Archive for 'Taxes'

Sep 21

Sometimes I am amazed at the lengths to which some people will go to not pay taxes.

I was reading Sollberger v Commissioner, recently decided by the Court of Appeals for the Ninth Circuit.

Before getting into Sollberger, let’s talk about Derivium Capital.  Derivium was based in Charleston, South Carolina, and was headed by Charles D. Cathcart, an economist whose resume included a University of Virginia Ph.D., a stint at the CIA and a term at Citicorp working with derivatives.  Derivium presented a way for taxpayers to dispose of significant stock positions without triggering immediate tax. At least that was their pitch. They would lend up to 90% of a stock position on a nonrecourse basis. Nonrecourse means that the borrower could walk away from the debt. If memory serves, their deals generally ran approximately three years, and their loans did not require interest payments. Rather the interest was added to the loan. At the end of the term, the borrower could repay the loan, plus interest, and get the stock back. It goes without saying that one would do this only if the stock had appreciated. Otherwise the borrower would simply walk away from the loan.

Derivium would immediately sell the stock, providing money for the loan back to the borrower. In addition, they wrapped the loans using offshore lenders, first using a company in Ireland and then another company in the Isle of Man. This was apparently a good deal for Derivium, as it received approximately $1 billion in stock, originated $900 million in loans, kept $20 million and sent the rest to the offshore lenders.

Nice payday, when you can get it.

You can guess how this tuned out. Derivium was investigated by the IRS and the state of California and then filed for bankruptcy. Once the IRS stepped-in, they began looking at the other side of the transaction, which meant looking at the individual returns of the people who had transacted with Derivium.

Enter Kurt Sollberger. He transacted with a company called Optech, not Derivium, but it was a Derivium-inspired deal. Sollberger was president of Swiss Micron, which adopted an Employee Stock Ownership Plan (ESOP). In 2000 he sold his shares to the ESOP for a little more than $1 million. With the money he bought floating rate notes (which is pretty esoteric by itself). In 2004 he entered into the loan deal with Optech. That deal was pretty sweet. Optech loaned him 90% on a seven year nonrecourse debt, with the option of adding interest into the loan. Optech would collect interest from the notes (at least, until Optech sold them) and in turn charge Sollberger interest. If there was net interest due, Sollberger could pay the interest or add it into the note. He could not prepay the loan for seven years, however, at which time he could get retrieve the notes by repaying the loan with accrued interest.  That would be awkward for Optech, seeing how it had SOLD the notes.

Then it gets weird.

Sollberger received quarterly statements from Optech for less than one year. He diligently paid the net interest due. Then Optech quite sending statements and he quit paying interest.

Sure, happens all the time. When was the last time Fifth Third forgot to bill the interest on your loan?

The IRS audited Sollberger, said he sold the notes in 2004 and sent him a bill for $128,979, plus interest and penalties.

Sollberger went to Tax Court, which recognized the Derivium-inspired deals. It did not go well. After losing there, Sollberger petitioned the Ninth Court of Appeals. The Court had some trenchant observations:

If the FRN’s lost value after Sollberger transferred them to Optech, he would have been foolish to repay the nonrecourse loan at the end of the loan term, as he had no personal liability for the principal or interest allegedly due.”

Sollberger’s and Optech’s conduct also confirms our conclusion that the transaction was, in substance, a sale. Although interest accrued on the loan, Sollberger stopped receiving account statements and making interest payments after the first quarter of 2005, less than one year into the seven-year term. Thus, neither Sollberger nor Optech maintained the appearance that a genuine debt existed for long.”

Although the transaction is byzantine, the tax concept involved is simple: how far can someone push the limits of a “loan” before a reasonable person simply concludes that there was a sale. A seven-year nonrecourse loan looks very aggressive, and stopping interest payments less than a year into the loan sounds like tax suicide. The Ninth Circuit decided against Sollberger and told him to pay the taxes.

My Take: Let me see. Sollberger received a little over $1 million and the IRS wanted approximately $129,000. This leaves him approximately $871,000, although there is still state tax. For this he enters into a complicated scheme involving folded interest, a “put” seven years out and bankers from Ireland and the Isle of Man?

A word of advice from a tax pro: one does not tax shelter at a 15% tax rate. The government could virtually eradicate tax shelters (and many tax advisors) by lowering the tax rate to a flat 15% and requiring everyone to pay-in their fair share.

Good grief, man. Just pay the tax.

Sep 15

We recently had an issue with the generation-skipping tax (GST). What is it? First of all think gift or estate tax. Pull your thoughts away from income taxes. Gift or estate tax is assessed when you either (a) gift property or (b) die with property. One would think would be sufficient, but there was a loophole to the gift and estate tax that Congress wanted to fix. That fix was the generation-skipping tax.

Let’s explain the loophole through a story. Joseph P. Kennedy (1888-1969) was a bank president by age 25. He made his chops through insider trading before the government ever thought of a Securities and Exchange Commission (SEC). He had the foresight to unload his stocks before 1929, and then added to his fortune by shorting stocks during the Great Depression. Frankly, this guy was THE Gordon Gekko of his time. Today he would be in jail with Bernie Madoff. In an example of the irony that is Washington D.C., he became the first chairman of the SEC.

Let’s continue. By the mid-thirties his fortune was closing in on $200 million. Joe had a problem: he wanted to pass the money on to his descendants, but the estate taxes were usurious. For much of his wealth years, estate taxes were 70% or more. Granted, there was an exclusion amount, but Joe had long since accumulated substantially more than any exclusion amount. What was Joe to do?

Here is what Joe did: he had multiple generations skip the estate tax entirely. How?

Joe did this by using trusts. In 1926 Joe set up his first trust for Rose and the children. He created another in 1936, and then another in 1949. This last trust was the one through which Joe would transfer to his 28 grandchildren. We have talked about dynasty trusts in the past, and Joe was apparently a believer. A dynasty trust will run as long as state law will allow (there is a legal doctrine called the “rule against perpetuities”). A dynasty trust can go to the grandkids, then the great-grandkids, then the great-great…. Well, you get the idea.

John F. Kennedy (JFK) was Joe’s son and a trust beneficiary. He was also the 35th President of the United States. JFK’s trust provided him income for life, as well as the right to withdraw up to 5% of the trust principal annually. It must have been a fairly sizeable income, as JFK donated his presidential salary to charity. Upon JF’s death, his interest in Joe’s trust was not taxable to his estate (which is pretty much the point of a skip trust). Joe’s trust then skipped to JFK’s children, John F. Kennedy Jr and Caroline Kennedy. By the way, JFK had never updated his will, and upon his death he left no provision for his children. It is possible that – had he lived – JFK would have settled his own skip trust, and then his children would have had TWO generations of skip trusts providing them income.

Eventually this technique came to Congress’ attention, and in 1976 they passed their first attempt at the GST. The law was very poorly drafted, and Congress kept postponing the law until they ultimately repealed it – retroactively – in 1986. In its place Congress substituted a new-and-improved GST.

What is it about the GST? First, it is not the easiest reading this side of Joyce’s Ulysses. Second, much of estate planning is done using trusts. This introduces trust techniques such as fractionalization (i.e., assets going to multiple individuals), control (i.e., the beneficiary can request but the trustee can reject), and timing (i.e., the grandchildren have to wait until the children are deceased).  Third, unlike the gift or estate tax, the GST may not be payable at the time of gift or death. The GST can spring up years later when the trust distributes or terminates. Try having that conversation with a client….

Let’s go through some examples.

(1)  You gift your grandchild $100,000 as a down-payment on a house.

1. OK, that seems pretty simple. You have a skip.

Let’s step through the taxation of this transaction:

i. You are out the $100,000.

ii. You paid the gift tax.

iii. What happens if you pay the GST for your grandchild?

SPOILER ALERT: The recipient (not the payer) is liable for the GST.

Your payment of the GST is treated as an ADDITIONAL gift!

(2) You set up a trust for your grandchild. You settle it with $100,000.

1. On its face I would say you have a skip.

(3) Let’s modify the trust. Say that you give a life estate to each of your two children. Your three grandchildren are residual beneficiaries.

1. Is there a skip? Yep.

2. How do you value the skip?

Let’s do ourselves a favor and “skip” that question for a moment.

3. When do you value it?

i. At the time the trust is created?

ii. When the children both pass away (leaving only the grandchildren)?

iii. When the trust actually distributes to a grandchild?

 ANSWER: at the death of the second-to-die child

 (4)    Let’s press on. The grandchildren are not yet born when you fund the trust. Attorneys refer to them as “contingent” beneficiaries.

1. Is there a skip? Probably.

Probably? What kind of weasel answer is that?

The truth is that there may never be grandchildren, or the grandchildren may not live long enough to benefit under the trust. In that situation, there is no skip. Otherwise there would be a skip.

2. How do you value the skip?

I tell you what I would do: I would allocate $100,000 of my GST exemption to the trust when settled. I would file a gift tax return and prominently announce to the IRS that I am allocating $100,000 of my exemption. This makes the trust GST exempt, now and forever. It will not matter how much the trust appreciates in the future, or if, when or to whom it distributes.

3. When do you value it?

If you followed my advice, when you funded the trust.

Now before you worry about the GST, remember that one has to skip a certain amount of money to even step onto the GST field. For 2012 you would have to skip more than $5 million. If there is no change in the tax law, in 2013 that amount will drop to $1 million. Still, $1 million will keep most of us out of GST trouble.

The estate tax was Congress’ effort to slow-down the accumulation of familial wealth, and the GST was an effort to close a loophole in the estate tax. Its purpose was to ensure that accumulations of great wealth were taxed at least once every generation. Congress did not want the establishment of an inherited class, somewhat like the House of Lords in England. How many Paris Hiltons – or William Kennedy Smiths – do we as a nation want to tolerate?

The irony of GST tax law is that wealthy had little incentive to establish dynasty trusts before 1986. There were several states, including Idaho and Wisconsin, which allowed trusts to be perpetual. Many states have since followed suit, liberalizing their state statutes to allow long-lived (although maybe not perpetual) trusts in an effort to attract the high-wealth investments out there. There was a study in the mid-2000s which estimated that more than $100 billion had flowed into states allowing these long-lived trusts. It appears that Congress has created a bit of a cottage industry.

Sep 05

There is a saying among tax pros: “do not let the tax tail wag the dog.” The point is to not let taxes so influence the decision that the final decision is not in your best interest. An example is failing to sell a profitable stock position for the sake of not paying taxes. Seems a good idea until the stock market – and your stock – takes a dive.

This past week I was reading about the estate of Marilyn Monroe. Did you know that her estate was the third highest-earning estate in 2011?  Her estate earned $27 million and came in behind the estates of Michael Jackson and Elvis Presley. What is driving this earning power?

What is driving it is “rights of publicity.” For example, the website Squidoo.com reports that Marilyn Monroe posters remain one of the top-sellers for students decorating their dorm rooms. A “right of publicity” exists at the whim of state statute. There is no federal law equivalent. Indiana is considered to have one of the most far-reaching statutes, recognizing rights to publicity for 100 years after death.

Marilyn Monroe divorced Joe DiMaggio in October, 1954. She then left California for New York. In 1956 she married Arthur Miller, and the couple lived In Manhattan’s Sutton Place. Marilyn still considered this her home when she died in Brentwood, California in August, 1962.

The executors of her estate had a tax decision to make: was her estate taxable to California (where she died) or New York (where she maintained the apartment and staff). They decided it would be New York, primarily because California’s estate taxes would have been expensive. By treating her as a New York resident, they were able to limit California to less than $800 in taxes.

Let’s go forward three or four decades, and states like California and Indiana now permit celebrities’ estates to earn large revenues, in large part by liberalizing property interests such as publicity rights. Some states have not been so liberal – states such as New York.

You can see this coming, can’t you?

Let’s continue. In 2001 The New York County Surrogate’s Court permitted the estate to close, transferring the assets to a Delaware corporation known as Marilyn Monroe LLC (MMLLC). The licensing agent for MMLLC is CMG Worldwide, an Indiana company that also manages the estate of James Dean. Is the selection of Indiana coincidental? I doubt it, given what we discussed above.

Marilyn is an iconoclastic image, and her photographs – and the rights to those photographs – are worth a mint. Enter Sam Shaw, who took many photographs of Marilyn, including the famous photo of her standing over a subway grate with her skirt billowing. The Shaw Family Archives (SFA) got into it with MMLLC, with MMLLC arguing that it exclusively owned the Monroe publicity rights.  SFA sued MMLLC in New York, and the court granted SFA summary judgment. The court noted that Marilyn Monroe was not a domiciliary of Indiana at her time of death, so her estate could not transfer assets to Indiana and obtain legal rights that did not exist when she died. She was either a resident of New York or California, and neither state recognized a posthumous right of publicity at her time of death.

MMLLC had no intention of rolling over. It called a few people who knew a few people.

In 2007 Governor Schwarzenegger signed into law a bill creating a posthumous right of publicity, so long as the decedent was a resident of California at the time of death. Even better, the law was made retroactive. The law could reach back to the estate of Marilyn Monroe. Wow! How is that for tax planning!

Now the estate of Marilyn Monroe started singing a different tune: of course Marilyn was a resident of California at her time of death. That entire issue of making her a New York resident was a misunderstanding. She had been living in California. She loved California and had every intention of making it her home, especially now that California retroactively changed its law 45 years after her death.

You know this had to go to court. MMLLC did not help by aggressively suing left and right to protect the publicity rights.

Last week the Ninth Circuit Court of Appeals (that is, California’s circuit) ruled that The Milton Greene Archives can continue selling photographs of Marilyn Monroe without paying MMLLC for publicity rights. The court noted that the estate claimed Monroe was a New York resident to avoid paying California taxes. The estate (through MMLLC) cannot now claim Monroe was a California resident to take advantage of a state law it desires.

NOTE: This is called “judicial estoppel,” and it bars a party from asserting a position different from one asserted in the past.

The appeals judge was not impressed with MMLLC and wrote the following:

“This is a textbook case for applying judicial estoppel. Monroe’s representatives took one position on Monroe’s domicile at death for forty years, and then changed their position when it was to their great financial advantage; an advantage they secured years after Monroe’s death by convincing the California legislature to create rights that did not exist when Monroe died. Marilyn Monroe is often quoted as saying, ‘If you’re going to be two-faced, at least make one of them pretty.’”

What becomes now of MMLLC’s rights to publicity? Frankly, I do not know. It is hard to believe they will pick up their tent and leave the campground, however.

I am somewhat sympathetic to the estate and MMLLC’s situation. It was not as though the estate made its decision knowing that property rights were at stake.  At the time there were no property rights. It made what should have been a straightforward tax decision. Who could anticipate how this would turn out?

On a related note, guess whose case will also soon come before the Ninth Circuit on the issue of post-mortem publicity rights?  Here is a clue: he was from Seattle, had a four-year career and died a music legend. Give up?

It’s the estate of Jimi Hendrix.

Aug 29

Let’s talk about IRAs – Individual Retirement Accounts.

Why? By mid-October the IRS is to report to Treasury its plans to increase enforcement of IRA contribution and withdrawal errors. TIGTA projects that there could be between $250 million and $500 million in unreported and uncollected IRA annual penalties.  This is low-hanging fruit for a Congress and IRS looking for every last tax dollar.

So what are the tax ropes with IRAs? Let’s talk first about putting money into an IRA.

IRA CONTRIBUTIONS

For 2012 you can put up to $5,000 into an IRA. That amount increases to $6,000 if you are age 50 or over. You can put monies into a regular IRA, a Roth IRA or a combination of the two, but the TOTAL you put in cannot exceed the $5,000/$6,000 limit. That $5,000/$6,000 limit decreases as your income increases IF you are covered by a plan at work. If you have a 401(k)/SIMPLE/SEP/whatever at work, you have to pay attention to the income limitation.

What errors happen with contributions? Let me give you a few examples:

(1)   Someone is over the income limit but still funds an IRA.

(2)   Someone funds their (say 2011) IRA after April 15 (2012) of the following year. An IRA for a year HAS to be funded by the following April 15th. There is no extension for an IRA contribution, even if the underlying tax return is extended. If you make an IRA contribution on April 20, 2012, that is a 2012 IRA contribution. It is not and cannot be for 2011, because you are beyond the maximum funding period for 2011. Say that you fund your 2012 IRA again by April 1, 2013. Congratulations, you have just overfunded your 2012 IRA. The IRS will soon be looking for you.

(3)   You have no earned income but still fund an IRA. What is earned income? An easy definition is income subject to social security. If you have income subject to social security (say a W-2), you may qualify for an IRA. If you don’t, then you do not. If I am looking at a return with a pension, interest, dividends and an IRA deduction, I know that there is a tax problem.

What happens if you over-fund an IRA? Well, there is a penalty. You also have to take the excess funding out of the IRA. The penalty is not bad – it is 6%. This is not too bad if it is just one year, but it can add-up if you go for several years. Say that you have funded $5,000 for seven years, but you actually were unable to make any contribution for any year. What happens?

Let’s take the first year of overfunding and explain the penalty. You overfunded $5,000 in 2005. The first penalty year for 2005 would be 2006. Here is the math:

            2005 IRA of $5,000

                        2006                $5,000 times 6% = $300

                        2007                $5,000 times 6% = $300

                        2008                $5,000 times 6% = $300

                        2009                $5,000 times 6% = $300

                        2010                $5,000 times 6% = $300

                        2011                $5,000 times 6% = $300

                        2012                $5,000 times 6% = $300

So the penalty on your 2005 IRA of $5,000 is $2,100.

Are we done? Of course not. Go through the same exercise for the 2006 contribution. Then the 2007 contribution. And 2008. And so on. Can you see how this can get expensive?

As bad as the penalty may be on excess IRA funding, it is nothing compared to the under-distribution penalty. To better understand the under-distribution penalty, let’s review the rules on taking money out of an IRA.

IRA WITHDRAWALS

The first rule is that you have to start taking money out of your IRA by April 1st of the year following the year you turn 70 ½.

From the get-go, this is confusing. What does it mean to turn 70 ½? Let use two examples of a birth month.

            Person 1:         March 11

            Person 2:         September 15

We have two people. Each celebrates his/her 70th birthday in 2012. Person 1 turns 70 ½ in 2012 (March 11 plus 6 months equals September 11), so that person must take a minimum IRA withdrawal by April 1, 2013.

Person 2 turns 70 ½ in 2013 (September 15 plus 6 months equals March 15). Person 2 must take a minimum withdrawal by April 1, 2014.

I am not making this up.

Say you are still working at age 70 ½, and the money we are talking about is in a 401(k). Do you have to start minimum distributions? The answer is NO, as long as you do not control more than 5% of the company where you work. What if you roll the 401(k) to an IRA? The answer is now YES, because the exception for working is a 401(k)-related exception, not an IRA-related exception.

Let’s make this more confusing and talk about withdrawals from inherited IRAs. We are now talking about a field littered with bodies. These are some of the most bewildering rules in the tax code.

Inherited does not necessarily mean going to a younger generation. A wife can inherit, as can a parent. The mathematics can change depending on whether you are the first to inherit (i.e., a “designated” beneficiary) or the second (i.e., a “successor” beneficiary).

There are several things to remember about inherited IRAs. First, the surviving spouse has the most options available to any beneficiary. Second, the IRA beneficiary (usually) wants to do something by December 31st of the year following death. Third, a trust can be the beneficiary of an IRA, but the rules get complex. Fourth, your estate is one of your worst options as your IRA beneficiary.

Did you know that you are supposed to retitle an inherited IRA, being careful to include the original owner’s name and indicating that it is inherited, e.g., Anakin Skywalker, deceased, inherited IRA FBO Luke Skywalker? Did you know that a common tax trap is to leave out the “deceased” and “inherited” language? Without those magic words, the IRS does not consider the IRA to be “inherited.” This can result in immediate tax.

Having gone though that literary effort, it seems understandable that you are not to commingle inherited IRAs with your other IRAs. Heck, you may want to keep the statements in a separate room altogether from your regular IRAs, just to be extra safe.

Forget about a 60-day rollover for an inherited IRA. A rollover is OK for your own IRA but not for an inherited IRA. Mind you, you can transfer an inherited IRA from trustee to trustee, but you do not want to receive a check. You do that – even if you pay it back within 60 days – and you have tax.

Let’s say you inherit an IRA from your mom/dad/grandmom/granddad. Payments are reset over your lifetime.  You must start distributions the year following death. What if you don’t distribute by December 31st of the following year? The IRS presumes you have made an election to distribute the IRA in full within five years of death. So much for your “stretch” IRA.

Confusing enough?

One more example. You have IRA monies at Fidelity, Vanguard, T. Rowe Price, Dreyfus and Janus. When you add up all your IRAs to calculate the minimum distribution, you forget to include Dreyfus. What just happened? You have under-distributed.

How bad is the penalty for not taking a minimum distribution, you ask? The penalty is 50% of what you were required to take out but did not. 50 PERCENT!!! It is one of the largest penalties in the tax code.

EXAMPLE: Let’s say that the Dreyfus share of your minimum distribution was $1,650. Your penalty for inadvertently leaving Dreyfus out of the calculation is $825 ($1,650 times 50%).

The IRS has traditionally been lenient with the under-distribution penalty. Perhaps that is because the intent is to save for retirement, and this penalty does not foster that goal. Perhaps it is because a 50% penalty seems outrageous, even to the IRS. However, will a Congress desperate for money see low-hanging fruit when looking at IRAs?

CONCLUSION

If you are walking into an IRA situation, consider this one of those times in life when you simply have to get professional advice. The rules in this area can bend even a tax pro into knots. I am not talking about necessarily using a tax pro for the rest of your life. I am talking about seeing a pro when you inherit that IRA, or when you close in on age 70 ½. Be sure you are handling this correctly.

Aug 21

I was glad to see that Senator Sherrod Brown (D – OH) introduced the Mobile Workforce State Income Tax Simplification Act on August 2, 2012.  The bill is being promoted by the American Institute of CPAs, and a version of the bill passed the House on voice vote May 15th.

The bill would establish a uniform standard for the withholding of state income taxes on nonresident employees.  It would lessen the burden the current system places on employers and traveling employees. 

Both bills would require nonresidents to work in a state for more than thirty days before becoming subject to a state‘s income tax withholding. 

Why is this an issue? Let’s say that you start a consulting firm. Business takes off. You develop a national client base and hire employees. You send your employees throughout the country, sometimes for 4 or 5 days and other times for longer. You meet with me to discuss your tax filing requirements, especially your payroll. You tell me that you have engagements coming up in the following states and ask me how to handle the employee withholding.

               State                                      Exempt from Employer Withholding if …

Arizona                                               60 days or less

California                                            exempt if less than $1,500

Delaware                                             no exception

Georgia                                               23 days or less

Hawaii                                                 60 days or less

Idaho                                                   exempt if less than $1,000

Maine                                                  10 days or less

Maryland                                             exempt if less than $5,000

Massachusetts                                     no exception

Ohio                                                    less than $300 in any quarter

Virginia                                               exempt if less than $7,000

Now seriously, how are we to work with this? Remember that payroll may have some very nasty penalties for just minor errors. Do we simply withhold from day one on all employees in all states? That is the safest way to go, but now you are going to have monthly or quarterly reporting to almost every state in the nation. Perhaps the report says “zero”, but it will still take time to prepare and file. You may have additional end of year considerations, such as submitting W-2s to the state. Why not just shut down the account every time, you ask? That likely will save little to no time overall and may create more problems whenever you try to reactivate an account.

This all takes time. It may be my time, it may be your employee’s time, but you will be paying for this time. You can now see the issue. If you ship an employee into Delaware for 1 1/2 days, do they really expect you to withhold, remit and keep reporting to Delaware until the cows come home? Perhaps this made sense years ago when our parents worked at the factory down the street, but it makes no sense today. It is unreasonable to threaten an employer with payroll taxes (and penalties) because they made the mistake of sending an employee into your state for 3 or 4 days. This is not the Lewis and Clark era.

Will this bill pass Congress? My hunch is that no tax bill will pass Congress until the elections are resolved, and then only a tax extender bill passed at the last hour of the last day. This bill will not pass this Congress, but at least the issue is being discussed and highlighted. Perhaps next time and next Congress.

Aug 17

There is good tax news for many U.S. expats and dual citizens. Beginning September 1st, the IRS is starting a new program allowing many expats to catch-up on late tax returns and late FBARs without penalties.

This new program is different from the “Offshore Voluntary Disclosure” programs of the last few years. For one thing, this program is more geared to an average expat. Secondly, and more important to the target audience of the OVD programs, this program does not offer protection from criminal prosecution. That is likely a nonissue to an average expat who has been living and working in a foreign country for several years and has not been trying to hide income or assets from the U.S.

Under this new program, an expat will file 3 years of income tax returns and 6 years of FBARs. This is much better than the 8 years of income tax returns and 8 years of FBARs for OVD program participants.

All returns filed under this program will be reviewed by the IRS, but the IRS will divide the returns into two categories:

Low Risk – These will be simple tax returns, defined as expats living and working in foreign countries, paying foreign taxes, having a limited number of investments and owing U.S. tax of less than $1,500 for each year. Low risk taxpayers will get a pass – they will pay taxes and interest but no penalties.

NOTE: When you consider that the expat will receive a foreign tax credit for taxes paid the resident country, it is very possible that there will be NO U.S. tax.

 Higher Risk – These will be more complicated returns with higher incomes, significant economic activity in the U.S., or returns otherwise evidencing sophisticated tax planning. These returns will not qualify for the program and (likely) will be audited by the IRS. This is NOT the way to go if there is any concern about criminal prosecution. However, it MAY BE the way to go if concern over criminal prosecution is minimal. Why? The wildcard is the penalties. Under OVDP a 27.5% penalty is (virtually) automatic. Under this new program the IRS may waive penalties if one presents reasonable cause for noncompliance.

NOTE: This is one of the biggest complaints about the OVD program and its predecessors: the concept of “reasonable cause” does not apply. The IRS consequently will not mitigate OVD penalties. This may have made sense for multimillionaires at UBS, but it does not make sense for many of the expats swept-up by an outsized IRS dragnet.

The IRS has also announced that the new program will allow resolution of certain tax issues with foreign retirement plans. The IRS got itself into a trap by not recognizing certain foreign plans as the equivalent of a U.S. IRA. This created nasty tax problems, since contributions to such plans would not be deductible (under U.S. tax law) and earnings in such plans would not be tax-deferred (under U.S. tax law). You had the bizarre result of a Canadian IRA that was taxable in the U.S.

QUESTION: If your tax preparer had told you that this was the tax result of your Canadian RSSP, would you have believed him/her? Would you have questioned their competency? Sadly, they would have been right.

Aug 16

The IRS itself has been in the news recently. Whether it is the ham-handed treatment of Section 501(c)(4) political/nonprofit groups or the shadow funding of ObamaCare, the agency has been drawing attention and criticism. Today we are going to talk about two recent studies requested by Charles Boustany (U.S. Rep – LA). He presently serves as the Chairman of the House and Ways Subcommittee on Oversight.

The first report is titled “There Are Billions of Dollars in Undetected Tax Refund Fraud Resulting From Identity Theft. It addresses identity theft, which has been the number one consumer complaint with the Federal Trade Commission for 12 consecutive years.

The IRS presently processes returns and issues refunds before receiving the information forms with which to crosscheck. For example, if someone receives his/her Form W-2 and files for a refund in January, the IRS is issuing that refund check before the underlying wage information has been received from the employer, much less integrated into IRS information systems. This weakness has been exploited and has become a virtual cottage industry in certain cities such as Tampa, Florida.

Consider what TIGTA discovered:

  • 2,137 returns resulting in $3.3 million in refunds were sent to one address in Lansing, Michigan
  • 518 returns resulting in $1.8 million in refunds were sent to one address in Tampa, Florida
  • 23,560 refunds totaling more than $16 million were issued to 10 bank accounts;  2,706 tax refunds totaling $7.3 million were issued to a single account

This is real money. TIGTA estimates that the IRS will issue almost $21 billion in identity-theft refunds over the next five years.

TIGTA made several recommendations, including:

  • Taking advantage of the information reporting available to the IRS. Social security benefit information, for example, is available in December – before filing season begins. Whereas this is a fraction of identity fraud, it is a positive step.
  • The IRS uses little of the data from its identity theft cases to develop patterns and trends which could be used to detect and prevent future tax fraud. Examples include whether the return was electronically or paper-filed, how the refund was issued, and, if issued by direct debit, the account number or debit card number receiving the refund.
  • Allow the IRS greater access to the National Directory of New Hires (NDNH). NDNH is a national database of newly-hired employees. It includes an employee’s name and address as well as wage information. By referencing information from prior year tax filings, the IRS could correlate NDNH data to determine whether reported wage reporting and claimed withholding appear fraudulent.
  • Encourage banks and work with federal agencies to ensure that direct deposit refunds are made only to an account in the taxpayer’s name.
  • Limit the number of tax refunds issued via direct deposit to the same bank account or debit card.

NOTE: That recommendation seems obvious.

 “Substantial Changes Are Needed to the Individual Taxpayer Identification Number Program to Detect Fraudulent Applications”

The second report is disturbing. IRS employees had contacted Congress directly about supervisor misconduct and potential fraud in a program that reviews and verifies individual taxpayer identification numbers (ITINs). Congress then called in TIGTA to investigate.

We should explain that an ITIN is an Individual Tax Identification Number. ITINs were started in 1996 as tax identification for individuals who may have U.S. tax filing requirements but are not eligible for social security.

How can this happen?

  • Consider a German businessperson who invests in and receives income from a Miami shopping mall
  • Consider a Nigerian graduate student attending the University of Missouri (many) years ago with yours truly
  • Consider my brother-in-law’s wife, who is English and married to a U.S. citizen 

An ITIN will allow one to open a bank account and file tax returns. For example, if one’s spouse is English and one lives in England, the spouse will need an ITIN to file a U.S. income tax return. The children – who possibly have never been to the U.S. – will need ITINs to be claimed as dependents on the U.S. income tax return.

OBSERVATION: This is one of the absurd consequences of the U.S. worldwide income tax regime. A U.S. citizen has to file tax returns, even if he/she has lived outside the U.S. for many years, has a family outside the U.S. and has no immediate plans of repatriating to the U.S.

When one finally obtains a green card, one can transfer work and wage information from the ITIN to the Social Security Administration.

One applies for an ITIN by filing a form (Form W-7) and attaching supporting documents to verify one’s identity and foreign status. A passport will satisfy both the identity and foreign status requirements. The IRS will otherwise accept a combination of documents, including a foreign driver’s license, a foreign birth certificate, a foreign voter’s registration, a visa or other IRS-listed documents. The process usually takes place through the mail, which means that no US-agency employee actually sees the person applying for the ITIN.

Unfortunately, ITINs have been swept-up in political battles. For example, there is fear that the IRS will share this information with Immigration, although the IRS is not permitted by law to do so. This may discourage people from obtaining ITINs, so the argument goes. On the other hand, there are states that will allow one to obtain a driver’s license solely with an ITIN, which seems a perversion of its intended purpose.

TIGTA goes into the IRS to investigate the complaints. Here are some of its findings:

  • IRS management is not concerned with addressing fraudulent applications in the ITIN Operations Department because of the job security that a large inventory of applications to process provides. Management is interested only in the volume of applications that can be processed, regardless of whether they are fraudulent.
  • IRS management has indicated that no function of the IRS, including Criminal Investigation or the Accounts Management Taxpayer Assurance Program, is interested in dealing with ITIN application fraud.
  • IRS management has:
    •  Created an environment which discourages tax examiners responsible for reviewing ITIN applications from identifying questionable applications.
    • Eliminated successful processes used to identify questionable ITIN application fraud patterns and schemes.
    • Established processes and procedures that are inadequate to verify each applicant’s identity and foreign status.

Good grief! The IRS disbanded an ITIN team that was having too much success, countered by provided virtually no training to new hires and transfers and put negative evaluations in overly-eager reviewers’ files.

TIGTA made nine recommendations in this report. The IRS agreed with seven and has already announced plans to implement interim changes. One has caused quite the consternation in the immigrant community by requiring copies of original documents with ITIN applications.

OBSERVATION: Let’s be fair here: would you be comfortable sending original copies of anything to the IRS? Assuming you can find that birth certificate from the mother country, how are you going to replace it when the IRS loses the thing?

 

Aug 07

Shepherd v Commissioner is a pro se case before the Tax Court. “Pro se” means that the taxpayer is representing himself/herself, without a professional. Technically that is not correct, as a taxpayer can go into Tax Court with a professional and still be considered “pro se.” This happens if the professional (say a CPA) has not passed the examination to practice before the Court. The CPA can then “advise” but not “practice,” and the taxpayer is considered “pro se.”

Today we will be talking about cancellation-of-debt income. Tax pros commonly refer to this is “COD” income. For many years I rarely saw a COD issue. In recent years it seems to be endemic. There are two common ways to generate COD: a home is foreclosed or a credit card is settled. If one pays less than the balance of the debt, the remaining balance is considered to be income to the debtor.

How can that be, you may ask. Let’s use an example. Say you go to your bank and borrow $50,000. When the loan is due, you cannot afford to pay in full. The bank agrees to accept $36,000 as full payment on the loan. From the IRS’ perspective, you received and kept a net $14,000. Perhaps you bought a car, went on vacation, or paid for a kid’s college, but you had an accession to wealth. The IRS considers the $14,000 to be income to you.

There are exceptions, and Shepherd involves the “insolvency” exception. This is different from the bankruptcy exception. Granted, in both cases you are likely insolvent, but for the insolvency exception you do not have to file with a bankruptcy court.

Let’s quickly take a look at the wording for insolvency in the tax code:

                108(d)(3) INSOLVENT.— For purposes of this section, the term “insolvent” means the excess of liabilities over the fair market value of assets. With respect to any discharge, whether or not the taxpayer is insolvent, and the amount by which the taxpayer is insolvent, shall be determined on the basis of the taxpayer’s assets and liabilities immediately before the discharge.

 An easy way to understand insolvency is the following formula:

  • Add the fair market value of everything you own, then
  • Subtract everything you owe

If the result is negative, you are insolvent. You owe more than you own. You are negative or upside-down. There are special rules for assets such as a pension, but you get the concept.

The IRS says that – if you are insolvent – then COD income not be taxable to you to the extent you are insolvent. Let’s use numbers to help understand this:

  • You own $160,000
  • You owe $175,000
  • Visa forgives $22,000

Your COD income is $22,000 (what Visa forgave).

Your insolvency is $15,000 (175,000 – 160,000).

Therefore $7,000 of your COD income (22,000- 15,000) will be taxable to you. The rest is not taxable.

The tax law requires you to do the calculation of what you own and what you owe as of the date the debt is forgiven. It is not two years later or 18 months before. Remember: this is tax law not a tax suggestion.

Let’s swing over to Shepherd. He and his wife lived in New Jersey and owed Capital One Bank approximately $10,000. In 2008 they settled for approximately $5,500, leaving COD income of $4,500.

The Shepherds claimed insolvency and did not report the $4,500 as 2008 income. The IRS looked into it and found that the key to the insolvency calculation was the value Shepherd attached to two houses.

The first was his beach house. Shepherd received a property assessment of $380,000 for the 2010 tax year. He appealed the assessment, claiming a value closer to $340,000. He presented this as evidence before the Court. The Court had two immediate issues:

  • There is a long-standing tax doctrine that the value of property for local tax purposes is not determinative of fair market value for federal income tax purposes. This is the Gilmartin case, and it clearly established the tax code’s preference for an appraisal over property tax bills.
  • Shepherd did not present to the Court the methodology, procedures or analysis, including comparable sales, for thinking that the value was closer to $340,000. At that point it was just an opinion, and the Court was not bound by his opinion.

The Court pointed out that these events took place two years after the debt forgiveness and said fuhgeddaboudit to Shepherd’s valuation of the beach house.

The second was his principal residence.

  • Shepherd showed the Court a tax bill. The Court duly dismissed that under the Gilmartin doctrine.
  • Shepherd applied for a loan modification in 2011. Chase Home Finance showed a value of $380,000 in a modification letter. The Court wasn’t buying into this, noting that Chase’s letter did not show any analysis or procedures used in arriving at value, such as comparable sales. That is, it was not an appraisal. Oh, and by the way, the letter was three years after the debt discharge.

What is a tax pro’s take? Folks, Shepherd had virtually no leg to stand on. How can one read the tax code stating “immediately before the discharge” and reason that three years later – and after one of the worst housing markets in U.S. history – would constitute “immediately before”? This is simply not reasonable. You are going to lose this if challenged by the IRS. Shepherd’s position is so preposterous that I suspect he was truly “pro se” and did not have a professional, either when he prepared his return or when he was presenting his arguments in Court.

Aug 01

As you probably know, the summer Olympics began last week. For a while, east London will be the newest tax haven going.

The basic UK individual income tax rate is 20%, although incomes over 150,000 pounds are taxed at 50%.  The basic corporate tax rate is 24% and a bargain compared to the U.S. corporate rate of 35%.

The UK does have a VAT of 20%, so it is unfair to compare only income taxes.

The “London Olympic Games and Paralympic Games Tax Regulations 2010” exempt the earnings of Olympic athletes and foreign nationals working on Games –related activity, such as judges, journalists and representatives of sports bodies. The Regulations do not exempt construction workers at the sites, nor do they exempt UK residents. The exemption is solely for nonresidents.

The exemption also extends to non-resident companies doing business at the Olympic sites. There has been pressure on companies to forego the tax holiday. Both McDonald’s and Coca Cola have declined the tax break, while General Electric said that all Olympic activities are being done through resident companies and therefore are not eligible for the tax holiday.

What was the reason for this break?

I am unsure about the corporate tax holiday, but the individual tax holiday is easy to understand. The UK’s general tax rule is to tax a proportion of an athlete’s earnings. The proportion is the number of UK appearance days to total annual appearance days. As an example, say a tennis player competes at the Olympics for a week and for 35 days in total during 2012.  The general rule is that 20% of the tennis player’s earnings would be subject to UK tax. That may or may not be fair. The general rule assumes that appearance earnings are proportional.

But it gets worse. The UK will tax both the athlete’s performance and endorsement income. Take someone with significant endorsement income – say Usain Bolt – and this can get expensive. It is the reason Usain Bolt had not previously set foot on a British track since 2009. Golfer Sergio Garcia has admitted to limiting his British appearances because of this tax. It is also the reason that Wembley Stadium lost its bid for the 2010 Football (that is, soccer) Champions League. 

So, HMRC waived the rule and created a temporary tax haven for the Olympic Games.

There has been controversy over the tax holiday, with pressure groups arguing that the holiday was unnecessary if not unjust. Just and unjust are slippery terms, but the general argument is that for-profit activities – whether corporate or athlete – should pay whatever taxes the host country deems to implement. The host country should be able to recoup the cost of its Olympic facilities, for example. Seems reasonable. Tax holidays however have become a factor in the IOC decision process. The unwelcome fact is that east London may not have had the Olympics without the holiday.

Should you be going to England during the first week of August, you may want to consider the Bristol Tax Avoidance Olympics on August 4th. In the spirit of protest, the events will include:

  • Cooking the books
  • Jumping through the tax loopholes
  • Avoiding the taxman
  • Hide (your profits) and seek

Heh.

Jul 27

This past Tuesday I submitted financial and other information regarding a collections appeal with an IRS officer in California. We have several clients with unpredictable income streams, and this client is one of them. We are pursuing something called a “manually monitored installment agreement,” which allows for changes in an IRS payment plan as one’s income varies. It can be difficult to obtain. In fact, a revenue officer I often work with informed me that this type of agreement was “above his grade.” That comment struck me as odd and is something I intend to follow-up on.

Back to our client. I was concerned as time was running out, and the client did not seem to register the urgency of the matter. I am working within a compressed time period. To her credit, the IRS officer showed patience and goodwill. She was within her rights to be much stricter with me, but she agreed to move the file and hearing back to Cincinnati. I was greatly relieved, as Rick wanted the file here.

“How much more do they want?” “They have everything.” “What are they going to do if I don’t?” These are all common questions. So much so I should just post the questions and answers on my office wall to save time.   

Today let’s talk about this part of IRS representation: the collections appeal. Let’s also talk about Pace v Commissioner, who got himself into collections appeal and perhaps should have been less confrontational and more forthcoming.

Your entry into the IRS will likely be through Examinations. This step is what we consider the “audit”, although these days the whole matter may be handled through the mail. The IRS is becoming fond of computerized matching, for example, as Congress provides it with ever-more tax reporting for anything that you do. Such is the new audit, I guess.

If you owe money your file will be transferred to Collections. Collections will send you a bill, and you will be working with Collections if you want a payment program, a cannot-collect status or an offer in compromise. The problem with Collections is that they are not really interested in the how-and-whys of you getting there, but they are very interested in getting money from you. They can back this up by garnishing your wages, liening your assets, levying your bank account or terminating your installment plan. Collections appeal exists as a safety valve for these more-aggressive collection actions. It takes your file out of Collections and gives it to an appeals officer. You have a chance to present information – geared to writing the IRS a check, of course – to someone who may be less “eager” to separate you from your last dollar at the earliest possible chance.

Perhaps you are talking to the appeals officer about delaying payments while you look for work, about setting up a payment plan, or having the IRS restart a payment plan they decided to terminate. Understandably, that appeals officer is going to want to know your finances. You will be sending him/her a Form 433-A or B, which is a listing of your assets and your earnings and expenses for (at least) the last three months. He/she will also want copies of bank statements as well as of significant bills, like your mortgage or car payments. You may have to send them a copy of your broker statement, for example, if you have a few dollars invested in the market. None of this is surprising. What if you don’t provide what he/she wants? Well, he/she can stop working with you and throw you back into the Collections pool. For you to do this seems self-defeating, doesn’t it? With that, let’s talk about Pace.

Pace operated a chiropractic business through a corporation (Dauntless). Pace fell behind on his 2006 and 2007 taxes. The IRS sent a Final Notice of Intent to Levy.  Pace did the right thing and requested a collection due process (CDP) hearing to discuss a collection alternative. The appeals officer requested a 433-A and B. During this process the officer learns that Pace is associated with two more entities – Achievement Therapeutic Services LLC (Achievement) and Kenneth D. Pace LLC (KDP). The officer requests a 433-B for them, as well as evidence that they are up-to-date on their tax filings. Pretty routine.

Pace provides none of it. He does have an argument. Whereas he is the registered agent for both, he has derived no income from these two entities, and he does not think producing any information regarding them is appropriate.

NOTE: Me? I think I can still play linebacker for the Bengals this upcoming football season.

The collections appeal hearing takes place.  Tell me, if you were the appeals officer, what would you do?

The appeals officer threw Pace back into Collections for their tender mercies, that is what he did. Pace next goes to Tax Court.

My Take: Pace is bonkers. I would have provided the IRS with copies of tax returns for Achievement and KDP, if tax returns existed. If the entities were dormant, then I would have discussed that fact with the appeals officer and asked what he considered a reasonable next step.  By not doing so, the Tax Court decided that Pace was the one being unreasonable.  Being unreasonable, Pace lost his case.