CCA 201040004
One of the greatest sources of tax controversy is whether something is depreciable (in the case of intangible assets we say amortizable.) Land is one of the primary examples of non-depreciable property. So if someone comes up with a way to write off even some of the cost of land it is worth paying attention to. Land is by it's nature non-fungible, but frankly some land is more non-fungible than other land. At the most extreme end of this non-fungibility is land that you grow grapes on to make wine.
It so happens that my favorite beverage is Mountain Dew. The various chemicals that go into making it can come from just about anywhere and they probably do. It doesn't work that way with wine. There is something called the Napa Declaration on Place. It is a bunch of "Whereas's" like :
Whereas, it is generally acknowledged that there are a handful of truly extraordinary places on earth from which great wine is consistently produced.
finishing up with :
Therefore, be it resolved that we, as some of the world’s leading wine regions, join together in supporting efforts to maintain and protect the integrity of these place names, which are fundamental tools for consumer identification of great winegrowing regions and the wines they produce.
I was kind of vaguely aware of this, but I always thought it had to do with that weird country where they eat snails and think Jerry Lewis was a good actor. It turns out that the same thing goes on in the United States.. A geographic region can be designated an American viticultural area (AVA), by the Alcohol and Tobacco Tax and Trade Bureau (“TTB”) of the United States Department of the Treasury. Once that happens you can't put that place name on the wine bottle label unless 85% of the grapes come from that region.
The Chief Counsel has determined that the designation is a "license, permit, or other right granted by governmental unit and isn't interest in land". This makes it an intangible asset covered by Section 197, which means it can be amortized over 15 years. This is a taxpayer friendly ruling, so I am inclined to like it, but it is really a little challenging to wrap my head around. You buy some land in Napa Valley or Mendocino or, I kid you not, Long Island (Check the list)on which grapes grow and you get to allocate some of the cost to the right to stamp Long Island on the label and write that portion off over 15 years.
The Chief Counsel noted a problem with the ruling:
We have concerns about how a taxpayer would value the right to use an AVA designation. It is unclear whether the value of the right to use an AVA designation attaches to an acquisition of a particular vineyard within an AVA. The benefit in value from the right to use an AVA designation accrues to all land whose highest and best use is as a vineyard within such designated viticultural area. Consequently, all of the closest comparable vineyards share the same intangible benefit thereby making an appraiser's determination of the increment of value assigned to the intangible benefit and finding comparable vineyards outside of the particular AVA factually difficult.
My study of labels is limited to making sure that I don't make the mistake of buying Diet Mountain Dew, a wretched tasting concoction often hazardously located adjacent to the good stuff. I would hazard a guess though that stamping Southeastern New England on your wine bottles is not going to make them fly off the shelves and that there are probably very few AVA designations that have any value.
Nonetheless the concept is very interesting. There have been discussions about whether the names of landmark buildings might be separate intangible assets. Do the owners of the Empire State Building get royalties on all the little chachkies that are shaped like their building ? That would seem to have the makings of a 197 intangible.
Friday, October 29, 2010
Chief Counsel Reiterates Dependency Option for Same Sex Couples
CCA 201040012
I am always on the lookout for anything that might be relevant for my mythical clients Robin and Terry, a couple of indeterminate gender and marital status, whose role in life is to help me avoid awkward pronoun problems. I introduced them in my post on CCA 201021050, which calls for income splitting for California domestic partners. They also appear in my post on Gill v OPM, which declared a portion of the Defense of Marriage Act unconstitutional. Incidentally the Justice Department filed a notice of appeal in Gill.
A CCA, by the way, is a Chief Counsel Advice. Here is the meat of the latest CCA bearing on Robin and Terry :
The issue raised by the agent was discussed here in the National Office and with Treasury in connection with the development of Notice 2010-38. The conclusion reached at that time is that the FICA and FUTA provisions relating to “dependent” aren't really definitions in the sense of an exclusive meaning. They're instead worded to say “dependents” “include” an employee's family members. They do not preclude the possibility that other individuals could also be dependents for purposes of the FICA and FUTA exclusions.
When the issue was discussed in connection with Notice 2010-38, we viewed the PLRs (e.g., PLR 200339001 and PLR 200108010) as expanding the group of dependents described in the FICA and FUTA regs to include individuals who are dependents under section 152. Therefore, even though the PLRs can't be relied on by taxpayers other than those who got them, it is Counsel's position that a domestic partner who is a dependent of an employee under section 152 is also a dependent for purposes of the FUTA exclusion. Thus, the value of the health coverage for the domestic partner isn't FUTA wages.
In order for someone to be your dependent you must meet three tests - relationship, support and gross income. One of the possible relationships is "member of your household" (with the quaint caveat that the household composition not violate local law). So if Robin provides more than 1/2 of Terry's support and Terry's gross income is below the threshold (currently $3,650) Terry can be Robin's dependent. This will qualify Robin for the more favorable head of household rates and exempt from payroll and withholding the health benefits that Robin's employer provides to Terry. To be someones dependent for medical purposes, however, does not require that you meet the gross income tax. So Terry could have substantial income and still be a dependent for purposes of the medical benefit exclusion.
An interesting question is what is going to happen to California domestic partners who have benefited from this technique. Thanks to CCA 201021050 Terry will now be taxed on 1/2 of Robin's income and presumably will no longer qualify as a dependent. I can hear somebody howling "That doesn't make any sense." The answer to that is that making sense is not a requirement.
I am always on the lookout for anything that might be relevant for my mythical clients Robin and Terry, a couple of indeterminate gender and marital status, whose role in life is to help me avoid awkward pronoun problems. I introduced them in my post on CCA 201021050, which calls for income splitting for California domestic partners. They also appear in my post on Gill v OPM, which declared a portion of the Defense of Marriage Act unconstitutional. Incidentally the Justice Department filed a notice of appeal in Gill.
A CCA, by the way, is a Chief Counsel Advice. Here is the meat of the latest CCA bearing on Robin and Terry :
The issue raised by the agent was discussed here in the National Office and with Treasury in connection with the development of Notice 2010-38. The conclusion reached at that time is that the FICA and FUTA provisions relating to “dependent” aren't really definitions in the sense of an exclusive meaning. They're instead worded to say “dependents” “include” an employee's family members. They do not preclude the possibility that other individuals could also be dependents for purposes of the FICA and FUTA exclusions.
When the issue was discussed in connection with Notice 2010-38, we viewed the PLRs (e.g., PLR 200339001 and PLR 200108010) as expanding the group of dependents described in the FICA and FUTA regs to include individuals who are dependents under section 152. Therefore, even though the PLRs can't be relied on by taxpayers other than those who got them, it is Counsel's position that a domestic partner who is a dependent of an employee under section 152 is also a dependent for purposes of the FUTA exclusion. Thus, the value of the health coverage for the domestic partner isn't FUTA wages.
In order for someone to be your dependent you must meet three tests - relationship, support and gross income. One of the possible relationships is "member of your household" (with the quaint caveat that the household composition not violate local law). So if Robin provides more than 1/2 of Terry's support and Terry's gross income is below the threshold (currently $3,650) Terry can be Robin's dependent. This will qualify Robin for the more favorable head of household rates and exempt from payroll and withholding the health benefits that Robin's employer provides to Terry. To be someones dependent for medical purposes, however, does not require that you meet the gross income tax. So Terry could have substantial income and still be a dependent for purposes of the medical benefit exclusion.
An interesting question is what is going to happen to California domestic partners who have benefited from this technique. Thanks to CCA 201021050 Terry will now be taxed on 1/2 of Robin's income and presumably will no longer qualify as a dependent. I can hear somebody howling "That doesn't make any sense." The answer to that is that making sense is not a requirement.
Wednesday, October 27, 2010
You Should Wear Shoes in Tax Court But Don't Bring the Box
Thomas F. Hale v. Commissioner, TC Memo 2010-229
Over 500 years ago Fra Luca Bartolomeo de Pacioli published a text book Summa de arithmetica, geometria, proportioni et proportionalita. Included in the text book was a description of the methods that Venetian merchants used to keep accounts. The method, known as double-entry became remarkably popular. During the 1980's a product known as Quicken tried to abolish double entry to the delight of many small businesses and the consternation of the world's accountants. The makers of Quicken, thankfully, came out with Quickbooks. Now double entry is there behind the scenes. Not as many people have to learn it anymore.
Even before computers became fairly pervasive, there were people who didn't want to learn double entry. I used to think that was odd, but then I realized that other people didn't break license numbers down into their prime factors while driving, so maybe I was the peculiar one. If such a person needed to do record keeping there was a solution. We used to call then "Dumb" books, but after I studied them some, I came to admire them. I only once saw somebody work the whole system thoroughly, but they did work. One-write was probably better, but Dome books worked. So I am glad to see that they still exist and can be purchased from Amazon.
Thomas Hale might have been well advised to purchase a Dome book. Thomas Hale was a professor at Idaho State University, an attorney and a landlord. God bless him, I can see why he never got to double entry. The IRS claimed that he understated his rental income and legal fees and claimed unsubstantiated deductions for 2003, 2004 and 2005 assessing tax deficiencies totaling over $60,000 and penalties over $10,000. Professor Hale petitioned the tax court. Things did not go that well.
At trial, petitioner introduced into evidence approximately 317 pages of uncategorized photocopies of receipts, canceled checks, invoices, and similar documents. He also offered copies of Federal and State tax returns that he had submitted to respondent during respondent's examination. He made no attempt to tie that evidence to respondent's adjustments underlying the deficiencies in question. At the conclusion of the trial, we set a schedule for briefing and provided petitioner with detailed instructions as to the form and content of briefs, directing him to Rule 151(e), which addresses that subject. In particular, we cautioned him to set forth in response to each adjustment made by respondent the facts in evidence that he believed supported his claim that respondent erred in making that adjustment. Petitioner failed to file any brief.
I must admit that I have not studied Rule 151(e). This case, however, should not have gotten beyond the agent level without categorizing the various receipts and cancelled checks and tying them to the tax return. That appears to be what the Tax Court was looking for.
In support of his claim that his only income was what he reported on his return and he has adequately substantiated all of his deductions, petitioner offers us what amounts in effect to a shoebox full of papers. Petitioner has ignored our specific instructions that he link his evidence to respondent's adjustments. We need not (and shall not) undertake the task of sorting through the voluminous evidence petitioner has provided in an attempt to see what is, and what is not, adequate substantiation of the items on petitioner's returns
Professor Hale taught European history. Europe has had an awful lot of history so his unfamiliarity with Fra Pacioli's contribution might be understandable. A Dome book would have done the trick for him though. Another possibility might be the deduction summary guides offered by a much more seasoned tax blogger than myself. Robert Flach still prepares tax returns by hands distrusting the "flawed software" that most of the rest of use.
What you can't tell from reading the case is to what extent Professor Hale was denied deductions that would have been legitimate, if they had been substantiated. Assuming they were significant, he could have saved himself quite a bit by engaging a tax professional at some point in the process.
Over 500 years ago Fra Luca Bartolomeo de Pacioli published a text book Summa de arithmetica, geometria, proportioni et proportionalita. Included in the text book was a description of the methods that Venetian merchants used to keep accounts. The method, known as double-entry became remarkably popular. During the 1980's a product known as Quicken tried to abolish double entry to the delight of many small businesses and the consternation of the world's accountants. The makers of Quicken, thankfully, came out with Quickbooks. Now double entry is there behind the scenes. Not as many people have to learn it anymore.
Even before computers became fairly pervasive, there were people who didn't want to learn double entry. I used to think that was odd, but then I realized that other people didn't break license numbers down into their prime factors while driving, so maybe I was the peculiar one. If such a person needed to do record keeping there was a solution. We used to call then "Dumb" books, but after I studied them some, I came to admire them. I only once saw somebody work the whole system thoroughly, but they did work. One-write was probably better, but Dome books worked. So I am glad to see that they still exist and can be purchased from Amazon.
Thomas Hale might have been well advised to purchase a Dome book. Thomas Hale was a professor at Idaho State University, an attorney and a landlord. God bless him, I can see why he never got to double entry. The IRS claimed that he understated his rental income and legal fees and claimed unsubstantiated deductions for 2003, 2004 and 2005 assessing tax deficiencies totaling over $60,000 and penalties over $10,000. Professor Hale petitioned the tax court. Things did not go that well.
At trial, petitioner introduced into evidence approximately 317 pages of uncategorized photocopies of receipts, canceled checks, invoices, and similar documents. He also offered copies of Federal and State tax returns that he had submitted to respondent during respondent's examination. He made no attempt to tie that evidence to respondent's adjustments underlying the deficiencies in question. At the conclusion of the trial, we set a schedule for briefing and provided petitioner with detailed instructions as to the form and content of briefs, directing him to Rule 151(e), which addresses that subject. In particular, we cautioned him to set forth in response to each adjustment made by respondent the facts in evidence that he believed supported his claim that respondent erred in making that adjustment. Petitioner failed to file any brief.
I must admit that I have not studied Rule 151(e). This case, however, should not have gotten beyond the agent level without categorizing the various receipts and cancelled checks and tying them to the tax return. That appears to be what the Tax Court was looking for.
In support of his claim that his only income was what he reported on his return and he has adequately substantiated all of his deductions, petitioner offers us what amounts in effect to a shoebox full of papers. Petitioner has ignored our specific instructions that he link his evidence to respondent's adjustments. We need not (and shall not) undertake the task of sorting through the voluminous evidence petitioner has provided in an attempt to see what is, and what is not, adequate substantiation of the items on petitioner's returns
Professor Hale taught European history. Europe has had an awful lot of history so his unfamiliarity with Fra Pacioli's contribution might be understandable. A Dome book would have done the trick for him though. Another possibility might be the deduction summary guides offered by a much more seasoned tax blogger than myself. Robert Flach still prepares tax returns by hands distrusting the "flawed software" that most of the rest of use.
What you can't tell from reading the case is to what extent Professor Hale was denied deductions that would have been legitimate, if they had been substantiated. Assuming they were significant, he could have saved himself quite a bit by engaging a tax professional at some point in the process.
Monday, October 25, 2010
FLP Good for the Family Business - But Maybe not the Family Jewels
JOHN W. FISHER and JANICE B. FISHER, Plaintiffs, v. UNITED STATES OF AMERICA, Defendant.09/01/2010
The family limited partnership is a fairly robust estate planning tool. It has been under attack for some time, but generally stands up pretty well. The IRS objection to it is understandable. Somehow it seems that taking a bunch of stuff and putting the stuff into an entity should not produce a whole that is of lesser value than the sum of its parts. It makes one wonder whether intellectual integrity is a key element in successful tax practice. On a really bad day it makes one wonder whether lack of intellectual integrity might be a requirement.
The Fishers formed a Limited Liability Company (LLC) called Good Harbor Partners LLC. Its principal asset was a tract of undeveloped land that bordered Lake Michigan. In 2000, 2001 and 2002, they gave 4.762% interests in the LLC to each of their children. The Good Harbor operating agreement has significant restrictions on the transferability of interests. The IRS argued that the restrictions on transferability should not be considered because the LLC did not constitute a bona fide business arrangement. The court agreed stating :
The facts of this case are analogous to those in Holman . There, two donors created a limited partnership, funded it with common stock from a publicly traded company, and gifted limited partnership shares to their children. 601 F.3d at 765. There was no evidence indicating that the partnership employed a particular investment strategy or that the donors were “skilled or savvy investment managers whose expertise [wa]s needed or whose investment philosophy need[ed] to be conserved or protected from interference.” Id. at 770, 771. The donors retained exclusive control of the partnership, and their children could not withdraw from the partnership or assign their interests unless certain transfer conditions were met. Id. at 766. The Eighth Circuit affirmed the Tax Court's conclusion that the restrictions upon the children did not serve a bona fide business purpose because the partnership was not a ““business,” active or otherwise.” Id. at 770. In so holding, the Holman court distinguished a line of cases where active, ongoing business interests were preserved by the transfer restrictions at issue.See, e.g., id. at 771 (“The underlying assett in [Estate of] Bischoff [v. Comm'r, 69 T.C. 32, 39–40, 1977 WL 3667 (1977)] was a pork processing business organized, controlled, and managed by three families who sought to assure their continuing ability to carry on their pork processing business without outside interference, including that of a dissident limited partner.”).
This case is troubling in that there doesn't appear to be any of the sloppy execution that is common in failed family limited partnership. It appears to call into question the use of this technique in the case of a single asset that does not have business characteristics.
Friday, October 22, 2010
Wag the Dog
You just couldn't play it smart, could you?
All you had to do was box, but no,
not you, you hardhead.
Funny thing is, there ain't gonna be
any boxing championships this year.
As I mentioned in my initial post on Fidelity International Currency Advisor, there is much material in the saga of Richard Egan's doomed tax shelters. I will wrap up my EMC trilogy with an observation on the greatest irony of the case. The Egan's had two partnerships one designed to shelter capital gain and the other ordinary income. I explained the capital gain scheme, but not the ordinary income one. Basically you get a free basis step-up by entering into offsetting option contracts and have an accountant handle one leg of the transaction and a tax attorney the other half. The debit goes on the left and the credit goes ... What credit ? The ordinary income refinement requires a foreign partner to be allocated gains and then be bought out. (Of course the buy-out cannot be prearranged wink, wink). This deal was done in 2000, a long time ago to some, but well after the 704(b) regulations were issued. Sadly the case does not explain the theory that deemed there to be substantial economic effect to the allocating of 160 million of gains to someone who was shortly bought out for around $325,000. That's not where I see the irony, though.
After a whirlwind tour of the Big Apple's accounting emproia where these brilliant maneuvers were presented Richard Egan, according to one of his advisers, told his son Michael, who headed his family office, that he wished his advisers would help make him money rather than save it. The advisor was told that she may have misheard and that "Dick" knows how to make money, but may not know how to save it. This presumably was how the advisers would distinguish themselves. One of the earliest events recorded in the case is something that James Reiss, CFO of Carruth Management (Egan's family office) wrote to attorney Stephanie Denby:
On April 25, 2000, Reiss wrote to Denby that Michael Egan was “anticipating unloading his father's EMC shares at $140” per share, and asked if she had a “good lead on a transaction and insurance.” The “transaction” he had in mind was one that would avoid taxes.
By the fall of 2000, the price of EMC exceeded $100 per share and had it kept appreciating at a similar rate $140 would have been achieved before long. The effort involved in selecting just the right tax shelter and making sure it was properly documented took time. Once all that energy was expended there was a desire to make sure the paid-for basis was properly used. Sadly the market did not cooperate with the plan.
At the beginning of September 2000, EMC stock was trading at $98.00 per share. Thereafter, the share price of EMC steadily declined, with the exception of a small increase in January 2001. By the end of November 2001, EMC stock was trading at $16.79 per share.
The Fidelity High Tech transaction had created a purported “basis” of $ 160 million. As the price of EMC stock began to decline, however, it became apparent to Michael Egan and others that the stock could not be sold for a sufficient gain to take advantage of that entire “basis.” In addition, the Egans did not want to show a loss on the sale of the stock. Accordingly, in 2001 the Egans added additional low-basis stock to the High Tech Fund—a practice that was referred to as “stuffing.” As Haber advised Pat Shea, the Egans could “stuff [High Tech] with more stock to get our per share basis lower [--] that will allow us to sell shares tax free.”
At least as early as May 2001, Michael Egan was being provided with spreadsheets prepared by Carolyn Fiddy that set forth the fair market value of the stock held in High Tech. The spreadsheets showed how much additional stock would need to be contributed to bring the value of the portfolio up to the amount of the $160 million purported basis,
In late 2001, employees at Carruth performed further calculations in order to determine how much additional stock needed to be contributed to Fidelity High Tech in order to take advantage of the purported $160 million basis. In addition to EMC stock, Michael Egan authorized contribution of other low-basis stock owned by the Egans to Fidelity High Tech to take advantage of the “stepped-up” basis (or, as Shea put it, to “absorb” that basis).
On December 19, 2001, Carolyn Fiddy reported to Reiss that “the final “stuffing” for Fidelity High Tech Advisor A has been organized.” . The same day, Shea reported to Reiss that “the “stuffing” of Helios I [High Tech] took place today.” On December 20, Fiddy reported to Haber that “additional contributions of low basis stock” had been made to High Tech.
On December 20, 2001, Pat Shea reported to Haber that “we have “stuffed” this fund with several other assets including more EMC stock.”
The beauty of the transaction was that it would have a "low reporting profile" since it was "merely" eliminating gains rather than creating a loss. Ultimately the transaction would be showing a loss as there was not enough fair market value of EMC stock contributed to take advantage of the basis.
In the end the capital gains tax had to be paid and apparently a 40% gross valuation overstatement penalty. Not to metnion all the fees which were estimated to be around 20% of the "tax savings". The really interesting question, though, is how much was lost due to stock being sold at less favorable prices than might have been obtained without the complications of the shelter planning ?
The Egans were not the only people afflicted by the belief that EMC stock could only go up. And of course EMC was part of the larger tech bubble. Just for perspective we can reflect on what might have happened to many of the EMC rankers. The belief that tax laws are rigged in favor of the ultra wealthy is really a delusion. Mr. Egan had to get somebody to find a friendly Irishman to pick up 160,000,000 dollars in currency gain and then be bought out to shelter his non-qualified option ordinary income. A regular EMC employee would have qualified options. So if such an employee exercised an option to buy at say $20 when the stock was at $90 all he or she had to do was hold onto the stock for a year in order to get capital gains treatment on the $70 plus of course the additional amount that the EMC stock would go up by in the course of the year. Of course there was that nasty alternative minimum tax so maybe there would be $15 or so to pay in April, which might have been about what the stock finally sold for. So as they stretched to turn a 40% tax into a 20 % tax, they ended up with, in effect, a 100% tax. They ended up with AMT credit carryovers and AMT capital loss carryovers, many of which have been used by now, but it was really painful in 2001.
The usual prize of the privilege of naming a topic for a future goes for identifying the quotation leading the post. In order to get full credit you have to name the historic event that corresponds to the tech bubble in the analogy that I am creating.
All you had to do was box, but no,
not you, you hardhead.
Funny thing is, there ain't gonna be
any boxing championships this year.
As I mentioned in my initial post on Fidelity International Currency Advisor, there is much material in the saga of Richard Egan's doomed tax shelters. I will wrap up my EMC trilogy with an observation on the greatest irony of the case. The Egan's had two partnerships one designed to shelter capital gain and the other ordinary income. I explained the capital gain scheme, but not the ordinary income one. Basically you get a free basis step-up by entering into offsetting option contracts and have an accountant handle one leg of the transaction and a tax attorney the other half. The debit goes on the left and the credit goes ... What credit ? The ordinary income refinement requires a foreign partner to be allocated gains and then be bought out. (Of course the buy-out cannot be prearranged wink, wink). This deal was done in 2000, a long time ago to some, but well after the 704(b) regulations were issued. Sadly the case does not explain the theory that deemed there to be substantial economic effect to the allocating of 160 million of gains to someone who was shortly bought out for around $325,000. That's not where I see the irony, though.
After a whirlwind tour of the Big Apple's accounting emproia where these brilliant maneuvers were presented Richard Egan, according to one of his advisers, told his son Michael, who headed his family office, that he wished his advisers would help make him money rather than save it. The advisor was told that she may have misheard and that "Dick" knows how to make money, but may not know how to save it. This presumably was how the advisers would distinguish themselves. One of the earliest events recorded in the case is something that James Reiss, CFO of Carruth Management (Egan's family office) wrote to attorney Stephanie Denby:
On April 25, 2000, Reiss wrote to Denby that Michael Egan was “anticipating unloading his father's EMC shares at $140” per share, and asked if she had a “good lead on a transaction and insurance.” The “transaction” he had in mind was one that would avoid taxes.
By the fall of 2000, the price of EMC exceeded $100 per share and had it kept appreciating at a similar rate $140 would have been achieved before long. The effort involved in selecting just the right tax shelter and making sure it was properly documented took time. Once all that energy was expended there was a desire to make sure the paid-for basis was properly used. Sadly the market did not cooperate with the plan.
At the beginning of September 2000, EMC stock was trading at $98.00 per share. Thereafter, the share price of EMC steadily declined, with the exception of a small increase in January 2001. By the end of November 2001, EMC stock was trading at $16.79 per share.
The Fidelity High Tech transaction had created a purported “basis” of $ 160 million. As the price of EMC stock began to decline, however, it became apparent to Michael Egan and others that the stock could not be sold for a sufficient gain to take advantage of that entire “basis.” In addition, the Egans did not want to show a loss on the sale of the stock. Accordingly, in 2001 the Egans added additional low-basis stock to the High Tech Fund—a practice that was referred to as “stuffing.” As Haber advised Pat Shea, the Egans could “stuff [High Tech] with more stock to get our per share basis lower [--] that will allow us to sell shares tax free.”
At least as early as May 2001, Michael Egan was being provided with spreadsheets prepared by Carolyn Fiddy that set forth the fair market value of the stock held in High Tech. The spreadsheets showed how much additional stock would need to be contributed to bring the value of the portfolio up to the amount of the $160 million purported basis,
In late 2001, employees at Carruth performed further calculations in order to determine how much additional stock needed to be contributed to Fidelity High Tech in order to take advantage of the purported $160 million basis. In addition to EMC stock, Michael Egan authorized contribution of other low-basis stock owned by the Egans to Fidelity High Tech to take advantage of the “stepped-up” basis (or, as Shea put it, to “absorb” that basis).
On December 19, 2001, Carolyn Fiddy reported to Reiss that “the final “stuffing” for Fidelity High Tech Advisor A has been organized.” . The same day, Shea reported to Reiss that “the “stuffing” of Helios I [High Tech] took place today.” On December 20, Fiddy reported to Haber that “additional contributions of low basis stock” had been made to High Tech.
On December 20, 2001, Pat Shea reported to Haber that “we have “stuffed” this fund with several other assets including more EMC stock.”
The beauty of the transaction was that it would have a "low reporting profile" since it was "merely" eliminating gains rather than creating a loss. Ultimately the transaction would be showing a loss as there was not enough fair market value of EMC stock contributed to take advantage of the basis.
In the end the capital gains tax had to be paid and apparently a 40% gross valuation overstatement penalty. Not to metnion all the fees which were estimated to be around 20% of the "tax savings". The really interesting question, though, is how much was lost due to stock being sold at less favorable prices than might have been obtained without the complications of the shelter planning ?
The Egans were not the only people afflicted by the belief that EMC stock could only go up. And of course EMC was part of the larger tech bubble. Just for perspective we can reflect on what might have happened to many of the EMC rankers. The belief that tax laws are rigged in favor of the ultra wealthy is really a delusion. Mr. Egan had to get somebody to find a friendly Irishman to pick up 160,000,000 dollars in currency gain and then be bought out to shelter his non-qualified option ordinary income. A regular EMC employee would have qualified options. So if such an employee exercised an option to buy at say $20 when the stock was at $90 all he or she had to do was hold onto the stock for a year in order to get capital gains treatment on the $70 plus of course the additional amount that the EMC stock would go up by in the course of the year. Of course there was that nasty alternative minimum tax so maybe there would be $15 or so to pay in April, which might have been about what the stock finally sold for. So as they stretched to turn a 40% tax into a 20 % tax, they ended up with, in effect, a 100% tax. They ended up with AMT credit carryovers and AMT capital loss carryovers, many of which have been used by now, but it was really painful in 2001.
The usual prize of the privilege of naming a topic for a future goes for identifying the quotation leading the post. In order to get full credit you have to name the historic event that corresponds to the tech bubble in the analogy that I am creating.
Wednesday, October 20, 2010
Bring A Gun To School But You Better Have Insurance
THOMAS MORE LAW CENTER v. OBAMA,
God made the angels to show Him splendor, as He made animals for innocence and plants for their simplicity. But Man He made to serve Him wittily, in the tangle of his mind.
The material for my posts comes mostly from scanning the original source documents in RIA's Checkpoint tax research service. It is a habit I developed long before I started blogging. My main focus is looking for things that might be of some relevance to my client base. I could not, however, pass something up called Thomas More Law Center v. Obama. I had a brief delusion that I might get ahead of the crowd, but there is already a lot of commentary out there on it.
The case is a request for an injunction against the implementation of the part of the Health Care Reform Act that calls for a tax on people who don't buy health insurance. The tax is scheduled to go in effect in 2014. Clearly we are dealing with a group of people who care about principles. How can you get excited about a tax that doesn't go into effect for a couple of years? A lot can happen between now and then. I guess the name of the organization clues you in that they care about principles.
The decision goes into a lot on whether they have standing. It seems that all the worrying they are doing about the extra money they have to pay in 2014 was enough to give them standing. So they got into the merits of the case. Basically, it is about Congress having the power to force every to buy insurance. The power comes from the right under the Constitution to regulate interstate commerce. The Thomas More guys think that that is a bit of stretch.
The crux of plaintiffs' argument is that the federal government has never attempted to regulate inactivity, or a person's mere existence within our Nation's boundaries, under the auspices of the Commerce Clause. It is plaintiffs' position that if the Act is found constitutional, the Commerce Clause would provide Congress with the authority to regulate every aspect of our lives, including our choice to refrain from acting.
The court notes that in analyzing whether Congress has the power to regulate something under the Commerce Clause, their role is a modest one :
The court need not itself determine whether the regulated activities, “taken in the aggregate, substantially affect interstate commerce in fact, but only whether a “rational basis” exists for so concluding.”
I translate that to "We don't have to agree with you as long as we don't think you're crazy for thinking it."
They note that the Supreme Court has placed some limits on the scope of the Commerce Clause. Notably :
Far from permitting the Commerce Clause to provide Congress with unlimited power to regulate, the Supreme Court has, in fact, placed limits on its reach. The Court was asked to review Congress's power to enact the Gun-Free School Zone Act of 1990 which criminalized possession of a gun within a statutorily defined school zone. United States v. Lopez, 514 U.S. 549 (1995). The government argued that possession of a firearm in a school zone may result in violent crime, which can be expected to affect the national economy in several ways. First, the costs of violent crime are substantial, and via insurance those costs are spread throughout the population. Second, violent crime reduces the willingness of individuals to travel to areas that are perceived to be unsafe. Finally, the presence of guns in schools threatens the educational process, which will result in a less productive citizenry. The government concluded that these adverse effects on the nation's economic well-being gave Congress the power to pass the Gun-Free School Zone Act under the Commerce Clause. The Lopez Court held that Congress could not “pile inference upon inference” to find a link between the regulated activity and interstate commerce.
The health care mandate apparently does not require a similar stretch
There is a rational basis to conclude that, in the aggregate, decisions to forego insurance coverage in preference to attempting to pay for health care out of pocket drive up the cost of insurance. The costs of caring for the uninsured who prove unable to pay are shifted to health care providers, to the insured population in the form of higher premiums, to governments, and to taxpayers. The decision whether to purchase insurance or to attempt to pay for health care out of pocket, is plainly economic. These decisions, viewed in the aggregate, have clear and direct impacts on health care providers, taxpayers, and the insured population who ultimately pay for the care provided to those who go without insurance. These are the economic effects addressed by Congress in enacting the Act and the minimum coverage provision.
The main reason for venturing to the very edge of this blog's field was for the literary/pop culture quiz opportunity afforded by this case. Whoever, can identify the leading quotation gets to claim the invaluable prize of specifying a future topic ? It happens that it is one of my favorite quotations. I expect this to be so easy that I was thinking about excluding Xavier graduates from the competition, but they can go for it too.
God made the angels to show Him splendor, as He made animals for innocence and plants for their simplicity. But Man He made to serve Him wittily, in the tangle of his mind.
The material for my posts comes mostly from scanning the original source documents in RIA's Checkpoint tax research service. It is a habit I developed long before I started blogging. My main focus is looking for things that might be of some relevance to my client base. I could not, however, pass something up called Thomas More Law Center v. Obama. I had a brief delusion that I might get ahead of the crowd, but there is already a lot of commentary out there on it.
The case is a request for an injunction against the implementation of the part of the Health Care Reform Act that calls for a tax on people who don't buy health insurance. The tax is scheduled to go in effect in 2014. Clearly we are dealing with a group of people who care about principles. How can you get excited about a tax that doesn't go into effect for a couple of years? A lot can happen between now and then. I guess the name of the organization clues you in that they care about principles.
The decision goes into a lot on whether they have standing. It seems that all the worrying they are doing about the extra money they have to pay in 2014 was enough to give them standing. So they got into the merits of the case. Basically, it is about Congress having the power to force every to buy insurance. The power comes from the right under the Constitution to regulate interstate commerce. The Thomas More guys think that that is a bit of stretch.
The crux of plaintiffs' argument is that the federal government has never attempted to regulate inactivity, or a person's mere existence within our Nation's boundaries, under the auspices of the Commerce Clause. It is plaintiffs' position that if the Act is found constitutional, the Commerce Clause would provide Congress with the authority to regulate every aspect of our lives, including our choice to refrain from acting.
The court notes that in analyzing whether Congress has the power to regulate something under the Commerce Clause, their role is a modest one :
The court need not itself determine whether the regulated activities, “taken in the aggregate, substantially affect interstate commerce in fact, but only whether a “rational basis” exists for so concluding.”
I translate that to "We don't have to agree with you as long as we don't think you're crazy for thinking it."
They note that the Supreme Court has placed some limits on the scope of the Commerce Clause. Notably :
Far from permitting the Commerce Clause to provide Congress with unlimited power to regulate, the Supreme Court has, in fact, placed limits on its reach. The Court was asked to review Congress's power to enact the Gun-Free School Zone Act of 1990 which criminalized possession of a gun within a statutorily defined school zone. United States v. Lopez, 514 U.S. 549 (1995). The government argued that possession of a firearm in a school zone may result in violent crime, which can be expected to affect the national economy in several ways. First, the costs of violent crime are substantial, and via insurance those costs are spread throughout the population. Second, violent crime reduces the willingness of individuals to travel to areas that are perceived to be unsafe. Finally, the presence of guns in schools threatens the educational process, which will result in a less productive citizenry. The government concluded that these adverse effects on the nation's economic well-being gave Congress the power to pass the Gun-Free School Zone Act under the Commerce Clause. The Lopez Court held that Congress could not “pile inference upon inference” to find a link between the regulated activity and interstate commerce.
The health care mandate apparently does not require a similar stretch
There is a rational basis to conclude that, in the aggregate, decisions to forego insurance coverage in preference to attempting to pay for health care out of pocket drive up the cost of insurance. The costs of caring for the uninsured who prove unable to pay are shifted to health care providers, to the insured population in the form of higher premiums, to governments, and to taxpayers. The decision whether to purchase insurance or to attempt to pay for health care out of pocket, is plainly economic. These decisions, viewed in the aggregate, have clear and direct impacts on health care providers, taxpayers, and the insured population who ultimately pay for the care provided to those who go without insurance. These are the economic effects addressed by Congress in enacting the Act and the minimum coverage provision.
The main reason for venturing to the very edge of this blog's field was for the literary/pop culture quiz opportunity afforded by this case. Whoever, can identify the leading quotation gets to claim the invaluable prize of specifying a future topic ? It happens that it is one of my favorite quotations. I expect this to be so easy that I was thinking about excluding Xavier graduates from the competition, but they can go for it too.
Monday, October 18, 2010
Debit by the Window - Credit out the Window
KRAUSE v. U.S., Cite as 106 AFTR 2d 2010-5382, 10/12/2010
There is an old joke about a CPA who used to come to work everyday, open his desk drawer and look at a slip of paper. After he retired someone found the slip of paper and saw written on it "Debits by the Window - Credits by the Door". If he went to law school and started doing Son of BOSS deals, he would have had to change it to something more in line with the title of this post.
My readers, who may well number in the scores, vary in their degree of tax geekiness. Those of you who come here out of friendship or because I have grovelled may want to just click on a few ads and move on, because this is one of those points that is a stretch for me. I feel I must comment on this synchronicity. My last two posts have been about Fidelity International Currency. The rather long decision was issued in May. It disallowed two partnerships which had been used by EMC founder Richard Egan to shelter capital gains from the sale of stock and ordinary income from the exercise of non-qualified options.
The decision was amended on October 6 to indicate that penalties would apply. Talk about waiting for the other shoe to drop. The Egans had already put up the 60 million or so in tax. Somehow I doubt they had been counting on the refund they were suing for to do their Christmas shopping. So the October 6 amendment might be what they were really sweating out. If the judge had wanted to make life even more difficult he would have waited until January. Mr. Egan died in August 2009 making the extended due date of his estate tax return fairly imminent. Presumably the penalty will go in as a debt of the estate.
In my post I indicated that since this was a partnership case, I was leaving it to the tax litigators as to whether that really was the venue for deciding individual penalties. Next time I take a break from October 15 returns and start crawling through decisions I find the case of J. Winston Krause. Mr. Krause was a tax attorney and CPA who built his own Son of BOSS shelter. I have to wonder if he has two sides to his personality. Right now the CPA side is yelling "Language of 752, language of 752 - I knew it couldn't work. The entry didn't balance. You can't get all that basis without crediting something." The tax attorney side has answers. I can show you an example of a CPA making beautifully balanced entries that make no impression on judges, who are lawyers.
Mr. Krause's partnership did not fight the disallowance of the Son of BOSS losses. He paid the assessed tax, penalty and interest and then sued for refund of the penalties. Mr. Krause, not being a high tech billionaire. "only" has about $112,000 in penalties. (I have a rule that the word "only" should not be used in connection with sums of money greater than four dollars, but I'm relaxing it in light of the Egan's 20 million plus penalty). In arriving at its ruling he court goes into a discussion on the partnership provisions of TEFRA. (Tax Equity and Fiscal Responsibility Act of 1982). The partnership provisions of TEFRA are a more subtle part of the war against tax shelters than passive activity loss rules of the Tax Reform Act of 1986. Without them each parter in a partnership could litigate the same transactions in tax court.
To avoid duplicative litigation stemming from the tax treatment of partnerships, Congress enacted TEFRA, which creates a unified procedure for determining the treatment of partnership tax transactions. TEFRA requires the differentiation between the tax treatment of partnership-level and partner-level items.Id . § 6221. Partnership items include all items of “income, gain, loss, deduction, or credit of the partnership,” along with “optional adjustments to the basis of partnership property pursuant to an election under section 754,” and “the accounting practices and the legal and factual determinations that underlie the determination of... items of income, credit, gain, loss, deduction, etc.”
The penalties assessed under the FPAA were directly attributable to the fraudulent $2.79 million loss KAAS alleged it incurred when it sold its Canadian currency. This loss, which passed through to Krause Holdings and then to Krause, occurred because of the overstated basis KAAS had claimed in the Canadian currency due to an earlier basis election. Thus, the penalty related to basis, basis adjustments, and losses, all of which are considered partnership items under § 6231
Further, the refund sought by Krause relates to penalties and penalty-related interest that are associated with partnership-level items, both of which are in and of themselves considered partnership-level items. I.R.C. §§ 6221, 6230(c)(4). In this regard, the Code is clear: these are items that must be contested before the IRS finalizes an FPAA. The district court did not err by concluding that it could not consider Krause's refund claims.
So if this decision holds, the Egan family might be able to appeal the Fidelity decision, but they won't get to have a fresh hearing on the penalties when they are assessed against the individual returns.
There is an old joke about a CPA who used to come to work everyday, open his desk drawer and look at a slip of paper. After he retired someone found the slip of paper and saw written on it "Debits by the Window - Credits by the Door". If he went to law school and started doing Son of BOSS deals, he would have had to change it to something more in line with the title of this post.
My readers, who may well number in the scores, vary in their degree of tax geekiness. Those of you who come here out of friendship or because I have grovelled may want to just click on a few ads and move on, because this is one of those points that is a stretch for me. I feel I must comment on this synchronicity. My last two posts have been about Fidelity International Currency. The rather long decision was issued in May. It disallowed two partnerships which had been used by EMC founder Richard Egan to shelter capital gains from the sale of stock and ordinary income from the exercise of non-qualified options.
The decision was amended on October 6 to indicate that penalties would apply. Talk about waiting for the other shoe to drop. The Egans had already put up the 60 million or so in tax. Somehow I doubt they had been counting on the refund they were suing for to do their Christmas shopping. So the October 6 amendment might be what they were really sweating out. If the judge had wanted to make life even more difficult he would have waited until January. Mr. Egan died in August 2009 making the extended due date of his estate tax return fairly imminent. Presumably the penalty will go in as a debt of the estate.
In my post I indicated that since this was a partnership case, I was leaving it to the tax litigators as to whether that really was the venue for deciding individual penalties. Next time I take a break from October 15 returns and start crawling through decisions I find the case of J. Winston Krause. Mr. Krause was a tax attorney and CPA who built his own Son of BOSS shelter. I have to wonder if he has two sides to his personality. Right now the CPA side is yelling "Language of 752, language of 752 - I knew it couldn't work. The entry didn't balance. You can't get all that basis without crediting something." The tax attorney side has answers. I can show you an example of a CPA making beautifully balanced entries that make no impression on judges, who are lawyers.
Mr. Krause's partnership did not fight the disallowance of the Son of BOSS losses. He paid the assessed tax, penalty and interest and then sued for refund of the penalties. Mr. Krause, not being a high tech billionaire. "only" has about $112,000 in penalties. (I have a rule that the word "only" should not be used in connection with sums of money greater than four dollars, but I'm relaxing it in light of the Egan's 20 million plus penalty). In arriving at its ruling he court goes into a discussion on the partnership provisions of TEFRA. (Tax Equity and Fiscal Responsibility Act of 1982). The partnership provisions of TEFRA are a more subtle part of the war against tax shelters than passive activity loss rules of the Tax Reform Act of 1986. Without them each parter in a partnership could litigate the same transactions in tax court.
To avoid duplicative litigation stemming from the tax treatment of partnerships, Congress enacted TEFRA, which creates a unified procedure for determining the treatment of partnership tax transactions. TEFRA requires the differentiation between the tax treatment of partnership-level and partner-level items.Id . § 6221. Partnership items include all items of “income, gain, loss, deduction, or credit of the partnership,” along with “optional adjustments to the basis of partnership property pursuant to an election under section 754,” and “the accounting practices and the legal and factual determinations that underlie the determination of... items of income, credit, gain, loss, deduction, etc.”
The penalties assessed under the FPAA were directly attributable to the fraudulent $2.79 million loss KAAS alleged it incurred when it sold its Canadian currency. This loss, which passed through to Krause Holdings and then to Krause, occurred because of the overstated basis KAAS had claimed in the Canadian currency due to an earlier basis election. Thus, the penalty related to basis, basis adjustments, and losses, all of which are considered partnership items under § 6231
Further, the refund sought by Krause relates to penalties and penalty-related interest that are associated with partnership-level items, both of which are in and of themselves considered partnership-level items. I.R.C. §§ 6221, 6230(c)(4). In this regard, the Code is clear: these are items that must be contested before the IRS finalizes an FPAA. The district court did not err by concluding that it could not consider Krause's refund claims.
So if this decision holds, the Egan family might be able to appeal the Fidelity decision, but they won't get to have a fresh hearing on the penalties when they are assessed against the individual returns.
Friday, October 15, 2010
Welcome to the Sausage Factory - RTFI
It's always a disappointment to me when something I get excited about turns out to be old news. Such was the case with Fidelity International Currency which was the topic of Wednesday's post. The decision, issued October 6 was an amendment of a decision issued in May. I must admit that I have not done a word for word comparison. but skipping to the end I found that in the section headed "The Court does not reach the following issues":
(4.) Whether specific accuracy-related penalties should be assessed against any member or partner of Fidelity High Tech or Fidelity International
was dropped in the amended finding.
In the conclusion section we find added
(6.) The following accuracy-related penalties are applicable to any understatement of the income tax liability of Richard Egan arising from the treatment of the Fidelity High Tech and Fidelity International transactions on the tax returns of those entities for the years 2001 and 2002.
(a.) a 40% penalty for gross valuation misstatement pursuant to § 6662(a), (b)(3), and (h);
(b.) a 20% penalty for substantial valuation misstatement pursuant to § 6662(a) and (b)(3);
(c.) a 20% penalty for substantial understatement of income tax pursuant to § 6662(a), (b)(2), and (d)(2)(A); and
(d.) a 20% penalty for negligence or disregard of rules and regulations pursuant to § 6662(a) and (b)(1).
The penalties are alternatively, and not cumulatively, applied
There are some complex court jurisdiction issues in this case, which don't interest me an awful lot. The Egans put up the estimated amount of tax that would be assessed if the partnership determination was upheld rather than go to Tax Court. The penalties discussed above are not the partnership's penalties. So I suppose there is some question as to whether the court is supposed to be ruling on them, particularly since they are not yet assessed. Whether Mr. Egan's executors can go to tax court over the penalties is a question for the tax litigators.
The two primary emotions I experience in my wanderings through the ever expanding body of primary source tax documents are compassion and schadenfreude (Curious that you have to go to German for that term.) Mr. Egan certainly doesn't need my compassion, but I do think it is sad that he was vilified in the media as a tax cheat in the final year of a life of high achievement. I think it would be tasteless and unprofessional to express schadenfreude with respect to any of the professionals involved in this debacle. I will, however, single out one for a special type of compassion. It is the "There, but for the grace of God, go I" variety of compassion. You see there is not very far distant alternate reality in which the Egans upset with their maltreatment by KPMG decide that leaving the warm embrace of a well established regional firm like O'Connon and Drew was a mistake. Maybe there are some other firms in their region of similar size to O'Connor and Drew with somebody who knows about partnerships and tax shelters. In that dystopia, the odds that this nightmare could have ended up on my desk are far from remote. Thankfully, the Egans decided to stay national. So my sympathy goes to Ron Wainwright of RSM McGladrey who got to sign the returns that KPMG wouldn't sign without disclosures that the tax attorneys said were not required.
In my previous post on this issue I analogized the people in the national firms who believed tax shelters still worked to isolated detachments of Japanese soldiers who were probably more prevalent in TV sitcoms than in real life in the fifties and sixties. Implicit in this analogy is analogizing the Tax Reform Act of 1986 to the atomic bomb. This may seem irreverent, but what can I say it's a metaphor. And it is a pretty good one because tax shelters had already been dealt very heavy blows and might have went down anyway. So in this elaborate metaphor Section 465, the at-risk rules, plays the role of ComSubPac, which sunk all the Japanese merchant ships.
At any rate to explain my own role in the world of tax shelters in similar terms it is necessary to switch sides. In this metaphor the Tax Reform Act of 1986 is the blitzkrieg. My part of the tax shelter world, low income housing, was like Vichy France. Our deals that were still in their pay in period were granted transitional relief. Somebody told me that the fiscal trade-off for that was fiscal years for S corporations. Not a good trade from my viewpoint. We got a whole new credit, which meant all the new deals had to be redesigned and kept on trucking. People capitalizing low income housing without much upside beyond the tax benefits was the way thing's were supposed to be. This particular metaphor really sucks because it makes the national guys the Maquis and me, well never mind its a metaphor. Basically we had to learn all the aggravating stuff in the 704(b) regulations and whatever other collateral damage the war against tax shelters did to Subchapter K, but we didn't have to hide in the woods while we were preparing returns.
I experienced this difference in world views in the mid-nineties when I was on the AICPA Tax Division's Partnership committee. (Hey it really impressed somebody on our peer review team once). When discussing some particularly arcane regulation a couple of the national guys indicated that they would be just as pleased if it stayed unclear. I must say that was exceptional. Generally the committee was striving for clearer regulations. I also remember that the anti- abuse regulations (1.701-2) were more or less hot off the presses at the time of our meeting. There were a lot of bent out of shape people. I, on the other hand, just looked at example 6 Special allocations; nonrecourse financing; low-income housing credit; use of partnership consistent with the intent of subchapter K and decided that there was nothing to worry about.
The Fidelity opinion got into the real nitty gritty of return preparation. The transaction I explained in my previous post was executed by a partnership called Fidelity High Tech. There were three partnership returns covering two years. The reason for the extra return was that the plan required a "technical termination" meaning that a change in ownership created a new partnership for income tax purposes. The "new partnership" was able to apply basis created by what a simple minded accountant like myself would see as an unbalanced entry to EMC stock the Egans had contributed to the partnership. In a nice bit of presentation work, they got Mellon Bank to present a capital gain (loss) schedule which incorporated the new basis. That can be a real challenge. The court mentions that they didn't file form 8275, but they had an opinion that there transaction was somehow different. What I see as the real "gotcha" is this:
Because Fidelity High Tech did not use cash cost to compute the stepped-up basis, it was required to attach an explanation to Schedule D. No such explanation was attached. An adequate explanation, as required by the instructions, would have included disclosure of the underlying transaction that resulted in the purported stepped-up tax basis used by Fidelity High Tech.
Back in the good old days, when we did returns by hand, my favorite review note was. RTFI - Read The Instructions. I really think that if I had been sweating this return out, I would have caught that. There would have been some sort of explanation. Likely it would not have been sufficient, but if you look at the revenue procedures on adequate disclosure (e.g. Rev Proc 2010-15), sometimes thoroughly filling out the form is what does the trick.
(4.) Whether specific accuracy-related penalties should be assessed against any member or partner of Fidelity High Tech or Fidelity International
was dropped in the amended finding.
In the conclusion section we find added
(6.) The following accuracy-related penalties are applicable to any understatement of the income tax liability of Richard Egan arising from the treatment of the Fidelity High Tech and Fidelity International transactions on the tax returns of those entities for the years 2001 and 2002.
(a.) a 40% penalty for gross valuation misstatement pursuant to § 6662(a), (b)(3), and (h);
(b.) a 20% penalty for substantial valuation misstatement pursuant to § 6662(a) and (b)(3);
(c.) a 20% penalty for substantial understatement of income tax pursuant to § 6662(a), (b)(2), and (d)(2)(A); and
(d.) a 20% penalty for negligence or disregard of rules and regulations pursuant to § 6662(a) and (b)(1).
The penalties are alternatively, and not cumulatively, applied
There are some complex court jurisdiction issues in this case, which don't interest me an awful lot. The Egans put up the estimated amount of tax that would be assessed if the partnership determination was upheld rather than go to Tax Court. The penalties discussed above are not the partnership's penalties. So I suppose there is some question as to whether the court is supposed to be ruling on them, particularly since they are not yet assessed. Whether Mr. Egan's executors can go to tax court over the penalties is a question for the tax litigators.
The two primary emotions I experience in my wanderings through the ever expanding body of primary source tax documents are compassion and schadenfreude (Curious that you have to go to German for that term.) Mr. Egan certainly doesn't need my compassion, but I do think it is sad that he was vilified in the media as a tax cheat in the final year of a life of high achievement. I think it would be tasteless and unprofessional to express schadenfreude with respect to any of the professionals involved in this debacle. I will, however, single out one for a special type of compassion. It is the "There, but for the grace of God, go I" variety of compassion. You see there is not very far distant alternate reality in which the Egans upset with their maltreatment by KPMG decide that leaving the warm embrace of a well established regional firm like O'Connon and Drew was a mistake. Maybe there are some other firms in their region of similar size to O'Connor and Drew with somebody who knows about partnerships and tax shelters. In that dystopia, the odds that this nightmare could have ended up on my desk are far from remote. Thankfully, the Egans decided to stay national. So my sympathy goes to Ron Wainwright of RSM McGladrey who got to sign the returns that KPMG wouldn't sign without disclosures that the tax attorneys said were not required.
In my previous post on this issue I analogized the people in the national firms who believed tax shelters still worked to isolated detachments of Japanese soldiers who were probably more prevalent in TV sitcoms than in real life in the fifties and sixties. Implicit in this analogy is analogizing the Tax Reform Act of 1986 to the atomic bomb. This may seem irreverent, but what can I say it's a metaphor. And it is a pretty good one because tax shelters had already been dealt very heavy blows and might have went down anyway. So in this elaborate metaphor Section 465, the at-risk rules, plays the role of ComSubPac, which sunk all the Japanese merchant ships.
At any rate to explain my own role in the world of tax shelters in similar terms it is necessary to switch sides. In this metaphor the Tax Reform Act of 1986 is the blitzkrieg. My part of the tax shelter world, low income housing, was like Vichy France. Our deals that were still in their pay in period were granted transitional relief. Somebody told me that the fiscal trade-off for that was fiscal years for S corporations. Not a good trade from my viewpoint. We got a whole new credit, which meant all the new deals had to be redesigned and kept on trucking. People capitalizing low income housing without much upside beyond the tax benefits was the way thing's were supposed to be. This particular metaphor really sucks because it makes the national guys the Maquis and me, well never mind its a metaphor. Basically we had to learn all the aggravating stuff in the 704(b) regulations and whatever other collateral damage the war against tax shelters did to Subchapter K, but we didn't have to hide in the woods while we were preparing returns.
I experienced this difference in world views in the mid-nineties when I was on the AICPA Tax Division's Partnership committee. (Hey it really impressed somebody on our peer review team once). When discussing some particularly arcane regulation a couple of the national guys indicated that they would be just as pleased if it stayed unclear. I must say that was exceptional. Generally the committee was striving for clearer regulations. I also remember that the anti- abuse regulations (1.701-2) were more or less hot off the presses at the time of our meeting. There were a lot of bent out of shape people. I, on the other hand, just looked at example 6 Special allocations; nonrecourse financing; low-income housing credit; use of partnership consistent with the intent of subchapter K and decided that there was nothing to worry about.
The Fidelity opinion got into the real nitty gritty of return preparation. The transaction I explained in my previous post was executed by a partnership called Fidelity High Tech. There were three partnership returns covering two years. The reason for the extra return was that the plan required a "technical termination" meaning that a change in ownership created a new partnership for income tax purposes. The "new partnership" was able to apply basis created by what a simple minded accountant like myself would see as an unbalanced entry to EMC stock the Egans had contributed to the partnership. In a nice bit of presentation work, they got Mellon Bank to present a capital gain (loss) schedule which incorporated the new basis. That can be a real challenge. The court mentions that they didn't file form 8275, but they had an opinion that there transaction was somehow different. What I see as the real "gotcha" is this:
Because Fidelity High Tech did not use cash cost to compute the stepped-up basis, it was required to attach an explanation to Schedule D. No such explanation was attached. An adequate explanation, as required by the instructions, would have included disclosure of the underlying transaction that resulted in the purported stepped-up tax basis used by Fidelity High Tech.
Back in the good old days, when we did returns by hand, my favorite review note was. RTFI - Read The Instructions. I really think that if I had been sweating this return out, I would have caught that. There would have been some sort of explanation. Likely it would not have been sufficient, but if you look at the revenue procedures on adequate disclosure (e.g. Rev Proc 2010-15), sometimes thoroughly filling out the form is what does the trick.
Wednesday, October 13, 2010
It's Over
FIDELITY INTERNATIONAL CURRENCY ADVISOR A FUND, LLC, by the Tax Matters Partner, Plaintiff, v. UNITED STATES of AMERICA
For some time, I have been of the belief that the Tax Reform Act of 1986 killed tax shelters. I'm still pretty much of that opinion. When I find a case like Fidelity International Currency Advisors A Fund, LLC, which was just issued by the US District Court for Massachusetts last week (amending their previous May findings in the case), I'm reminded of a trope that would pop up on television series in the 1950's and 1960's. One or more Japanese soldiers on a remote island have to be convinced that they have lost the war and can go home now. Gilligan and the Skipper had to deal with the problem in Episode 16 and Ensign O'Toole and the Appleby ran into it in Episode 6.
Fidelity International has local gossip value too it I guess, but not because it has anything to do with the Boston firm that runs mutual funds. The name is not a coincidence either, but that's part of the story. The tax matters partner of Fidelity was Richard Egan, recently deceased. He was one of the founders of EMC, which has its headquarters in Hopkington, MA. He was also the US Ambassador to Ireland, which, is in part, what led to this drama.
This case will likely merit more than one post. Actually there are probably a couple of good novels in there, but for now I will explain one of the transactions and comment on the feature I find most intriguing. Mr. Egan owned approximately 25 million shares of EMC, which traded at over $100 per share (Back then at the dawn of the millennium it was a well established law of nature that EMC stock could only go up). His basis was approximately two cents per share. Given that he founded a company noted for memory storage, it would have not been reasonable to try invoking the Steve Martin Rule (That is not pay the tax and say "I forgot"). So he and his son Michael, who ran his family office, consulted with an attorney and some national firms. They wanted to find a way to eliminate capital gains and also shelter the income from the exercise of non-qualified stock options. In this post I will comment only on the former.
The plan for eliminating capital gains works like this. You write a very large option which entitles you to receive a large premium. You use that premium to buy a very similar option. When it unwinds you will most likely have a loss, particularly after fees, but not a very large loss relative to the notional amount of the options. Get ready for the magic and if you are passionately attached to double entry remain calm. Form a partnership and contribute these two contracts to the partnership. Slowly. Carefully. One at a time. First there is that option you bought for say 150,000,000 (Never mind where you got it from). That's easy. Your basis is 150,000,000, the partnerships basis in it is 150,000,000. Increase your basis in your partnership interest by 150,000,000. You probably want to take a break. Now you've got that other thing. The option that you wrote. Well you got a lot of money and it seems like it could require you to pay out a lot of money. In some ways it seems like a liability. But remember this is a partnership. You need to check Section 752. Well something that you maybe have to pay isn't going to pass muster as a liability under 752. So now you are done. Your basis in your partnership interest is 150,000,000.
Now you put in your stock in Bigco which is worth 150,000,000 and has effectively zero basis. After those options sort themselves out for some relatively negligible effect, you are ready for your next step. You contribute your partnership interest into an LLC and make a 754 election. You now have to allocate your basis in your partnership interest among the assets of the technically new partnership. Your basis is still 150,000,000 and the only thing to allocate it to is the Bigco stock. So now your partnership has basis in your Bigco stock. It can sell it at a small gain or no gain or, as worked out in this case, a loss. Mr. Egan's minions needed to put more and more EMC stock into the partnership to take advantage of all the shelter they had bought as the price of EMC collapsed.
There is something really really neat about this plan that I couldn't emphasize if I was presenting it to you as a client. You see I am a member of the American Institute of Certified Public Accountants and thereby subject to its Statements on Standards for Tax Service, which were issued around the turn of the millennium. Among the things I can't do is recommend a tax position that "Exploits the audit selection process of a taxing authority." But since you and I are just pals and I am certainly not recommending this position I can tell you the really neat thing about it. If it works as planned, you never have to put a really big ugly looking negative number anywhere on any return you file. The basis that you created, as if by magic, enters into computing the gain or loss on your sale of Bigco stock. If Bigco stock behaves like everybody thought EMC stock was going to behave it means you will be reporting a gain. Just not as big a gain. No tax shelter here just a hard working high tech billionaire paying more taxes than most people.
The only thing wrong with the plan is that creating basis out of thin air doesn't even make good nonsense.
This brings me to the part of the case I find most interesting. The low reporting profile of the transaction was a big attraction. What amazes me is how big a paper trail the advisers created discussing the low reporting profile of the transaction. Stephanie Denby, an attorney, wrote in a memo to Mr. Egan:
. The IRS is certainly aware that these transactions are out there. They have implemented new reporting requirements to try to stop these transactions. To date new reporting requirements have focused solely on C corporations. Although, they could have easily applied similar restrictions to individuals, they have failed to do so.
These transactions clearly take advantage of “loopholes.” The reporting is consistent with tax law although the results are unintended. The promoters will provide tax opinion letters to avoid penalties if audited. It appears that there is a very low chance that these transactions would ever be picked up by the IRS. The promoters I have talked to have not had any audits
You see that's the neat part that I couldn't use to recommend the deal.
She also investigated insurance for the plan then sent an e-mail to James Reiss, CFO of Carruth Associates, Mr Egan's family office :
Fidelity International has local gossip value too it I guess, but not because it has anything to do with the Boston firm that runs mutual funds. The name is not a coincidence either, but that's part of the story. The tax matters partner of Fidelity was Richard Egan, recently deceased. He was one of the founders of EMC, which has its headquarters in Hopkington, MA. He was also the US Ambassador to Ireland, which, is in part, what led to this drama.
This case will likely merit more than one post. Actually there are probably a couple of good novels in there, but for now I will explain one of the transactions and comment on the feature I find most intriguing. Mr. Egan owned approximately 25 million shares of EMC, which traded at over $100 per share (Back then at the dawn of the millennium it was a well established law of nature that EMC stock could only go up). His basis was approximately two cents per share. Given that he founded a company noted for memory storage, it would have not been reasonable to try invoking the Steve Martin Rule (That is not pay the tax and say "I forgot"). So he and his son Michael, who ran his family office, consulted with an attorney and some national firms. They wanted to find a way to eliminate capital gains and also shelter the income from the exercise of non-qualified stock options. In this post I will comment only on the former.
The plan for eliminating capital gains works like this. You write a very large option which entitles you to receive a large premium. You use that premium to buy a very similar option. When it unwinds you will most likely have a loss, particularly after fees, but not a very large loss relative to the notional amount of the options. Get ready for the magic and if you are passionately attached to double entry remain calm. Form a partnership and contribute these two contracts to the partnership. Slowly. Carefully. One at a time. First there is that option you bought for say 150,000,000 (Never mind where you got it from). That's easy. Your basis is 150,000,000, the partnerships basis in it is 150,000,000. Increase your basis in your partnership interest by 150,000,000. You probably want to take a break. Now you've got that other thing. The option that you wrote. Well you got a lot of money and it seems like it could require you to pay out a lot of money. In some ways it seems like a liability. But remember this is a partnership. You need to check Section 752. Well something that you maybe have to pay isn't going to pass muster as a liability under 752. So now you are done. Your basis in your partnership interest is 150,000,000.
Now you put in your stock in Bigco which is worth 150,000,000 and has effectively zero basis. After those options sort themselves out for some relatively negligible effect, you are ready for your next step. You contribute your partnership interest into an LLC and make a 754 election. You now have to allocate your basis in your partnership interest among the assets of the technically new partnership. Your basis is still 150,000,000 and the only thing to allocate it to is the Bigco stock. So now your partnership has basis in your Bigco stock. It can sell it at a small gain or no gain or, as worked out in this case, a loss. Mr. Egan's minions needed to put more and more EMC stock into the partnership to take advantage of all the shelter they had bought as the price of EMC collapsed.
There is something really really neat about this plan that I couldn't emphasize if I was presenting it to you as a client. You see I am a member of the American Institute of Certified Public Accountants and thereby subject to its Statements on Standards for Tax Service, which were issued around the turn of the millennium. Among the things I can't do is recommend a tax position that "Exploits the audit selection process of a taxing authority." But since you and I are just pals and I am certainly not recommending this position I can tell you the really neat thing about it. If it works as planned, you never have to put a really big ugly looking negative number anywhere on any return you file. The basis that you created, as if by magic, enters into computing the gain or loss on your sale of Bigco stock. If Bigco stock behaves like everybody thought EMC stock was going to behave it means you will be reporting a gain. Just not as big a gain. No tax shelter here just a hard working high tech billionaire paying more taxes than most people.
The only thing wrong with the plan is that creating basis out of thin air doesn't even make good nonsense.
This brings me to the part of the case I find most interesting. The low reporting profile of the transaction was a big attraction. What amazes me is how big a paper trail the advisers created discussing the low reporting profile of the transaction. Stephanie Denby, an attorney, wrote in a memo to Mr. Egan:
. The IRS is certainly aware that these transactions are out there. They have implemented new reporting requirements to try to stop these transactions. To date new reporting requirements have focused solely on C corporations. Although, they could have easily applied similar restrictions to individuals, they have failed to do so.
These transactions clearly take advantage of “loopholes.” The reporting is consistent with tax law although the results are unintended. The promoters will provide tax opinion letters to avoid penalties if audited. It appears that there is a very low chance that these transactions would ever be picked up by the IRS. The promoters I have talked to have not had any audits
Secondly, some of the transactions focus on generating basis as opposed to capital loss. Basis is more discrete [sic] and less likely I believe to cross the IRS radar screen.
You see that's the neat part that I couldn't use to recommend the deal.
She also investigated insurance for the plan then sent an e-mail to James Reiss, CFO of Carruth Associates, Mr Egan's family office :
Marsh &; McLennan does not issue insurance for “transactions with no economic purpose other than the tax benefits.” I think if we pursue this and get rejected, we would be creating a bad trail. Accordingly, I think this is not something to pursue. Let me know if you agree.
Mr. Reiss responded
They probably help insure “straight” transactions. What fun is there to that? I agree with your comment.
The search went on. Eventually Ms. Denby prepared a comparison of various methods being promoted by national firms rating them positively or negatively based on various attributes including :
Denby also rated and commented with respect to the manner in which the tax loss was generated, noting a plus if the transaction was “harder for [the] IRS to find” and a minus if the transaction was “easier” for the IRS to find
Denby also rated and commented with respect to their complexity, noting a plus if the complexity of the structure made it harder for the IRS to “unwind” or “pick-up” and a minus if the simplicity of the structure made it easier for the IRS to trace.
Ultimately they went with a plan being promoted by KPMG. As part of the deal KPMG would prepare the returns. Unfortunately, the landscape shifted between the time of the committment to the transactions and the filing of the affected returns. KPMG decided that the transactions did need to be explicitly disclosed. This was upsetting:
On August 30, 2002, Stephanie Denby sent Reiss and Shea a proposed draft letter to Tim Speiss at KPMG. (Ex. 3429). The letter stated that Denby was “astonished” that KPMG would not sign the tax return without a disclosure statement, and that she found the firm's position “shocking” and “untenable,” as well as “a breach of KPMG's fiduciary duty and patently unprofessional.” In her cover e-mail, she wrote that “it would make sense to send out [the letter] after we have confirmation that [Speiss] has purged his files.”
So they fired KPMG and got McGladrey to prepare the returns. I have never seen a case go into as much detail on the minutiae of return preparation. I'm hoping to write more on it in the weeks to come.
The end result of the case was to blow up the transaction and subject it to a 40% gross overstatement penalty. All the lesser 20% penalites were also found applicable, but they are not cummulative. The letters from attorneys saying that positions were reasonable and disclosure was not required were of no avail.
When this case was announced in the media earlier this year there was some villification of Mr. Egan, which I really think was misplaced. Mr. Egan was part of the team of people that helped put men on the moon. His team of adivsers believed that there were geniuses in the national firms that had figured out a legitimate capital gain strategy. In retropsect, it is easy to say that they should have realized the game was up when KPMG told them they had to disclose. That was like the real life case of Second Lieutenant Hiroo Onoda on Lubang Island in the Philliphines. When his former commander Major Taniguchi told him the war was over he came out of the jungle with his rifle, 500 rounds of ammo and some hand grenades. It was 1974. He was lucky not to have a letter from a law firm to contradict him.
So they fired KPMG and got McGladrey to prepare the returns. I have never seen a case go into as much detail on the minutiae of return preparation. I'm hoping to write more on it in the weeks to come.
The end result of the case was to blow up the transaction and subject it to a 40% gross overstatement penalty. All the lesser 20% penalites were also found applicable, but they are not cummulative. The letters from attorneys saying that positions were reasonable and disclosure was not required were of no avail.
When this case was announced in the media earlier this year there was some villification of Mr. Egan, which I really think was misplaced. Mr. Egan was part of the team of people that helped put men on the moon. His team of adivsers believed that there were geniuses in the national firms that had figured out a legitimate capital gain strategy. In retropsect, it is easy to say that they should have realized the game was up when KPMG told them they had to disclose. That was like the real life case of Second Lieutenant Hiroo Onoda on Lubang Island in the Philliphines. When his former commander Major Taniguchi told him the war was over he came out of the jungle with his rifle, 500 rounds of ammo and some hand grenades. It was 1974. He was lucky not to have a letter from a law firm to contradict him.
Monday, October 11, 2010
Sauce for the Goose
Donald J. Byk v. Commissioner, TC Summary Opinion 2010-137
Some things are disturbing. Other things are heartening. Occasionally I encounter something that is both. Such is the case of Donald J. Byk. Tax court summary opinions are the reality TV of the system. Taxpayers who prepare their own returns according to their own notions get a chance to tell it to the judge. Frequently they end up seeming - well kind of lame. I'll point these cases out from time to time, like the fellow who claimed 96,000 business miles in his part time activities. "Anytime you're moving, you're in business." There is nothing particularly disturbing about them or heartening either of course.
What I do find disturbing is when the IRS is really lame. Byk v Com. is an appeal from a collection due process hearing. Here is how it came about. Sometime in 2007, Dr. Byk, a dentist, received a notice that his June 30, 2000 Form 941 payroll return had not been filed. His accountant, as luck and foresight would have it, had a copy of the return. Said copy was sent to the IRS to show that the Form had in fact been filed. The IRS treated the copy as an initial filing and assessed the reported tax and interest and penalties. They sent Dr. Byk a notice of federal tax lien.
Dr. Byk responded with Form 12153. Form 12153, you may discern from the large number is a relatively recent addition to the pantheon of tax forms. It is the result of the IRS Restructuring and Reform Act of 1998. The title of the form is Request for A Collection Due Process or Equivalent Hearing. I'm tempted to say that there are two types of tax practitioners. One is not familiar with Form 12153. The other isn't familiar with any of the other forms except Form 656 (Offer in Compromise). The point is that the IRS has a system for determining what your tax is, in which you cooperate to a greater or lesser extent. Once that determination is made, there is a fairly distinct system for actually collecting that amount. The latter group, collections, can be sensitive to the fact that you can't get blood from a stone, at least not quickly, but they are generally not well attuned to the notion that you might not actually owe the money
So Dr. Byk's collection due process hearing, conducted by telephone was fairly perfunctory. The resulting notice stated :
Collection followed all legal and procedural requirements and the actions taken or proposed were appropriate under the circumstances
The 1998 Act not only created the right to a hearing, it also provided that the hearing decision could be appealed to tax court. That was Dr. Byk's next step. I'm going to be quoting from the case some so its important that you keep track of the players. Dr. Byk is the petitioner. The IRS is the respondent.
The parties' confusion is understandable; the relevant timeline and tax amounts have been reconstructed using photocopied forms, computer screen printouts, and dot-matrix printouts of tax account balances. Many of these records have no supporting explanation (and therefore are inscrutable to any non-employee of the IRS)
Respondent apparently relied upon transcripts for petitioner's general dentistry business and his corporation that respondent was unable to fully explain to either petitioner or the Court. The Court questioned respondent about entries in the transcripts, specifically asking about entries concerning nonfiling of returns.Respondent agreed with the Court that the Internal Revenue Service routinely offers a transcript documenting the nonfiling of a return or a Form 3050, Certification of Lack of Record. No such documentation was provided. No explanation, other than for two codes, was given to decipher the numerous symbols and codes in respondent's transcripts. Petitioner testified that he did not understand the letters and numbers that make up the code in respondent's transcripts. To complicate matters, respondent's witness could not explain to the Court many of the codes and acronyms referenced in the transcript. Respondent simply asserted, on the basis of the incomplete testimony of his witness, that petitioner's Form 941 for that tax period was not filed until 2008
Petitioner supplied an apparent copy of a Form 941 from his accountant that respondent had requested. Petitioner asserts that the original return was properly filed and the reported tax liability timely paid. The issue of petitioner's filing a Form 941 raises questions about the validity of respondent's determination and an irregularity in the assessment procedure.
The court did not bother to remand the case back to appeals given the amount of time that had passed. The IRS behaviour in this case is rather disturbing. My bet would be that Dr. Byk did in fact file his second quarter 941 near the dawn of the millennium. Either way the IRS looks really lame, though, not being able to explain the codes on documents that they introduce as evidence. On the other hand it is heartening to know that the tax court is there for us in this situation.
I'm sure there must be somebody working on a financial MMORPG. The government monsters will have liens and levies and all sorts of other nasty stuff to cast. If you are playing a dentist or any other such tax paying character you'll be sure to have some 12153's in your potion stash.
.
Some things are disturbing. Other things are heartening. Occasionally I encounter something that is both. Such is the case of Donald J. Byk. Tax court summary opinions are the reality TV of the system. Taxpayers who prepare their own returns according to their own notions get a chance to tell it to the judge. Frequently they end up seeming - well kind of lame. I'll point these cases out from time to time, like the fellow who claimed 96,000 business miles in his part time activities. "Anytime you're moving, you're in business." There is nothing particularly disturbing about them or heartening either of course.
What I do find disturbing is when the IRS is really lame. Byk v Com. is an appeal from a collection due process hearing. Here is how it came about. Sometime in 2007, Dr. Byk, a dentist, received a notice that his June 30, 2000 Form 941 payroll return had not been filed. His accountant, as luck and foresight would have it, had a copy of the return. Said copy was sent to the IRS to show that the Form had in fact been filed. The IRS treated the copy as an initial filing and assessed the reported tax and interest and penalties. They sent Dr. Byk a notice of federal tax lien.
Dr. Byk responded with Form 12153. Form 12153, you may discern from the large number is a relatively recent addition to the pantheon of tax forms. It is the result of the IRS Restructuring and Reform Act of 1998. The title of the form is Request for A Collection Due Process or Equivalent Hearing. I'm tempted to say that there are two types of tax practitioners. One is not familiar with Form 12153. The other isn't familiar with any of the other forms except Form 656 (Offer in Compromise). The point is that the IRS has a system for determining what your tax is, in which you cooperate to a greater or lesser extent. Once that determination is made, there is a fairly distinct system for actually collecting that amount. The latter group, collections, can be sensitive to the fact that you can't get blood from a stone, at least not quickly, but they are generally not well attuned to the notion that you might not actually owe the money
So Dr. Byk's collection due process hearing, conducted by telephone was fairly perfunctory. The resulting notice stated :
Collection followed all legal and procedural requirements and the actions taken or proposed were appropriate under the circumstances
The 1998 Act not only created the right to a hearing, it also provided that the hearing decision could be appealed to tax court. That was Dr. Byk's next step. I'm going to be quoting from the case some so its important that you keep track of the players. Dr. Byk is the petitioner. The IRS is the respondent.
The parties' confusion is understandable; the relevant timeline and tax amounts have been reconstructed using photocopied forms, computer screen printouts, and dot-matrix printouts of tax account balances. Many of these records have no supporting explanation (and therefore are inscrutable to any non-employee of the IRS)
Respondent apparently relied upon transcripts for petitioner's general dentistry business and his corporation that respondent was unable to fully explain to either petitioner or the Court. The Court questioned respondent about entries in the transcripts, specifically asking about entries concerning nonfiling of returns.Respondent agreed with the Court that the Internal Revenue Service routinely offers a transcript documenting the nonfiling of a return or a Form 3050, Certification of Lack of Record. No such documentation was provided. No explanation, other than for two codes, was given to decipher the numerous symbols and codes in respondent's transcripts. Petitioner testified that he did not understand the letters and numbers that make up the code in respondent's transcripts. To complicate matters, respondent's witness could not explain to the Court many of the codes and acronyms referenced in the transcript. Respondent simply asserted, on the basis of the incomplete testimony of his witness, that petitioner's Form 941 for that tax period was not filed until 2008
Petitioner supplied an apparent copy of a Form 941 from his accountant that respondent had requested. Petitioner asserts that the original return was properly filed and the reported tax liability timely paid. The issue of petitioner's filing a Form 941 raises questions about the validity of respondent's determination and an irregularity in the assessment procedure.
The court did not bother to remand the case back to appeals given the amount of time that had passed. The IRS behaviour in this case is rather disturbing. My bet would be that Dr. Byk did in fact file his second quarter 941 near the dawn of the millennium. Either way the IRS looks really lame, though, not being able to explain the codes on documents that they introduce as evidence. On the other hand it is heartening to know that the tax court is there for us in this situation.
I'm sure there must be somebody working on a financial MMORPG. The government monsters will have liens and levies and all sorts of other nasty stuff to cast. If you are playing a dentist or any other such tax paying character you'll be sure to have some 12153's in your potion stash.
.
Friday, October 8, 2010
They Also Serve
James F. Moss, et ux. v. Commissioner, 135 T.C. No. 18, Code Sec(s) 469; 6662.
God doth not need
Either man's work or his own gifts. Who best
Bear his mild yoke, they serve him best. His state
Is kingly: thousands at his bidding speed,
And post o'er land and ocean without rest;
They also serve who only stand and wait
So this is another post about a development in the passive activity loss rules. The rules require us to group our trade or business activities into different buckets depending on our level of participation. Losses in the passive activity bucket can be used against gains from passive activities, but a net loss is suspended until the related activity is fully disposed of. A special feature of the rules is that rental activities are "per se" passive. Persons who are in real estate trades or businesses can be exempted from this "per se" passive rule. They may need to make a special election to take advantage of this benefit.
I've discussed the election in a previous post. I've also discussed the biggest problem, people have, which is proving how they spend their time. James Moss has introduced a new angle. Mr. Moss worked full time at a nuclear power plant. The total hours worked at this job for 2007 came to 1900. Included in his work hours were 200 to 300 hours of "call out" or "standby time". Apparently, this was time where he had to be ready to go in, if they needed him. Maybe it was the days when Homer Simpson was working alone, but I'm pretty sure that's a different power plant.
Mr. Moss also rented out some property that he owned. There was a four unit apartment building and three single family homes. He apparently kept meticulous track of his time. (His "day job" involved planning the maintenance activities of a nuclear power plant, so the habits there may have carried over). He spent 507.75 hours working on his properties and 137.75 hours travelling two and fro for a grand total of 645.50 hours. The court noted that the IRS did not say that Mr. Moss failed to make the election to group his properties, so they figured he must have.
You guys who know all the answers, I need you to slow down here. Mr. Moss has done better than most real estate exception wannabees in tax court. The court isn't calling his time records a ballpark guesstimate and they are giving him credit for the election. It doesn't make him win, but he deserves a cheer. Sadly, one of the necessary, though not sufficient, conditions is that you have 750 hours in a real estate trade or business. So by his own meticulous records Mr. Moss loses. He has another argument, though. All the time that he wasn't working at the power plant, he was "on-call" for his tenants. That should easily put him over the 750 hours. OK wise guys. He actually has to beat 1900 hours, because another condition is that you spend more time in real estate than anything else. Well by my reckoning the "on-call" theory could be another 6,000 hours.
Sadly the tax court wouldn't buy it. So he has to pay the tax. He also got hit with an accuracy related penalty. He proffered two arguments. The first was that the penalty should be waived, because the IRS mistreated him. Sadly we don't get the details. The other was reliance on his CPA, but it is indicated that he did not tell his CPA how many hours he worked.
First reader to identify the poem above can chose the topic of a future post.
God doth not need
Either man's work or his own gifts. Who best
Bear his mild yoke, they serve him best. His state
Is kingly: thousands at his bidding speed,
And post o'er land and ocean without rest;
They also serve who only stand and wait
So this is another post about a development in the passive activity loss rules. The rules require us to group our trade or business activities into different buckets depending on our level of participation. Losses in the passive activity bucket can be used against gains from passive activities, but a net loss is suspended until the related activity is fully disposed of. A special feature of the rules is that rental activities are "per se" passive. Persons who are in real estate trades or businesses can be exempted from this "per se" passive rule. They may need to make a special election to take advantage of this benefit.
I've discussed the election in a previous post. I've also discussed the biggest problem, people have, which is proving how they spend their time. James Moss has introduced a new angle. Mr. Moss worked full time at a nuclear power plant. The total hours worked at this job for 2007 came to 1900. Included in his work hours were 200 to 300 hours of "call out" or "standby time". Apparently, this was time where he had to be ready to go in, if they needed him. Maybe it was the days when Homer Simpson was working alone, but I'm pretty sure that's a different power plant.
Mr. Moss also rented out some property that he owned. There was a four unit apartment building and three single family homes. He apparently kept meticulous track of his time. (His "day job" involved planning the maintenance activities of a nuclear power plant, so the habits there may have carried over). He spent 507.75 hours working on his properties and 137.75 hours travelling two and fro for a grand total of 645.50 hours. The court noted that the IRS did not say that Mr. Moss failed to make the election to group his properties, so they figured he must have.
You guys who know all the answers, I need you to slow down here. Mr. Moss has done better than most real estate exception wannabees in tax court. The court isn't calling his time records a ballpark guesstimate and they are giving him credit for the election. It doesn't make him win, but he deserves a cheer. Sadly, one of the necessary, though not sufficient, conditions is that you have 750 hours in a real estate trade or business. So by his own meticulous records Mr. Moss loses. He has another argument, though. All the time that he wasn't working at the power plant, he was "on-call" for his tenants. That should easily put him over the 750 hours. OK wise guys. He actually has to beat 1900 hours, because another condition is that you spend more time in real estate than anything else. Well by my reckoning the "on-call" theory could be another 6,000 hours.
Sadly the tax court wouldn't buy it. So he has to pay the tax. He also got hit with an accuracy related penalty. He proffered two arguments. The first was that the penalty should be waived, because the IRS mistreated him. Sadly we don't get the details. The other was reliance on his CPA, but it is indicated that he did not tell his CPA how many hours he worked.
First reader to identify the poem above can chose the topic of a future post.
Wednesday, October 6, 2010
Owe It to You or Cheat You out of It
Carolee F. Argyle v. Commissioner, TC Summary Opinion 2010-129
Time for another lesson on not reflexively filing joint returns. Carollee Argyle was turned down for innocent spouse relief on her tax debt from the 2002 joint return she filed with her then husband, James Newkirk.
Early in 2002 both Ms. Argyle and Mr. Newkirk were laid off from their jobs with AT&T. Mr. Newkirk withdrew $144,205 from his pension during 2002. They ended up selling their home in Florida and buying a new home in Utah. Between this and that and the other thing, the pension money pretty much went. When it came time to file their 2002 tax return, there was a balance due of $27,539. Neither of them paid it.
The couple divorced in 2006. (This being a Tax Court Summary decision we are left to fill in the intervening drama in our imagination). The divorce agreement indicated that any debts incurred during the marriage should be the responsibility of the one who incurred the debt. The agreement did not address the unpaid tax.
It may well be that the storm clouds of marital dissolution were not on the horizon in 2003, so my previous post on this issue would not seem relevant. Nonetheless filing separately should have been considered. Presumably the liability on two separate returns was greater than the joint liability. Does that really matter though ? I have a theory that all amounts greater than you can conceivably pay will end up being equal to what somebody else thinks you can afford to pay. Maybe another couple would have seen a way to pay the $27,539, the Newkirks did not. By filing a joint return they were telling the IRS to get as much as it could up to $27,539 from both of them. Had they filed separate returns they would have been telling the IRS to get as much as it could up to say $40,000 from Mr. Newkirk.
Here is the interesting wrinkle. If it turned out that between both of them they could actually come up with $27,539, they could amend to a joint return at that point.
Filing a timely return even though you don't have the money to pay the tax is definitely the right thing to do. When you are filing such a return, think before you make it a joint return. If you are the part of the couple who doesn't have the income think three times.
Time for another lesson on not reflexively filing joint returns. Carollee Argyle was turned down for innocent spouse relief on her tax debt from the 2002 joint return she filed with her then husband, James Newkirk.
Early in 2002 both Ms. Argyle and Mr. Newkirk were laid off from their jobs with AT&T. Mr. Newkirk withdrew $144,205 from his pension during 2002. They ended up selling their home in Florida and buying a new home in Utah. Between this and that and the other thing, the pension money pretty much went. When it came time to file their 2002 tax return, there was a balance due of $27,539. Neither of them paid it.
The couple divorced in 2006. (This being a Tax Court Summary decision we are left to fill in the intervening drama in our imagination). The divorce agreement indicated that any debts incurred during the marriage should be the responsibility of the one who incurred the debt. The agreement did not address the unpaid tax.
It may well be that the storm clouds of marital dissolution were not on the horizon in 2003, so my previous post on this issue would not seem relevant. Nonetheless filing separately should have been considered. Presumably the liability on two separate returns was greater than the joint liability. Does that really matter though ? I have a theory that all amounts greater than you can conceivably pay will end up being equal to what somebody else thinks you can afford to pay. Maybe another couple would have seen a way to pay the $27,539, the Newkirks did not. By filing a joint return they were telling the IRS to get as much as it could up to $27,539 from both of them. Had they filed separate returns they would have been telling the IRS to get as much as it could up to say $40,000 from Mr. Newkirk.
Here is the interesting wrinkle. If it turned out that between both of them they could actually come up with $27,539, they could amend to a joint return at that point.
Filing a timely return even though you don't have the money to pay the tax is definitely the right thing to do. When you are filing such a return, think before you make it a joint return. If you are the part of the couple who doesn't have the income think three times.
Monday, October 4, 2010
The Mills of the Gods Grind Slowly
IN RE: BRYEN, Cite as 106 AFTR 2d 2010-5835, 08/13/2010
There are a number of sayings that I have accumulated over the course of my business career. Some I have even coined myself. An example of the latter is what I perceived to be the essence of business wisdom that my first managing partner, a second generation CPA, had distilled from perhaps a century of family public accounting experience (counting his father and his brother). "Money coming in is good. Money going out is bad." In my callow youth, I thought of that as ironic.
A real favorite, which I did not coin, is the saying "It is better to be lucky than good." (There is a contra saying that states a strong positive correlation between luck and hard work). A corollary is the observation "There but for the grace of God, go I." (Joan Baez says "fortune", but I don't find that as poetic.) That is what I reflect on contemplating the fate of Bruce Bryen, a fellow CPA.
Like Mr. Bryen, I devoted a significant part of my early professional career to tax shelters. I was fortunate in two regards. The first was that the tax shelters that my firm was involved in were quite legitimate. Shelters were attacked on a variety of grounds, one of which was that there was not a real desire for an economic return exclusive of the tax benefits. The "for profit" requirement was, however, relaxed in the case of tax shelters designed to promote low income housing, since Congress wanted people to put money into low income housing without expecting to get large economic returns or any economic return at all as it often turned out. My other piece of luck, if you might call it that, was not making enough money prior to 1986 to be tempted to buy any of the things myself.
Mr. Bryen became involved with "employee leasing" shelters. This was a type that escaped my notice in what turned out to be the waning days of real tax shelters. I may not appreciate the fine points, but the deals worked something like this. A partnership borrowed money from an operating company. The partnership then hired all the people who worked for the operating company and leased them to the operating company. The lease payments were deferred and the partnership was on the cash basis. When the partnership switched to the accrual basis it adopted a four year spread. The thing about a shelter like this is that it was pure deferral. Real estate held out the promise of conversion. That is that the income when it turned around on you would be a capital gain. Regardless, Mr. Bryen and his father, also a CPA, did quite a few of these deals. The IRS ended up making a project out of it. Finally, in 1996 one test case was heard with the decision to be binding on over 120 cases. Bealor v. Commissioner, 72 T.C.M. (CCH) 730, 1996, as you might guess found that the employee leasing arrangement was a sham. Among the facts noted was that the original "loan" by the corporation to the partnership was handled by a check that never was introduced into the banking system.
So this is all ancient history. These were cases from 1980 - 1988. The particulars aren't all that interesting because there are several law changes that would kill these deals as shelters even if they were respected. That's not what this story is about.
What happened after the Bealor decision is where it gets interesting. Given this whole test case concept you would think that Mr. Bryn would have gotten a bill sometime in 1996 or maybe 1997. That's not what happened. Here's what happened :
Once the Bealor Decision was final, the Debtor knew that he would be subject to additional tax liability and that the IRS would send him notice of the amount the IRS believed that he owed. While the Debtor knew that he also would be subject to interest and penalties, he did not know, at that time, the precise amount of additional tax that ultimately would be assessed.
For approximately five (5) years after the Bealor Decision was issued in 1996, the Debtor did not receive any communication from the IRS regarding the specific amount of his additional tax liability.
On June 27, 2002, the parties' negotiations culminated in the Debtor signing three (3) stipulations with the IRS All three (3) stipulations stated that the Debtor owed taxes due to substantial underpayment attributable to tax motivated transactions.
The total tab tax and penalties was $2,808,444. Then they added the interest. That brought the total tab to $13,556,124.82. Mr. Bryen's total payments on this obligation were exactly 0. The court noted that in the years from 1996 to 2003 Mr. Bryen's income ranged from the mid sixties to as much as $190,000. In 2004, when he filed for bankruptcy his projected annual income was $125,000. He listed 23 million dollars in debts of which 19 million was due to the IRS. (I don't know how it got from 13 to 19. It probably doesn't matter).
The court describes Mr. Bryen's lifestyle during this period in what to me sounds like a critical tone. He spent as much as $25,000 on travel in some years and shared the expenses of a beach house owned by his girl friend, whom he subsequently married. They spent $5,000 on their wedding the cost being evenly split between them.
I have this real mental split about how I respond to amounts of money. I have a rule with my kids that they can't use the word "only" in conjunction with any sum of money greater than four dollars (My kids are 17 and 21, by the way). I've not had a particularly onerous life, but as a teenager living with my mother, I was technically below the poverty line. When I was in VISTA, I used to consider how many cans of tuna fish I had to be a significant portion of my net worth. To this day, I get a warm fuzzy feeling when I open the cabinet and see 10 or more cans of tuna fish. So I understand the perspective that sees Mr. Bryen living real high during that period. On the other hand I've lived in a business world not that far removed from Mr. Bryen's where an income of $150,000 might be referred to as a buck and a half. The court is criticizing Mr. Bryen because he didn't live a frugal lifestyle for the five years that the IRS spent dithering after they won the Bealor case. The thing is that you could have teamed up Suzie Orman and my mothers friend "Aunt" Melba, who would mix four cans of water with the frozen orange juice, to run Mr. Bryen's life while he was waiting for the hammer to fall and he might have been able to save up something like $300,000 or so. In which case he would have owed more than he could ever conceivably pay. Choosing instead to live a less than frugal lifestyle he ended up owing more than he could ever conceivably pay.
The court did not say how much of a payment would have made a difference, but since he paid nothing and lived high on the hog for those five years, his debt was not discharged in bankruptcy. I'd love to have some comments from people who work with collections as to how they think this drama will play out from here.
Saturday, October 2, 2010
Clock is Ticking On Amending Returns of Same Sex Couples
Taxpayers who extended their 2006 returns have until October 15, 2010 to amend. In a previous post, I discussed at some length the Gill decision. Under the Defense of Marriage Act, same sex couples are not considered to be married for purposes of federal law. The Gill decision found that a significant portion of DOMA is unconstitutional. Among many other things, the Court ruled that couples married under Massachusetts law should be entitled to file joint federal income tax returns.
This will generally be more beneficial to the extent that there is a difference in the couples income. For example if Robin and Terry each make $100,000, they will likely be better off single. If Robin makes $200,000 and Terry makes nothing a joint return will produce a lower tax. The way various exemptions, phase-outs and limitations work, though, makes any general rule like that of limited applicability. If, for example, Robin had disallowed investment interest and Terry had investment income, a joint return might producing savings even if their incomes were equal. They only way to tell for sure is to run the numbers.
As I have pointed out in another post, the decision to file a joint return is not just a numbers exercise. Joint returns create joint and several liability. The Gill decision applies to couples who are married under state law.
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