LLC Member Not Presumed to be Passive

In Action On Decision 2010-002 the IRS acquiesced in a Court of Claims decision (Thompson v. US 104 AFTR 2d 2009-5381) holding that a membership interest in a LLC was not presumptively passive.  Since the LLC is really the entity of choice, if you want a flow through this can be of significance. The passive activity loss rules were probably the most novel element of the Tax Reform Act of 1986.  They created a new taxonomy of business undertakings based on each individual taxpayers participation in the business.

The income or loss created by passive activities are aggregated and, in general, the losses are only allowed to the extent of the income.  It is erroneous to think of the process as an offset, because the various types of income and losses retain their character.  So if you have a capital gain from one passive activity and an ordinary loss from another activity, the ordinary loss will be allowed, while the capital gain will retain its character as a capital gain.  Losses without accompanying gains languish suspended from year to year until they are released by the total disposition of the activity giving rise to them.  It all gets tracked by Form 8582.  If you have been involved in passive activities it could be a worthwhile exercise to review your 8582's from year to year.  You will have two sets, one for the regular tax and another for the alternative minimum tax.  If you have switched tax preparers, there is a decent chance something got lost in transition.  It can happen even from preparers switching software.

The cleanest way out of the morass of passive activity concerns is "material participation".  The regulations give an individual seven ways to establish material participation :

(1) The individual participates in the activity for more than 500 hours during such year.


(2) The individual's participation in the activity for the taxable year constitutes substantially all of the participation in such activity of all individuals (including individuals who are not owners of interests in the activity) for such year;


(3) The individual participates in the activity for more than 100 hours during the taxable year, and such individual's participation in the activity for the taxable year is not less than the participation in the activity of any other individual (including individuals who are not owners of interests in the activity) for such year;


(4) The activity is a significant participation activity (within the meaning of paragraph (c) of this section) for the taxable year, and the individual's aggregate participation in all significant participation activities during such year exceeds 500 hours;


(5) The individual materially participated in the activity (determined without regard to this paragraph (a)(5)) for any five taxable years (whether or not consecutive) during the ten taxable years that immediately precede the taxable year;


(6) The activity is a personal service activity (within the meaning of paragraph (d) of this section), and the individual materially participated in the activity for any three taxable years (whether or not consecutive) preceding the taxable year; or


(7) Based on all of the facts and circumstances (taking into account the rules in paragraph (b) of this section), the individual participates in the activity on a regular, continuous, and substantial basis during such year.

The regulations go on to state that if the taxpayers interest in the activity is as a limited partner qualification for material participation can only come from items 1, 5, and 6 above. Thus a limited partner who does more than any other individual in the activity will not be considered to be materially participating if that amounts to less than 500 hours.  In the Thompson case the service had argued that an LLC membership interest was the same as a limited partnership interest for purposes of this regulation.  The Court of Claims did not agree and the service has thrown in the towel on this issue.

This decision should further bolster the LLC as the entity of choice where a flow though is desired.  Taxpayers should bear in mind though that if they are posting negative numbers from an activity, the IRS will likely attack any reconstruction of their time as a ballpark guesstimate (This has become a term of art apparently).

Sorry We're The Tax Court Not Divorce Court

Tax court summary opinions lack value as precedent, but they are so rewarding in other ways.  This week I wrote about the Gill decision which, if sustained, will allow same sex couples who's marriages are recognized by state law to file joint federal returns.  Well, as I titled my post on the tax advantages of  not being married ,Just because they won't let you do it doesn't make it a good idea.  A big draw back to joint returns is the joint and several liability that it creates.

With that said, we now get to empathize with Caron W. Riganti (TC Summary Opinion 2010-113). She found out that she had liability on some joint returns sometime after her divorce.  Apparently her practice had been to give her husband her W-2 and whatever other information she had and let him have the return prepared.  She discovered that he had not taken the further step of paying the balance due when she received notice that expected refunds had been intercepted to apply to the outstanding balance for the years 2004 and 2005.  Laura Brady , another distressed ex-spouse whom the Tax Court couldn't help, whom I discussed earlier this month, found out about her liability the same way.

Apparently the tax debt was not the only unpaid bill that Ms. Riganti thought Mr. Riganti was not stepping up to.  The tax court conceded that her request was fairly modest :

Petitioner's request for section 6015 relief was prompted by her belief, triggered by some forced collection action, that she would be required to pay the full amounts of the unpaid portions of the 2004 and 2005 income tax liabilities arising from the joint return filed for each year. As petitioner views the matter, the 2004 and 2005 income tax liabilities should be treated in a manner consistent with the other marital debts taken into account in the agreement; that is, she and her former spouse should each be responsible for one-half of the tax liability for each year. She is not so much seeking relief from those liabilities as she is seeking some assurance that her former spouse will be required to pay what she considers to be his fair share of those liabilities. Because petitioner's former spouse has otherwise failed to live up to other of his financial obligations, we appreciate petitioner's concern that she might be required to pay the full amounts of the outstanding 2004 and 2005 tax liabilities. Her concern, of course, is completely consistent with the concept of joint and several liability.



It was a modest request, but sadly she was apparently not addressing someone who could help her :

We expect it is of no consolation to her to point out that her former spouse remains equally responsible for payment of the outstanding tax liabilities. Nevertheless and simply put, the type of relief she seeks, perhaps available through the local court having jurisdiction over her divorce from her former spouse, is outside that contemplated under section 6015.

The moral of the story is that taxpayers and advisers need to look at joint returns not as a simple exercise of what produces the lowest total tax, but also consider the implications of joint and several liability.  There is some relief available, but it is by no means assured.

Should Mass Same Sex Couples Consider Amending Returns ?

The recent decision on the constitutionality of California Proposition 8, Perry vs. Schwarzenegger, may have stolen a bit of the thunder from Gill v OPM, which concerns not same sex couples who want to marry, but those who already are or have been married. I'm more interested in Gill, because, among other things, it is a tax case.  Gill is a district court decision.  It's holding is that a portion of the Defense of Marriage Act is unconstitutional.  The ruling was rather harsh on Congress not holding that DOMA needed to be subject to "strict scrutiny", but rather that it had no rational basis.  The Justice Department was required to defend DOMA, even though the Obama administration has indicated that it would favor its repeal.  They refused, however, to advance any of Congress's reasons for passing he bill in the first place. 

DOMA (Defense of Marriage Act) had two main points. One is that states that do not allow same sex marriages are not  forced to recognize such marriages performed in other states. The other is that for purposes of federal law marriage is limited to marriages between members of the opposite sex and the word spouse mean someone of the opposite sex. Gill v. OPM attacked only the second part of DOMA. The plaintiffs were or had been legally married in Massachusetts and were being denied some sort of benefit, because their marriages were not recognized under federal law. The Court found that DOMA had no rational basis. In a follow up ruling that was issued on August 19, the judge spelled out the specific results of the ruling. Among them were refunds of income tax totalling approximately $50,000 to three of the plaintiff couples who were permitted joint filing status. The effect of the ruling has been stayed pending appeal.GLAD (Gay and Lesbian Advocates and Defenders) which managed the case approved of the stay since it would be not good for the plaintiffs to receive the refunds and then have to pay them back if they lose on appeal. The Justice Department has until October 18 to appeal.

Prior to this case, there has not been much in the tax area on DOMA.  The same taxpayer asked the Tax Court to declare it unconstitutional twice and both times appealed to the seventh circuit.  The second time (MUELLER v. COMM., Cite as 90 AFTR 2d 2002-5309), he was cautioned about filing frivolous appeals.  Mr. Mueller, however, was not actually married under the laws of any state, so DOMA had no more bearing the second time he appealed than it did the first time which concerned years prior to DOMA's enactment.

In PLR 9717018, the service ruled that a taxpayer was taxable on otherwise excludable fringe benefits provided to the taxpayer's domestic partner and the domestic partner's dependents. In PLR 9850011 health benefits provided to a domestic partners were excludable, because the taxpayer established that the domestic partner qualified as a dependent under Code Section 152(a)(9)(Note 152 has since been amended).  In INFO 2001-0294 the service informed a taxpayer that partners in a Vermont civil union, who are by definition of the same sex, could not file a joint return because of DOMA.  It is interesting to speculate as to what the answer to that question will be if DOMA is unconstitutional.

Does the Gill decision require any immediate action?

  I have this mythical couple called Robin and Terry who's function in life is to help me avoid awkward pronoun problems.  You may have met them in my post on a potential windfall for California domestic partners or one on the tax advantages of not being married.   For the moment Robin and Terry are of the same gender, at least for now, and were married in Massachusetts in 2006.  They have filed joint Massachusetts returns since then and file federal returns as being single.  They decided not to try to exploit one of the Achilles heels of DOMA (Defense of Marriage Act), which is that the IRS doesn't ask you what your gender is.  Somehow I doubt that they have someone in the service center culling the Adam and Steves out from the Adams and Eves.  I never advise people to exploit the audit lottery, though, and it will certainly not be tolerated in my imaginary clients.


So what should Robin and Terry do ?  If their 2006 return was extended they still have time to file an amended joint return.  If their total income was $250,000 and it was all Terry's, there would be a refund of about $10,000.  If the IRS denies the refund claim they have two years to sue for a refund.  With the variety of phase-outs and thresholds that are built into the tax computations, it is really not possible to come up with a simple formula. In general the closer Robin and Terry are to having equal income, the less likely they are to benefit by joint filing. It is probably worth running the numbers regardless though just to be sure.  Robin might have a capital loss carryover and Terry a capital gain, for example. It is even possible that joint status can cost money, in which case Robin and Terry can thank DOMA for a small blessing.  There is no point in doing anything for years after 2006, since more will be known by the time the next deadline comes up (in April of 2011 for unextended 2007 returns).  If Justice throws in the towel the IRS may issue a revenue procedure giving specific instructions on how to claim refunds.  The probabilities on that are beyond my feeble prognosticating skills.

As I have mentioned elsewhere the decision to file a joint return is not a simple numbers exercise.  By joining in a joint return with Terry, Robin is assuming joint and several liability for any deficiency.  If Terry omitted a very large amount of income, it would not be prudent for Robin to go joint even at this late date, since a six year statute might apply.

I'll be following the ramifications of this case as they evolve in the next few months, so stay tuned.

LLC or S Corporation - Six of One A Dozen of the Other

PLR 20107019

I've known some people who mangle common expressions without realizing it.  "He wants everything handed to him on a silver spoon."  "She'll just have to fish or get off the pot." I don't think I do it myself very often.  If I mangle a common expression, its on purpose.  So I am well aware that the expression is "Six of one - half a dozen of the other".  I owe the modification to a friend of mine, who I will gladly credit, if he should claim priority. (I checked with my friend Alan Jacobs.  He doesn't remember coining the phrase, but he grants it was characteristic.)  He thought "Six of one - half a dozen of the other" was a stupid expression like the oxymoronic "same difference".  By using the even stupider "Six of one - a dozen of the other", he made you pay attention. 

In general, a corporation is a tax paying entity.  Individuals who realize income from corporations either as dividends or from gains on selling interests in corporations are taxed on that income.  Profit from an activity can thus be taxed twice before it goes to the ultimate beneficiary of the profit.  Used to be if you didn't like that you could just do business as an individual and have unlimited liability or in a partnership where at least one person had unlimited liability.  That was a long time ago, though.

Skipping over much history there are two ways in which you can have an entity that provides a liability shield without being subject to double taxation, as some loosely term it.  One is to for a corporation make an S election, which requires the consent of all the shareholders.  The other is to form a Limited Liability Company (LLC).  You can elect to have your LLC treated as a corporation, but absent that election the LLC will be treated as a partnership, if it has more than one owner, or it will be disregarded, for income tax purposes, if it has a single owner.

There, are, however, many difference between the taxation of S Corporations and LLC's, which are treated as partnerships. Generally speaking the partnership form is much more flexible than that of the S Corporation.  There is a perception that partnerships are much more complicated than S Corporations.  This is mainly due to people taking advantage of the flexibility of the partnership form to do more complicated things. An example of a significant difference is that partners (read LLC members) have basis in their share of the partnership's liabilities, where as S Corporation shareholders do not even if they have personally guaranteed them.  So if you had a shopping mall owned by an S corporation that refinanced and used the proceeds to make a distribution, the shareholders might have to recognize gain on the distribution.  It is unlikely that LLC members would.  These differences will be a persistent theme in this blog as various developments illustrate them.

PLR 20107019 was issued on April 30, 2010 making it still reasonably fresh.  It concerns one of the things that make S Corporations appear simpler than entities treated as partnerships.  That is the single class of stock rule.  An S Corporation can have more than one class of stock.  There might be for, example, be voting and non-voting stock.  The stock must, however, have identical rights with respect to current and liquidating distributions.  Entities taxed as partnership can split the pie up any way that they want.  The complexity comes in from the regulations that require that allocations of taxable income reasonably relate to the economic deal.  The single class of stock rule makes S corporations a bad choice for deals in which money investors are to get their original investment and a preferred return.

The thing that is scary about S Corporations is that if you screw up badly enough you no longer have a flow through entity.  Screw up a non-corporate entity and you are talking more about moving the income or losses around among the different parties, not creating a whole new layer of taxation.  The PLR comes out of that type of concern.  I had originally considered titling the article "Possible Triumph of Common Sense".

The shareholders of S corporations and partners in partnerships (which includes most LLC members) are taxed on the entity's income regardless of whether it is distributed.  Other than in very closely held situations, this creates a business problem. A non-controlling owner has to be concerned that they won't have the cash to pay the taxes that the entity creates for them.  This is typically dealt with by having an agreement by the entity to make tax distributions.  Generally the distribution is some sort of formula.  Certainly in the case of an S corporation it could not be the exact amount of each shareholders federal and state tax, since this amount is unlikely to work out exactly on  a per share basis.  For example, if you distributed more to a shareholder who happened to live in California, you would probably be violating the single class of stock rule.

PLR 20107019 has a unique wrinkle though.  Its tax distribution plan is based on making distributions in proportion to ownership at the time that the taxable income is generated rather than based on ownership when the distribution is declared.
If X's taxable income is increased or its creditable foreign taxes are decreased after X's original return for a particular taxable year is filed, the Stockholder's Agreement allows X to make a distribution to its shareholders, in accordance with their respective interests in X's taxable income or loss for that period, with respect to the deficiency resulting from such increase or decrease within a reasonable time after the amount of the increase or decrease becomes final (the Discretionary Payment Provision). The Discretionary Payment Provision is intended to allow X to assist its shareholders in paying their additional tax liability resulting from adjustments to X's originally filed tax returns.


So imagine that in 2009 X had shown no taxable income and then you sold your stock in early 2010.  Sometime in 2012 X settles an audit and you get a corrected K-1 for $20,000.  X will then declare a special distribution some of which will go to you even though you have not been a shareholder for over two years.

The IRS ruled that this special plan did not violate the single class of stock rule.  Advisers to substantial S Corporations may want to take a look at this ruling as might owners of minority interests in S Corporations.

You've Got Your Aliens and Then There's Your Real Aliens

I made an offer in Facebook that I would write on a subject chosen by whoever would first comment on one of my blog posts.  I hadn't expected that the winner would be someone who is almost as much of a tax nerd as I am.  He asked me to comment on NSAR 1698, which was issued in 1992.  It's one of those things that Research Institute uses the Freedom of Information Act to pry from the IRS so we have something to read after we have read all the rulings and procedures and decisions that are meant to be public.  I haven't looked up what the acronym stands for (Nothing Sacred After Reagan ?Maybe).  It doesn't really matter.  It is a letter denying an organization exempt status.

My friend maintains that it should stand for the proposition that the IRS should be able to tell some people that they just can't have exempt status and really shouldn't have to give them a detailed explanation.  Personally I disagree.  Somebody who goes to the trouble of applying for exempt status is entitled to a good explanation.  Furthermore, any policy which has the effect of placing really humourous material just waiting to be discovered is a good policy.  If you think there is no humor in this area see my post on Free Fertility Inc.

So what was NSAR 1698 (whatever it might stand for) all about ?  It seems that there is an advanced race known as the Pleiadians who are speaking to us through a particular person. She had started a business to disseminate their teachings and the proposed NFP was to carry the teachings further along.  It is some pretty interesting stuff :

“The Pleiadians of are a collective of extraterrestrials from the star system the Pleiades. The Pleiadian culture is ancient and was 'seeded' from another universe of love long before Earth was created. They have formed a tremendous society which operates with love, with ideas and ideals that we are yet unfamiliar with. The Pleiadians call themselves our ancient family because many of us come here from the Pleiades to participate in the new experiment of Earth. The Pleiadians are now here as ambassadors from another universe to help Earth through her difficult transition from the third dimension to the fourth dimension and to assert each of us in our personal endeavors of awakening, remembering and knowing”.

Apparently though, the Pleidans are only speaking to one person.  The IRS ruled that passing along the revelations could not be considered to constitute education within the meaning of 501(c)((3).  They were also concerned that there was no change in control.

I actually found the IRS answer somewhat unsatisfying.  It is also a bit of a disappointment that the ruling wasn't appealed.  The Tax Court can be quite eloquent in addressing these type of things.  At least I thought they were in Free Fertility.  You'll be glad to know that failure to gain exempt status has not silenced the Pleiadians.   You can read all about them at http://pleiadians.net/     (Notice its .net not .org).

It is interesting to note that the Pleidians have a specific instruction to not turn their teachings into a religion or worship the people who are channelling them.  I don't know if they thought through how this might affect their channeller's chances of gaining exempt status.

I'm going to further extend my offer to write on anything that is requested by someone who comments on the blog.  This one was fun anyway.

Divorcing Spouses Should be Careful About Joint Returns

Laura Brady (TC Summary Opinion 2010-107)
Sometimes when I advise taxpayers, I have to preface my advice with a warning that it is a minority opinion.  One of those minority opinions is on the subject of filing joint returns in the final year of a marriage.  Generally it is viewed as a simple numbers exercise.  Figure out what the individual returns would be.  Figure out what the joint return would be. If the joint return produces a saving spend about half of it having the attorneys argue about how to split the saving.  That makes four winners, maybe five if the returns are really complicated and the accountant can get paid too.  If you have read enough "innocent spouse" cases in which the purportedly innocent spouse loses, you have to ask a preliminary question - " Do you have any reason to think that your soon to be ex might be less than thorough in reporting gross income ?"

When you file a joint return you are signing it under "pains and penalties of perjury" and asserting that "to the best of your knowledge" the information is true and complete.  There are two other things about a joint return.  One is that it is an irrevocable election.  In other words, you can't decide that it would have been a better idea to file separately and amend.  (You can, however, amend from a separate return to a joint return).  The other is that you are jointly and severally liable for the entire tax.  So they can collect the whole thing from either one of you.  My experience advising in this area, however, is that most advisers don't even consider this issue.  I know of one instance where someone was ordered by a probate judge to sign a joint return that he had reason to believe was less than accurate.  Hopefully, he would qualify as a truly innocent spouse, but I'm not certain.

Th sad case of Laura Brady (TC Summary Opinion 2010-107) has inspired me to add a little addendum to my advice about being cautious in signing a joint return.  Ms. Brady's marriage to Gregory Harris was her third.  The tax court noted that in this case, the third time did not prove to be a charm.  They met in early 2002, were married in March of 2003, separated in early 2004 and were divorced in July of 2004.  All told they lived together for less than a year. 

At some point before October of 2004 Ms Brady gave Mr. Harris her social security number and that of her child from one of her previous marriages.  On October 18, 2004 the IRS received a tax return signed, apparently, by Mr. Harris and Ms. Brady.  The tax was not fully paid.  Ms. Brady first learned about this return when the IRS withheld her $28 refund from her 2004 return to apply to her 2003 liability.  "What 2003 liability ?" she may have exclaimed.  She did not work and had no other income during 2003 and was not required to file a return.

Here is where things start getting complicated.  The Court noted :

According to petitioner, the 2003 return Mr. Harris prepared should not be treated as her return because she neither signed it nor consented to its being signed on her behalf. Respondent now agrees that petitioner did not sign the return. Nevertheless, according to respondent, Mr. Harris prepared the 2003 return with the implicit consent of petitioner, and it would not be inequitable to hold her liable for the income tax liability arising from that return. See secs. 6013(a), 6015(f).


We recognize that if both spouses intend and consent to file a joint Federal income tax return for any given year, then the failure of one spouse to sign the return for that year will not necessarily preclude its treatment as a joint return.

In order to treat the return as a joint return, there must evidence that the non-signing spouse consented.  The consent can be inferred from behavior.  There are eight factors to consider:

(1) Whether the returns were prepared pursuant to an established practice of preparing and filing joint returns;
(2) whether the nonsigning spouse failed to object to the filing of a joint return;
(3) whether an affirmative act was taken indicating an intention to file other than jointly;
(4) whether one spouse entirely relied on the other spouse to file returns;
(5) whether the spouse examined returns presented for a signature;
(6) whether separate returns were filed;
(7) whether the returns included the income and deductions of the nonsigning spouse; 
(8) whether the nonsigning spouse was aware of the contents of the purported joint returns.

IRS argued that providing the social security numbers was evidence that she had consented to a joint return.  The court noted that her former husband would have needed the numbers if he were claiming her and her child as dependents.

So the tax court determined that she had not consented to the joint return.  Therefore she doesn't owe anything on 2003 and the IRS should cough up her $28 right ?  Not so fast.  She had asked the tax court for innocent spouse relief and :

We find that the 2003 return Mr. Harris prepared that gave rise to the 2003 income tax liability from which petitioner seeks relief is neither a joint return as contemplated by section 6013(a) nor petitioner's return. Accordingly, because petitioner did not file a joint return with Mr. Harris for 2003, relief from her outstanding 2003 Federal income tax liability, if otherwise available, is not available in this proceeding.


Hopefully, the mess will be straightened out administratively.

The lesson that I take away from this is that a divorcing spouse who does not intend to sign a joint return, should file a separate return even if he or she is not otherwise required to file.  That should send a pretty clear message to the IRS as to their intent.

One further note.  Another reason not to file a joint return is that you or your soon to be ex, though he or she might be honest as the day as long, may have a high audit potential.  One of you might, for example, be involved in a lot of flow through entities or family businesses.  If you are the one being audited, you probably don't want your ex-spouse involved in the audit and you probably wouldn't want to get sucked into an audit triggered by your ex-spouse's activities.  Granted this is an amorphous concern which would be weighed against real dollar savings from filing a joint return.  Remember, though, filing jointly is irrevocable, while filing separately is not.  You could consider amending to a  joint return when the statute is close to having run out on separate returns.  Like a few of my clever ideas, I have not seen this one played out in practice, so I offer it with caution.

Credit Card Rebates May Yield Charitable Deductions

If you have been lying awake nights worried about whether you have to report your credit card rebates as gross income, relief has finally arrived. Unfortunately, if you really were lying awake worrying about the credit card rebates, you actually have some other sort of problem and will commence worrying about something else.  Maybe you will manage to slip in one good nights sleep, though,  now that I am telling you all about PLR 201027015.

The ruling has two holdings and also a little bonus if you are the treasurer of a struggling not-for-profit.  The ruling must have been requested by a credit card company on behalf of its customers.  And you probably thought all along they weren't really doing anything to earn that usurious interest and those maddening fees.  Don't you feel mean sprited now.  Well, neither do I, but they took the trouble to invest a couple of seconds worth of their interest income in getting this ruling, so we should all pay attention.

Someone who gets this particular credit card can choose to either receive a cash rebate or have the rebate donated to charity.  The first part of the ruling is that, regardless of which choice you make, you do not have gross income,  The rebate is deemed to be a purchase price adjustment.  Presumably if you charged something deductible, you should be getting a smaller deduction, but they don't get into it.  It is interesting (to me anyway) to note that if receiving the rebate were gross income, then diverting it to charity would not necessarily avoid the gross income.  

The next part, which is intuitively obvious only if you think in double entry, is that you are entitled to a charitable deduction if you let the rebate go to charity.  Imagine you put a $2,000 big screen TV on your credit card.  The $20 rebate instead of going to you went to Free Fertility Inc (before its exempt status was pulled See my post of July 15),  What if instead of that process you had found a big screen TV that cost $2,000, but realized that if you spent all that money on the TV, you wouldn't be able to fulfill your desire to be charitable to would be mothers.  So you hunted high and low until you found one that you could get for $1,980 and managed to mail the check before their exempt status was revoked.  Well then you would have a $20 charitable deduction.  So the credit card company saved you a lot of trouble,  The least you can do is take a few years to pay off that TV so they can collect a few thousand dollars in interest from you.

The other neat thing in the ruling is a recommended acknowledgement to be sent by the charitable organization :

Dear Contributor:


This letter is to acknowledge your contribution made to the __________, an organization described in section 501(c)(3) of the Internal Revenue Code and qualified to receive contributions deductible for federal income tax purposes, provided the contribution is made exclusively for charitable purposes.




We appreciate your contribution of $_______ made in calendar year ____ and wish to confirm for you that no goods or services were provided to you in consideration, in whole or in part, for your contribution.


Sincerely, __________________


I will sometimes see organizations sending out acknowledgements that do not meet the substantiation guidelines of the regulations.  They are not being nice to their donors when they do that and they are indicating, at least to me, that there is at least one area where they are not on the ball.  So now you have a handy template that is IRS approved.  And you can thank a nameless credit card company.

Aggressive Life Insurance Plan Fails - Or Maybe Not

One of my favorite plays is Guys and Dolls.  My daughter and I occasionally attempt to sing Sit Down You're Rocking the Boat.  You should be glad this is a text blog and not You-tube.  Trust me.  At any rate, at an early point in the play, somebody proposes a bet to Sky Masterson.  He then tells a story about his father explaining to him that someday someone would come up to him with a fresh pack of cards, with an unbroken seal and offer to bet that the jack of spades would jump out of the pack and squirt cider in his ear.  Sky's father tells him to not take the bet, because he can be certain that if he does there will be cider in his ear. 

I can picture my son someday reflecting on the various pieces of wisdom he may have garnered from me.  If he were to craft a parable like the jack of spades story, it might well involve someone saving vast amounts of income tax by purchasing a life insurance policy.  Of course the poor kid has had to listen to his sister and I attempting Sit Down You're Rocking the Boat, so he may be more focused on old people not attempting to sing.

Life insurance actually is a very tax efficient vehicle.  The build-up in value, if there is any, is tax deferred and proceeds paid by reason of death are free of income tax.  The claim that it saves estate taxes is somewhat fallacious.  The key there is to have the policy owned by an entity that is not includable in the taxable estate.  Any appreciating asset that goes into an entity not included in the estate will achieve the same result.  What is particularly good about the life insurance is that it provides liquidity just when it is needed.  Or when your heirs need it to be a little more glum.

Despite all its merits, life insurance is a product that is sold more often than it is bought.  And when you are trying to sell something, particularly something financial, there is nothing like a tax gimmick to help the sale along.  So when presented with a complex plan involving life insurance, bear in mind the fate of Karl and Deborah Mathies who were featured in 134 TC 6 this February. 

The  plan that the Mathies's bought into was called PAT - for Pension Asset Transfer.  How did the Mathies learn about the plan ? Well it was like this :


 1998 petitioners employed an attorney of their long acquaintance, Philip Spalding, Sr., to help plan their estate. Philip Spalding, Sr., introduced petitioner to his son, Philip Spalding, Jr., who was an insurance agent. The Spaldings proposed, among other things, that petitioner use some of his IRA funds to buy life insurance through a profit-sharing plan pursuant to a so-called Pension Asset Transfer (PAT) plan marketed by GSL Advisory Service (GSL) and Hartford Life Insurance Co. (Hartford Life).
 
The plan called for a roll over of IRA funds into a profit-sharing plan of their S corporation.  Then the S corporation makes a very large premium payment on a life insurance policy.  Next the taxpayer buys the policy and transfers it to an irrevocable life insurance trust. The irrevocable life insurance trust then trades it for a fully paid up policy. So what's the trick ?  The trick is that the policy has a very large surrender charge. (I'm shifting to round numbers here.) The pension plan paid 2,500,000 for an  $80,000,000 "interest sensitive" second-to-die policy.  At the time of the transfer, the policy had a cash value of 1,300,000, but a surrender charge of $1,000,000.  The theory was that if the pension plan were to ask the insurance company for a check, the plan would get a check for 300,000, so why should it expect to get anything more from a plan beneficiary. 

When the irrevocable trust received the policy, it was able to convince the company to waive the surrender charge by exchanging the policy for a fully paid up second-to-die policy for almost 20,000,000.  The IRS contended that the policy was really worth 1,300,000 and tagged Mr. and Mrs. Mathies with 1,000,000 of additional income.  The tax court agreed with the IRS.  So the Mathies have too come up with an additional $300,000 in taxes plus about 9 years worth of interest.  They were residents of California at the time, so there is probably close to another $100,000 on the tab.

I am putting this forth as a cautionary tale, because this could be an incredible disaster for the Mathies if they don't have the odd half million or so to pay the tax bill that they hadn't planned on when they first went into the plan.  Presumably the asset in the irrevocable trust isn't available for that purpose.  We also don't know if there was any gift tax assessment or if that just slid by.  Assuming for the sake of argument, that there was no gift tax problem and then they had put some money aside for the income tax contingency, the plan doesn't seem to have done that badly.  They had 2.5 million in an IRA and the assumed side fund that I just made up.  They don't have either of those now, but when they die their heirs get almost 20 million free of income and estate taxes.  At least one of them has to live a really long time for that to not be a fairly decent deal.

It is worth noting that in 2008, the IRS got an injunction against promoters of the PAT plan (US v Lichtig 102 AFTR 2d 2008-7064).  The tax court did not sustain an accuracy related penalty against the Mathies, but such will likely not be the fate of people who in the future attempt variants of this particular scheme.

Does Tax Court Ruling on Gender Reassigment Go Far Enough ?

Rhiannon G. O'Donnabhain (134 TC 4)


There has not been much on the deductibility of gender reassignment.  In 1983 PLR 8321042 allowed the travel expenses of a parent who accompanied an adult child who was having gender reassignment surgery.  The surgery was performed in a clinic and it was necessary to have someone stay with the patient while they stayed in a motel.  Then in 2006, we have CCA 200603025 which denied a deduction for the surgery itself.  What had happened in the meantime was an amendment to the Code that denied medical deductions for "cosmetic surgery"

Although the subject of the CCA is anonymous, the facts seem to be the same as that in the case of Rhiannon G. O'Donnabhain (134 TC 4) which was decided in February.  I have to admire Ms. O'Donnabhain for taking the case to the next level.  The amount of money ($5,679) was not enormous compared to the hassle and sacrifice of privacy entailed.  Who else has to have their pre-augmentation cup size published to the world ? (You'll have to read the case if you want to know.  I'm not telling.)  I think this was clearly one of those situations where somebody was thinking about principle not principal.

The taxpayer was mostly victorious being allowed deductions for hormone therapy, counselling and reassignment surgery.  No deduction was allowed for breast augmentation, the hormones having apparently done enough in that regard (at least in the mind of the tax court).

This case received more media attention than most of the more obscure things that you can only read about in this blog, if you don't want to go slogging through the primary source material yourself, but I think there may have been a planning point missed in the discussions.  The case summarized the deductions in question as follows :


During 2001 petitioner incurred and paid the following expenses (totaling $21,741) in connection with her hormone therapy, sex reassignment surgery, and breast augmentation surgery: (1) $19,195 to Dr. Meltzer for surgical procedures, including $14,495 for vaginoplasty and other procedures, $4,500 for breast augmentation, and $200 towards a portion of petitioner's postsurgical stay at Dr. Meltzer's facility; (2) $60 for medical equipment; (3) $1,544 in travel and lodging costs away from home for presurgical consultation and surgery; (4) $300 to Ms. Ellaborn for therapy; (5) $260 for the consultation for a second referral letter for surgery; and (6) $382 for hormone therapy. These payments were not compensated for by insurance or otherwise.

The case featured dueling experts on the validity of the Benjamin standards of care, which defines a process that should be followed in the treatment of Gender Identity Disorder.  Basically you do a lot of therapy and have to publicly live as a member of the other gender for 12 months prior to having reassignment surgery,  The IRS experts didn't put up a very good fight as the Court noted :


Even if one accepts respondent's expert Dr. Schmidt's assertion that the validity of the GID diagnosis is subject to some debate in the psychiatric profession, the widespread recognition of the condition in medical literature persuades the Court that acceptance of the GID diagnosis is the prevailing view. Dr. Schmidt's own professed misgivings about the diagnosis are not persuasive, given that he continues to employ the diagnosis in practice, believes that psychiatrists must be familiar with it, and recently gave a GID diagnosis as an expert in another court proceeding. On balance, the evidence amply demonstrates that GID is a widely recognized and accepted diagnosis in the field of psychiatry.

The question I would raise is whether there should not in fact have been even more deductions.  If the 12 months of presenting as a member of the opposite gender is part of the treatment, then it would seem that the expenses associated with that should also be deductible.  This could include voice coaching, training in walking or how to do make-up.  It would be aggressive to argue that the initial work wardrobe might be viewed as part of the treatment cost.  A variant of this might be the cost of abandoning the existing work wardrobe after the change becomes permanent.

The existing case law on work clothing would make me generally pessimistic on succeeding on the clothing, but something like voice coaching is clearly part of the whole treatment process. The legal cost of a name change should also be included. It may be that the 12 month process is not as challenging and expensive as I imagine it might be, since it is being done by someone who has been working up to it for a life-time.  When I read the Benjamin standard description of the real life experience, though :

The act of fully adopting a new or evolving gender role or gender presentation in everyday life is known as the real-life experience. The real-life experience is essential to the transition to the gender role that is congruent with the patient’s gender identity. Since changing one's gender presentation has immediate profound personal and social consequences, the decision to do so should be preceded by an awareness of what the familial, vocational, interpersonal, educational, economic, and legal consequences are likely to be. Professionals have a responsibility to discuss these predictable consequences with their patients. Change of gender role and presentation can be a factor in employment discrimination, divorce, marital problems, and the restriction or loss of visitation rights with children. These represent external reality issues that must be confronted for success in the new gender presentation. These consequences may be quite different from what the patient imagined prior to undertaking the real-life experiences. However, not all changes are negative.

it sounds like the process includes spending some money and if it is integral to the process, it is part of the GID treatment and should be deductible. 

You Have to be Able to Keep Your Face Straight

Willie J. Moore, et ux. v. Commissioner, TC Summary Opinion 2010-102 is a good illustration of the principle that Summary opinions make up in entertainment value  what they lack in precedent.  The issue was car and truck expense totalling just over $36,000 supported by logs recording approximately 94,000 business miles driven in three cars.  Mr. Moore was an employee of the City of Houston, but also worked as a mortgage broker and a real estate agent.  From the case:

At trial, petitioners introduced two Excel spreadsheets that petitioner described as mileage logs for the Mercedes-Benz and the Cadillac. The mileage log for each vehicle consists of a 12- page spreadsheet with one page for each month of the year and an entry for each day of the month. Each daily entry includes the beginning and ending odometer readings, the total “deductible business miles driven” and the total “nondeductible commuting miles driven”, and the destination and “business reason” for the “business miles driven”. For all entries, the beginning odometer reading matches the ending odometer reading for the previous entry.

On petitioner's mileage log the entry for “business miles driven” typically exceeds 100 miles per day and occasionally is over 200 miles per day. For every Monday through Friday throughout the year petitioner listed 60 commuting miles; these miles were included on the log even for those days that petitioner admitted were holidays for his City of Houston position. ...... The daily entry for Thanksgiving Day 2004 indicates that petitioner commuted to his City of Houston job and also drove 119 miles to “preview bank foreclosure” at some undisclosed location; the daily entry for Christmas Day 2004 indicates that petitioner drove 150 miles to Hempstead, Texas, to “preview property for investment”. Daily entries were not made on January 31, February 29, July 31, and October 30 and 31.
On Mrs. Moore's mileage log the entry for “business miles driven” also typically exceeds 100 miles per day and is as much as 345 miles for a single day. Every day, Sunday through

Other than the commuting miles, petitioner's log includes no personal miles whatsoever. Saturday, includes an entry of 15 commuting miles.  ... The daily entry for Thanksgiving Day 2004 indicates that Mrs. Moore commuted 15 miles and drove 95 business miles from La Marque to Galveston to “place ad in newspaper/visit client”.
Petitioners contend that these vehicles were used solely for business and not for any personal purpose (other than commuting) such as going to church or to the grocery store. According to petitioner, “anytime you're moving, you're actually in business”. So, for example, “when you drive to the grocery store, you will transact business.” In this regard, when asked by the Court what part of the grocery store was most conducive to conducting his business, petitioner replied as follows:

MR. MOORE: I would say the meat section, where they have the chips and all that good stuff. That's where people stop, and the fruit section; that's where I, you know—and if you're an agent and people know you're an agent, they will stop you and you will—you know, just have a conversation with them. If they're in the store and you pass a [business] card out.

THE COURT: I mean, do you wear a sign that says, I'm an agent, and stop them-- MR. MOORE: No. This is only the people that know you, not strangers. You know, this would be individuals who live in the same community you live in and may have wanted to talk to you but haven't seen you. When they get to chance to see you—it might be a church member, you know, a deacon at the church *** . We find petitioner's theorem regarding the transmutation of nondeductible personal expenses into deductible business expenses through kinesis to be so fundamentally flawed that we reject it without further discussion, and we move on to a consideration of the proffered mileage logs.

The mileage logs are, of course, the bedrock of petitioners' case. Unfortunately for petitioners, we are unable to accept those logs at face value because we are not convinced that they reliably record petitioners' use of their automobiles. By way of example, we point to the following.


Petitioner's mileage log claimed commuting miles for several days that were holidays for his full-time position with the City of Houston. In addition, petitioner stated that “my commuting miles include occasional *** personal use”; however, petitioner's log shows the same 60 commuting miles for each entry Monday through Friday.

Petitioner also stated that some personal miles were included in business miles because, as previously quoted, “any time you are moving, you're actually in business”. Although petitioner stated that he worked every day of the year, the log for his vehicle is missing entries for several days; nevertheless, the ending odometer reading from the last entry before the skipped day or days is the same as the beginning odometer reading of the next entry. Petitioner argued that the log is not “incorrect”, but he did admit that there are some days on which “there might have been an error on the log.”


Mrs. Moore's mileage log lists 15 commuting miles for each day except for the 5 days for which there is no entry. However, the mileage from League City, where petitioners' home is located, to La Marque is approximately 13 miles. Thus, round trip travel or commuting miles from petitioners' home to the La Marque office is approximately 26 miles. Therefore, every entry for commuting miles on Mrs. Moore's mileage log is understated by approximately 11 miles.


Finally, petitioners were unable to produce third-party records of their vehicles' odometer readings, such as service records, for 2004 or any other year, or any other evidence which might support the claimed mileage.

There didn't seem to be any doubt that Mr. Moore actually had the two businesses and used his cars so you would think that the court would have allowed him something.  Maybe you think Mr. Moore was being a smart negotiator by starting high. I could really delude myself and say you might be thinking about my post of December 30 which explains the Cohan rule. Unfortunately, automobile expenses are covered under Code Section 274, which takes them out of the Cohan rule.  Which means if you don't have good records, you get nothing, which is what Mr. Moore got.

Guess me Out of the Ballpark

The case of Marcel Ajah (TC Summary Opinion 2010-90) is about the ultimate oxymoron - "passive activities".  The concept of passive activities embodied in Section 469 is a creature of the Tax Reform Act of 1986's attempt to drive a stake through the heart of the tax shelter vampires after the silver bullet of the at-risk rules under 465 had failed to eliminate them.  Oddly enough while the at-risk rules specifically excluded real estate, the passive activity rules specifically target it, by indicating that rental activities are per se passive.  This was a source of real aggravation to people who actively manage their own real estate.  In the 1990's there was a relaxation for people who spent most of their time in trades or businesses related to real estate.

In order to take advantage of the relief many taxpayers needed to make a special election to treat all their rental real estate activities as one activity.  Otherwise, the exception to the "per se" passive rule would do them no good unless they were "materially participating" in each of their properties.  Since the basic standard of material participation is 500 hours per year (there is a separate 750 hour requirement to be recognized as being in a real estate trade or business), even very hard working people can't materially participate in more than a couple.  There are wonderful regulations that explain to you how to go about grouping your activities to keep track of whether you are meeting the material participation standard.

Marcel Ajah illustrates the Achilles heel of the whole system, though.  Most people don't keep very good track of how they spend their time.  The regulations do not specify a particular method, but the cases beginning with William Goshorn in 1993 (TCM 1993-578) seem to characterize any method that taxpayers use to reconstruct their time as being a "post-event ballpark guesstimate".  "Ballpark guesstimate" which seems to me to be a fairly robust concept is apparently limited to estimates of time spent to satisfy material participation requirements. 

Marcel Ajah and his wife owned two rental properties, the commercial building out of which he operated his medical practice in Jamaica, NY and a single family residence in Baltimore MD.  They claimed that Mrs. Ajah qualified as a real estate professional.  They lost the case on two grounds.

Mrs. Ajah argues that she qualifies as a real estate professional for the year in issue. She relies upon certificates from the Long Island Board of Realtors, Inc., the Multiple Listing Service of Long Island, Inc., and the State of New York Department of State Division of Licensing Services. These certificates reflect, respectively, that for 2005 she pledged to adhere to the realtor code of ethics, had completed required courses on broker rules and regulations, and was licensed as a real estate broker. Mrs. Ajah testified that she worked at least 20 hours a week for the 52 weeks of 2005 on the two rental properties. Mrs. Ajah did not offer any evidence as to the number of hours she worked as an attorney in 2005. No contemporaneous record, calendar, appointment book, or any other method of recording time spent between rental real estate activities and activities as an attorney was provided. Thus, the Court is unable to conclude that more than one-half of Mrs. Ajah's personal services were devoted to the rental properties.


We conclude that Mrs. Ajah's method of calculating her time spent participating in the rental activities constitutes an impermissible “ballpark guesstimate”.

The other problem was that the Ajahs had not filed the election to aggregate meaning that she would have to meet the 750 hour requirement on each of the properties which wasn't even in her ballpark.

Earlier in the year Donald Trask (TCM 2010-78) who owned 33 rental properties managed to convince the tax court that he spent more than 750 hours working on them, but he was hung by the failure to make the election to aggregate.  The fact that he had aggregated the properties in reporting his income and loss was not sufficient.

It is not always advantageous for the real estate professionals to make the election, but it is definitely something that should be looked at.  There is no question that if you are posting negative numbers from real estate or side businesses on your returns you should be doing something to keep a current record of your time.  My own experience working with appeals on this issue is that the Service will characterize almost any reconstruction of time spent as being a "ballpark guesstimate".  And they aren't handing out any peanuts or cracker jacks,

It Doesn't Have to Be a Good Idea

Tax court summary opinions lack value as precedent. They frequently make up for it in their entertainment value.  They also give a better glimpse of the gritty reality of audits.  They often seem to concern issues of substantiation.  Since you have already had two bites at the substantiation apple by the time you get there, the cases can sometimes sound a little silly.  Taxpayers do sometimes win though and I was particularly pleased that Trieu M. Le was successful (TC Summary Opinion 2010-94).  I always say that fairness and making sense don't have anything to do with whatever the right answer is, but that doesn't mean I'm not rooting that way.

 Trieu M. Le had lost over 200,000 playing slot machines in 2006.  He claimed that he was a professional gambler, although he did not take the net loss against other income,  The Service took the position that he was not a professional gambler.  They increased his gross income and reduced the losses as itemized deductions subject to the 2% floor.  This produced a deficiency of just under $10,000.  During 2006 Mr. Le and his wife had spent every weekend playing slot machines sleeping only a few hours.  For this dedication the Tax Court awarded them an A for effort noting that it added up to as much time as they spent on their regular jobs.

Having disposed of the issue that they were not full time gamblers, the court moved onto the Service's contention that their "business plan" was irrational :

Before petitioner's decision to become a professional gambler, petitioners had been casual gamblers but they did not wager large amounts. Sometime during 2005 petitioners began to invest heavily in gambling (mainly playing slot machines). Petitioners were born in Vietnam, and their religious and cultural beliefs were derived from their Vietnamese background. They believed in Feng Shui. Because of this belief and other religious and cultural beliefs, they expected that certain days were “lucky days” or days on which their chances of successful gambling increased. They were cognizant that slot machine odds favored the casinos but expected to overcome those odds by attempting to gamble on their “lucky days”. In addition, petitioners would watch other slot machine players; and if they had excessive losses, petitioners believed that taking over machines of losing players provided more opportunity. That was their plan for making a profit.

Petitioner is from a culture different from that generally extant in the United States, and he drew upon that culture to formulate his business plan. His plan was to use Feng Shui to determine which days were his or his wife's “lucky days” and have that person bet heavily on those days.  He also used a technique of watching other players; and if they left a slot machine after heavy losses, petitioner believed that the machine was due for a payoff.

 The standard, however, requires only that the profit objective be actual and honest. It would be difficult to find on the record before the Court that petitioner's approach to making a profit was irrational. For example, if someone's investment in a stock or a business were based on Feng Shui or some other cultural judgment, that would not per se be “irrational”. Petitioners used their best judgment and successfully tested their business approach. Ultimately, the fact that their approach was unsuccessful does not make it irrational.