group.

Nonetheless, the case would be much less disturbing if the Court had just gone with the IRS theory. The entities did not do anything and that's who you paid instead of yourselves.  Instead the court accepted, arguendo, that the payments might be compensation to the "big guys" and did a reasonable compensation analysis, which is very disturbing.  The IRS may use this decision as a weapon against personal service C corporations.  Whatever you think you are getting out of remaining a C corporation may no longer be worth it in light of this case.

I haven't seen a lot of other commentary on this case.  One blogger observed that it would have been better to get expert opinion on splitting the pie before doing it.

Wednesday, May 18, 2011

Conservation Easesments A New Field For Villainy

Private Letter Ruling 201110020

Sometimes I've contemplated go over to the dark side.  I've made it this far with a chaotic good alignment so its probably not going to happen.  In the event I do, though, I have two resolutions one of which I can only try for but the latter I guarantee.  The first is that my villainy will be so subtly masterful that no one will ever realize it has happened.  In the unlikely event that someone does get wind of it I will not gloatingly explain it all to them before I dispatch them thereby giving them a chance to turn the tables on me.  The other resolution is that my villainy will not in anyway involve religion, charity or exempt organizations.  It is very bad to manipulate people through their fear and greed but to use their higher aspirations is beyond despicable.

This disinclination to mix charitable endeavors with scamming caused me to miss some of the potential in conservation easements.  I remember talking to one of my clients who deals in land and asking him what it really meant to own 10,000 acres of land somewhere.  What is that you really have ?  His answer was "a bundle of rights".  Included in that bundle is the right to do some level of developing subject to local zoning.  This might be a valuable right or it might not.  If the property is already at its "highest and best use", which in appraiser speak is the use that gives you the greatest economic return then your development rights are of negligible value. 

The "highest and best use" might be best for the owners bank balance but not for the rest of us.  It's handy to have a CVS every mile or so as you are driving along in case you have to suddenly fill a prescription or desperately need a bottle of Mountain Dew, but its also nice to have some bucolic scenery and places for the birds to nest and there's all that global warming stuff people are worrying about, which is where conservation easements come in.  A property owner gives up development rights and gets a charitable deduction.  In addition the value of the property is reduced which could have a favorable effect on real estate, gift and estate taxes.  For someone who really wants the property to remain unchanged, it's about as close to a free lunch as you can get.

Of course it is not entirely free.  A fundamental law of taxation that I have discovered is that any reasonably complex tax matter involving significant dollars, regardless of whatever else it might be, is a white collar jobs program.  Here is an estimate of the costs of doing a conservation easement.  Palmer Land Trust comes up with $40,000 to $60,000 all in.  That seems a little on the high side but I haven't shopped around.  The interesting question is to whom is it that you give the conservation easement.  Putting aside all the tax goodies, the goal is that the property not be developed after you have gone.  It is up to the donee organization to enforce the restriction.  So obviously it can't be just anybody.  The regulations address the issue:

To be considered an eligible donee under this section, an organization must be a qualified organization, have a commitment to protect the conservation purposes of the donation, and have the resources to enforce the restrictions.

Probably The Nature Conservancy would do the trick.  ORG, the nameless organization in the PLR was trying to break into the field.  Apparently the motives of ORG's Founder/President were not exclusively concerned with preserving nature.

When asked about resources to enforce easements the answer was:

Easements are monitored, but the ability to legally enforce easements is done by sending a copy of the deed is sent to the planning department. This in effect flags the property.

There is no special fund or account containing funds that are allocated to enforcement of easements.

Also ORG had other things going on besides conservation:

CO-1 website (i.e., website) and the limited liability company known as the CO-2 (hereinafter sometimes referred to as the "CO-2"). The CO-2, which advertises approximately 510 acres of land for sale on the website, uses potential conservation easement donations as a selling point and it lists the same contact information for the CO-2 (i.e., contact name, address, telephone number and email address) that ORG provided to the IRS for ORG.

ORG was able to provide its donors with a fairly convenient one-stop shopping type of service.
The normal procedure for accepting easements includes President's judgment call on whether or not to proceed and/or accept a conservation easement. The board of directors approves or disapproves recommendations that are made by President. President is compensated as an independent consultant to the donors. He is responsible for paying the appraiser. The donors are responsible for the consulting fees that are paid to President.

The Board was fine with this arrangement:

The institution has no paid employees. In addition to being the President of the Institute, President supports himself as a consultant on, among other subjects and endeavors, conservation easements. The Board grants to President the authority, acting in his capacity as an independent consultant, to perform work which he negotiates separately with grantors of conservation easements to the Institute. This work includes assisting in the valuation of the properties consistent with professional guidelines and as long as he does not act as the principle appraiser.

I'm a pretty easy going guy but there are three things that outrage me besides chiseling with not for profits- thinking that "imply" and "infer" can be used interchangeably, not distinguishing between "i.e." and "e.g." and confusing "principle" with "principal".

There were some other things.  President donated his car to ORG, but ORG had been paying the car expenses before the donation.  ORG paid President consulting fees but did not issue 1099 until audit commenced.  The extent of the one-stop shopping benefits really takes the cake, though:

ORG has demonstrated that it lacks commitment to protect the conservation easements. For example, during the years under examination, ORG accommodated a property owner whose land was subject to a conservation easement and casement restrictions. ORG worked with the property owner to modify the easement restrictions which allowed the property to be further developed in violation of its exempt purposes. Also, President, the President of ORG, benefited financially from this transaction by receiving a consulting fee for assisting with the amendment transaction. This consulting fee was not reported by ORG as income until the IRS initiated its examination.

You pay President to get ORG to accept your conservation easement so that you can get the tax benefits.  It turns out that you went a little overboard with the easements and you want to do something that violates them.  Pay President and ORG and they will modify them for you.  Is this a great country or what ?

That should be enough but the IRS continues to pile it on:

ORG has stated in writing that it monitors the easements it holds on an annual basis. ORG has also stated that President is the sole official who performs the monitoring duties. ORO relies on city and county entities to provide advance warning on easement infringements. The government contends that it is virtually impossible for one person to annually monitor (in one month's time) a total of 35 easements with an average affected area of % acres each. ORG was asked to provide documentation and substantiation of the monitoring activities that were performed by President and it was asked to provide

President's qualifications to perform such monitoring activities. To date, ORG has failed to provide the requested information and documentation. The government contends that ORG is not monitoring the conservation easements on a regular basis, if at all. Additionally, ORG lacks the resources and the staff to monitor the conservation easements and to defend the restrictions if called upon to do so.
Moreover, as a consequence of ORG's failure to determine whether each easement serves a conservation purpose, ORG's subsequent monitoring activities (such as they arc) also fail to serve any conservation purpose.

ORG made a campaign contribution in the amount of $$ to a mayoral race in City of during 20XX. During an interview with the President, President, he confirmed that ORG had made previous political campaign contributions.

The contribution that ORG made to the mayoral race is strictly prohibited by I.R.C. § 501(cX3) which prohibits participation in, or intervention in (including the publishing or distributing of statements), any political campaign on behalf of (or in opposition to) any candidate for office.

ORG is not giving up the ship.


The following are specific areas of disagreement with the taxpayer as stated in the response received by the IRS on April 1, 20XX: * ORG disagrees with the government contention that the organization was liable for filing Forms 990 for the years of 20XX and 20XX because the organization's monetary receipts were below SS. * ORG contends that it provided organization documents shortly after the initial interview via mail. * ORG provided several corrections pertaining to the responses to questions during the initial interview. The corrections can be read in the correspondence dated April 1, 2030C. * ORG provided clarification to responses provided to the IRS on July 1, 20XX. * ORG contends that it provided the examining agent records which illustrate that the organization monitored its easements for infringements. * ORG provides in its response that many of the casement donations accepted concern wetlands and therefore meets the Code § 170(h) requirements of a conservation purpose. * ORG disagrees with the IRS position that it's Founder (President) has not been able to demonstrate that he has sufficient experience and expertise in dealing with conservation related issues.

ORG provides in its response several examples of President's experience in this field. * ORG disagrees with the IRS position that it acted for private benefit when it amended a conservation easement deed at the request of the owner. * ORG disagrees with the IRS position that it acted for private benefit of it its founder by allowing the founder to be compensated as a "private consultant" to many of its conservation easement donors. * ORG disagrees with the IRS position that it allowed inurement to President in form of payments and compensation. * ORG disagrees with the IRS position that it made a political campaign contribution. * ORG disagrees with the IRS conclusion that its exempt status should be revoked due to a failure to operate for an exempt purpose

I don't know if we will be reading about this in a Tax Court decision in a couple of years.  We can only hope.

Tuesday, May 17, 2011

Serial Guest Blogger Comments on Family Limited Partnership Case

Matthew F. Erskine

Matt Erskine was my first guest blogger.  Now he is back with commentary on an important family limited partnership case.

Another Attack on FLPs: Jorgensen v. Comm’r. 107 AFTR 2011

Erskine Comment: The 9th Circuit Court of Appeals has taken another swipe at the use of Family Limited Partnerships for transferring stock between generations. In this case, the deceased, Erma V. Jorgensen, transferred stock to two Family Limited Partnerships. The Court affirmed the decision of the Tax Court which sided with the IRS position that the entire value of the stock in the FLP should be included in her estate and denied the use of the discounted value, as the Estate alleged.

The Appeals Court affirmed the Tax Court’s using the post-transfer operations of the FLP to determine that the deceased 1) retained some economic interest in the assets of the FLP and 2) the transfer to the FLP by the deceased was not a bona fide sale for good and adequate consideration.

The retained economic interest was based on the decedent writing $90,000 worth of checks from the partnership for her personal expenses (even though there was an attempt to correct this by her accountant when this “error” was discovered) and because $200,000 of her estate taxes where paid from the Partnership.

The bona fide sale defect was based on the facts that:

“The type of assets transferred (marketable securities) did not require significant or active management, there was some disregard of partnership formalities, and the nontax justifications are either weak or refuted by the record (including formation of a second family partnership to hold higher-basis assets for gift-giving purposes, purportedly for the same nontax justifications that the original partnership could have already served).”

This reinforces the high level of scrutiny that FLPs and FLLCs incur by the Courts and the Service and the requirement that not only the set up but the ongoing operations of the entities be done with exactitude to insure that the discounting is not disallowed.

Overall, I cannot see that FLPs should be relied upon now that they are under both legislative and court attack for any long term tax planning.

PAOO Comment - I'm not sure that I go all the way with Matt on rejecting FLP's as a valid tool.  For one thing they  frequently would be a good idea even if there were no discounts.  Jorgensen was definitely a case of poor execution.  In my post on the original case I mention the son's difficulty in "getting his head around" the idea that the partnership wasn't just like a bank account.  The most recent Jorgensen decision was in my backlog of draft posts.  I am planning on looking at it along with a couple of other cases.  Be sure to check out the Erskine and Company blog.