You Don't Need a Matchmaker at the Family Reunion

I have these silly rules that I make up and then go ahead and break all the time.  One is to not use the word only in association with any sum of money greater than $4.00 (Yes there is a decimal point. Four dollars).  Another is to rule out of the discussion the concepts of "making sense" and "being fair" when discussing what the tax rules actually are.  I compound this latter rule by not paying much attention to theories about what the tax laws should be.  This comes from some hard experience I had in 1987, trying to keep straight what actually made it into the Tax Reform Act of 1986 as opposed to the "Treasury II Proposals". 

I somewhat relax the "making sense" and "being fair" proscriptions for purpose of enunciating one of my general rules of tax planning.  "Any clever idea you have has been thought of and probably ruled against."  An extension of this is that most of the thing that you think don't make sense actually do make sense.  They are there to squelch an abusive transaction dreamed up by someone even more clever than you are.  All of this is just me apologizing for saying that the Eleventh Circuit's decision in Ocmulge Fields v. Com (106 AFTR 2d 2010-5820) makes sense.

The case concerns like-kind exchanges, a topic which I discuss here and  there.  At issue is the application of the related party resale rules.  Suppose you owned two companies (Call them Highoco and Lowco)and each one owned a piece of real estate worth $1,000,000.  Further suppose that the basis of one property (High-B)was $900,000 and the other (Low-B) was $100,000.  Along comes buyer who perversely is willing to pay $1,000,000 for Low-B, but has no interest in High-B.  Wouldn't it be nice if you could move the basis in High-B over to Low-B ?  Well you can.  Highco and Lowco can do a like-kind exchange.  Highco's basis in Low-B will be $900,000, its basis in the property that it surrendered.  Clever.

Unfortunately, if Highco disposes of Low-B within two years of the exchange Lowco has to recognize gain.

There is another set of rules involving like-kind exchanges.  Since the person that has the property you want is rarely the person who wants your property many exchanges use qualified intermediaries.  The qualified intermediary receives the money from the sale of your property and uses it to purchase another property.  You have 45 days from the date of sale to identify the target property and you must receive it within 180 days of the sale (If the sale is later in the year you may have to extend your tax return in order to have the full 180 days).

Ocmulgee Fields Inc decided that they should go the qualified intermediary route. The hired Security Bank of Bibb County to serve as qualified intermediary. The bank received the proceeds for the sale of Ocmulgee's property known as Wesleyan Station to the McEachern Family Trust.  Ocmulggee then searched high and low for a replacement property.   They used up all of six days. Finally they identified a Barnes and Nobles.  It just kind of happened, sort of by coincidence, that the Barnes and Nobles was owned by a company named Treaty Fields.  Come to find out, Treaty Fields was pretty much owned by the same people as owned Ocmulgee.

Seems like since they already were acquainted with one another, they did not really need a qualified intermediary.  Just as well they used one, though, since it got them out of that nasty related party resale rule.  Well that's what they thought.  It's not what the IRS thought, though.  And the Tax Court and the Eleventh Circuit agreed with the IRS.  Treaty Fields, surprise, surprise, had higher basis in the Barnes and Nobles than Ocmulgee had in the Weslyan property.  But that's not all.  Ocmulgee was a C corp and Treaty Fields was a partnership.

I would have been awfully upset if Ocmulgee won this case.  Not because I root for the IRS.  I would have been upset at myself for not telling my own clients about such an obvious end run around the related party resale rules.  The resale rules have this nice little ending (1031(f)(4)), which disallows any exchange which is a part of a transaction or series of transactions to avoid the purposes of the resale rules. It reads:

This section shall not apply to any exchange which is part of a transaction (or series of transactions) structured to avoid the purposes of this subsection

Read by itself, it doesn't make a lot of sense.  What it says is that you can't fix a bad exchange by throwing in a couple of extra seemingly good ones.

Shoemaker's Children

WALLIS v. COMM., Cite as 106 AFTR 2d 2010-5755, 08/11/2010

Many tax professionals practice as partners in partnerships.  So you would think the tax aspects of professional partnerships would be pretty well worked out.  Think again.  When I think about thoroughly applying 704(c), for example, to an ongoing professional firm that has partners coming and going, I get a headache.  Thus, I can't really say I am shocked, shocked that a tax attorney couldn't prevail on the proper treatment of the guaranteed payments from his own partnership, but I'd still like to give you some comments on Wallis v Com. (106 AFTR 2d 2010-5755).  I'm not sure if my motivation is compassion or schadenfreude.  Since it's a tax attorney rather than a CPA it's probably schadenfreude.

Donald Wallis was a partner in the firm Holland & Knight. Under the partnership agreement he was awarded something called Schedule C units for each year of service.  When he withdrew from the partnership in 2003 he had a capital account of  $98,161.75 and $240,000 in "Schedule C" units.  In 2003 he began receiving quarterly payments of $28,180.15.  $20,000 of each payment was with respect to "Schedule C" payments and the the balance toward his capital account.  In 2005 the partnership sent him From 1099-MISC in the amount of $80,000 and deducted the payment to him in computing its taxable income. 

In preparing his 2005 return Mr. Wallis did not report the $80,0000 at all.  He subsequently abandoned the theory that the payment was non-taxable and took the position that it was in exchange for his partnership interest and should be accorded capital gains treatment.  The 11th circuit sustained the tax court in treating the payment as ordinary income and allowing an accuracy related penalty to be charged.

The argument about the penalty was the most interesting.  The court cited Section 6662 which requires you to be consistent with a partnership's treatment of transactions unless you notify the IRS that you are being inconsistent.  The notification is done by attaching Form 8082 which has the apt title of Notice of Inconsistent Treatment.  Mr. Wallis argued that since he didn't have a disagreement with his K-1, which apparently did not include the payment but rather with the 1099-MISC, the consistency requirement didn't apply.  The court was unsympathetic:


Section 6222 provides a means for a partner to inform the IRS when his own treatment of a partnership item “is (or may be) inconsistent with the treatment of the item on the partnership return.” 26 U.S.C. § 6222(b)(1). Given that Donald Wallis has 35 years of experience as a tax lawyer, the Tax Court reasonably could conclude that Wallis should have been aware there were inconsistencies between (1) his not reporting the Schedule C payments at all to the IRS and (2) the income Form 1099 he received from H&K. See Treas. Reg. 1.6664-4(b)(1).


The Wallises argue that they had no obligation to report under § 6222 because their inconsistency was with H&K's Form 1099-MISC, not with H&K's 2005 return. Nonetheless, § 6222 requires partners to report even possible inconsistencies to the IRS if they wish to treat partnership items differently on their own return from the partnership's return. And, Wallis's receipt of the Form 1099-MISC should have alerted him that the Schedule C payments would be reflected as deductions on H&K's partnership return. Rather than alerting the IRS to Wallis's (now-abandoned) theory that the payments did not represent taxable income, the Wallises made no mention of the Schedule C payments when they filed their return. Under the circumstances, the Tax Court did not clearly err in finding that the Wallises did not have reasonable cause for the underpayment or act in good faith with respect to it.


It is interesting to note that the instructions Form 8082 state "... you generally must report items consistent with the way they were reported to you on Schedule K-1."  It goes on to state, however, that you should report "any inconsistency" between your tax treatment and the way the partnership reported on "its return".  Presumably Mr. Wallis didn't see the H&K return, but apparently the 1099-MISC was supposed to be enough of a clue.

Joint Extension Payments

CCA 201035023 highlights one of the problems that arises from routinely filing joint returns and then shifting to a separate return.  The IRS received Form 4868 (Extension request) from a couple along with a payment.  The couple did not, however, file a joint return.  Therefore the payments were allocated in accordance with regulation 1.6654-2(e)(5). Please be patient here.  Readers of this blog number in the scores and not all of them have memorized the regulations - yet.  The payment was therefore apportioned based on the taxpayers gross tax liability.  When husband got wind of this he requested that the portion applied to wife be allocated to him since he was the source of the funds for the payment.  He cited the MacPhail case (96 AFTR 2d 2005-6066). 

The IRS noted that the MacPhail case concerned a refund not the application of an estimated payment.  (In MacPhail all payments on a return were made by wife's family partnership.  The business that the husband and wife ran together produced only losses.)  So they are sticking with the application of the extension payment. 

It's not unusual for the need to  make estimated or extension payments to be generated more by one member of the couple than the other.  I have a mythical couple called Robin and Terry who's function is to help me with awkward pronoun problems.  For purposes of this discussion Robin is a partner in a law firm and Terry is an employee of a high tech company.  Robin gets a monthly draw of 6% of total guaranteed pay and quarterly draw payments of 7%.  The latter are used to make estimated tax payments.  Terry of course has withholding.  If things ever get rocky for this couple Robin could be in a tricky position.  Terry's withholding is Terry's, but absent an agreement Terry would be entitled to a share of Robin's estimated tax payments. 

It's not unusual for family businesses or trusts to make estimated tax payments for beneficiaries or family owners.  Controllers or trustees charged with that responsibility would be prudent to make those payments as individual, not joint, estimated tax payments.  Whoever was making the payments on behalf of Sarah Crane (Angus MacPhail's ex-spouse) probably wishes they had followed that course.

Short Note on Purging Earnings and Profits

I recently wrote on a strategy for old C corporations with appreciated properties.  The idea is to make an S election and wait out the built-in gains period.  Among the provisions of the Jobs Act which just passed the House and is now awaiting signature is a shortening of the period to five years.  This is a lot less than 10, but it is still greater than 3.  So a corporation that cannot rely on having active income will still want to purge its earnings and profits before the favorable rate on dividends goes away.  The shortening of the recognition period makes this strategy much more viable.

I need to thank Jeff for pointing out that the shortening of recognition period is not a permanent provision.  Someone electing in 2011 still faces a 10 year period.  The period was shortened to seven years for sales in 2009 and 2010.  We can't count on the shorter period sticking for someone who elects in 2011.

OOPS I Should Have Had A LLC

Randy M. Javorski, et ux. v. Commissioner, TC Summary Opinion 2010-136


I try to cultivate humility.  I have several people who assist me in this most notably my children.  And I do plenty of things to be humble about.  I mention this because I reread the Javorski case after coming up with the flippant title to the post.  I noticed that the company involved was a Canadian company, so there may have been practical cross-border issues that dictated the structure that they used. 

Nonetheless, the tale of woe in this case is a great illustration of the benefits of an LLC structure.  Randy Javorski was a manufacturer's rep for several lines of furniture and lighting.  He had long wanted to own his own furniture store.  In 2002 he formed Lucca Interiors, Inc with Stephan Eberle.  Mr. Javorski contributed $150,000 in exchange for a 49% ownership position in Lucca.  Mr. Eberle received the balance of the stock in exchange for his services.  Besides its own profit potential Mr. Javorski would also benefit from having Lucca as a customer.

Lucca was not profitable.  Mr. Javorski exhausted one line of credit and then another in making advances to allow Lucca to fund its operations.  Design Institute of America, one of the lines that Mr. Javorski represented, held him accountable for Lucca's failure to pay its bills promptly, creating more pressure for Mr. Javorski to advance funds.  In total Mr. Javorski put $382,000 into Lucca.

Lucca was unsuccessful and went into bankruptcy in 2005.  Mr. Javorski did not put in a claim, but it was conceded that he would not have received anything if he did.  The controversy in the case was the nature of Mr. Javorski's loss.  He was arguing for bad debt treatment in 2005.  The IRS said a capital loss in 2006.  The advances were not well documented as loans so the Court went with the IRS on characterization.

What would have happened if this were an LLC ?  The entity's operating losses would have been 100% allocated to Mr. Javorski (loss allocations to Mr. Eberle would not have had substantial economic effect).  It is possible that the losses would have been suspended depending on how much time Mr. Javorski spent on the enterprise and whether it would have been permissible to group it with his manufacturer's rep activity (possibly not).  Even if the losses were suspended, they would have been allowed in full since the bankruptcy would have been a total disposition.

Now we just have to hope that Mr. Javorski has some good returns in the stock market to use up that capital loss carryover.  Maybe next year.

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.

Blast From The Past

Tax court summary opinions frequently feature taxpayers bringing fairly lame arguments forward.  Like the couple who managed to log 90,000 miles, because whenever they were out and about they were in business.  We should expect higher standards from the IRS.  So it is a little disturbing to witness the IRS being lame.  On the other hand, taxpayer victories in the tax court help us continue to have faith in the system.

Dennis W. Gaffney v. Com (TC Summary Opinion 2010-128) concerns cancellation of indebtedness income.  Accountants understand cancellation of indebtedness income, because they think in double entry.  Some of them think there is a big balance sheet in the sky.  If somebody writes something off without somebody picking up income the fabric of space time will become disturbed.  They can be extremely disturbed by asymmetrical results.  Personally I put taxing debt discharge income in the same category as the GAAP going concern qualification.  It's kicking somebody when they are down.

The exact year that you recognize income is always an important issue, since your tax is an annual computation.  It is particularly significant with COI income though, since COI income is excludable to the extent that you are insolvent.  One has to wonder why anybody would be cancelling your indebtedness for you when you are not insolvent.  The Gaffney case is all about timing.

The Gaffneys had lived in Hawaii, but because of some business disputes they found that they had to abandon their residence and in 1993 they moved to Carefree, Arizona.  Apparently there is something magical in that towns name.  In 1994 the Bank of America foreclosed their Hawaii home and in 1995 obtained a deficiency judgement in the amount of $90,845.  News of these events did not make it to the Gaffneys who were at least free of those cares in Carefree.  In August of 1995 they moved to Cave Creek, Arizona where they continued to have mailed forwarded from their former Hawaii residence.  No news of the foreclosure or deficiency judgement reached them there either.  In 1998 they moved to Oregon.

In 1996 Mr. Gaffney had settled a dispute with the insurer of his business and paid off his various creditors.  He was not aware of the judgment by Bank of America and they were not involved in the settlement.  The problem may have been related to the fact that BOA attributed the loan deficiency to Thomas Gaffney, who according to BOA had the same address and social security number as Dennis Gaffney, who is apparently unacquainted with his fiscal doppelganger.  BOA finally gave up collection action in 2001.  Their last activity was the creation of an asset profile on Thomas Gaffney in April of 2003.

There must have been a BOA accounting minion troubled by perturbances in the big balance sheet in the sky.  In 2006 they issued a 1099-C to the mysterious Thomas using Dennis's social security number and 1998 address.  What the IRS brought to the tax court was the 1099-C and a letter from Bank of America saying that they had reviewed the file and that the amount of discharge was correct and had occurred in 2006.

The court was not impressed.  There was a discussion of when the discharge may have occurred.  The argument for 1994 was fairly strong, but it wasn't really necessary to make an exact determination.  The important point was that whenever the discharge occurred it was well before 2006.

Time to Purge C Corporations

Generally in this blog addresses specific developments - a tax court decision or a private letter ruling for example - issued in the last few months.  I'm celebrating entity extended due date (one of the four major holy days in the tax nerd religion) by pointing out a major planning opportunity.  It requires action before December 31 and if applicable may require significant study, so the time to start looking at it is right now. 

Are you involved in anyway with a C corporation with significant appreciated assets ?  A youngster might wonder how such a thing came to be.  Well have you ever noticed that when you see a copy of the Code it says Internal Revenue Code of 1986 ?  Did you ever wonder what it was like before that ?  Under the Internal Revenue Code of 1954 that is.  Individual rates were much much higher.  The maximum individual rate was 70% (and that was down from higher levels).  There was a special maximum rate on earned income of 50%.  The first 50,000 of corporate income was taxed at significantly lower rates.  Prior to the Tax Reform Act of 1969 it was possible to have multiple corporations with common ownership take advantage of this feature.  (That is getting before my time.)

The neat thing that you could do back then was sell the assets of the corporation in a complete liquidation without recognizing gain at the corporate level.  The proceeds were then distributed to the shareholders who had capital gains treatment.  Eliminating this feature, sometime referred to as the General Utilities doctrine, was one of the biggest changes in TRA 1986, which is really saying something.  To prevent people getting around the gain recognition by a last minute S election, the S corporation built in gain tax was created.  If in 1985 you had a C corporation the thing to do was to look at it closely and see if there was a reason to not make an S election.  Over the years I've encountered a few instances of C corps that really should have converted in 1985.  I suspect there are probably a few still kicking around. As a matter of fact, I just read about one in the case of Estate of Marie J. Jensen, et al. v. Commissioner, TC Memo 2010-182.  The decedent had owned stock in a corporation that owned real estate, a moribund summer camp.  In valuing the stock interest the estate was allowed to deduct the capital gains tax that the corporation would have to pay if the real estate were sold.  Now I wouldn't want to deprive the Jensen estate of its discount, but there is a strategy that an entity like that might consider.

The built-in gains tax (Section 1374) only applies to the appreciated value of the real estate at the time of the S election. (I know you don't think that there is any such thing as appreciated real estate anymore, but you have to remember we might be talking about something a corporation purchased in 1957.)  So any future appreciation will not be subject to double taxation.  More significantly the built-in gains tax only applies for ten years.  (Well maybe I should not have used the word "only" there.)   So imagine you have inherited Oldco, Inc, a C corporation, which owns land worth $10,000,000.  Your basis in the stock is $5,000,000.  The corporations basis in the land is $500,000. 

If you can take a long view an S election can solve the double tax problem.  You have to be able to wait out the ten years, though.  An installment sale will not do the trick.  A like-kind exchange will.  I have written here and there about the perils of like-kind exchanges, but there is no question that they can be a fantastic wealth building device.  The owners of Oldco, Inc would have to do a really bad job in selecting a target property to make them wish they had just paid the taxes.  A likely strategy would be property that is triple net leased to a credit tenant.  You always wanted to own a Walgreen's right ?  So now Oldco, Inc without incurring any tax is flowing through $800,000 of rental income to its shareholders subject to a single tax.  The built in gains tax taint has transferred from the raw land to the Walgreen's, but it will go away in 10 years and nothing prevents you doing another like kind exchange.   Everything would be great except that now you have an S corporation with excess passive income(Section 1375).  So your $800,000 is subject to double taxation.  And you are not going to be able to wait out the ten years, because if you have excess passive income for three years running your S election is revoked.  The two sections 1374 and 1375 sit their like Scylla and Charybdis waiting to devour you (I leave it to one with better classical training to decide which section is Scylla and which Charybdis).

There are at least two approaches to solve the problem.  One is to make sure that Oldco Inc has active business income at least three times as great as its passive income.  I could go on at length about this strategy.  It could work, but it has the danger of creating a tail wagging the dog type of problem.  I will note, though, that rental income which is passive for purposes of the passive activity loss rules might be considered active for purposes of the S corporation tax on excess passive income.  Conceivably you might solve the problem by swapping your triple net Walgreen's for a strip mall, but there is another solution. Section 1375 applies to S corporations that have excess passive income and accumulated earnings and profits.  If Oldco, prior to making its S election, distributes its accumulated earnings and profits it will be not be subject to the tax on excess passive income.

Why is this timely ?  Under current law dividends are taxed at 15%.  So Oldco's purging of its accumulated earnings and profits may be much less expensive if it is accomplished in 2010.  Assuming Oldco is really on the old side determining what the amount of its earnings and profits is may turn out to be a non-trivial question.  As Biker and Eustice note :

To compute a corporation's earnings and profits is often no simple task, especially if the corporation has gone through a series of reorganizations or other adjustments. It may be necessary to decide how a transaction occurring many years ago should have been treated under a long-interred statute because of its effect on accumulated earnings and profits; and, because there is no statute of limitations governing the effect of prior transactions on accumulated earnings and profits, it is advisable to retain corporate records permanently.

There may be a host of other problems to solve including, most likely, stubborn inertia.

Have Some Free Insurance - Not

Previously I have waxed, eloquently (at least by my lights). on the tax advantages of life insurance.  The build up in value is tax deferred and if it is realized by the death of the insured, it is tax free.  I also indicated that any complicated plan involving life insurance usually merits scrutiny, since frequently the actual point of the plan is make a sale.

The case of Gerlie V. Richard et ux TCM 2010-159 provides a cautionary tale.  They received some life insurnace without having to go out of pocket in the first year.  Apparently the commission on the policies ranged between 110% and 145% of the first year premium. 

Eagle Financial Group, Inc, by some sort of wild coinidence a company owned by the agent who sold the policies, issued them a check in the amount of the first year's premium.  They issued a recourse note in the amount of the premium advance to Eagle.  There were, however, never any payments made on the note.  The policies were cancelled in 2003 and Mr. Smith, the agent, was sued by Ohio National Insurance Co for "rebating".

Here is the cautionary part of the tale.  The tax court ruled that the loan was not bona fide.  Therefore, the Rickards were taxable on the rebate and owe $75,966 in income tax for 2001.  Ouch.

IRS Declines Rubbing Salt in The Wound

It's getting a little stale, so I think I should post now on Rev Proc 2010-14 (issued March 5, 2010) or forever hold this piece.  Although it is a taxpayer favorable ruling, its recipients are probably not dancing in the streets.  They are probably even more miserable than the beneficiaries of PMTA 2010-05 whom I discussed back in June.

We are talking here about like-kind exchanges.  I'll give you just a bit of context.  A common misconception is that you only have taxable income when you get money.  In reality, the most general rule is that when you exchange one thing for anything else you should recognize gain or loss by comparing the fair market value of what you received to the basis (generally what you paid) of the thing you gave up.  There are of course many exceptions.  One of the better known is the like-kind exchange.  It is well known enough that its section number 1031 has like 401(k) and 501(c)(3) become part of the language.  (You will find wikipedia entries on each of those three.  Don't go looking for 704(b) in wikipedia).  In order for an exchange to be deferred under 1031 both the relinquished and acquired property must be held for investment or used in a trade and they must be of like-kind.  Also there are several types of property that cannot be the subject of a like-kind exchange (e.g. securities, stock in trade and choses in action (whatever they are)). Whether property is of like kind can be a huge complicated question.  There is, however, a huge simplification.  All real estate in the United States is like-kind to all other real estate.  So although you might have rental car companies exchanging their fleet vehicles  and the like, much of the action and excitement in the 1031 area concerns real estate.

Out there in the real world you don't have many instances of the two farmers exchanging pasture land that are contemplated in the old 1031 regulations,  The chance that someone who wants to buy your property would have a property for sale that you want is pretty slim.  People began using middlemen to facilitate exchanges.  There was a lot of creativity in the area.  Beginning in 1984, which I guess is getting to be a while ago, the Code was amended to place limits on deferred exchanges.  Cutting through a lot of complexity you can have a third party receive the money from the sale of your property.  You have 45 days to identify a replacement property and they have to get it to you within 180 days (or by the due date of your return including extensions. (You can always get 180 days, but if the sale is later in the year you have to extend your return)). 

There are rules about who can hold the money for you.  A simple summary of the rules is that if it somebody who pops into your head, they probably can't do it.  Can't be the realtor, can't be your lawyer or your accountant, etc.  It doesn't matter.  Exchange facilitation is an industry.  You want to use a company that has done many exchanges.  Now we are finally getting to Rev Proc 2010-14.  What happens if some time during the 180 days your facilitator goes bankrupt ?

People used to worry that you would be really screwed if that happened.  Since your exchange wasn't any good you would recognize gain from the sale of the property.  Of course you wouldn't have any money from the sale to pay the tax, which is why you are really screwed.  The IRS isn't quite as malevolent as some people make them out to be, though.  Rev. Proc. 2010-14 says, in part :

The Internal Revenue Service and the Treasury Department are aware of situations in which taxpayers initiated like-kind exchanges by transferring relinquished property to a QI and were unable to complete these exchanges within the exchange period solely due to the failure of the QI to acquire and transfer replacement property to the taxpayer (a “QI default”). In many of these cases, the QI enters bankruptcy or receivership, thus preventing the taxpayer from obtaining immediate access to the proceeds of the sale of the relinquished property. The Service and the Treasury Department generally are of the view that a taxpayer who in good faith sought to complete the exchange using the QI, but who failed to do so because the QI defaulted on the exchange agreement and became subject to a bankruptcy or receivership proceeding, should not be required to recognize gain from the failed exchange until the taxable year in which the taxpayer receives a payment attributable to the relinquished property.

Whoopee.  So now you are just screwed as opposed to really screwed. 

There is really no excuse for people having gotten themselves in this situation.  It is true that some facilitators have a sort of black box business model in which the money disappears when you sell the relinquished property.  In that model, its none of your concern where the money is in the mean time as long as they deliver the target property.  That is not the only the model though.  It is also permissible for the funds to be segregated in separate bank accounts and some facilitators are affiliated with major banks.  Your transaction costs might be a little higher, but it is definitely the way to go.

Deemed Partnership

The case of Holdner v Com TCM 2010-175 is giving me pause.  When I read what William Holdner and his son Randal achieved over the years in business  I am very impressed.  Mr. Holnder seems a much sharper businessman than I am.  It makes me hesitate to criticize him as an accountant, which he also is. It's just that I think he picked an unnecessary fight.

The issue in the case was whether he and his son had a partnership.  The facts make up one of those family sagas that make some tax court cases a good substitute for novels.  The years in question were 2004-2006, but the story begins in 1968 when Mr. Holdner bought his son and daughter two cows, a bull and a horse, which were kept on a 3.36 acre property.  As the years went by the children's livestock increased and multiplied. In 1972 Mr. Holdner purchased a 17 acre property in the same town.

Apparently Future Farmers of America had found a prime recruit in son Randall.  When he graduated from high school in 1977, he showed little interest in college.  So in lieu of higher education his father offered to back him in farming.  The enterprise was called Holdner Farms and duties were divided as follows:


Randal Holdner was responsible for managing the farm, and his duties included feeding the cattle, maintaining farm equipment, and tending to sick animals. William Holdner was primarily responsible for Holdner Farms' financial affairs, and his duties included arranging cattle sales, making payments to suppliers, and obtaining financing to purchase new farm properties. William Holdner also agreed, at least initially, to contribute money to the farm, though it is unclear how much money he actually contributed or whether he expected to be repaid.

If I was going to go into farming with my son, that's exactly the deal that I would make reserving for youth the activities involving moving heavy objects from one place to another and dealing with animals significantly larger than myself.  Mr. Holdner besides being an astute businessman was also apparently an effective parent.  I would never be able to persuade my son to go for such a deal.

During the period 1977 - 2004 Holdner farms expanded by joint purchases of land which were paid for from the operations.  By 2004 they owned or leased over 1,000 acres and had as many as 2,000 head of cattle at a time.  Although, joint ownership did not include right of survivorship, there was an understanding that Randall would inherit full ownership of the farm.  There were not written agreements documenting their arrangement. (Here we must genuflect to Goldwyn's law of contracts - "A verbal contract isn't worth the paper it is written on.").

While all this was going William Holdner maintained a successful accounting practice with several partners.  So what was the problem?

Mr. Holdner did not treat Holdner farms as a partnership.  Instead he and his son separately reported income and expenses from the operations.  Apparently the IRS did not dispute the total income and total expenses.  Here is where one of my partners would be wont to remark "So no harm. No foul."  Well not exactly.  The gross income was reported 50/50, but the expenses were divided - well :

In a few instances petitioners shared expenses in the same way they shared gains; i.e., 50-50. In most instances, however, William Holdner allocated Holdner Farms' expenses between himself and his son as he saw fit. Indeed, the allocation of Holdner Farms' expenses between petitioners did not bear any apparent relationship to petitioners' respective ownership interests in, or their respective levels of involvement with, Holdner Farms. In fact, the allocation of expenses made by William Holdner had no apparent rational basis  and appeared completely arbitrary...

Actually the rational basis is pretty apparent.  William had over $250,000 per year in taxable income from his accounting practice while Randal, devoting all his time to being the farmer in the dell, had no other source of income.

I have to wonder how this case was handled at the agent and appellate level, because when it came time for the deficiency notices, the IRS, in order to avoid being whipsawed, asserted deficiencies based on taxing both William and Randall on 100% of the income and allowing them each 0% of the deductions.  For the three years the business had net income of roughly $80,000 which had admittedly been reported and the deficiency notices totalled over $1,000,000 in tax. 

The court's finding was, not surprisingly, that Holdner farms was in fact a partnership and that absent any agreement or other evidence, the expenses should be split 50/50 just as the income was.  What is ironic is that if they had been filing as a partnership, it would have been perfectly reasonable to allow Randall a guaranteed payment based on the extent of his services to the partnership.  It is also possible that special allocation of deductions to William would have been reasonable in years in which he had to provide funds to the partnership. 

There are times when it is very important that an entity not be considered a partnership.  For example, a partnership interest cannot be the subject of a like-kind exchange. If you are actually jointly running a business with somebody, though, it is difficult to argue that you don't have a partnership and, frankly, you might just as well go ahead and admit it.  There is a great deal of flexibility in how you allocate income and expense provided that your allocations reflect the economic reality of the arrangement between the partners.  Although there is one more return to file, this is somewhat offset by simplifying the returns of the partners.

It could be that when they started out the Holdners were running separate enterprises with father owning the land and son chasing the cattle.  Once they started buying land jointly and having a joint account where income was deposited and from which expenses were paid,  there was an entity and there was not really a strong argument for the entity being anything other than a partnership.

Real estate election relief

When I titled this blog Passive Activities and Other Oxymorons, it was by no means, because I intended to write only on the passive activity loss rules.  If I was going to totally devote myself to one tax topic it would be the capital account maintenance rules of 704(b) (That blog would be titled "Minimum Gain - Maximum Pain").  Fortunately, I once saw the slides of a presentation of someone else who is passionate about those rules.  I think they also had a thing for 704(c).  One of the slides practically screamed "There is no such thing as negative basis".  I feel a certain bond with that person, but I'm really not anxious to meet with them.

At any rate the passive activity loss rules do seem to be cropping up quite a bit.  In a recent case which I'm thinking doesn't merit its own post (Gregory J. Bahas, et ux. v. Commissioner, TC Summary Opinion 2010-115) Linda Bahas tried to use the real estate professional exception.  She hadn't made the aggregation election and the services she provided were as an employee not as a business owner.  Other than that Mrs. Lincoln how did your enjoy the play ?  At least she didn't have to put up with the court telling her she was ballpark guestimating her time.

There is some good news, though.  A quick review of the context might be in order first.  The passive activity loss rules were created more or less out of whole cloth by the Tax Reform Act of 1986.  They require us to sort trade or business activities into those in which we materially participate and those in which we don't.  One of the concepts in the rules is that rental activities are per se passive.  This may have been an example of someone getting their notions about reality from watching TV infomercials about making a fortune in real estate with no capital and very little work.  Regardless, my philosophy about tax rules is that they are what they are.  In the early 1990's relief from the per se passive rule was granted to real estate professionals.

In order for this relief to be effective, though, it is frequently necessary for them to elect to aggregate all their real estate activities.  Without the election they would have to establish material participation in each property. Donald Trask (TCM 2010-78) was able to establish that he spent enough time to be considered a real estate professional, but he had not made the election and his time was spread over 33 properties. 

PLR 201033015 was addressed to taxpayers who were qualified, but had failed to make the election.  Since they had relied on a tax preparer who had failed to advise them of the necessity of making the election, the service granted them an extension of time to make it.

If you have been posting negative numbers from real estate investments to your return on the theory that you or your spouse is a real estate professional, you should make sure that you have made the election.  If not you may want to consider requesting relief.  Furthermore, I generally believe in keeping tax returns indeefinitely, but if you must dispose of some of them, be sure to keep the return for the year that you made the election.  It is relevant for all future returns in which you are claiming its effect and I know from experience that you cannot rely on the IRS to preserve it for you.

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.

Need Form for Dependency Deduction

I've told a couple of sad stories of damsels in distress who the Tax Court couldn't help.  Well here's hoping for a little schadenfreude for Caron Riganti  and Laura Brady as they contemplate the fate of Gary Knorad in TCM 2010-179.  I hate the apparent gender stereotyping from having two women going for innocent spouse treatment followed by a guy getting stiffed on a dependency deduction, but I'm stuck with the raw material that I find.  Except by special request, my material is less than a year old and sometimes hot off the press.

The dependency deduction probably absorbs more attention in divorce negotiations than it really deserves.  It it never going to amount to a very large amount of money.  It probably has to do with the emotions involved. What seems to be common nowadays is an every other year deal between the custodial and non-custodial parent.  What is commonly missed though is that in order for the non-custodial parent to take the deduction he or she must have a release signed by the custodial parent. If that detail is neglected, the non-custodial parent is not entitled to the deduction.

By the terms of his divorce decree Mr. Konrad believed he was entitled to a dependency deduction.  He submitted the decree to the tax court.  They noted it was signed by a clerk of the court and the judge, but not the former Mrs. Konrad.  She had refused to sign Form 8332 when it was provided to her.  Accordingly Mr. Konrad did not have a signed copy to attach to his return. 

The stipulation and the judgment petitioner submitted do not conform to the form and substance of Form 8332. Petitioner failed to procure Ms. Konrad's signature on either the stipulation or the judgment. When petitioner later attempted to procure Ms. Konrad's signature on Form 8332, Ms. Konrad refused. The signatures of the judge and the clerk from the divorce proceeding are not adequate substitutes for Ms. Konrad's signature. Thus, without her signature on a form that releases her claim to the dependency exemption deduction, petitioner failed to satisfy section 152(e)(2)(A) and may not claim L.W.K. for the purpose of receiving the exemption.

My response to this is that maybe you shouldn't get all that excited about crafting how the dependency deduction will be shared.  If you are going to be excited about it though remember that the non-custodial parent will need that form.  Custodial parents are unlikely to be willing to sign an unconditional permanent release, which is the only sure solution, but it is unlikely to be worth pursuing them in court if they are uncooperative in the future.  Such are the human dynamics that assure we will read more on this issue in years to come.