Mark E. Stroff v. Commissioner, TC Memo 2011-80
This was a run of the mill substantiation case, with an unusual feature. The Tax Court went with the Service on disallowing many expenses but they allowed casual labor expenses to some extent with fairly minimal proof.
Self-employed handyman was granted partial Code Sec. 162 deduction of claimed “casual labor” expenses: although lacking any proof of actual amounts paid, taxpayer did submit list of laborers that corresponded with names entered in his weekly planner, which was enough to allow Tax Court to make Cohan estimate of deductible amount.
It wasn't a very large number or they probably would have allowed the expenses and gone after him for back-up withholding and 1099 filing penalties.
Andrew R. Bosque, et ux. v. Commissioner, TC Memo 2011-79
There were a couple of issues in this case. One was the real estate professional issue which is starting to get really tedious. The main problem was substantiation of time spent. If you have another profession, I can't emphasize enough how important that is. The other was an attempt to double dip on the home office deduction. Interestingly they were allowed deduction for amounts paid to para-legals in husbands law practice. This strikes me as another case where I would be worried about 1099 penalties and back-up withholding.
Home office deductions—principal place of business—multiple businesses— double deductions. Attorney/real estate consultant and wife/nurse weren't entitled to home office deduction for husband's consulting business: deduction would amount to doublecounting because taxpayers had already taken home office deduction for same office space on husband's law practice business's Schedule C.
Attorney/real estate consultant and wife/nurse were denied deductions claimed on husband's consulting business's and law practice's Schedules C for rental or lease of business properties: taxpayers didn't offer any proof of those expenses. But, they were entitled to deduction for paralegal fees that were substantiated with check copies containing names of cases worked on, phrase “paralegal fees,“ and corroborative testimony.
Kurt Sollberger v. Commissioner, TC Memo 2011-78
One of my favorite comments on some schemes is "Sometimes you should just pay the taxes." Taxpayer had sold his closely held stock to an ESOP and purchased floating rate notes, which qualified for deferral. Then he met someone who "loaned" him 90% of the value.
Capital gains—deferred gain on sale of employer securities to ESOP; disposition of qualified replacement property; sale vs. loan. Manufacturing co. owner's transfer of floating rate notes to promoter of ostensible ESOP-QRP loan program was sale triggering deferred gain from prior ESOP stock sale: taxpayer's attempt to treat transfer as loan rather than sale was belied by evidence showing no material distinction between this and other sale cases wherein benefits and burdens of ownership clearly passed to promoter, which didn't then hold notes as collateral but rather immediately sold same and passed 90% of proceeds back to taxpayer.
Optech agreed under the MLSA to serve as the lender or as agent for another lender. The MLSA provided that petitioner, as the borrower, remained the beneficial owner of the FRNs posted as collateral during the term of the loan and the FRNs would not be subject to the claims of any of Optech's creditors. The MLSA stated, however, that the lender had the right to register the FRNs in the lender's name, and Optech could “assign, transfer, pledge, repledge, hypothecate, rehypothecate, lend, encumber short sell and/or sale” the FRNs during the term of the loan without notifying petitioner. Moreover, petitioner waived his rights in the MLSA to receive interest and other benefits from the FRNs during the term of the loan, and he could not prepay on the loan.
The question that intrigues me about this is what he did with the $900,000. If it was used for personal purposes then this deal would have been a bad deal even if it had worked since he would still be picking up the supposed interest on the notes, without having a corresponding deduction. Even if the interest was deductible as investment interest it still would not have been a wash because of the effect on AGI. Also even if the plan worked he was giving up something like half of his "savings" (and it was actually just a deferral) depending on what state he lived in.
IN RE: JOHNSON, Cite as 107 AFTR 2d 2011-XXXX
The whole discussion is a bit lawyerly for me, but the result is an important one. Inherited IRA's that were rolled over are exempt assets under federal bankruptcy law.
The Trustee, however, argues that the Inherited IRAs do not constitute “retirement funds” because they do not contain any contributions from the Debtor. 11 U.S.C. § 522(d)(12), however, contains no such requirement. “ Section 522(d)(12) requires that the account be comprised of retirement funds, but it does not specify that they must be the debtor's retirement funds.” Nessa, 426 B.R. at 314. The plain language of a statute is determinative under federal law. Patterson v. Shumate, 504 U.S. 753, 757, 112 S. Ct. 2242, 2246 (1992). By its plain terms, all that the Bankruptcy Code requires is that the funds at issue be retirement funds. Even though the Inherited IRAs do not contain the Debtor's own retirement funds, they were originally deposited by his parents as retirement funds and retained their status as such when properly transferred to the Debtor's account in compliance with the IRC.
Showing posts with label capital gains. Show all posts
Showing posts with label capital gains. Show all posts
Thursday, July 7, 2011
Thursday, June 2, 2011
State Tax Credits as Capital Assets
George H. Tempel, et ux. v. Commissioner, 136 T.C. No. 15
How often have I said to you that when you have eliminated the impossible, whatever remains, however improbable, must be the truth?
I have been sitting on this case for a while now. It's part of the pile of late tax season developments that I have been slogging through. As I study it more I am surprised that it does not seem to have generated a lot of interest. Many states hand out tax credits to encourage all sorts of different activities. Cleaning up brownfields, rehabilitiating historic structures, making movies. Sometimes the credits are transferable. The transfer of those credits will have federal income tax consequences. A recent case about Virginia credits concerned whether payments were for the credits or capital contributions to a parntership. What is the nature of the income from the sale of the credit ? Frankly, I thought it was pretty obvious that somebody who does something like making a film that generates a credit, which is sold, should offset the expenses by the proceeds of the credit. So there would either be an expense reduction or the reduction in the basis of a capital asset. Well, silly me. The holding in this case is that the transfer of the state credit creates capital gain.
In 2004 Ps donated a qualified conservation easement to a qualified charitable organization. As a result, Ps received conservation easement income tax credits from the State of Colorado. These credits were transferable to other taxpayers. That same year Ps sold a portion of those credits.
Ps reported short-term capital gains from the sales of the State credits. Ps claimed an allocated portion of the professional fees they incurred to complete the conservation easement donation, as adjusted basis in the State tax credits they sold.
R determined the State income tax credits that Ps sold were not capital assets and that Ps had no adjusted basis in the credits. R filed a motion for partial summary judgment and Ps filed a cross-motion. In their cross-motion, Ps also claim that proceeds from their sales of State tax credits should have been reported as long-term capital gains.
On December 17, 2004, petitioners, George and Georgetta Tempel, husband and wife, donated a qualified conservation easement to the Greenlands Reserve, a qualified organization, on approximately 54 acres of petitioners' land in Colorado. Petitioners claimed the fair market value of their donation was $836,500. They incurred $11,574.74 of expenses in connection with the donation that primarily consisted of various professional fees. As a result of the donation petitioners received $260,000 of conservation easement income tax credits from the State of Colorado.
Petitioners sold $110,000 and gave away $10,000 of their $260,000 of State tax credits, leaving them with $140,000 of State tax credits to use. There is no evidence and respondent does not assert that petitioners sold credits they could have otherwise used to receive a refund. Therefore, petitioners' proceeds from the sale of their credits are not a substitute for a tax refund.
It is also apparent that the transferred State tax credits never represented a right to receive income from the state. Instead, they merely represented the right to reduce a taxpayer's State tax liability. It is without question that a government's decision to tax one taxpayer at a lower rate than another taxpayer is not income to the taxpayer who pays lower taxes. A lesser tax detriment to a taxpayer is not an accession to wealth and therefore does not give rise to income.
The defiinition of a capital asset is "property held by the taxpayer". Essentially everthing is a capital asset except for the specific things that are not such as stock in trade or a copyright in the hands of the person who produced the work. We don't need to get into the whole list. It suffices that state tax credits are not included. There is a doctrine that something that is a substitute for ordinary income is not a capital asset even if it is not specifically excluded. As outlined above, that is not the case with state credits.
Conclusion The State tax credits petitioners sold do not represent a right to income; therefore, the substitute for ordinary income doctrine is inapplicable. None of the categories of property in section 1221 that Congress specifically excepted from the term capital asset is applicable to the State tax credits. Accordingly, we hold the State tax credits petitioners sold are capital assets.
The taxpayers had argued that they had basis in the credits. On the intial return it was the fees that they had incurred in structuring the easement. In the case they argued that a portion of the basis in the land should be allocated to the credits. The Court rejected both those arguments.
The taxpayers also tried to argue that their holding period for the credit should be a tacked holding period from the land. The Court also rejected that argument indicating that the holding period for the credit begins when it is issued.
This decision might be very significant for some taxpayers. If they can hold state credits for a year after they are issued they will be able to get long term capital gain treatment.
How often have I said to you that when you have eliminated the impossible, whatever remains, however improbable, must be the truth?
I have been sitting on this case for a while now. It's part of the pile of late tax season developments that I have been slogging through. As I study it more I am surprised that it does not seem to have generated a lot of interest. Many states hand out tax credits to encourage all sorts of different activities. Cleaning up brownfields, rehabilitiating historic structures, making movies. Sometimes the credits are transferable. The transfer of those credits will have federal income tax consequences. A recent case about Virginia credits concerned whether payments were for the credits or capital contributions to a parntership. What is the nature of the income from the sale of the credit ? Frankly, I thought it was pretty obvious that somebody who does something like making a film that generates a credit, which is sold, should offset the expenses by the proceeds of the credit. So there would either be an expense reduction or the reduction in the basis of a capital asset. Well, silly me. The holding in this case is that the transfer of the state credit creates capital gain.
In 2004 Ps donated a qualified conservation easement to a qualified charitable organization. As a result, Ps received conservation easement income tax credits from the State of Colorado. These credits were transferable to other taxpayers. That same year Ps sold a portion of those credits.
Ps reported short-term capital gains from the sales of the State credits. Ps claimed an allocated portion of the professional fees they incurred to complete the conservation easement donation, as adjusted basis in the State tax credits they sold.
R determined the State income tax credits that Ps sold were not capital assets and that Ps had no adjusted basis in the credits. R filed a motion for partial summary judgment and Ps filed a cross-motion. In their cross-motion, Ps also claim that proceeds from their sales of State tax credits should have been reported as long-term capital gains.
On December 17, 2004, petitioners, George and Georgetta Tempel, husband and wife, donated a qualified conservation easement to the Greenlands Reserve, a qualified organization, on approximately 54 acres of petitioners' land in Colorado. Petitioners claimed the fair market value of their donation was $836,500. They incurred $11,574.74 of expenses in connection with the donation that primarily consisted of various professional fees. As a result of the donation petitioners received $260,000 of conservation easement income tax credits from the State of Colorado.
Petitioners sold $110,000 and gave away $10,000 of their $260,000 of State tax credits, leaving them with $140,000 of State tax credits to use. There is no evidence and respondent does not assert that petitioners sold credits they could have otherwise used to receive a refund. Therefore, petitioners' proceeds from the sale of their credits are not a substitute for a tax refund.
It is also apparent that the transferred State tax credits never represented a right to receive income from the state. Instead, they merely represented the right to reduce a taxpayer's State tax liability. It is without question that a government's decision to tax one taxpayer at a lower rate than another taxpayer is not income to the taxpayer who pays lower taxes. A lesser tax detriment to a taxpayer is not an accession to wealth and therefore does not give rise to income.
The defiinition of a capital asset is "property held by the taxpayer". Essentially everthing is a capital asset except for the specific things that are not such as stock in trade or a copyright in the hands of the person who produced the work. We don't need to get into the whole list. It suffices that state tax credits are not included. There is a doctrine that something that is a substitute for ordinary income is not a capital asset even if it is not specifically excluded. As outlined above, that is not the case with state credits.
Conclusion The State tax credits petitioners sold do not represent a right to income; therefore, the substitute for ordinary income doctrine is inapplicable. None of the categories of property in section 1221 that Congress specifically excepted from the term capital asset is applicable to the State tax credits. Accordingly, we hold the State tax credits petitioners sold are capital assets.
The taxpayers had argued that they had basis in the credits. On the intial return it was the fees that they had incurred in structuring the easement. In the case they argued that a portion of the basis in the land should be allocated to the credits. The Court rejected both those arguments.
The taxpayers also tried to argue that their holding period for the credit should be a tacked holding period from the land. The Court also rejected that argument indicating that the holding period for the credit begins when it is issued.
This decision might be very significant for some taxpayers. If they can hold state credits for a year after they are issued they will be able to get long term capital gain treatment.
Wednesday, December 15, 2010
Flipping Properties
Wendell V. Garrison, et ux. v. Commissioner, TC Memo 2010-261
This case addresses an important issue that I run into from time to time. How do you distinguish between investing in real estate or acquiring for use in a trade or business as opposed to being in the business of buying and selling real estate ? If you are a pure investor your gain on sale will be capital gain, your loss will be capital loss and your expenses will be itemized deductions subject to a variety of limitations depending on which ones we are talking about. If you are holding the property as a rental your gain will be a capital gain (with gain attributable to accumulated depreciation subject to a special rate) and your deductions will go against adjusted gross income. If you have a net loss, it may be suspended by the passive activity loss rules. Loss on the sale of a rental property is ordinary. If you are in the business of buying and selling real estate all income and loss is ordinary and subject to self employment tax.
There is, of course, more to it than that. Investors and rental property holders can do tax deferred like-kind exchanges. Someone in the business of buying and selling can shelter some their income with a Keogh or SEP or something like that. Not that they ever will. Real estate flippers will only stop when they die or own all the real estate in the world (I used to include bankruptcy as another end point, but that is really just a brief interruption). I am also leaving out owning the real estate involved in a business that you operate. Frequently that ends up being a rental situation, although there are some special rules.
Wendell and Sharon Garrison filed returns that fell somewhere between investor and rental operation. They didn't claim any operating expenses, but reported sales of property on Form 4797, which is the form for reporting sale of assets used in a trade or business (which for this purpose includes rental). They claimed capital gain treatment. Since most of the sales were short term I wonder what difference this made. It can make a big difference to someone who has capital loss carryovers, but based on the rest of the facts that didn't seem that likely. More significantly they did not pay self-employment tax on their earnings.
It seems like Mr. Garrison, more or less, shot himself in the foot:
Petitioner husband testified: “I'm in the business of buying material, fixing houses and reselling them.”
Still the court got into the factors to consider.
Typically, the factors in making this determination include:
(1) The taxpayer's purpose in acquiring the property;
(2) the purpose for which the property was subsequently held;
(3) the taxpayer's everyday business and the relationship of the income from the property to the total income;
(4) the frequency, continuity, and substantiality of sales of property;
(5) the extent of developing and improving the property to increase the sales revenue;
(6) the extent to which the taxpayer used advertising, promotion, or other activities to increase sales;
(7) the use of a business office for the sale of property;
(8) the character and degree of supervision or control the taxpayer exercised over any representative selling the property;
(9) the time and effort the taxpayer habitually devoted to the sales.
Petitioners engaged in at least 15 sales over 3 years, and most of the sales occurred within 4 months after they purchased the property.
That pretty much summed it up. The case also got into substantiation of expenses. They had nothing so the additional expenses they claimed were not allowed. The Cohan Rule was not even mentioned.
My own rough guideline in this area is that when you do your third renovation sale your in the business of buying and selling property, particularly if the first two did not have any rental activity. If you are doing this to scale it is worth consulting the Phelan decision (Timothy J. Phelan, et ux. v. Commissioner, TC Memo 2004-206). By isolating different activities in different entities it is possible to get capital gains treatment on some of the economic return from a development even though related entities might be doing ordinary income type activities. In order for this type of thing to work though it is critical that the entities be treated with respect. As with family limited partnerships, the devil is in the details.
This case addresses an important issue that I run into from time to time. How do you distinguish between investing in real estate or acquiring for use in a trade or business as opposed to being in the business of buying and selling real estate ? If you are a pure investor your gain on sale will be capital gain, your loss will be capital loss and your expenses will be itemized deductions subject to a variety of limitations depending on which ones we are talking about. If you are holding the property as a rental your gain will be a capital gain (with gain attributable to accumulated depreciation subject to a special rate) and your deductions will go against adjusted gross income. If you have a net loss, it may be suspended by the passive activity loss rules. Loss on the sale of a rental property is ordinary. If you are in the business of buying and selling real estate all income and loss is ordinary and subject to self employment tax.
There is, of course, more to it than that. Investors and rental property holders can do tax deferred like-kind exchanges. Someone in the business of buying and selling can shelter some their income with a Keogh or SEP or something like that. Not that they ever will. Real estate flippers will only stop when they die or own all the real estate in the world (I used to include bankruptcy as another end point, but that is really just a brief interruption). I am also leaving out owning the real estate involved in a business that you operate. Frequently that ends up being a rental situation, although there are some special rules.
Wendell and Sharon Garrison filed returns that fell somewhere between investor and rental operation. They didn't claim any operating expenses, but reported sales of property on Form 4797, which is the form for reporting sale of assets used in a trade or business (which for this purpose includes rental). They claimed capital gain treatment. Since most of the sales were short term I wonder what difference this made. It can make a big difference to someone who has capital loss carryovers, but based on the rest of the facts that didn't seem that likely. More significantly they did not pay self-employment tax on their earnings.
It seems like Mr. Garrison, more or less, shot himself in the foot:
Petitioner husband testified: “I'm in the business of buying material, fixing houses and reselling them.”
Still the court got into the factors to consider.
Typically, the factors in making this determination include:
(1) The taxpayer's purpose in acquiring the property;
(2) the purpose for which the property was subsequently held;
(3) the taxpayer's everyday business and the relationship of the income from the property to the total income;
(4) the frequency, continuity, and substantiality of sales of property;
(5) the extent of developing and improving the property to increase the sales revenue;
(6) the extent to which the taxpayer used advertising, promotion, or other activities to increase sales;
(7) the use of a business office for the sale of property;
(8) the character and degree of supervision or control the taxpayer exercised over any representative selling the property;
(9) the time and effort the taxpayer habitually devoted to the sales.
Petitioners engaged in at least 15 sales over 3 years, and most of the sales occurred within 4 months after they purchased the property.
That pretty much summed it up. The case also got into substantiation of expenses. They had nothing so the additional expenses they claimed were not allowed. The Cohan Rule was not even mentioned.
My own rough guideline in this area is that when you do your third renovation sale your in the business of buying and selling property, particularly if the first two did not have any rental activity. If you are doing this to scale it is worth consulting the Phelan decision (Timothy J. Phelan, et ux. v. Commissioner, TC Memo 2004-206). By isolating different activities in different entities it is possible to get capital gains treatment on some of the economic return from a development even though related entities might be doing ordinary income type activities. In order for this type of thing to work though it is critical that the entities be treated with respect. As with family limited partnerships, the devil is in the details.
Monday, November 8, 2010
We Only Wash Losses Here
INFO 2010-0188
I've been sitting on this one for a while. It was issued July 27, 2010. It refers to the flash crash of the stock market on May 6 which caused many stop-loss orders to be triggered some of which resulted in gain recognition. Whoever (I don't think Redacted Text was his real name) wrote to the IRS more or less logically (as if that means anything) thought investors should be able to reestablish those positions with appropriate basis as if no gain were recognized. Here was the response :
Dear [Redacted Text]:
This is in response to your May 20, 2010, letter to Commissioner Shulman concerning the May 6, 2010, “flash crash” of the stock market. You point out that many investors had their holdings sold that day because of stop-loss orders and that, in some cases, these investors realized gains subject to tax. You ask that these investors be allowed to reinvest in the stock sold, that the replacement stock be given the same basis as the stock originally held, and that the investors be excused from recognizing gain.
Stop-loss orders direct a broker to sell a stock at the best price currently available if the stock reaches a specified price. As the result of the speed and scope of the decline in stock prices during the afternoon of May 6, 2010, many stop-loss orders, which are executed as market orders, were triggered. The paucity of bids for many stocks resulted in sales at prices significantly below those of prior trades. Those sales triggered additional stop-loss orders and more stock sales at current market prices. Many investors incurred losses as the result of such sales, although stock prices rebounded significantly thereafter. The dramatic recovery in stock prices was a source of frustration to investors whose stock holdings were liquidated as the result of the execution of stop-loss orders during the market decline. The closing price for many stocks was higher than either the price at which investors' stop-loss orders were triggered or the price realized on the sale of stock as a result of the triggering of a stop loss order.
Reinvestment in securities sold at a loss in some circumstances requires application of the wash sale rules set forth in section 1091 of the Internal Revenue Code, so that the loss cannot be recognized fully for federal income tax purposes. Example: An investor bought 1,000 shares of X Co. stock at $70.00 at the opening of the market on May 6, 2010, and placed a stop-loss order at $66.50 (5% below the cost of the stock). When the stock declined to $66.50, the investor's stop-loss order became a market order. As a market order, the order was executed at $61.00, the best available price. The saleresulted in a loss of $9.00 per share to the investor. If the investor, within 30 days before or after the sale of the X Co. stock, purchased X Co. stock, the wash sale rules would apply to limit or deny deduction of the loss. The amount of the disallowed loss would be reflected in the investor's basis in the X Co. stock purchased within 30 days before or after the sale under the stop-loss order.
On the other hand, there is no similar rule allowing nonrecognition of gain on the sale of stock if an investor purchases replacement stock within a prescribed period. Example: An investor who had purchased X Co. stock on July 20, 2009, at a cost of $40.00 per share had placed a stop-loss order at $66.50 (5% below the closing market price of the stock on May 5, 2010). During the flash crash, the investor's stop-loss order was triggered, and the investor's X Co. stock was sold at $66.50 per share. The investor realized a gain of $26.50 per share on the stock and would be required to recognize the realized gains, i.e., include the gains in gross income, irrespective of whether the investor acquired X Co. stock within a prescribed period, e.g., 30 days, before or after the sale at a loss.
Various nonrecognition provisions in the Code are not applicable. Section 1031 provides for deferral of recognition of gain on like-kind exchanges of property held for productive use in a trade or business or held for investment, but specifically excludes stocks, bonds, and notes from its scope. Section 1033, which provides for deferral of gain if property is compulsorily or involuntarily converted into property similar or related in service or use to the property so converted, or to money, applies only to dispositions resulting from destruction, theft, seizure, or requisition or condemnation.
In sum, absent the enactment of a relief provision by Congress, there is no authority that would allow the Internal Revenue Service to provide for the nonrecognition of gain for stop-loss orders executed on May 6, 2010.
Sorry Red.
I've been sitting on this one for a while. It was issued July 27, 2010. It refers to the flash crash of the stock market on May 6 which caused many stop-loss orders to be triggered some of which resulted in gain recognition. Whoever (I don't think Redacted Text was his real name) wrote to the IRS more or less logically (as if that means anything) thought investors should be able to reestablish those positions with appropriate basis as if no gain were recognized. Here was the response :
Dear [Redacted Text]:
This is in response to your May 20, 2010, letter to Commissioner Shulman concerning the May 6, 2010, “flash crash” of the stock market. You point out that many investors had their holdings sold that day because of stop-loss orders and that, in some cases, these investors realized gains subject to tax. You ask that these investors be allowed to reinvest in the stock sold, that the replacement stock be given the same basis as the stock originally held, and that the investors be excused from recognizing gain.
Stop-loss orders direct a broker to sell a stock at the best price currently available if the stock reaches a specified price. As the result of the speed and scope of the decline in stock prices during the afternoon of May 6, 2010, many stop-loss orders, which are executed as market orders, were triggered. The paucity of bids for many stocks resulted in sales at prices significantly below those of prior trades. Those sales triggered additional stop-loss orders and more stock sales at current market prices. Many investors incurred losses as the result of such sales, although stock prices rebounded significantly thereafter. The dramatic recovery in stock prices was a source of frustration to investors whose stock holdings were liquidated as the result of the execution of stop-loss orders during the market decline. The closing price for many stocks was higher than either the price at which investors' stop-loss orders were triggered or the price realized on the sale of stock as a result of the triggering of a stop loss order.
Reinvestment in securities sold at a loss in some circumstances requires application of the wash sale rules set forth in section 1091 of the Internal Revenue Code, so that the loss cannot be recognized fully for federal income tax purposes. Example: An investor bought 1,000 shares of X Co. stock at $70.00 at the opening of the market on May 6, 2010, and placed a stop-loss order at $66.50 (5% below the cost of the stock). When the stock declined to $66.50, the investor's stop-loss order became a market order. As a market order, the order was executed at $61.00, the best available price. The saleresulted in a loss of $9.00 per share to the investor. If the investor, within 30 days before or after the sale of the X Co. stock, purchased X Co. stock, the wash sale rules would apply to limit or deny deduction of the loss. The amount of the disallowed loss would be reflected in the investor's basis in the X Co. stock purchased within 30 days before or after the sale under the stop-loss order.
On the other hand, there is no similar rule allowing nonrecognition of gain on the sale of stock if an investor purchases replacement stock within a prescribed period. Example: An investor who had purchased X Co. stock on July 20, 2009, at a cost of $40.00 per share had placed a stop-loss order at $66.50 (5% below the closing market price of the stock on May 5, 2010). During the flash crash, the investor's stop-loss order was triggered, and the investor's X Co. stock was sold at $66.50 per share. The investor realized a gain of $26.50 per share on the stock and would be required to recognize the realized gains, i.e., include the gains in gross income, irrespective of whether the investor acquired X Co. stock within a prescribed period, e.g., 30 days, before or after the sale at a loss.
Various nonrecognition provisions in the Code are not applicable. Section 1031 provides for deferral of recognition of gain on like-kind exchanges of property held for productive use in a trade or business or held for investment, but specifically excludes stocks, bonds, and notes from its scope. Section 1033, which provides for deferral of gain if property is compulsorily or involuntarily converted into property similar or related in service or use to the property so converted, or to money, applies only to dispositions resulting from destruction, theft, seizure, or requisition or condemnation.
In sum, absent the enactment of a relief provision by Congress, there is no authority that would allow the Internal Revenue Service to provide for the nonrecognition of gain for stop-loss orders executed on May 6, 2010.
Sorry Red.
Friday, October 22, 2010
Wag the Dog
You just couldn't play it smart, could you?
All you had to do was box, but no,
not you, you hardhead.
Funny thing is, there ain't gonna be
any boxing championships this year.
As I mentioned in my initial post on Fidelity International Currency Advisor, there is much material in the saga of Richard Egan's doomed tax shelters. I will wrap up my EMC trilogy with an observation on the greatest irony of the case. The Egan's had two partnerships one designed to shelter capital gain and the other ordinary income. I explained the capital gain scheme, but not the ordinary income one. Basically you get a free basis step-up by entering into offsetting option contracts and have an accountant handle one leg of the transaction and a tax attorney the other half. The debit goes on the left and the credit goes ... What credit ? The ordinary income refinement requires a foreign partner to be allocated gains and then be bought out. (Of course the buy-out cannot be prearranged wink, wink). This deal was done in 2000, a long time ago to some, but well after the 704(b) regulations were issued. Sadly the case does not explain the theory that deemed there to be substantial economic effect to the allocating of 160 million of gains to someone who was shortly bought out for around $325,000. That's not where I see the irony, though.
After a whirlwind tour of the Big Apple's accounting emproia where these brilliant maneuvers were presented Richard Egan, according to one of his advisers, told his son Michael, who headed his family office, that he wished his advisers would help make him money rather than save it. The advisor was told that she may have misheard and that "Dick" knows how to make money, but may not know how to save it. This presumably was how the advisers would distinguish themselves. One of the earliest events recorded in the case is something that James Reiss, CFO of Carruth Management (Egan's family office) wrote to attorney Stephanie Denby:
On April 25, 2000, Reiss wrote to Denby that Michael Egan was “anticipating unloading his father's EMC shares at $140” per share, and asked if she had a “good lead on a transaction and insurance.” The “transaction” he had in mind was one that would avoid taxes.
By the fall of 2000, the price of EMC exceeded $100 per share and had it kept appreciating at a similar rate $140 would have been achieved before long. The effort involved in selecting just the right tax shelter and making sure it was properly documented took time. Once all that energy was expended there was a desire to make sure the paid-for basis was properly used. Sadly the market did not cooperate with the plan.
At the beginning of September 2000, EMC stock was trading at $98.00 per share. Thereafter, the share price of EMC steadily declined, with the exception of a small increase in January 2001. By the end of November 2001, EMC stock was trading at $16.79 per share.
The Fidelity High Tech transaction had created a purported “basis” of $ 160 million. As the price of EMC stock began to decline, however, it became apparent to Michael Egan and others that the stock could not be sold for a sufficient gain to take advantage of that entire “basis.” In addition, the Egans did not want to show a loss on the sale of the stock. Accordingly, in 2001 the Egans added additional low-basis stock to the High Tech Fund—a practice that was referred to as “stuffing.” As Haber advised Pat Shea, the Egans could “stuff [High Tech] with more stock to get our per share basis lower [--] that will allow us to sell shares tax free.”
At least as early as May 2001, Michael Egan was being provided with spreadsheets prepared by Carolyn Fiddy that set forth the fair market value of the stock held in High Tech. The spreadsheets showed how much additional stock would need to be contributed to bring the value of the portfolio up to the amount of the $160 million purported basis,
In late 2001, employees at Carruth performed further calculations in order to determine how much additional stock needed to be contributed to Fidelity High Tech in order to take advantage of the purported $160 million basis. In addition to EMC stock, Michael Egan authorized contribution of other low-basis stock owned by the Egans to Fidelity High Tech to take advantage of the “stepped-up” basis (or, as Shea put it, to “absorb” that basis).
On December 19, 2001, Carolyn Fiddy reported to Reiss that “the final “stuffing” for Fidelity High Tech Advisor A has been organized.” . The same day, Shea reported to Reiss that “the “stuffing” of Helios I [High Tech] took place today.” On December 20, Fiddy reported to Haber that “additional contributions of low basis stock” had been made to High Tech.
On December 20, 2001, Pat Shea reported to Haber that “we have “stuffed” this fund with several other assets including more EMC stock.”
The beauty of the transaction was that it would have a "low reporting profile" since it was "merely" eliminating gains rather than creating a loss. Ultimately the transaction would be showing a loss as there was not enough fair market value of EMC stock contributed to take advantage of the basis.
In the end the capital gains tax had to be paid and apparently a 40% gross valuation overstatement penalty. Not to metnion all the fees which were estimated to be around 20% of the "tax savings". The really interesting question, though, is how much was lost due to stock being sold at less favorable prices than might have been obtained without the complications of the shelter planning ?
The Egans were not the only people afflicted by the belief that EMC stock could only go up. And of course EMC was part of the larger tech bubble. Just for perspective we can reflect on what might have happened to many of the EMC rankers. The belief that tax laws are rigged in favor of the ultra wealthy is really a delusion. Mr. Egan had to get somebody to find a friendly Irishman to pick up 160,000,000 dollars in currency gain and then be bought out to shelter his non-qualified option ordinary income. A regular EMC employee would have qualified options. So if such an employee exercised an option to buy at say $20 when the stock was at $90 all he or she had to do was hold onto the stock for a year in order to get capital gains treatment on the $70 plus of course the additional amount that the EMC stock would go up by in the course of the year. Of course there was that nasty alternative minimum tax so maybe there would be $15 or so to pay in April, which might have been about what the stock finally sold for. So as they stretched to turn a 40% tax into a 20 % tax, they ended up with, in effect, a 100% tax. They ended up with AMT credit carryovers and AMT capital loss carryovers, many of which have been used by now, but it was really painful in 2001.
The usual prize of the privilege of naming a topic for a future goes for identifying the quotation leading the post. In order to get full credit you have to name the historic event that corresponds to the tech bubble in the analogy that I am creating.
All you had to do was box, but no,
not you, you hardhead.
Funny thing is, there ain't gonna be
any boxing championships this year.
As I mentioned in my initial post on Fidelity International Currency Advisor, there is much material in the saga of Richard Egan's doomed tax shelters. I will wrap up my EMC trilogy with an observation on the greatest irony of the case. The Egan's had two partnerships one designed to shelter capital gain and the other ordinary income. I explained the capital gain scheme, but not the ordinary income one. Basically you get a free basis step-up by entering into offsetting option contracts and have an accountant handle one leg of the transaction and a tax attorney the other half. The debit goes on the left and the credit goes ... What credit ? The ordinary income refinement requires a foreign partner to be allocated gains and then be bought out. (Of course the buy-out cannot be prearranged wink, wink). This deal was done in 2000, a long time ago to some, but well after the 704(b) regulations were issued. Sadly the case does not explain the theory that deemed there to be substantial economic effect to the allocating of 160 million of gains to someone who was shortly bought out for around $325,000. That's not where I see the irony, though.
After a whirlwind tour of the Big Apple's accounting emproia where these brilliant maneuvers were presented Richard Egan, according to one of his advisers, told his son Michael, who headed his family office, that he wished his advisers would help make him money rather than save it. The advisor was told that she may have misheard and that "Dick" knows how to make money, but may not know how to save it. This presumably was how the advisers would distinguish themselves. One of the earliest events recorded in the case is something that James Reiss, CFO of Carruth Management (Egan's family office) wrote to attorney Stephanie Denby:
On April 25, 2000, Reiss wrote to Denby that Michael Egan was “anticipating unloading his father's EMC shares at $140” per share, and asked if she had a “good lead on a transaction and insurance.” The “transaction” he had in mind was one that would avoid taxes.
By the fall of 2000, the price of EMC exceeded $100 per share and had it kept appreciating at a similar rate $140 would have been achieved before long. The effort involved in selecting just the right tax shelter and making sure it was properly documented took time. Once all that energy was expended there was a desire to make sure the paid-for basis was properly used. Sadly the market did not cooperate with the plan.
At the beginning of September 2000, EMC stock was trading at $98.00 per share. Thereafter, the share price of EMC steadily declined, with the exception of a small increase in January 2001. By the end of November 2001, EMC stock was trading at $16.79 per share.
The Fidelity High Tech transaction had created a purported “basis” of $ 160 million. As the price of EMC stock began to decline, however, it became apparent to Michael Egan and others that the stock could not be sold for a sufficient gain to take advantage of that entire “basis.” In addition, the Egans did not want to show a loss on the sale of the stock. Accordingly, in 2001 the Egans added additional low-basis stock to the High Tech Fund—a practice that was referred to as “stuffing.” As Haber advised Pat Shea, the Egans could “stuff [High Tech] with more stock to get our per share basis lower [--] that will allow us to sell shares tax free.”
At least as early as May 2001, Michael Egan was being provided with spreadsheets prepared by Carolyn Fiddy that set forth the fair market value of the stock held in High Tech. The spreadsheets showed how much additional stock would need to be contributed to bring the value of the portfolio up to the amount of the $160 million purported basis,
In late 2001, employees at Carruth performed further calculations in order to determine how much additional stock needed to be contributed to Fidelity High Tech in order to take advantage of the purported $160 million basis. In addition to EMC stock, Michael Egan authorized contribution of other low-basis stock owned by the Egans to Fidelity High Tech to take advantage of the “stepped-up” basis (or, as Shea put it, to “absorb” that basis).
On December 19, 2001, Carolyn Fiddy reported to Reiss that “the final “stuffing” for Fidelity High Tech Advisor A has been organized.” . The same day, Shea reported to Reiss that “the “stuffing” of Helios I [High Tech] took place today.” On December 20, Fiddy reported to Haber that “additional contributions of low basis stock” had been made to High Tech.
On December 20, 2001, Pat Shea reported to Haber that “we have “stuffed” this fund with several other assets including more EMC stock.”
The beauty of the transaction was that it would have a "low reporting profile" since it was "merely" eliminating gains rather than creating a loss. Ultimately the transaction would be showing a loss as there was not enough fair market value of EMC stock contributed to take advantage of the basis.
In the end the capital gains tax had to be paid and apparently a 40% gross valuation overstatement penalty. Not to metnion all the fees which were estimated to be around 20% of the "tax savings". The really interesting question, though, is how much was lost due to stock being sold at less favorable prices than might have been obtained without the complications of the shelter planning ?
The Egans were not the only people afflicted by the belief that EMC stock could only go up. And of course EMC was part of the larger tech bubble. Just for perspective we can reflect on what might have happened to many of the EMC rankers. The belief that tax laws are rigged in favor of the ultra wealthy is really a delusion. Mr. Egan had to get somebody to find a friendly Irishman to pick up 160,000,000 dollars in currency gain and then be bought out to shelter his non-qualified option ordinary income. A regular EMC employee would have qualified options. So if such an employee exercised an option to buy at say $20 when the stock was at $90 all he or she had to do was hold onto the stock for a year in order to get capital gains treatment on the $70 plus of course the additional amount that the EMC stock would go up by in the course of the year. Of course there was that nasty alternative minimum tax so maybe there would be $15 or so to pay in April, which might have been about what the stock finally sold for. So as they stretched to turn a 40% tax into a 20 % tax, they ended up with, in effect, a 100% tax. They ended up with AMT credit carryovers and AMT capital loss carryovers, many of which have been used by now, but it was really painful in 2001.
The usual prize of the privilege of naming a topic for a future goes for identifying the quotation leading the post. In order to get full credit you have to name the historic event that corresponds to the tech bubble in the analogy that I am creating.
Sunday, September 19, 2010
Incentive to Innovate
I attended the Mass Innovation Night Wednesday It is a pretty neat event. Neuron Robotics is making a central control unit to use in robot applications. Another neat start up was Isabella Products which has a picture frame with a linked e-mail address. I really wish my mother was still around. I would definitely have gotten her one. I was chatting with an attorney who does a lot of start-ups and I was really surprised to find that he wasn't aware of the special tax treatment available for patents. It's not the first time that I've run into so I thought it might be worth a blog post even though I haven't noticed any striking developments in that area.
Code Section 1235 applies to inventors and their financial backers. It allows capital gains treatment on payments in exchange for the transfer of a patent even if the payments are over a period of time or contingent on the use of the property. An analogy that can be used for distinguishing capital transactions from ordinary income is that of a tree and its fruit. If you sell the tree that's a capital transaction. If you sell the fruit that is ordinary income. This distinction and the ways that people try to confound it are sources of much tax complexity which I will discuss from time to time. There is an assumption that when payments for property are spread over time, some portion of the payments represent compensation for the time value of money (which used to amount to something). Another principle is that things that you create yourself are not capital assets in your hand.
Code Section 1235 suspends both these principles when it comes to compensating inventors. Payments that qualify under 1235 are 100% capital gain even though long deferred and the relief is targeted to the creators. The requirements for 1235 treatment are that the taxpayer be a "holder", which is either the inventor or someone who acquired all rights from the inventor before the invention is reduced to practice. The inventor can transfer rights even before patents are issued and still qualify for capital gains treatment. In one case the courts allowed 1235 treatment for the sale of patentable designs even though no patents were ultimately applied for.
In order to qualify for the treatment the sale must be of all substantial rights in the patent or an undivided interest in all the substantial rights. This might create a significant business issue, since a sale that is restricted to a particular industry or geographic area will not qualify. I think it is possible that 1235 is not thought about a lot, because the end game of a lot of start ups is the creation of a public company or being taken over by one. I think this is what accounts for the strange popularity of C corporations. Nonetheless, it can be a great benefit in the right circumstances and should not be neglected.
Code Section 1235 applies to inventors and their financial backers. It allows capital gains treatment on payments in exchange for the transfer of a patent even if the payments are over a period of time or contingent on the use of the property. An analogy that can be used for distinguishing capital transactions from ordinary income is that of a tree and its fruit. If you sell the tree that's a capital transaction. If you sell the fruit that is ordinary income. This distinction and the ways that people try to confound it are sources of much tax complexity which I will discuss from time to time. There is an assumption that when payments for property are spread over time, some portion of the payments represent compensation for the time value of money (which used to amount to something). Another principle is that things that you create yourself are not capital assets in your hand.
Code Section 1235 suspends both these principles when it comes to compensating inventors. Payments that qualify under 1235 are 100% capital gain even though long deferred and the relief is targeted to the creators. The requirements for 1235 treatment are that the taxpayer be a "holder", which is either the inventor or someone who acquired all rights from the inventor before the invention is reduced to practice. The inventor can transfer rights even before patents are issued and still qualify for capital gains treatment. In one case the courts allowed 1235 treatment for the sale of patentable designs even though no patents were ultimately applied for.
In order to qualify for the treatment the sale must be of all substantial rights in the patent or an undivided interest in all the substantial rights. This might create a significant business issue, since a sale that is restricted to a particular industry or geographic area will not qualify. I think it is possible that 1235 is not thought about a lot, because the end game of a lot of start ups is the creation of a public company or being taken over by one. I think this is what accounts for the strange popularity of C corporations. Nonetheless, it can be a great benefit in the right circumstances and should not be neglected.
Friday, September 3, 2010
Pigs Get Fed
I've been struggling with the title for this particular post. "Sometimes You Should Just Pay The Taxes" seemed apt, but I've used that title not that long ago. My method of gathering material for the blog presents the danger of developing a jaundiced view toward aggressive tax planning. Studying original source material can overemphasize the plans that go astray. Even a taxpayer victory in Tax Court is not something to be envied.
Nonetheless, we used to have a saying "Pigs get fed. Hogs get slaughtered.". I tried to research the origin of the expression and the claims of origin I found all post dated my first exposure to it. As one of my partners commented we really had no idea if there was any agricultural reality to the expression. Unlike some other expressions ("Same difference" "No harm. No foul."), though, I had a pretty clear idea of the inherent advice. It was that you should be aggressive, but not too aggressive. At the time I was working for somebody named Cohan and I was actually surprised to find that the Cohan Rule was named for somebody else.
Nowadays the way you tell if somebody was way too aggressive is when the penalties get piled on and are sustained by the tax court (Of course there are the people who are deprived of their liberty, but what they do has to have some characterization beyond aggressive). Lizzie W. Calloway, et vir. v. Commissioner, 135 T.C. No. 3 makes for an interesting story in this regard.
Albert Calloway (he's the et vir.) owned stock in IBM with relatively low basis. Rather than sell the stock, he entered into an agreement with Derivium Capital LLC which offered to loan him 90% of the value of the stock. The stock was to serve as collateral . In three years Mr. Calloway could pay off the loan with interest and reclaim the stock - or not.
At the end of the day, the tax court ruled that the transaction was not really a loan. What is interesting though is that the tax court decision was not unanimous at least in its reasoning. The problem that they had with the transaction is that Derivium didn't actually hold the IBM stock. It immediately sold it. The proceeds of the "loan" were not determined by a valuation of the stock when it was delivered. Rather it was 90% of the proceeds that Derivium received from selling it.
There is a long complicated analysis that brings the court to conclude that the transaction was not really a loan. What I find most significant is that even the judges who did not agree with the analysis agreed with the deficiency and the penalties. Their reasoning was that the taxpayer did not act like it was a loan. They did not recognize as income the supposed IBM dividends that were being applied to the supposed interest charges. Most significantly, when the three years elapsed they did not recognize the sale or income from the discharge of indebtedness.
The IRS likes to win when they go in to tax court. So they pick on people with the worst facts. The transaction was probably not such a hot idea to begin with, but once adopted, it should have been followed through in detail, meticulously.
The one thing that really troubles me about this case is the numbers. The Calloway received $93,586.23 for IBM stock in which they had $21,171 in basis. The deficiency in tax (before considering interest and penalties) was $30,911. It was a 2001 case and although not explicitly stated it seemed that it was a long term gain. I've decided to move on, but if someone can figure out the mystery, post a comment.
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