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Archive for January, 2012

While Mitt Romney’s 13.7% effective tax rate finds itself squarely in the crosshairs of both the Republican and Democratic parties, Janet Novack over at Forbes correctly points out that Newt Gingrich used some savvy tax planning of his own to minimize his overall tax liability. Gingrich owns two S corporations, and he leveraged a fifty-year old Revenue Ruling to his advantage by taking “only” $450,000 of compensation from the corporations, while allowing the net profits of $2.4 million to flow through to his individual tax return free from payroll taxes.

In this article published in the Tax Adviser, a certain Aspen-based author takes a thorough look at the issue of S corporation reasonable compensation and explains in detail the mechanism by which Gingrich — and many wealthy business owners like him — are able to save on payroll taxes by minimizing salary in favor of distributions. The article also examines the substantial case history surrounding S corporation compensation, and offers guidance on how to minimize the risk of a successful IRS attack. Fortunately for all, the Tax Adviser article is devoid of the low-brow humor, grammatical errors, and misspellings that have come to define the author’s mildly popular blog:

This S corporation flow-through income has long enjoyed an employment tax advantage over that of sole proprietorships, partnerships and LLCs. This advantage finds its genesis in Revenue Ruling 59-221,[i] which held that a shareholder’s undistributed share of S corporation income is not treated as self-employment income. In contrast, earnings attributed to a sole proprietor, general partner or many LLC members are subject to self-employment taxes.[ii]

As these employment tax obligations have climbed, the advantage of operating as an S corporation has become magnified. Since S corporation income is not subject to self-employment tax, there is tremendous motivation for shareholder-employees to minimize their salary in favor of distributions, which are also not subject to payroll or self-employment tax. Consider the following example:

Example 1: A owns 100% of the stock of S Co., an S corporation. A is also S Co.’s president and only employee. S Co. generates $100,000 of taxable income in 2011, before considering A’s compensation. If A draws a $100,000 salary, S Co.’s taxable income will be reduced to zero. A will report $100,000 of wage income on his individual income tax return, and S Co. and A will be liable for the necessary payroll taxes. S Co. will be required to pay $7,650 (7.65% of $100,000) as its share of payroll tax, and S Co. will withhold $5,650 (5.65% of $100,000) from A’s salary towards A’s payroll obligation, resulting in a total payroll tax bill of $13,300.  

Example 2: Alternatively, A may choose to withdraw $100,000 from S Co. as a distribution rather than a salary. S Co.’s taxable income will remain at $100,000 and will be passed through to A and reported on his individual income tax return, where it is not subject to self-employment tax. The $100,000 distribution is also not taxable to A, as it represents a return of basis.[iii]  By choosing to take a $100,000 distribution rather than a $100,000 salary, S Co. and A have saved a combined $13,300 in payroll taxes.

Now, let it be said, while some may paint Gingrich’s $450,000 salary as unreasonably low — particularly in light of the fact that majority of the earnings of the S corporations appear to be attributable solely to services provided by Gingrich and his wife — there is no precedent in which the courts have held a salary of this magnitude to be unreasonable low.* To the contrary, the majority of IRS challenges have come when shareholders pay themselves less than the social security wage base, thereby avoiding the 12.4% (10.4% in 2011) social security tax on wages below $106,800 in addition to the 2.9% Medicare tax on all foregone wages.

Once a shareholder has paid himself  — at minimum — the social security wage base as compensation, the avoided payroll tax becomes limited to the 2.9% Medicare piece, and the risk of an IRS challenge appears to become significantly reduced. In Gingrich’s case, taking a salary of $450,000 allowed him to avoid only the 2.9% Medicare tax on the additional profits of $2.4 million; and while $70,000 is not a paltry sum by any means, it will certainly not go down among the great tax avoidance strategies of all time.

 Hat Tip: Tax Prof


[i] Rev. Rul. 59-221, 1959-1 C.B. 225.

[ii] Sec. 1402(a).

[iii] Sec. 1368.

* Also note, Novack’s article does not quantify how much of the $2.4M earnings of the S corporations was distributed to Gingrich or his wife as distributions. There appears to be no significant exposure to an S corporation shareholder who foregoes significant compensation provided they also forego taking distributions; the risk begins when a shareholder draws distributions but not a reasonable amount of salary.

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Ed note: If you received an email earlier today, please disregard. I had a case of premature publication. It’s embarassing, but it happens, and I’m not ashamed to admit it.

In response to increased scrutiny regarding the effective tax rate paid on his substantial income, Republican Presidential candidate Mitt Romney released his tax returns late last night. Yours truly was given an opportunity to review the returns immediately upon their release for Bloomberg and provide comment. You can read that article here, but in the interest of keeping this blog self-contained, the most revealing items included in Romney’s 2010 individual tax return are discussed below:

  •  His real name is Willard? I’d go with Mitt, too.
  • Romney paid $3,000,000 of federal tax on $21,600,000 of gross income, for an effective rate of 13.9%. While this is sure to draw ire from the 99-percenters, it is 100% legal, and is largely attributable to two things:
  1. Romney’s $18,000,000 of alternative minimum taxable income (he paid a small amount of AMT)  consisted of $15,500,000 of income eligible for the preferential tax rate of 15%. In specific, $3.3M of Romney’s $4.7M of dividend income was eligible to be taxed at this lower rate, a break that was added to the Code with the Bush tax cuts. In the absence of the Bush legislation, Romney’s entire $4.7M of dividends would have been taxed at the maximum ordinary income rate, currently 35%. In addition, Romney’s also recognized $12.2M of long-term capital gains, which similarly benefitted from the Bush cuts. The gains are currently taxed at 15% rather than the 25 or 28 percent rates that existed previously.
  2. As expected, Romney benefits greatly from the current treatment of “carried interest” as provided for under administrative rulings issued by the IRS. In short, a carried interest is a partnership interest granted to a partner — typically a money manager in a private equity firm — in only the future profits of the partnership in exchange for managing the money of the private equity firm, choosing its investments, divestitures, etc… Under Rev. Procs. 93-27 and 2001-43, the granting of a pure profits interest is not a taxable event; thus, when Romney receives a profits interest in a private equity firm, it is not taxed as compensation (or capital gain), and the future income of the private equity partnership that is allocated to him — typically long-term capital gains — is eligible for the preferential 15% rates.

The reason carried interests have come under attack — particularly from the Obama administration — is obvious. On the surface, the amounts allocated to the managing partner certainly appear to be compensation for services; thus, according to critics, they should be taxed at ordinary income rates rather than capital gain. While this law may change in the future, it is important to note that Romney is completely correct in treating the amount of income allocated to him from his carried interests — $7,000,000 of the total $12,200,000 of capital gain according to his campaign — as LTCG rather than compensation.

  • Of Romney’s $3,000,000 of charitable contributions, half were made in cash to the Church of Latter Day Saints (which would appear to be part of Romney’s tithing requirement), and half made in stock to Romney’s private foundation, the Tyler Foundation.
  • How bad were things in 2009 if even Mitt Romney had a $4,000,000 capital loss carryforward to 2010?

All in all, there as nothing shocking about Romney’s tax returns. Yes he paid only 13.7% of his income to the IRS in federal tax, but such is life under the current tax regime when the overwhelming majority of your income is earned in the form of long-term capital gains and qualified dividends. Critics, however, are sure to focus on four things:

  1. The effective rate. Again, for right or wrong, Romney paid only 13.7% of his income in tax, but he did so legally and in total compliance with the current rules.
  2. The pure size of the numbers. Even for a Presidential candidate, $20M of AGI is a lof to income, which may not be particularly well received in this time of the Occupy Wall Street movement, cries of economic inequality, and other opening salvos of class warfare.
  3. Romney received a $1.6M tax refund in 2010. Now you and I know that tax refunds are purely a function of your tax liability compared to the estimated payments you’ve made, but the public is likely to find it hard to swallow that someone with $20M of income received a refund exponentially larger than most people’s income for the year. Again, it’s not the right reaction, but it’s likely to occur.
  4. Prior to the release of his returns, Romney admitted to a 15% effective rate, stating that he did generate some ordinary income from speaking fees, but “not much.” It turns out “not much” was in excess of $500,000, a sum most would be more than happy to accept for a few hours of speaking. This could position Romney as “out of touch” with the average American, an angle many of his critics and opponents may embrace.

Additional coverage:

The Washington Post

The NY Times

CBS News

Wall Street Journal

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As a young CPA, I had tremendous difficulty grasping the difference between a taxpayer’s “effective” tax rate and his “marginal” tax rate. Of course, I also have tremendous difficulty grasping how Twitter works, so perhaps I’m not the best barometer for this sort of thing.

But if you find yourself similarly challenged, this piece from the USA Today may help end the confusion. The impetus for the article is the recent hubbub surrounding Republican Presidential candidate Mitt Romney’s admission that he paid a tax rate of approximately 15% on his millions of taxable income. As the author points out:

Under the United States’ progressive tax system, income is taxed at graduated rates. An individual’s tax bracket, sometimes referred to as the marginal tax rate, refers to the percentage of income that’s taxed at the top tax rate — not the rate for the entire amount. (Ed note: this marginal rate is often referred to as the tax rate imposed on the last dollar of taxable income earned.) The effective tax rate, meanwhile, is the amount a taxpayer pays in taxes as a percentage of total income.

Thus, assume Romney earned $500,000 in speaking fees and $5,000,000 in long-term capital gains from his role as a retired partner in Bain Capital. While Romney’s marginal tax rate would be 35%, as his income level reaches the highest tax bracket, the fact that the overwhelming majority of his taxable income qualifies for the preferential tax rate on capital gain means his effective tax rate would approximate 15%.

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A few things you may have missed while watching Lee Evans and Kyle Williams let the Super Bowl slip between their fingers.

Some key numbers to have handy during individual filing season.  The most important one?  It’s only 85 days until April 17th.

Despite the fact that the federal deficit is growing faster than Kobe’s divorce settlement, the IRS is cutting agents. Did you know that based on a 2,080-hour work year, cutting one senior corporate auditor would cost the U.S. $19 million in lost revenue.  If I were a senior corporate auditor, I’d totally use that factoid to pick up chicks.

Obama would like to see the U.S. corporate tax rate lowered, but its reach extended.  He should make sure to leave a reminder on a  Post-it note for the new guy. HI-YO!

Speaking of unpopular Presidents, the Bush tax cuts apparently made the rich richer and the poor poorer. Odd. I would have thought the lower and middle classes — what with their expansive stock portfolios — would have stood to benefit the most from reduced capital gains rates.

If you’re over 70 1/2, pull yourself away from that Murder She Wrote  marathon on AMC long enough to check out this article, reminding you that your ability to make a contribution from your IRA directly to a charity without generating taxable income is gone. For now.

Lastly:    Wooderson + Butch Walker = Awesomeness. That’s just science.

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This goes without saying, but the Internal Revenue Code is needlessly complicated. It reads as cleanly as Chinese arithmetic, rife with exceptions to exceptions, meandering cross-references and nuanced requirement after nuanced requirement. Miss or misinterpret just one, and all of your best laid tax planning efforts could go for naught.

Consider the case of John Owen (Owen), where a failure to meet one of several statutory requirements cost Owen a $2,000,000 tax deferral.

Owen built a corporation up from scratch, eventually selling the stock and realizing a $4,000,000 capital gain. Hoping to defer a portion of the gain, Owen enlisted the help of a CPA, who advised Owen of the potential for deferral provided by I.R.C. § 1045.

Section 1045

Under I.R.C. § 1045, a taxpayer other than a corporation can defer gain on the sale of qualified small business “QSB” stock held for more than six months to the extent the taxpayer reinvests the proceeds from the sale in replacement QSB stock within 60 days from the date of sale.

In general, a QSB is a subchapter C corporation that:  

  • Has gross assets of less than $50,000,000 up to and immediately after the issuance of the stock to the taxpayer; and
  • Meets an “active business requirement:” At least 80 percent (by value) of the assets of a QSB must be used by the corporation in the active conduct of one or more qualified trades or businesses”.[i]

In search of an adequate replacement investment, Owen decided to start a retail jewelry business, which Owen and his CPA determined would qualify as QSB stock and provide the sought-after deferral of the previously realized capital gain. Owen invested  $2,000,000 of the proceeds from his stock sale into his new venture, J&L Gems, which in turn purchased sixteen pieces of jewelry for a total cost of $147,000 during its first two years of operation.

Believing that he had appropriately reinvested half of his proceeds from the sale of one QSB into another QSB within the requisite time period of I.R.C. § 1045, Owen excluded half of the $4 million capital gain on his tax return for the year of sale.

The IRS denied the deferral, arguing that J&L Gems failed to qualify as a QSB. The Tax Court agreed, holding that J&L Gems did not meet the active business requirement of I.R.C. § § 1045 and 1202:

…the active business requirement requires that at least 80 percent of the assets of the new corporation be used in an active trade or business. During the first 6 months J&L Gems purchased 16 pieces of jewelry for a total cost of $147,026. This is a mere 8 percent of the $1,916,827 deposited into J&L Gems’ account from the sale of FFAE. [Two]years after the money was injected, J&L Gems was still not using it. We hold that under the surrounding facts here the fact that 92 percent of J&L Gems’ assets were held in cash causes it to fail the active business requirement.

As for Mr. Owen, well, he just wanted to make it clear that he tried to meet the requirements of the Code:

My view of active business is just that. I went out and I purchased. I took the stock of this company and put it into the stock of this other company. I put the money from the sale of the company within the 60-day period he told me to put it in, and I started buying up gems. So in my opinion, I thought I was doing everything correctly.

The lesson? Neither the IRS nor the courts care about your best intentions. We’re stuck with the statute we’ve got, and it’s incumbent upon the taxpayer and his advisors to make sure that any tax planning strategy has the proverbial I’s dotted and T’s crossed.  


[i]A “qualified trade or business” is further defined as any trade or business other than any ones involving the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of 1 or more of its employees.[i]

 I.R.C. § 1202(c)(2)

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Life Lessons

Ed note: This post has absolutely nothing to do with tax, but if you’ll humor me I suspect there’s something to be learned that’s far more important than anything found in the Internal Revenue Code.

On Saturday morning, I stood atop the 12,400 foot summit of Highland Peak, my lungs searing and legs shaking from the final push to the top. Among a handful of skiers sharing the summit that day was an Aspen Highlands patroller, who after offering a friendly “hello,” removed his helmet to reveal a partially shaved head and an ominous, angry-looking scar running from his widow’s peak to his ear.

I responded with a hello of my own before quickly asking about the origin of the scar, internally justifying my rude, overly personal inquiry with the belief that my breach of etiquette would soon be forgiven, for I was certain — even before hearing his answer — that we were members of the same exclusive club.

You see, in the spring of 2008, I underwent a nine-hour craniotomy to repair an aneurysm in my brain. As a result, I’m keenly aware of the trademark signs of brain surgery, most notably the telltale half-moon shaped scar sported by the patroller, an exact replica of which could be found under my own helmet and hairline.  

The patroller introduced himself as Steven[i] before explaining that in late October, he had undergone his third craniotomy to remove a relentless tumor. After divulging my story, Steven and I shared a quick laugh at the unlikeliness of the moment; the two of us taking a minute to appreciate the long climb — both figuratively and literally — we had endured to return to this summit.

As we talked, I realized that in Steven presence on that summit, I was bearing witness to an accomplishment nothing short of superhuman. Understand this: a craniotomy is a horribly invasive and violent procedure; one that leaves those fortunate enough to survive remarkably weakened for the better part of a year. From my own experience, it was five weeks before I could walk across a room unassisted, three months before I could travel from one lifeguard stand to the next in soft sand, and nearly five months before I was able to put together what only the most polite among us would call a jog. As daunting as that may sound, however, I assure you that the physical recovery pales in comparison to the ensuing emotional one. 

For as your legs and lungs regain strength, the temptation to return to your pre-surgery life becomes overpowering, as your subconscious seeks to allay the fear that things will never be the way they once were. But as your heart rate rises and that familiar burn permeates your muscles, the self-assurance you seek remains elusive, replaced instead by a silent war that wages within your brain. For every moment spent celebrating, “I’m doing it again!” there is exponentially more time spent questioning, “Should I be doing it again? Will I get another aneurysm? Will I get another tumor?” It is a cruel and tortuous dichotomy of emotions.

And yet here was Steven, only ten weeks removed from surgery, thriving in the harshest of settings without a hint of the self-doubt that defined my recovery. As a ski patroller, he works nine-hour days, six days a week, all of it spent on his feet in the unforgiving environment of the high alpine. Unlike my coddled life as a CPA, Steven returned to a job where hurricane force winds, blizzard conditions and bitter cold are the norm, and where mitigating the threat of a deadly avalanche on the slopes of Highland Bowl depends largely on the physical strength and keen focus of the ski patrol. Mere months after a life-altering event, Steven had rushed to return to a position where he was responsible for the safety of the thousands of skiers that visit Aspen Highlands each winter day.

It goes without saying, such a career allows for no “mail-it-in efforts.” Steven was required to be in peak condition, both physically and mentally. Given that he was less than three months out from having his skull opened and his brain fiddled with for the third time, I had to know: how had he returned so quickly? Steven’s response:

“I just decided I wasn’t going to let anything keep me from living.”

And that is precisely why I felt the need to share Steven’s story. At the risk of infringing on the copyright of a Ray Lamontagne tune, I’ve met far too many people who’ve never truly appreciated that their life was theirs for making. I’ve witnessed what adversity, what fear of death, can do to a person. How visions of a foreshortened future can elevate one’s instinct for self-preservation above all others, tempting a person once brimming with life to spend his remaining days in a self-imposed protective bubble. To die without dying.

And then there was Steven, a man with every reason to live out his days from the safety of his couch, seeking pity for the bad hand he was dealt while wondering what could have been had life been a little more kind. But instead, Steven refused to allow his bad moments to become the defining ones of his life; he willed himself to return to the mountains we share a passion for. Steven understands what so many of us don’t: there’s little point in being alive if you can’t — or won’t — pursue the things that make life worth living.  


[i] Not his real name

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“Cost segregation” studies have been a popular tax saving strategy ever since the Tax Court’s 1997 decision in Hospital Corporation of America[i] and the Service’s subsequent acquiescence in 1999.

In short, cost segregation studies involve breaking down the cost of a building that would ordinary be depreciated over 39 or 27.5 years into its components assets,[ii] some of which can be depreciated over shorter 7, 10 , or 15 year lives.  These studies are often performed several years after the acquisition, with the building owner entitled to a “catch-up” of the depreciation they would have been permitted to deduct had they performed the study prior upon the building’s purchase. This catch-up is captured in the form of a change in accounting method and a favorable I.R.C. § 481 adjustment.

Yesterday, the Tax Court dealt a blow to the cost segregation movement, ruling that cost segregation was not permitted when the taxpayer purchased the building as part of a larger asset acquisition in which the buyer and seller allocated the purchase price among the transferred assets — including the building — and reported the allocation on Form 8594.[iii]

Peco Foods was the common parent of a consolidated group of corporations. In 1995, the group entered into two assets acquisitions in which it acquired processing plants as well as other hard assets and goodwill. Peco and the two sellers agreed to an allocation of the purchase price among all the transferred assets, including  the two buildings. As required, the parties reported the allocations on the Forms 8594 attached to their 1995 tax returns.

In 1999, Peco engaged a firm to perform a cost segregation study related to the acquisition of the plants. The study resulted in nearly $6,000,000 in additional depreciation deductions by reclassifying amounts previously allocated to the buildings to shorter-lived assets. Peco reported these adjustments as a I.R.C. § 481 adjustment on a Form 3115 attached to its 1998 tax return.

The IRS disallowed the I.R.C. § 481 adjustment, and the Tax Court upheld the disallowance. In reaching its conclusion, the court ruled that the original allocation of the purchase price was binding, and Peco could not subsequently reclassify amounts previously allocated to buildings to other assets:

…amended section 1060(a) [provides] that where the parties to an applicable asset acquisition agree in writing as to the allocation of any amount of consideration, or as to the fair market value of any of the assets transferred, that agreement is “binding” on the transferee and the transferor unless the Commissioner determines that the allocation (or fair market value) is not appropriate.

The purpose for this unyielding flexibility, in the eyes of the court, was to protect the IRS against the potential whipsaw the Form 8594 was designed to prevent:

In binding Peco to that schedule, [the IRS] ensures that the transferee (Peco) and the transferor treat the assets consistently for Federal tax purposes. Allowing Peco to treat the acquired assets in a way other than the one in which it agreed to, subjects [the IRS] to a potential whipsaw. Such a whipsaw might occur if, for example, Peco treated certain property as section 1245 property but Marshall Durbin treated that property as section 1250 property. Even if a danger of whipsaw did not occur, binding Peco to the original allocation schedule prevents it from realizing a better tax consequence than the one it bargained for.

So how does the Tax Court reconcile its decision in Peco with its previous landmark decision in Hospital Corp. which opened the door to cost segregation studies?

The dispute in the instant case is far more simplistic than the one presented in Hosp. Corp. of Am. Unlike the taxpayers in Hosp. Corp. of Am., Peco is bound by the clear and unambiguous terms of the original allocation schedules. Thus, whether the acquired assets may be subdivided into component assets is immaterial because Peco may not deviate from its characterization of those assets as stated in the original allocation schedules.

This differentiation by the IRS would seem to be the death knell for cost segregation studies performed on a building acquired as part of an asset acquisition with an agreed upon purchase price allocation. In the coming days, I will be reaching out to WS+B’s cost segregation experts to see if they agree.

Peco Foods, Inc. & Subsidiaries, T.C. Memo 2012-18


[i] 109 T.C. 21

[ii] Such as land improvements, parking lots, landscaping, etc…

[iii] The purpose of the Form 8594 is to alert the IRS to an asset acquisition so it may ensure that both parties have treated the acquisition the same. In the absence of such a form, the seller may allocate the majority of the purchase price to self-created goodwill (to achieve long-term capital gains), while the buyer could allocate the majority of the purchase price to machinery and equipment to take advantage of a 5 year depreciation period, allowing them to recover the purchase price three times faster than if the purchase price were allocated to goodwill.

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From Reuters:  N.J. Governor Chris Christie would like to see all state income tax brackets cut by 10%.

Christie, saying that New Jersey competes with neighboring New York and Connecticut for jobs, noted that both states have raised income taxes on the wealthy. New York’s top rate is 8.82 percent and Connecticut’s highest rate is 6.7 percent, both below New Jersey’s current 8.97 percent rate.

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From WS+B Tax Partner Steve Talkowsky comes this reminder that not everything that makes you feel good constitutes a deductible medical expense:

Leave it to an attorney – and a tax attorney, no less – to push the envelope on what qualifies as a deductible medical expense.  

During 2004 and 2005, William Halby (Halby) frequented prostitutes in New York and purchased pornography for self-prescribed “sex therapy.” He was not, however, ever formally diagnosed with a condition warranting such therapy, nor did Halby discuss these visits with his doctors afterwards to determine their impact on his health.

On his 2004 and 2005 tax returns, Halby claimed medical expense deductions on his Schedule A, Itemized Deductions of $76,314 and $49,203 for the cost of prostitutes and smut, and I can only assume, a heaping supply of penicillin. (Ed note: Halby apparently had never been introduced to a little thing called the “internet,” which has no shortage of free pornographic material. Or so I’m told.)

As one might expect, the IRS issued a notice of deficiency disallowing nearly all of Halby’s claimed medical deductions.

While Halby’s attempt at reaping a tax benefit for his dalliances into America’s sex trade may seem both egregious and frivolous, they are not entirely without merit. IRC Section 213(a) permits a deduction for a taxpayer’s medical and dental expenses that were paid and not compensated for by insurance, to the extent the expenses exceed 7.5 percent of the taxpayer’s adjusted gross income.  The term “medical care” means amounts paid “for the diagnosis, cure, mitigation, treatment, or prevention of disease, or for the purpose of affecting any structure or function of the body”.[i]  Importantly, however, the regulations further provide that amounts expended for illegal operations or treatments are not deductible.[ii]

The Tax Court was left to decide whether Halby’s payments for prostitutes and porn represented the “treatment of a disease.”  The IRS argued the obvious: Halby was not entitled to deduct amounts paid to prostitutes because such payments were illegal, and was not entitled to a deduction for amounts paid for pornographic material because those amounts were incurred for his general welfare, not pursuant to a doctor’s prescription or for a specific medical condition.  

To the contrary, Halby remained firm in his contention that his support of the perverted arts was “sex therapy” that yielded a positive effect on his health, and cited book and magazine articles to support his claim. Thus, he should  be permitted to take a deduction for such costs despite the illegality of his conduct or the fact that his doctor did not prescribe this treatment.

To the surprise of absolutely no one, the court disallowed the prostitute visits as an illegal activity and personal expense and the books etc. as a personal item as well. According to the court, neither expense was intended to treat a medical condition of any sort or prescribed by a physician. 

While the ruling is not surprising, it does beg two questions:  

1. Would these types of activities be deductible as a medical expense if they were incurred to treat a diagnosed medical condition? Maybe the smut would make the cut, but the prostitutes would still fall within the legality requirement of the Section 213 regulations.

2. OK, but what if the visits to prostitutes were at some sort of legal brothel, like on the outskirts of Vegas? Possible, but still doubtful. While the U.S. government allows each state to regulate prostitution, it is still considered a “public order crime” by some parts of the government. Thus, the IRS may well point to Revenue Ruling 97-9, which provides that no medical expense deduction is allowed for an operation or treatment that’s in violation of federal law, even if state or local law permits the procedure or drug to be used.

William G. Halby v. Commissioner, TC Memo 2009-204


[i] I.R.C. § 213(d)(1).

[ii] Treas. Reg. § 1.213-1(e)(1)(ii).

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The most brilliant members of society are often among its most corrupt. Consider Richard Nixon. Or Bernie Madoff. Or Dr. Evil.

Or Joseph Nacchio. Nacchio is the former chairman and CEO of Qwest Communications who leveraged insider information to sell Qwest stock for $44,000,000 in 2007.  A more honest tax filer than businessman, Nacchio properly reported his illegal gains on his 2007 tax return and paid the resulting $18,000,000 tax liability to the IRS.

Since insider trader is generally frowned upon, Nacchio was later convicted on criminal charges and sentenced to 70 months in rich-white-guy-prison. As part of his penance, he was forced to repay the $44,000,000 proceeds, with the government tacking on a $19,000,000 penalty for good measure.

Nacchio is now asking the perfectly logical question, “Since I had to pay back all of the proceeds on the sale of my stock, shouldn’t I be entitled to a refund of my $18,000,000 tax liability?” and suing the IRS to get it.

Will it work?

Interestingly, the statute does provide Nacchio an opportunity to effectively receive a “refund” of the tax attributable to the stock sale in the form of I.R.C. § 1341. Section 1341 allows a taxpayer who included an amount in income during a year because they believed they had an unrestricted right to the income to receive a refund of taxes paid on the income in the event they later have to pay back the previously recognized amounts.

To maximize the tax benefit to the taxpayer, two alternatives are permitted in computing the amount of the refund:

1. The taxpayer can simply deduct the repayment in the year it occurs, or

2. The taxpayer can go back to the year the amount was included in income and recalculate taxable income by excluding the amount, and take the decrease in the prior year’s tax liability as a reduction in the current year tax liability. 

Applying I.R.C. § 1341 to Nacchio’s situation, he could either deduct the $44,000,000 repayment on his tax return for the year of the repayment or alternatively, remove the gain from his 2007 return, compute the reduction in 2007 tax, and seek a refund for that amount on a current year return.

However, it is highly unlikely that Nacchio’s suit for refund will be successful. It is much more likely that the IRS and the courts will maintain either:

1) Nacchio may not avail himself of I.R.C. § 1341, as he could not have believed he had an unrestricted right to the income received in 2007 because he knowingly broke the law to earn it; or

2) Allowing Nacchio to recover his previously paid tax will frustrate public policy by shifting the burden of a portion of his ill-gotten gains away from Nacchio and to the government.

Obviously, Nacchio is extremely hopeful he’ll win his suit. Eighteen million is the minimum buy-in at the weekly country club prison poker game, and he’s sick and tired of watching that smug Jeffrey Skilling clean up every week.

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