Double Taxation: A Take On All Things Taxes

Such was the lesson learned from Douglas v. Commissioner, T.C. Memo 2011-214, decided by the Tax Court today.

Douglas was the sole shareholder of an S corporation engaged in the trucking business. As timely delivery was crucial to a successful business, in 2007 the S corporation purchased a Cessna for $135,000 to use in the event that drivers grew ill or were otherwise unable to meet their delivery schedule.

Douglas spent the better part of 2007 taking flying lessons in the Cessna, though she never advanced beyond the level of obtaining a “student license,” a level of proficiency which, quite frankly, probably shouldn’t exist when the required task involves flying a multi-ton metal object 20,000 feet above the earth’s surface. 

 None of the S corporation’s employees held a pilot’s license, nor did the corporation have “stand-by” pilots at the ready should the trucking business need one on an expedited schedule. As a result, at no point was the plane actually used in any of the S corporation’s business during 2007.

On the S corporation’s 2007 tax-return, however, it took a full Section 179 deduction of $125,000 related to the purchase of the Cessna. The IRS, as you might imagine, had other ideas. 

Section 179, it turns out, has this pesky little requirement that a property must be used more than 50% for business in order to benefit from the first year expensing election. (Treas. Reg. 1.179-1(d)). The IRS argued that the property was never used for business, and thus ineligible for any depreciation, let alone the Section 179 deduction.

The Tax Court sided with the IRS, but not before examining the little-known “idle asset” rule, under which an asset, while not in actual use, may nonetheless be depreciated if it is “devoted to the business of the taxpayer and ready for use should the occasion arise.” (Piggly Wiggle S., Inc. v. Commissioner, 84 T.C. 739 (1975)).

Unfortunately for Douglas, the court held that the plane did not benefit from the “idle asset” rule, as it was being used for Douglas’ flight lessons, and thus simply never available for its alleged business function. In reaching its decision, the court stated the obvious:

An aircraft cannot be considered ready and available for business use without a suitable pilot to fly it. During 2007 no employees or officers of Bantam held a pilot’s license that would have enabled them to use the aircraft to transport a replacement driver. There is no evidence in the record of any agreement between a qualified pilot and Bantam that might suggest his or her availability for the purpose of flying drivers to disabled vehicles on short notice.

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OK, I’ll admit it, that title may be a bit harsh, but let’s not kid ourselves…Ken Lay’s resume isn’t exactly worthy of admittance into the pearly gates.  

Need I remind you, while CEO of Enron — the once-thriving Houston-based energy company that has since become synonymous with corporate fraud and corruption –Lay oversaw deceptive accounting practices that cost 20,000 employees their livelihoods and life savings while bilking investors out of billions of dollars, leading to the largest bankruptcy in U.S history and the sudden demise of my first employer, Arthur Andersen LLP.

Lay was eventually convicted on ten counts of securities fraud and related charges, but while awaiting a probable 30-year prison sentence, he died of a heart attack. (Ed note: the rather fortuitous timing of Lay’s demise, coupled with his relationship with former president George W. Bush, has led many conspiracy theorists to speculate that Lay is still alive.)  

The decade-long string of bad news for the Lay family finally took a turn for the better today, however, as the Tax Court ruled in the favor of Lay’s estate, holding that Lay and his wife were not responsible for a $3.9 million tax deficiency related to 2001.

The case revolved around Lay’s sale of two annuity contracts to Enron in 2001. At the time, Lay had planned to retire as CEO, but when his hand-picked successor suddenly left the company, Enron’s Board of Directors urged Lay to consider staying on.

To motivate Lay to continue as CEO, the Board sought a way to provide Lay with liquidity while simultaneously offering him an incentive to fulfill a 4-year contract. Their solution was to purchase from Lay two annuity contracts he had previously acquired on behalf of he and his wife, with an agreement to transfer the contracts back to Lay in the event he fulfilled his contract. Enron set a purchase price for the contracts of $10,000,000; an amount equal to Lay’s previous investment in the two contracts, but also a fair representation of the FMV of the contracts at the time.

To facilitate this form of compensation, Lay and Enron took the steps necessary to transfer ownership of the contracts from Lay to Enron. The investment firm holding the contracts — Manulife, and as successor after a subsequent merger, John Hancock — acknowledged and recorded the change in ownership of the annuities. On his 2001 tax return,  Lay reported the sale of the contracts, reflecting a sales price and basis of $10,000,000, and no gain or loss.

The IRS argued that Lay did not actually “sell” the two annuity contracts in 2001. Rather, the IRS contended, the $10,000,000 paid to Lay was a cash bonus, and Lay remained the true owner of the contracts.

After analyzing both Texas state law and federal tax precedents to determine whether the benefits and burdens of ownership of the annuity contracts had moved from Lay to Enron in 2001, the Tax Court sided with Lay, holding that a sale had occurred. In reaching its decision, the court noted:

The Lays sold the Annuity contracts to Enron on September 21, 2001. In doing so, they complied with the requirements of the agreement and took the steps required to transfer the annuity contracts to Enron. The benefits and risks of ownership of the annuity contracts were transferred to Enron in the annuities transaction. The Lays, therefore, properly reported the transaction on their Federal income tax return as a sale of the two annuity contracts.

In perhaps the most interesting aspect of the case, the IRS argued in the alternative that the clause in the compensation agreement providing that Enron would transfer the annuity contracts back to Lay upon completion of his term as CEO should be subject to taxation under Section 83, causing Lay to recognize ordinary income to the extent of the FMV of the contracts in 2001.

What makes this argument fascinating is that three elements are required for property transferred in connection with the performance of services to be subject to immediate taxation under Section 83: You must have 1) “property,” that is 2) transferred to a service provider, and 3) the property must be transferable and not subject to a substantial risk of forfeiture in the hands of the service provider. In this case, none of the three elements were present, but that didn’t stop the IRS from posing the argument.

First, the contracts were not “property” for purposes of Section 83, as they merely represented unfunded and unsecured promises to transfer property in the future. They were not set aside from the claims of creditors by Enron on Lay’s behalf. Nor were the contracts “transferred” to Lay, as Enron retained the benefits and burdens of ownership in 2001. Lastly, the contracts were not transferable by Lay in 2001 (as Lay had no interest in the contracts at that time) and they were subject to a substantial risk of forfeiture (Lay was required to fulfill his four-year contract in order to receive the annuities).

Citation: Estate of Kenneth Lay v. Commissioner, T.C. Memo 2011-208 (August 29, 2011).

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From those geniuses at the Onion

Obama Proposes Tax Increase On Meanest 2% Of Population

August 12, 2011

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As we’ve discussed here, here, and here, rental real estate activities are considered passive by default. Passive losses, of course, may generally only offset passive income.  Unless, that is, you qualify as a “real estate professional” under Section 469(c)(7), in which case you can deduct rental losses in full against nonpassive income.   

In order to qualify as a real estate professional, a taxpayer needs to pass two tests under Sec. 469(c)(7)(B). The taxpayer must satisfy both of the following tests:  

• More than one-half of the personal services performed in trades or businesses by the taxpayer during such tax year are performed in real property trades or businesses in which the taxpayer materially participates.
• Such taxpayer performs more than 750 hours of services during the tax year in real property trades or businesses in which the taxpayer materially participates.

Furthermore, Section 469(c)(7)(A)(ii) provides that each interest owned by the taxpayer in rental real estate will be treated as a separate activity unless the taxpayer makes an election to treat all rental real estate activities as a single activity.

What is the significance of the underlined portion of the text? In this author’s view, it is these two concepts that — when read in conjunction — have been misinterpreted by the IRS and the Tax Court in recent years. Based on a case settled yesterday, however, the courts may finally be getting it right.

Allow me to clarify…

In several cases, the IRS has taken the position that if a taxpayer owns multiple rental properties and fails to make the election to aggregate the activities, the 750-hour prong of the real estate professional test must be applied to each separate rental property in order to determine if the taxpayer is a real estate professional.  

Now, I’m not the smartest man on the planet, but this seems rather silly. Here’s why:

Say I own one rental property. I spend 1,000 hours of my year managing the rental property, and also meet the “more than half” prong of the real estate professional test. The 1,000 hours I spend not only means I materially participate in my activity under Section 469, it also means I pass the 750 test. I’m a real estate professional. Good for me.

Now, assume instead I own 5 rental properties and spend 200 hours per year on each property, which is more than anyone else spend managing the properties. However, I neglect to elect to aggregate the properties. As a result, the IRS and the Tax Court would have you believe that I must now pass the 750 hour test for each individual property, which I have not done. The fact that I materially participated in each property, by virtue of the 3rd test of Treas. Reg. 1.469-5T (>100 hours and more than anyone else), does nothing for me in the government’s eyes, as I did not meet the 750 mark on a property by property basis.

The Tax Court ruled this way in Jahina, a case settled in 2002. I can remember reading the decision shortly after it was published, and thinking the result seemed unduly harsh. The Tax Court’s reasoning begged the following questions:

Isn’t the purpose of the real estate professional exception to remove those individuals who devote the majority of their time to real estate trades or businesses from having their rental activities treated as de facto passive?

Why would a taxpayer, who instead of spending 1,000 hours on one property spends 250 hours on five separate properties, be treated as less of a real estate professional merely for failing to make an election?

The answer, of course, is that they shouldn’t be treated any differently.

It has always been my take that the IRS and the Tax Court have misinterpreted the requirement that the taxpayer performs more than 750 hours of services in real property trades or businesses in which the taxpayer materially participates. I have never believed that this requirement necessitates electing to aggregate the activities or else be left trying to meet the 750 hour test for each individual property.

Based on my reading, even if a taxpayer fails to make the election, they should be able to satisfy the 750-hour test on an aggregate basis. I believe the statute requires a two-part examination of the taxpayer’s activities:

First, the taxpayer must identify the activities in which he materially participates. This material participation can be satisfied under any of the seven tests provided for in Treas. Reg. 1.469-5T.

After identifying those activities in which the taxpayer materially participates, the total hours spent on those activities must exceed 750 hours.

Harkening back to my previous example, if a taxpayer spends 200 hours on each of 5 properties and satisfies one of the material participation tests for each property, then even if failing to make an election to aggregate the activities, the total hours spent of 1,000 on activities in which the taxpayer materially participates will pass the 750 test.

As clarification, if, for argument’s sake, the taxpayer failed to meet the material participation test for one of the properties (perhaps due to another individual spending more time on the property), then the taxpayer would remove that property from the computation for purposes of the 750 test. Instead, the taxpayer would look to the four properties in which they did meet the material participation tests, total the 800 hours, and still meet the test.

By approaching the statutory language in this manner, you avoid the rather anomalous result of having two taxpayers — working equally in the real estate field — being treated differently simply because one failed to make an election.

Yesterday, however, the Tax Court decided Harnett v. Commissioner, T.C. Memo 2011-191, another “real estate professional case.” In Harnett, the taxpayer owned over a dozen properties. The taxpayer failed to meet the 750 test and did not qualify as a real estate professional because the taxpayer could not prove the hours test was met with a contemporaneous log, and the court did not find his testimony credible. But that’s not what’s important. What is important is that the Tax Court made no mention of an election to aggregate the activities, and in performing it analysis, the court combined the hours spent by the taxpayer on only those properties in which it appeared the taxpayer materially participated. Perhaps I’m being overly optimistic, but it would appear the Tax Court may now be interpreting the 750 hour test correctly.

So in essence, while Harnett may have lost the battle, future taxpayers may win the war.

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In the most shocking revelation since Ricky Martin samba’d his way out of the closet, the Treasury Inspector General for Tax Administration released a report indicating that the IRS ain’t so good at hollerin’ back at taxpayers.  TIGTA performed two statistical samples and one judgmental sample from three IRS functions, revealing that most taxpayers do not receive quality responses to their correspondence.

• Of 73 correspondence cases sampled from the Accounts Management function, only 14 (19 percent) taxpayers received timely and accurate responses.

 • Of 48 correspondence cases sampled in the Automated Underreporter Program, all 48 taxpayers received accurate responses, but only 27 (56 percent) of 48 taxpayers received their responses timely.

 • Of 73 correspondence cases from the Field Assistance Office, only six (8 percent) taxpayers received timely and accurate responses.

Read it yourself right here.

http://www.treasury.gov/tigta/auditreports/2011reports/201140058fr.pdf

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A few months ago, a CPA friend of mine asked me for advice. He had just picked up a new client, a very successful businessman who earned significant income from his 9-5 gig.  In addition, the client also operated a horse breeding activity that generated large losses used by the taxpayer to partially offset his taxable income. The client’s horse breeding ”business” had never generated a profit in its five-year history, and in light of the string of losses, the client had recently made the decision to abandon the activity.  

The question posed was the following:  how concerned should the CPA be that his client will find his horse breeding activity subject to IRS scrutiny? 

My answer: very. As we’ve discussed in the past,  Section 183 — the so-called “hobby loss rules — exist for the sole purpose of determining whether a taxpayer’s activity is a “trade or business” or a “hobby.” If the activity is a trade or business, losses of the activity may be deducted in full and can offset other sources of income, subject to certain limitations. If the activity is a hobby,however,  a taxpayer can only deduct losses to the extent of the income. The regulations establish nine factors the courts will examine to aid in their determination:

1. The manner in which the taxpayer carries on the activity. 

 2. The expertise of the taxpayer or his advisers.  

3. The time and effort expended by the taxpayer in carrying on the activity. 

 4. The expectation that the assets used in the activity may appreciate in value. 

 5. The success of the taxpayer in carrying on similar or dissimilar activities.

6. The taxpayers history of income or losses with respect to the activity.  

 7. The amount of occasional profits.

8. The financial status of the taxpayer. 

 9.  Does the activity lack elements of  personal pleasure or recreation?

The reason for my concern is that the Section 183 case history is literally filled with decisions holding that a horse breeding activity is a hobby, rather than a business. This is due in large part to the large recreational element  of the “business,” and the fact that losses from the activities often offset otherwise taxable income of the taxpayer, as the typical horse breeder is an affluent taxpayer to begin with.

Yesterday, however,  the Tax Court provided a glimmer of hope for horse breeders with its decision in Blackwell v. Commissioner, TC Memo 2011-188. In Blackwell, the taxpayer was able to overcome the horse breeding “taint” by carrying on the activity in a very professional manner, satisfying the majority of the Section 183 factors. In particular, the taxpayers:

• Prepared to start up the horse breeding and training activity by taking educational courses relating to the care, management, breeding, and economics of horses, and by purchasing, caring for, training, and selling a number of horses. 
• Developed a rather comprehensive written business plan relating to the proposed horse activity.
• Took 6 or 7 years learning about horse breeding and management before attempting to engage in a for-profit horse breeding activity. 
• Were not absentee, aloof, or recreational horse owners. They managed and worked diligently and daily on the horse activity, doing essentially all of the horse maintenance herself.
• They consulted expert horsemen, hired expert horse trainers to assist in training the horses, advertised, showed the horses, and paid significant stud fees to have their mares bred with stallions which they regarded as having good bloodlines.
• In their efforts to make improvements to the horse activity, taxpayers’ made adjustments in their business plan, moving from reining horses to cutting horses and selling their horses as yearlings.
• Maintained reasonably good books and records of income and expenses relating to their horse activity.
• After nine years, the taxpayers terminated their unprofitable horse activity in light of the losses realized.

Interstingly, the Tax Court held that Blackwell’s activity did not have significant elements of personal pleasure, even though the taxpayer had a lifelong interest in horses. The court added: 

The facts of this case do not indicate that petitioners’ FHF horse activity was motivated or driven by personal pleasure alone. As we have found, petitioners had actual hopes for the sale of their horses at a profit, and petitioners’ horse activity is appropriately described as a “business”. Petitioners’ business plan did not work out and income did not exceed expenses, but we discern few recreational and sports aspects in petitioners’ FHF horse activity; rather, in petitioners’ motive, efforts, and investment in carrying on their FHF horse activity during the years in issue we discern and find a profit objective.

See prior discussions here:

http://double-taxation.com/2011/07/13/drag-racer-completes-impressive-feat-in-tax-court-loses-all-nine-hobby-loss-factors/

http://double-taxation.com/2011/04/07/tax-court-farming-activity-was-not-a-hobby/

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What an age we live in. When I was 23, all the internet was good for was sending emails, arguing in chat rooms, and searching for nude photos of Gillian Anderson. Fast forward a little more than a decade, and now an aspiring tax professional can garner a top-notch education without leaving the comfort of their parent’s basement.  

According to my bio on the sidebar to the right, I am a proud alumnae  alumni alumnus of the University of Denver’s Graduate Tax Program. For a variety of reasons, attending the program was the single best decision I’ve made in my career. Just sayin’.

From the website:

Participating in GTP Online is restricted to students who live more than 50 miles from Denver. Unlimited access to a computer and a broadband Internet connection are required. All commonly available computer operating systems are supported, for both PCs and Macs, and no special software need be purchased.

To apply, use the Graduate Tax Program application for admission available on this website or in the GTP bulletin. Check the box for “GTP Online” or write “ONLINE” in large letters at the top of the first page of the application.

Tuition and course materials for GTP Online cost the same as for onsite students. Online students will incur some additional costs for shipping materials and paying exam proctors.

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