Archive for 'Taxes'

Jun 07

Joseph Mohamed seems a good sort. He and his wife live in Sacramento, California. He is a successful real estate professional. In 1998 they formed the Joseph Mohamed Sr. and Shirley M. Mohamed Charitable Remainder Unitrust II. Tax pros call this a “CRUT.”

QUESTION: What is a CRUT? This is a special trust involving a charity. You can guess that a purpose of the trust is to make a charitable donation. In a CRUT, an annuity goes to the donor (in this case, Joseph and Shirley) for a period of years. At the expiration of that period, the remainder goes to a charity. In the Mohamed’s case, that period is twenty years. Why would you do that in place of simply donating twenty years out? Because the CRUT allows you to claim the charitable deduction now.

In 2003 and 2004 the Mohameds donated several properties to the CRUT. The properties were worth somewhere between $18 million and $21 million. Joseph Mohamed prepared his own taxes. This means he ran into Form 8283 to report the property donations. He did not read the instructions though, as he did not think he had to. The form seemed straightforward enough.

Form 8283 has several parts. Part 1 Section B required a description of the donated property and “can be completed by the taxpayer and/or appraiser.” It also had the following text:

“If your total art contribution deduction was $20,000 or more you must attach a complete copy of the signed appraisal. See instructions.”  

Mohamed was contributing real estate, not art. He read that to mean that he did not have to attach an appraisal. He did attach all types of statements and documentation to his return, including his own valuation of the real estate.

The return gets audited (who is shocked?). The IRS was displeased that Mohamed had self-valued such a large dollar donation of property. The IRS first goes after the valuation. Makes sense. Mohamed then gets an independent appraisal which shows that the properties are worth more than he claimed.

The IRS then pulls back and realizes something. Regulation 1.170A-13(c) requires the following for donations of this nature and amount:

  1. A qualified appraisal must be made not more than 60 days before the donation and no later than the due date of the return.
  2. It must be signed by a qualified appraiser, who cannot be the donor or person claiming the deduction.
  3. The qualified appraisal must contain defined information, such as a description of the property, its basis and fair market value.

Mohamed had a problem. You see, he did not have a qualified appraisal. That requires an independent appraiser, and he obtained that after the filing of his return. There was of course no signature, as there was no qualified appraisal. While he attached numerous statements to his return, they did not completely address the litany of questions that the IRS wanted in Reg 1.170A-13(c).

The IRS disallowed the donations. Mohamed goes to Tax Court and raises three arguments:

  1. The extreme result indicates that the Regulations are invalid.
  2. The IRS-designed Form 8283 misled him.
  3. He substantially complied with the documentation requirements.

The Court quickly dismissed arguments 1 and 2. It went through an analysis (which we will skip) and concluded that the Regulations were valid and reflected Congressional intent. The IRS, for example, was ordered by Congress to issue Regulations requiring appraisals for donations of property in excess of $5,000. A Regulation that implements Congressional intent is difficult to rule invalid. The Court was sympathetic to argument 2, but it pointed out that the form is not the tax law. The Court even added that “a taxpayer relies on his private interpretation of a tax form at his own risk.”

Now we get to argument 3. What does “substantially comply” mean? There was a previous case (Bond) where the Court found substantial compliance, but succeeding cases have ever compressed the reach of that decision. The Court determined that substantial compliance meant complying with the “essential requirement” of the statute. Problem is, the “essential requirement” of the statute is the need to obtain a qualified appraisal. With that verbal loop, there was no way that Mohamed could substantially comply.

Here is the Court:

We recognize that this result is harsh – a complete denial of charitable deductions to a couple that did not overvalue, and may well have undervalued, their contributions – all reported on forms that even to the Court’s eyes seemed likely to mislead someone who did not read the instructions.”

MY TAKE: I am sympathetic to the Mohameds, but I am also confused. They must have used a tax professional in the past to establish the CRUT. They then make a near-$20 million donation but do not hire a pro to walk it through? It doesn’t make sense to me.

In both Mohamed and Durden there was no question that contributions were made; there were also no question as to the amounts. The taxpayer may have felt comfortable thinking: what are they going to do, put me in jail? No, they won’t put you in jail, but they will take away your charitable deduction. Don’t think that a court will bail you out, as there may be limits to what a court can do.

What is the answer? I would encourage the use of a tax professional if there is even a whiff of a question on your return. I know – it costs money. The problem is that you may not know you have hit a slick spot until after the IRS contacts you. As Mohamed and Durden have shown, that may be too late.

Jun 04

Our next two blogs discuss tax fails involving charitable contributions.

What each has in common is congressional resolve to address an area considered subject to tax abuse. How so? How many times has someone overvalued a Goodwill clothing donation, for example? Congress therefore placed restrictions – primarily documentation requirements – on one’s ability to deduct contributions. The general tax rule is simple: no documentation equals no deduction.  The key is to understand what Congress considers documentation, as your understanding may be different from theirs.

Let’s talk about Durden.

David and Veronda Durden contributed $25,171 in 2007 to the Nevertheless Community Church. With the exception of five checks (totaling $317), all checks were over $250.

FIRST RULE: Under Code Section 170(f)(8)(A), no deduction is allowed for any contribution of $250 or more unless taxpayer has contemporaneous written acknowledgment of the contribution by the charity organization that meets specified requirements.

The Durdens cleared the first rule, as they had a letter from the church dated January 10, 2008.

SECOND RULE: Under Code Section 170(f)(8)(B), the charity must state in the acknowledgment whether it provided any goods or services as consideration for the contributed property or cash. If so, it must include a description and good faith estimate of the value of any goods or services provided.

There is a problem: the church did not include language “no goods and services have been provided” in their letter.

The Durdens obtained a second letter dated June 21, 2009 containing the same information found in the first letter, plus a statement that no goods or services were provided in exchange for the contributions.

THIRD RULE: Code Section 170(f)(8)(C) considers the acknowledgment as contemporaneous if obtained on or before the earlier when the tax return is due or the actual filing date.

The IRS disallowed all but $317 of the charitable deduction for insufficient documentation. The Durdens go to Tax Court. Their argument is reasonable: we substantially complied with the spirit of the law. We had a letter. It might not be exactly the letter the IRS wanted, but we had a letter. When the IRS wanted more, we got them more. The IRS went too far in disallowing the deduction when everyone knows we gave to the church. We even showed them cancelled checks.  The wording in Code Section 170(f)(8)(C) is only one way – a safe harbor maybe – of meeting the “contemporaneous” standard.

The Tax Court disagreed. It noted that Congress intended to tighten the rules in this area and placed specific language in the Code requiring and defining “contemporaneous.” This was not the IRS’ doing; it was Congress’ doing.  The Court in the past had been lenient in cases involving substantial procedural compliance. This was not procedure. This was legislative compliance, and the matter was outside the Court’s hands.

The Durdens did not have the correct letter when they filed their return. That is the last possible date according to the law. There is no deduction. The Court did let them deduct $317, however. Since those individual contributions were under $250, those didn’t require a letter.

MY TAKE: I can understand Congress passing near-incomprehensible tax law to address complex and sophisticated tax issues. Those taxpayers are likely to have expert tax advisors and planners. This is not one of those issues. This is someone donating to a church. I strongly disapprove of routine activities triggering tax rules that make no sense to an average person.  

Congress should have included a “sanity” clause in this statute. They could have given the IRS discretion to accept “other but equal” documentation. True, the IRS could refuse to do so, but at least there would be a chance that the IRS – or a court reviewing the IRS – could blunt the capriciously sharp edge of this tax law.

Next time we will talk about Mohamed.

May 31

Let’s say that you were born in Brazil. Your family was wealthy. Due to safety concerns (such as the risk of kidnapping), they moved you to the United States when you were young. You grew up in a southern and international city – perhaps Miami. You went to Harvard. While there you met and bankrolled a cantankerous near-friendless computer genius who came up with the next great social media idea. He tried to boot you out of the fledging company, but after a lawsuit and hard feelings, you kept about 4% or so of the shares. Much to your delight, the company went recently went public and made you a multibillionaire. Prior to that, you met with high-powered attorneys and tax advisors. You renounced your U.S. citizenship and are now living in Singapore. Where is Singapore? Think Vietnam, and then turn south. It is a former British colony, and you like pasties and room-temperature beer. Seems a fit.

Why would you do this?

Let’s go over several tax reasons. We need numbers in this conversation. Let’s use the following:

            Proceeds from IPO                             $ 4.0 billion

            Expected annual salary                    $ 7.5 million

            Expected annual dividends             $ 40 million

            Expected capital gains                      $ 25 million

What are your U.S. 2013 taxes if you remain a U.S. citizen?

(1)   Your salary may be taxed as high as 39.6% next year. Let’s say that it will be. The federal tax would be $7,500,000 times 39.6% equals $2,970,000.

(2)   If your dividends are “qualified” dividends, you would pay a 15% tax rate this year. The President’s proposed 2013 budget would increase this to 39.6%. In previous budgets, however, he has proposed 20%. What rate should we use? Let’s use 20%.  Your tax would be $ 40,000,000 times 20% equals $8,000,000.

(3)   The capital gains are a wild card. Let’s say that you will be selling stock periodically to fund your lifestyle. What amount? Let’s say $25 million annually. Let’s also say that your basis is so low that any sale is virtually all gain. The long-term capital gains rate is currently 15%, but everyone expects this rate to go up. Unless Congress acts, the rate will increase to 20% in 2013. Let’s use 20%. Your tax would be $5,000,000.

(4)   Starting in 2013, there is a new surtax on investment income if your income exceeds either $200,000 or $250,000, depending on filing status. You have clearly blown past that speed bump like Steven Tyler’s new Hennessey Venom GT Spyder. That new tax is 2.9% and will cost you $1,885,000.

(5)   Starting in 2013, there is a Medicare surcharge for persons earning more than $200,000. The surcharge is 0.9% and will cost you $67,500.

 What are your 2013 taxes in Singapore?

(1) The top tax rate in Singapore is 20%. Taxes on your salary will be $1,500,000.

(2) Taxes on your dividends will be $8,000,000.

(3)There are no taxes on your capital gains.

 OK, let’s look at the scorecard. A quick back-of-the-envelope calculation shows:

            United States             $17,922,500   

            Singapore                    $  9,500,000

 Is there more? Well, yes.

 (1) Let’s say that you invested in mutual funds to obtain those dividends. Chances are these funds will be considered PFIC’s (“pea-fics”) and carry some heavy U.S. tax disapproval.

 The best you can do with a PFIC is make a QEF election and pay taxes every year on your share of income, whether distributed to you or not. This requires the PFIC manager to want to go to the trouble of assembling this information for you, as the PFIC tax is an American concept. A fund manager in Hong Kong, for example, might be less than interested in IRS mandates. In any event, the U.S. wants to accelerate your tax without regard to whether you received any cash.

If the fund manager is unwilling, you go to an ugly place in U.S. taxation. Without belaboring this, it may require you to go back and recalculate your prior year taxes on an “as if” basis. You will then write a real check to the IRS for that “as if” calculation. You also have to pay the IRS interest for not having paid taxes in the earlier “as if” tax year.

 (2) Don’t forget your FBAR filing every June 30.

You have financial accounts overseas, so you will have an FBAR filing.

Penalties for failure to file an FBAR border can be severe. Penalties begin at $10,000 for each non-willful violation. If willful, the penalty goes to the greater of $100,000 or 50% of the account for each violation. Oh, each year is considered a separate violation. And the IRS gets to decide what is willful.

 You got it: if the IRS considers your violation to be willful for two years, you have wiped-out the account.

 (3)   You have to file the new Form 8938 disclosing foreign financial assets.

This is the FATCA and its reason for existing reads like a bad dream. In essence, the IRS felt that it was not getting enough information from the FBAR, and it really wanted more information.

Think about this. The FBAR is mailed to the U.S. Treasury, and technically the IRS is part of the U.S. Treasury. One would think that the IRS and Treasury would speak, perhaps weekly for breakfast. Treasury did not upgrade the FBAR, nor did it replace the FBAR with the IRS Form 8938. No sir, the IRS created a new form and they kept both filing requirements. Well, it is one more opportunity to confuse the populace and maximize those penalty dollars. Brilliant!

Penalties can be rough: $10,000 for each failure to file. If you both fail to file the 8938 and fail to pay tax on the foreign income, there is a super-penalty of 40% on the tax underpayment. Don’t do that.

 (4)   Should you leave family behind, gifting to them will certainly be a problem. These transfers will be picked up under the expatriation rules of Section 877 and trigger tax at the maximum gift tax rate. That rate is currently 35% but is expected to increase to 55% next year.

You read that right: Uncle Sam is your biggest beneficiary. More so than your mom, son or daughter. 

You may want to take them with you.  Singapore has no gift tax.

 (5)   Should you remain a U.S. citizen, consider hiring an experienced tax attorney and/or CPA to navigate all this. It is another expense, but least you can write-off the professional fees on your taxes. Oh, wait. No you can’t. Chances are the fees will not exceed 2% of your income. If you are in the AMT, they will not be deductible in any event.

There are reasons other than taxation to renounce. There are many expatriates overseas who have no intention of returning to the U.S. They have lives, spouses, children, jobs and friends there. Perhaps they will return, but it will be at some unknown and distant date.

It is unfortunate to renounce citizenship over tax reasons. The U.S. does press your hand by taxing you on your worldwide income, irrespective of where you live, work or maintain family. The U.S. is virtually alone in the world with this type of taxation. If this ever made sense, does it still make sense? Leaving the U.S. doesn’t mean that you leave its mandates. You have to renounce.

What would you do?

May 24

Why would Eduardo Saverin renounce his U.S. citizenship?  Saverin is one of the Facebook insiders and presently is unbelievably wealthy.

Saverin was not born here. His family is from Brazil, and they were wealthy before Mark Zuckerberg starting working on a networking site from his Harvard dormitory. Saverin became a citizen in 1998 and is now expatriating to Singapore.

A possible reason is U.S. tax policy. The U.S. will tax a citizen or permanent resident (think green card) no matter where you are on planet earth, how long you have lived there or whether you have any intention of ever returning to the U.S. I have family, for example, that has lived outside the U.S. since the 80s, yet the IRS expects to receive a tax return from them annually. If they have over $10,000 in a foreign bank account, Treasury expects an FBAR every June 30th. If they have accumulated enough assets over the last 30-something years, they are subject to the new IRS “specified foreign financial asset” filings. Their bank may even have to report their banking activity to the U.S. under the new FATCA rules. That is assuming the bank doesn’t close their account to avoid having to deal with these U.S. mandates.

Does this sound even remotely reasonable? Do we wonder why someone would renounce his/her citizenship?

Let’s go over the general rules in this area. The U.S. tax system differentiates between U.S. citizens and permanent residents, on the one hand, and nonresident aliens (NRAs) on the other. We can further differentiate the tax system between income taxes and estate and gift (i.e., transfer) taxes.


A  U.S. citizen or permanent resident is taxed on his/her worldwide income. It doesn’t matter where you earned the income (you could be mining ore from the ocean floor) or whether you have or have not been in the U.S. since elementary school. That citizenship will follow you like a bad tattoo.

A nonresident alien (NRA) is a different matter. How an NRA pays income tax is generally based on one key question: is there a business activity involved? The tax term is “effectively connected.”

  • If no, then figure on a flat 30% tax rate
  • If yes, then the NRA gets the same graduated tax rates that you or I use


You can guess the drill at this point. A U.S. citizen or permanent resident is taxed on everything, wherever located, whether in the sky above or the earth below, in days past or yet to come. 

In contrast that NRA is subject to estate tax only on property located in the U.S.

There is an odd rule that stock of domestic corporations is treated as property located in the U.S. I have never quite understood that one. Fortunately, that tax overreach can be stymied by relatively easy tax planning, such as putting the stock in a foreign entity.

The gift tax applies to an NRA to the extent of tangible personal property or real estate located in the U.S. That definition excludes most stock from the reach of the gift tax.


Let’s clarify terms. Any American who lives overseas is an expatriate. It doesn’t mean the one has renounced his/her citizenship. However, renouncing also uses the term “expatriate.” Unfortunate, somewhat like the track record of Bengals linebackers and the court system. We will use the term “expatriate” to refer to renouncing citizenship for the balance of this article.


Back when, a person renouncing citizenship was subject to tax for the succeeding 10-year period, unless he/she could show that expatriation did not have as one of its principal purposes the avoidance of taxes.

The expatriate was subject to income tax on income from sources within the U.S. or effectively connected with the U.S. There were convoluted rules to slow down the tax planners, such as shutting-down nontaxable exchanges of property and outbound transactions with a controlled foreign corporation.

It didn’t take much to prompt the government to think that one was tax-driven:

(1)     Average income (not tax) for the last 5 years exceeding $100,000, or

(2)    Net worth of $500,000

The estate tax continued to apply, but it was generally limited to assets located in the U.S.

The gift tax however was expanded to include gifts of stock.

One could contest the government’s presumption that one was tax-motivated. One would request and pay for a tax ruling. I presume that everyone did so.

Also, one had to send-in an annual Christmas card to the U.S. government which included one’s address, the foreign country of residence as well as information on one’s assets and liabilities.


The IRS found it very difficult to determine tax motivation as previously required under the tax Code. Interestingly, it also found that it could not keep up with the number of people requesting rulings. Congress in response changed the determination standard from a subjective to an objective test.

If one met the new income and asset thresholds, one was now presumed guilty of tax avoidance.

At least they increased the thresholds:

(1)    Average tax of $124,000 for the last 5 years

(2)    Net worth of $2 million

An expatriate under those limits would not be taxed under the expatriate rules even if the motivation was tax-driven. Conversely, one over those limits would be taxed, even if there was no tax motivation. Congress removed the option to request a ruling from the IRS to exempt the expatriate from taxation.

The annual Christmas card was revised to include one’s annual income and the number of days physically present in the U.S. The expatriate could not be present in the U.S. for 30 days in any one year, or one would be treated for tax purposes as a citizen and taxed on all worldwide income.

NOTE: This is pretty harsh stuff, and the U.S. may have been alone among advanced countries with this extraterritorial tax reach. Obviously, you do not spend 30 days in the U.S., for any reason.

2008 and the Heart Act

The current expatriation regime came into the Code in 2008, and it was a revenue-raiser intended to “pay” for other tax provisions of the Heart Act.


Let’s add one new threshold:

(1)    Average tax of $124,000 for the last 5 years

(2)    Net worth of $2 million, or

(3)    Fail to certify that one has complied with all tax requirements for the preceding five years

If one falls into one of these categories, one is a “covered” expatriate. Generally speaking, in taxation the adjective “covered” is bad.

There is a brand-new mark-to-market income exit tax.  The tax applies to the unrealized gain in the expatriate’s property as if the property had been sold for its fair market value. One is granted an exemption of $600,000, adjusted for inflation.

NOTE: This “make believe” sale may be surprising, but other countries – for example, Australia and Denmark – do it with their expatriates.

So you now pay tax on the way out.

The covered expatriate can defer tax on property by posting a bond or other security acceptable to the government. This is an election, and the election is irrevocable. One can elect on a property-by-property basis. The deferred tax is due the year the covered expatriate sells the property. 

There are special rules for deferred compensation, trusts and such matters which do not concern us here.


The key here is whether the “covered expatriate” transfers to a U.S. resident or permanent resident. These transfers are called “covered” gifts or bequests and have their very own special transfer tax. The rate will be the maximum estate or gift tax rate at the time.

If the transfer is made to a domestic trust, then the trust has to pay the tax. If made to a foreign trust, the tax is payable when distributions are made to a U.S. citizen or permanent resident.

The transfer tax appears to be in addition to existing estate and gift tax. One already had to pay transfer tax on property located in the U.S. This new tax also pulls-in transfers of property located outside the U.S., if the transfers are to a U.S. citizen or permanent resident.

So if my wife and I renounce but our daughter stays in the U.S., we would have a problem transferring assets to her. Those would be “covered” transfers and trigger tax at the maximum rate. I suppose our daughter will have to renounce with us to avoid that “covered” problem.


In truth, the new regime is an improvement – in many ways – over the previous system. The potential tax is now calculated once, although its payment may be deferred. The previous system required monitoring for 10 subsequent years and was very difficult to administer. In addition, this regime is not based on one’s ability to live on non-covered assets for 10 years. That of course was a previous way to wait-out the tax and favored the uber-wealthy over the merely wealthy.     

Expect disagreement with the IRS over the valuation of difficult-to-value assets. Here is an example: Eduardo Saverin’s pre-IPO stock in Facebook. The stock was restricted and non-tradable. What do you think it was worth, before its IPO, when Saverin renounced? I’ve got nickels-to-dollars that the IRS will come-in with higher numbers than Saverin does.

Another issue is when to expatriate. If one has assets that are going to appreciate significantly and soon, one wants to leave immediately. Why? Because there is little or no present appreciation in the asset, but the clock is ticking. An example would be land where a new interchange or mall will be built, or Facebook pre-IPO stock. Compare this to prior law where one would still be subject to U.S. tax for 10 years.

What if you have a big inheritance? Same incentive. The inherited asset received a step-up to fair market value at the date of death. If it is appreciating and fast, it is in one’s interest to exit as soon as possible.


We will talk more about Eduardo Saverin and his expatriation in another post.

May 22

Yesterday the IRS announced that it was relaxing its rules under the offer in compromise (OIC) program. This is part of the IRS’ “Fresh Start” program, and is in response to the ongoing unemployment and financial crisis.

For example:

(1) The IRS will look at one year’s future income for offers paid in five or fewer months. This is down from four years.

(2) The IRS will look at two years of future income for offers paid in six to 24 months. This is down from five years.

Fewer months means a reduced collection potential. You can negotiate a smaller payment now. These offers must be paid within 24 months, however. This may exclude some taxpayers, but it will open the door to many others.

Many practitioners, including me, have been frustrated by the IRS’ unwillingness to acknowledge certain expenses and payments when evaluating installment agreements and OICs. The classic is credit card payments. We are presently negotiating child care payments with a revenue officer, as another example. The IRS has now expanded the National Standard miscellaneous allowance to allow for bank fees and credit card payments.

The IRS is also relaxing how it handles student loan payments when evaluating offers. It intends to do the same with state income tax obligations.

There is good stuff here.

May 19

I have previously argued against draconian laws to protect against the morally unscrupulous. The key concept here is draconian: the little good the law does is far outweighed by its burden on society. Sometimes I believe that recent tax regulation is approaching this line.

And then I read about Todd Halpern, a tax preparer in New Jersey.

In 2008 Halpern purchased a tax preparation business from the widow of the prior owner. He received all the computers and client records in the purchase. Makes sense: the widow didn’t need them. The new practice required a new electronic filing number, but Halpern did not obtain one. He kept the previous owner’s number. Why? Because Halpern’s criminal record would keep him from getting a new number.

Then he prepares a tax return for the mom of a client. The problem is that the mom had no income. She collected social security and was claimed as a dependent on her son’s return.  Halpern falsified her return, using fake income and deductions, to generate a refund. To complete the loop, he had the refund deposited to his account.

He kept doing this. After all, what could go wrong? The IRS estimates that he received approximately $375,000 in diverted refunds between July and August, 2009.

The guy is a crook. There exist enough laws to put him in jail.

Or maybe he can run for Congress.

May 18

I am somewhat impressed with the amount of information the IRS processes in order to generate CP2000 notices. The CP2000 is the “Underreported Income” notice. I have seen the IRS flag bank and broker accounts, independent contractor payments and even W-2s that clients failed to clue us on.

The IRS receives almost 2 billion information statements (think W-2s and 1099s) annually.

NOTE: Do you wonder what the cost to employers and financial institutions is to generate these documents? The government doesn’t care, but it is a societal cost. Ignoring it doesn’t make it free.

It matches these against approximately 140 million individual tax filers.

The IRS generates notices to almost 5 million taxpayers.

The IRS unit responsible, the Automated UnderReporter Unit, has approximately 2,500 employees.

You have to admit, there is lot going on for only 2,500 employees.

CP2000 notices come out twice a year. The IRS begins matching information during the summer with the goal of a December mailing. The second wave comes right after tax season – in the second half of April.

The IRS is notorious for skipping line with these ACS notices. You might find yourself with a deficiency notice while you still have time remaining on the ACS notice. Been there. Often you can get the IRS to walk-back the deficiency notice.

By the way, do not send an amended return in response to an ACS notice. These go to different units and will likely cause unnecessary correspondence and telephone time with the IRS. Been there too.

May 18

Good grief!

U.S. Senator Charles Schumer (D, N.Y.) has proposed a 30% exit tax on people like Facebook co-founder Eduardo Saverin. Schumer is unhappy because Saverin has renounced his U.S. citizenship. Schumer believes this is tax-motivated, because Saverin is coming into quite a bit of money from Facebook’s IPO.

Here is the senator:

“Eduardo Saverin wants to de-friend the United States of America just to avoid paying taxes.  We aren’t going to let him get away with it.”

Schumer apparently is a telepath, as he can read other people’s minds. Maybe he can star in the next X Men movie.

Let’s take this a step further. Have you ever heard of Jack Reed? This guy is a Democrat senator from Rhode Island. He wants Homeland Security Secretary Janet Napolitano to bar Saverin from entering the U.S.


I wager I could get a million signatures – without really trying – wanting to bar Congress from entering the United States.

May 17

You may know that Facebook is going public. This means an IPO, hotly anticipated and all but guaranteed to make the founders incredibly wealthy. You may have read about Eduardo Saverin, who has renounced his U.S. citizenship and intends to become a resident of Singapore. There is discussion about tax motivations for his expatriation. Could be. Singapore has more lenient tax treatment of capital gains than the U.S. To be fair, Saverin only became a U.S. citizen in 1998, so his ties may not be as strong as that of a natural-born citizen.

I intend to blog about on Saverin and his tax implications, but for today I wanted to talk about founder Mark Zuckerberg. Facebook’s prospectus lists eight “annuity trusts” set up by insiders, including Zuckerberg, Dustin Moskovitz, Sean Parker, Sheryl Sandberg, Reid Hoffman and Michelle Yee. These trusts hold approximately 22 million shares, which could be worth around $700 million at IPO.

You can afford a lot of tax planning with $700 million. The insiders have not spoken about this matter, nor should one expect them to. I have been reading tax commentary speculating that these trusts are grantor retained annuity trusts, also called GRATs. I agree. Let’s talk about it.

A GRAT is used to shift wealth from one taxpayer to another. In my experience, it has been from one generation to another.

The GRAT has to pay-out a stream of payments to its settlor (the grantor). The payment stream is called the annuity. There are two more considerations: how much to pay out and for how long. The shortest GRAT I have seen is two years. At the end of the term, the remaining money in the GRAT goes to the beneficiary.

All right, so the settlor gifts the remaining money in the GRAT. There may be gift tax, depending on the amount of money gifted. There is a version of a GRAT where “nothing” passes at the end, so the gift is zero. Why the quotation mark around “nothing?” Ah, there is where tax planners make their money.

You see, “nothing” does not actually mean nothing. In this area of the tax world, “nothing” can be something, and quite a lot of something. The “nothing” is a mathematical calculation and not an actual dollar amount. The key to the calculation is the interest rate. 

Say that I put $1 million into a GRAT. I want payments over ten years. I have to use an interest rate, because payments are being made over time. The IRS publishes minimum interest rates for this purpose. As long as I use their interest rate (or higher), there is no problem. Say that their interest rate is 5% and I am looking to zero-out the GRAT. In year one I would take out $150,000 ($1,000,000 divided by 10 years plus $1,000,000 times 5%). What if the money was invested in something that pays – or appreciates – at more than 5%? That is the key that starts the GRAT engine. Let’s say that the investment actually pays 10%. The GRAT is paying out 5%, or only ½ of its actual earnings. The trust is accumulating, isn’t it? Let it accumulate for 10 years and I can transfer a tidy sum at the end. However, for IRS purposes I am deemed to have transferred zero, zippo, nada, because the IRS allows me to assume that the investment is paying only 5%. According to IRS math, there is no money left over to accumulate. Ten years of zero is zero. There is no gift. There is no gift tax. The IRS cannot be wrong.

Let’s go back to the Facebook insiders. What interest rate do they have to use? Last time I checked it was around 1.6%. Do you think there is an accumulation possibility here with Facebook stock? Yes, I think so.

I am not making this up. I wish I could have been one of the advisors.

Actually, I wish I could have been one of the insiders.

May 15

We have received several inquiries over the last year or so about using IRAs for nontraditional investments. This frequently means real estate, perhaps commercial real estate to house a closely-held business. It might also mean using the IRA to start the business itself.

These types of transactions are not without risk. One has the risk of business failure or decline in property value, of course, but also the risk of disqualifying the IRA itself. This would be very bad, as this makes the IRA immediately taxable. To protect against this, one should roll-over the required funds from the “main” IRA into a separate IRA. Should the unfortunate occur, only the roll-over IRA will blow-up. One has contained the damage.

A nontraditional investment requires a self-directed IRA. You will need to find a custodian that will permit nontraditional investments. Most will not. Let’s say you found one. Let’s use the acronym SDIRA for a self-directed IRA in our discussion.

A SDIRA can invest in a privately-owned business. We already know that an IRA can invest in a non-private business, as these are the publicly-traded companies whose stocks are in your IRA or are in the mutual funds in your IRA. This is your Google stock or your Fidelity Contrafund.

The type of business entity is important. The SDIRA can invest in a C corporation but not in an S corporation. Why not? Because the IRS does not permit an IRA to be a shareholder in an S corporation.

The level of involvement in the business owned by the SDIRA is also critical. There are two key tax issues here:

  • The SDIRA cannot enter into a “prohibited transaction.” This is a death sentence. The SDIRA will lose its tax-exempt status and become immediately taxable. If you are under age 59 ½, there will also be penalties.
  • The SDIRA might enter into investments which themselves trigger a tax. This is not as bad as a prohibited transaction, as the overall SDIRA does not become taxable. There is tax only on the income. If the deal is good enough, paying tax may be acceptable.

Prohibited Transactions

The IRS defines a disqualified person as

  • The IRA account holder
  • A family member of the account holder.
    • This goes vertical: grandparents, parents, children and spouses
  • An entity owned 50% or more by the account holder

Think about that last one. Here at Kruse & Crawford, I could theoretically use my IRA, buy an office building and rent it to the firm, as I am not a 50%-or-more owner. Rick Kruse however could not.

Let’s go though the prohibited transactions:

(A) Sale, exchange or leasing of any property between an IRA and a disqualified person

Example 1: My SDIRA purchases property from me or my wife.  This is prohibited. It doesn’t matter if it purchases the property in a “commercially reasonable” manner – i.e. obtain an appraisal. It is not allowed. Period.

Example 2: My SDIRA pays my daughter twenty-five dollars to mow the lawn on the property.  My daughter is a family member. It is prohibited. The amount of money is irrelevant. 

(B) Lending of money or other extension of credit between an IRA and a disqualified person

Example 3: I lend you $10,000 from my IRA.

Example 4: I personally guarantee a bank loan to my IRA.

Example 5: My IRA loans money to me. 

(C) furnishing of goods, services, or facilities between an IRA and a disqualified person

Example 6: I buy a piece of property through my SDIRA and hire my wife to manage the property.

(D) transfer to, use by or for the benefit of a disqualified person of IRA income or assets

Example 7: My SDIRA purchases real estate in Ireland. The SDIRA rents out the property for most of the year. However, my wife and I use the property for one week twice a year.   Even if my wife and I pay fair-market-value rent, this is a prohibited transaction. 

 (E) Act by a disqualified person who is a fiduciary whereby he deals with IRA income or assets in his own interest or for his own account

Example 8: I charge my SDIRA a fee to manage its stocks, bonds, mutual funds or other investments.

(F) receipt of any consideration for his own personal account by any disqualified person who is a fiduciary from any party dealing with the IRA in connection with a transaction involving IRA income or assets.

Example 9:  My SDIRA purchase a vacation house is in Augusta. I am offered the use of a Wyoming condo in exchange for use of the Augusta property during the Master’s tournament.

IRA Taxes

(1) Active Business Income (UBTI)

Earnings within an IRA are generally tax exempt. However, certain investments can create taxable income called “unrelated business taxable income” (UBTI).  Generally, UBTI is trade or business income which is not otherwise related to the tax-exempt purpose of the IRA. The idea here is that Congress does not want a tax-exempt entity competing with the taxable business enterprise next door to it.

So if you buy a Panera’s or a Caribou Coffee, you have UBTI.

There are some exceptions to UBTI, including but not limited to:

  • dividends
  • interest
  • royalties
  • rent from real property (however see debt-financed below)
  • sales of real property, if the property is not held as inventory or held in the ordinary course of business

Dividends and interest make immediate sense, as this means stocks and bonds – the traditional investments in an IRA.

UBTI Examples:

Example 1:  The SDIRA purchases a restaurant.  The income from the restaurant will be treated as UBTI.

Example 2:  The SDIRA purchases 25% of an LLC that flips (buys, fixes and sells) real estate. Since the real estate is considered inventory, the income to the SDIRA will be UBTI. 

(2) Debt-Financed Income ( UDFI)

If there is debt involved there will likely be UDFI.

Fortunately, UDFI refers only to the percentage of income resulting from the debt-financed portion of the property,

UDFI Example:

Example 3: My SDIRA purchases a B&B in Ireland putting down 75% and borrowing 25%. 

Note that if there was no debt, the rent would be tax-free to the SDIRA.

But there is 25% debt. This means that 25% of the rent is taxable to the SDIRA. The SDIRA does get to claim rental expenses, however.

Wealth Planning

You may have read that nontraditional IRAs are being used for wealth planning. For example, Max Levchin, the chairman of the social review site Yelp, sold over 3 million shares of Yelp held in his Roth IRA. There is no tax on Roth withdrawals if one waits until age 59 ½. Levchin is in his mid-30s. He will have to wait a while, but the money will be tax-free when it comes out.

Peter Thiel did a similar transaction. He bought shares of PayPal for approximately 30 cents per share while he was CEO of the company. In 2002 eBay bought PayPal for $19 a share. 

Now how did Levchin and Thiel avoid the prohibited transaction rules? Actually, it is very simple. You have to control the company to get into a prohibited transaction. Control is usually defined as at-least-50%. When you drain your IRA to buy that Five Guys Burgers and Fries location, chances are you will own 100%. Compare that to a publicly-traded company with tens if not hundreds of millions of shares. Neither Levchin nor Thiel came close to owning 50%. 

Is this fair? I would lead off by noting that “fair” is subjective, somewhat like asking what music one likes. Levchin and Thiel played the game between the lines. You or I could do the same. It might take a new skill set and a tractor-trailer load of luck, but you or I could (theoretically) do it.

Congress has noted these transactions. There is debate about whether this type of wealth accumulation should be permitted. Discussion has sometimes involved a “ceiling” on the amount invested/deferred in the Roth, but until now nothing has developed.