Double Taxation: A Take On All Things Taxes

Dimiter Hristov operated his medical practice thorough a wholly owned S corporation. Tired of handing over 45% of his income to the IRS each year, he began searching for tax saving alternatives. Because Hristov regular tax preparer was an enrolled agent who — admittedly — did not have the sophistication to conjure up such tax solutions, he eventually sought the help of a snake-oil salesman named William Alexander.

Alexander pitched pension plans and Section 419 plans for a living, and he pitched them hard. Fraudulently holding himself out as an enrolled agent, Alexander claimed to have “learned from 8-10 of the sharpest and most aggressive CPAs in the country” about how to take advantage of retirement plans and defend them on audit. To hear Alexander tell it, Hristov could lower his tax liability with large retirement contributions, yet still have access to the cash to make additional income-producing investments.

 And if Hristov’s regular accountant didn’t agree, well…she just didn’t know any better:

 What do most accountants and tax attorneys say about all of this? Most would never advise you to put these plans together and do what I do because they don’t understand and know about what I do. Why? By nature, it seems like U.S. accountants are conservative and backward people that are not creative. It’s really easier for them just to have you pay a lot of tax. You have a lady accountant now, who is conservative and backward, but if she does what I tell her to do, you can keep her; otherwise, use one of my accountants * * *.

Though skeptical at times, Hristov signed on, allowing Alexander to establish retirement plans for the S corporation. Each year from 2004 through 2006, Hristov would make a cash payment to the retirement account,  Alexander would take his cut, and the rest would be “loaned” back to Hristov, never to be repaid; a rather large violation of the qualified plan rules. But that didn’t concern Alexander:

 If I put $400K into the pension plans, you would have no tax, but obviously, you would have to borrow a lot of money from the pension plans, which my clients do as I promote this. Assets in the money purchase plan can be invested anywhere while I use fixed and variable annuities for the 419 plan, you really are not supposed to borrow money from the 419, but I’m aggressive so I have my clients do this * * *.

As if that weren’t egregious enough, Alexander encouraged Hristov to amend his 2002 return by reclassifying large expenses paid for assets to retirement plan contributions, resulting in a $100,000 refund request, from which Hristov took his 10% cut.

Throughout the process, Alexander continued to assuage Hristov’s fears with letters such as this:

 “I also think this amendment will move through easily without IRS even asking for copies of the checks because we are amending a K-1, but if I am wrong, and IRS asks for checks, we can come up with check[s]…we are just asking for a refund so the worse thing that could happen is to be denied, but typically I get the refund although sometimes it takes a while”.

To be fair, with the smooth delivery and impeccable grammar evidenced in that communication, who wouldn’t have their nerves calmed?  

 The IRS, however, predictably began auditing Hristov, resulting in a full disallowance of all the pension plan contributions and leaving Hristov on the hook for over $400,000 in back taxes. And despite Alexander’s previous assurances to Hristov that he was an acclaimed audit negotiator,  he cut and run, refusing to provide documentation to the IRS before eventually having an order of injunction filed against him, prohibiting him from promoting his pension plan scam.

But here’s the real lesson of the Hristov case: despite being rooked by Alexander, Hristov was not able to use the “reasonable cause” defense of I.R.C. § 6664 to avoid understatement penalties.

In general, the most common taxpayer appeal for reasonable cause comes in the form of “reliance upon the advice of a tax professional.” In determining whether a taxpayer’s reliance on a professional is reasonable, the courts tend to look at three factors:

 1. Was the adviser a competent professional who had sufficient expertise to justify reliance?

 2.Did the taxpayer provide necessary and accurate information to the adviser; and

 3. Did the taxpayer actually rely in good faith on the adviser’s judgment?

Hristov, the Tax Court concluded, was not reasonable in relying on Alexander for two reasons: First, there was an obvious conflict of interest: Alexander only got paid to the extent Hristov made contributions to the retirement plan pitched and managed by Alexander. Furthermore, reliance on the professional advice of a tax shelter promoter is unreasonable when the advice would seem to a reasonable person to be “too good to be true.” Because Hristov was made aware by Alexander that he would both 1) get a tax deduction for the funds contributed to the retirement plans, and 2) have access to the cash, he should have sought independent confirmation from a reliable and disinterested adviser familiar with retirement plans.

Failure to do so cost him dearly.

The IRS has recently completed a probe of 30 state schools and private nonprofit schools — including Ivy League institutions Cornell and Harvard — that focused on the schools’ tax filings and the reporting of unrelated business income.

From Bloomberg:

The IRS has been stepping up scrutiny of both private nonprofit universities and public schools as they expand and collect more revenue from operations such as bookstores, restaurants and sports arenas. While the institutions are tax- exempt, they are supposed to pay federal tax on any income that is unrelated to their educational and research missions, for instance when the public uses hotels they open for faculty and alumni.

The IRS found in a survey it sent in October 2008 to 400 universities that many are failing to fully account for and disclose what may be taxable income. The survey, which also probed compensation and endowments, led to the audit of more than 30 of the institutions, including the University of Texas at Austin and the University of North Carolina.

The audit has already resulted in increased collections of payroll taxes and unrelated business income tax. The IRS has not yet finished its examinations.

The Winklevoss twins could not be reached for comment.

[ Ed note: In lieu of the customary Weekend Roundup, I was hoping you'd allow me a brief digression from the normal tax discussion in favor of a bit of self-indulgence.

Last Wednesday saw the birth of my second child, a beautiful and healthy daughter named Emily. When my son Ryan was born three years ago, I was barely a year removed from life-saving surgery to repair a brain aneurysm, a brush with mortality that left me keenly aware of my own frailties.  Concerned that I might not be around to see him grow into a man, I wanted a way to pass along the most important life lessons I'd learned, while simultaneously urging him not to repeat my mistakes or share my shortcomings.

The result was the following letter. Though it was initially written for my son, the message holds equally true for Emily. I hope you enjoy it.]

Dear Emily,

Well, it’s been a couple of days now, and I’m starting to think you’re here to stay.

I have to admit, I’ve had a suspicion you’d be arriving for some time. My first hint came back in the fall, when I walked into your parents’ bedroom to find your Mom and Dad sharing a big hug and more than a few tears. What was different about these tears — and what has always stuck in my memory — is that they fell on smiling faces.

In the months that followed, it was clear they were scrambling to prepare for the arrival of something; reinventing the extra bedroom, frantically assembling furniture, and filling the house with wonderful new toys I was forbidden to touch.

But it was only recently when I put together who all those tears and all those tools and all those toys were for. These past few months, there’s been considerably less room on your Mom’s side of the bed. And late at night, if I snuggled up just right against her belly, I could feel the new life within.

You probably haven’t taken notice of me yet at the foot of your crib – what with all the new sights, sounds and smells you’ve been inundated with — but I have a sneaking suspicion we’ll be the best of friends before long.

In the meantime, I’ll let you in on a little secret: I sit where I do, not in some desperate ploy to garner a small piece of the attention that was once lavished upon me, but because you seem awfully important to your Mom and Dad, so I’d happily sacrifice my life to protect you from harm. This may seem a bit sudden to you, but it’s just the way we dogs are wired.

While I may look like nothing more than a lazy pile of yellow fur, I assure you I’m a lot smarter than you think. I’m five now, which puts me at thirty-five in my years. So while I’m still blessed with the beauty of youth, I’ve started to add the wisdom that comes with age.

Sadly, my accelerated maturity comes at the price of an abbreviated life span, which means I won’t always be here to look after you. That’s why I wanted to pass on some things I’ve learned from my time with your Mom and Dad that I think you’ll find invaluable as you grow into a woman.

Revisit these three rules throughout your life, Emily, and you’ll turn out just fine, despite your parents’ best efforts to screw you up.

Tell Time Like a Dog

There’s a theory about dogs and our concept of time that humans like to perpetuate. They say that dogs only understand time in terms of now and never.

Living in the now, they’ll tell you, is why I’m willing to play and play and play until my tongue hangs and legs shake. Living in the never, they’ll say, is why I get so sad each and every time your parents leave me….

…and so overwhelmed with joy each and every time they return.

Here’s the thing Emily: that theory is 100% correct.

What’s interesting, however, is that humans look at our concept of time as a sign of lesser intelligence; as some sort of detriment. They view themselves as superior in part because of their understanding of yesterday and tomorrow.

This is going to sound strange, but I beg you to spend the majority of your life telling time like a dog. What you have to understand is that by having no concept of yesterday or tomorrow, dogs are incapable of regretting the past or worrying about the future. And for that I am thankful every day of my life.

I’ve witnessed what worry can do to you humans. In the short time I’ve spent with your parents, I’ve watched them spend more and more time agonizing over what’s to come, and less and less time enjoying what’s unfolding before them. They dwell on whether they’ll be good parents, about whether they’ll have enough money to send you to college, about whether your Dad will get sick again. And all the while, the beauty of everyday life is passing them by. In their concern about endless tomorrows, they’ve sacrificed far too many todays.

Your Dad and I have seen some amazing places together. We’re always hiking or biking or skiing in the mountains; and in our first few years together it was in these moments that I watched your father’s soul flourish. But recently, I’ve found that even when surrounded by the places he most enjoys, even when doing the very things he rushed to return to after his illness, his head is elsewhere. Worried about tomorrow. About whether he’ll ever get to share these moments, these mountains, with you. Or whether he’ll get sick again instead.

It’s been painful for me to watch. You can’t imagine how many times I’ve wanted to grab your Dad with my paws and insist he stop obsessing over what may happen next and simply be present, and cherish what he’s experiencing right now. Unfortunately, I have neither the opposable thumbs nor the functioning larynx to carry out such a threat, so my message goes undelivered.

I understand that as a human, you have to consider tomorrow, to have a plan. But please, don’t let it consume you. Don’t let your life go by only to realize that you’ve spent so much time focused on tomorrow, you forgot to enjoy today. Tell time like a dog, and live in the now. You’ll be glad you did.

Laugh Until it Hurts

While there aren’t many traits people possess that dogs covet, there is one thing you have that inspires great jealously in my species. Your sense of humor. Your ability and willingness to laugh. I would gladly sacrifice a year of belly rubs to experience just one moment of the unfettered laughter people seem to enjoy daily.

For all their faults, for all their worry, your parents sure know how to laugh. They laugh at one another. They laugh at themselves. They laugh at silly stuff and they laugh at life’s so-called “serious” things. Come to think of it, your father laughs at things even I find juvenile and disgusting, and I’ve been known to eat goose poo from time to time.

I’ve learned something fascinating about people. After your Dad came home from the hospital a few years ago, I was scared the mood of the house would change; that the severity of the situation would make our daily lives more somber. I was certain that the harsh dose of reality dealt to your parents would change them in irreversible ways, and the laughter that had filled our home would diminish or disappear.

What I was amazed to find, however, is that just the opposite was true. With their lives turned upside-down by unexpected adversity, your Mom and Dad actually spent more time joking with one another. It’s as if they realized that some things in life are so unpredictable, so beyond your control, that at times the best you can do is have a good laugh and live to fight another day.

I implore you to seek out others who show a willingness to laugh. If you surround yourself with people who can’t find humor in the illogicality of daily life, you’ll start taking yourself far too seriously, and that’s among the worst sins a person can commit.

In choosing your friends and eventually your mate, know that laughter is more than a moment of levity; it’s a wonderful indicator of intellect. More than anything, it’s the ability to laugh that separates man from the animals…well, except the hyena. Having a sense of humor shows that you not only recognize the things that are right with the world, but also the ridiculousness of the things that aren’t.

As you go through life, make sure to take the time to chuckle at the silliness of it all. I’ve seen your Mom’s worst day turned around by the simplest of your Dad’s jokes, and I’ve seen the effect it has on his heart when she gives in and lets loose a giggle. There must be magic in laughter, Emily, and I hope to hear it from you often.

Look Before You Leap, but I Highly Recommend Leaping

If I may, I’d like to share two stories from my life with you in hopes of illustrating a point.

The first tale is set in my days as a young pup, not much older than you are now. At that age, the world was mine to be explored. Every scent represented a wonderful new discovery, every stick, scrap, or shoe a potentially delicious meal, and every dog a possible new playmate.

I harbored no fear of the unknown. Nor should I have, as up to that point, I had seen nothing to indicate the potential cruelty life can wield.

One day, while walking with your Dad, I ran up to the wrong dog in the wrong place. He wasn’t a bad dog, per se, he just thought I posed a threat and did what came naturally to him as a response. Unfortunately for me, what came naturally to him landed me in the emergency room with punctures in my ear and head that required stitches.

It would have been easy to let this incident scar me permanently. I could have made great efforts to avoid all strange dogs from that point on, or even worse, turned aggressive towards dogs and even people.

But I didn’t. Instead, I took the lesson learned from that incident and changed my approach to making new friends. If a bigger dog approaches, I’ll cower like a Frenchman for a few moments, allowing them to take a sniff and decide if they want to play…

…but if they want to play, it’s on.

You see, while I’m not going to ignore the knowledge gained from that unfortunate incident, I’m also not going to allow one bad moment to rob me of the opportunity to wrestle around with a new playmate. It’s simply not worth it.

Let’s fast forward to last fall.

I have to confess, much like your Dad, I’m a bit of an adrenaline junkie. While many dogs — and all self-respecting Labradors – love to swim, I discovered early on that merely paddling around in the water wasn’t going to cut it. I needed more.

To that end, I found myself seeking out the highest entry point into the pool or lake or bay, getting a good head of steam going, and launching myself into my big blue landing zone. I don’t know if it’s the brief feeling of flying, the rush that accompanies the impact, or the instant change of sensation upon hitting the water, but either way, I’m hooked.

This fall, as the water in the lake behind our house started to recede, I finished one of my trademark leaps by landing on a rock that had once been well submerged, but now lurked just beneath the water’s surface.

This caused a nice sized gash in my knee, and another visit to the doggie ER. This time, they had to stitch me without any anesthesia, as I’d had a bad reaction a couple of months prior. It hurt more than you can imagine, but your Mom got me through it by stroking my head while the doctor did his thing. She’s good at that sort of thing, you’ll find.

Two weeks later, after the stitches had been removed, I was cleared to swim again. As your Dad let loose a tennis ball deep into the belly of the lake, I approached cautiously, gradually accelerated, and by the time I hit the down-sloping edge of the water, felt compelled to leap.

As I was engulfed by that familiar splash, I knew I’d made the right decision. Was I scared I’d get hurt again? Sure I was. But I didn’t really have a choice. After all, if you refuse to launch, how can you ever know what it feels like to fly?

The moral of these two stories, Emily, is that life, at one point or another, will deal you an unexpected blow. You’re going to go on to do things much more precarious than making new friends and leaping into lakes, and along the way, you’re going to get bit and you’re going to come up short, just as I did. As a result of these setbacks, you will know adversity, and you will learn fear. But it’s how you handle that adversity, what you do with that fear, that will ultimately be the measure of who you become as a woman.

A little bit of fear is a healthy thing – a wonderful thing – as it helps us negotiate that fine line between aggressiveness and foolishness. But allow the fear that is born from adversity to paralyze you, and you’ll find that life has passed you by without ever having experiencing anything worth experiencing. And that, my new friend, is THE worst sin a person can commit.

Emily, I realize it may seem odd to receive your first piece of life advice from a dog, but trust me, I’ve learned a lot in my time with people about the things that do — and more importantly do not — make them happy. Focus on enjoying each moment, limit your time spent worrying about tomorrow, laugh as often as possible, and don’t let the inevitable negative experiences keep you from taking the risks necessary to experience a full and rich life, and you’ll enjoy more happiness than most, I promise you.

And if that doesn’t work, you can always just curl up on your Dad’s chest with your brother and I and take a nap. That always  makes us plenty happy.

Faina Bronstein and her father-in-law purchased a home in Brooklyn for $1,300,000 in 2007, with each buyer jointly and severally responsible for the $1,000,000 mortgage.  

Throughout 2007, Bronstein and her husband used the home as their primary residence, with Bronstein paying the full interest expense on the $1,000,000 loan, amounting to $50,000 for the year.

Bronstein and her husband chose to file their 2007 tax returns separately. On her separate return, Bronstein claimed the full $50,000 interest deduction related to the Brooklyn home.

As a reminder,  Code Section 163 provides an exception to the general rule that personal interest is not deductible by permitting a deduction for qualified residence interest.

In general, a qualified residence is defined as a taxpayer’s principal residence

and one other home that is used as a residence by the taxpayer.[i] Qualified residence interest means any interest paid or accrued during a tax year on acquisition indebtedness or home equity indebtedness with respect to the taxpayer’s qualified residence.

 Section 163(h)(3)(B) defines the term “acquisition indebtedness” as any indebtedness which–

 (I) is incurred in acquiring, constructing, or substantially improving any qualified residence of the taxpayer, and

(II) is secured by such residence.

 The deduction is subject to a limitation: The aggregate amount treated as acquisition indebtedness for any period shall not exceed $1,000,000 ($500,000 in the case of a married individual filing a separate return).

 Additionally, Section 163(h)(3)(C) defines “home equity indebtedness” as any indebtedness (other than acquisition indebtedness) secured by a qualified residence. The interest deduction on home equity debt is similarly limited: the aggregate amount treated as home equity indebtedness for any period shall not exceed $100,000 ($50,000 in the case of a separate return by a married individual).

The IRS, using a plain interpretation of the statute, disallowed half of Bronstein’s interest deduction, arguing that because Bronstein’s filing status was “married filing separately,” she was limited to deducting the interest paid on only $500,000 of acquisition debt and $50,000 of home equity debt.

In her defense, Bronstein looked to the intent of the statute, arguing that the purpose of cutting the limitations in half for married filing separately taxpayers was to accommodate situations where the husband and wife jointly paid mortgage interest, allowing each spouse to take interest deductions on half of the full limitation amounts. In a situation where one spouse pays all the interest expense — as Bornstein did in the immediate case — she argued that she should be entitled to deduct interest on the full debt amounts of $1,000,000 and $100,000.

The Tax Court disagreed:

We believe section 163(h)(3)(B)(ii) clearly states that a married individual filing a separate return is limited to a deduction for interest paid on $500,000 of home acquisition indebtedness. Similarly, we believe section 163(h)(3)(C)(ii) clearly states that a married individual filing a separate return is limited to a deduction for interest paid on $50,000 of home equity indebtedness. Petitioner has not offered any unequivocal evidence of legislative purpose which would allow us to override the plain language of section 163(h)(3)(B)(ii) and (C)(ii). As a result, we agree with respondent that petitioner is not entitled to a deduction for the interest paid on the entire $1 million of acquisition indebtedness incurred in purchasing the property. Rather, petitioner is entitled to deduct interest paid on only $550,000 of the mortgage indebtedness.

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